**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-K**

 

(Mark One)

 

| **ý**                                            | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**     |
|-------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                  |       |                                                                                                     |   |   |
| **For the  fiscal year ended December 31, 2005** |
|                                                  |       |                                                                                                     |   |   |
| **OR**                                                |
|                                                  |       |                                                                                                     |   |   |
| **o**                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For thetransition period from        to      **

 

**Commissionfile number 0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name ofregistrant as specified in its charter)

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

 

**Two HopkinsPlaza**

**Baltimore,Maryland 21201**

(Address ofprincipal executive offices) (Zip Code)

 

**(410) 237-5900**

(Registrant’stelephone number, including area code)

 

Securities registeredpursuant to Section 12(b) of the Act:

 
| **Title of each class** | ** ** | **Name of each exchange on which registered** |
|-------------------------|------------|-----------------------------------------------|
| None                    |       | None                                          |

 

Securities registeredpursuant to Section 12(g) of the Act:

 

Common Stock ($2par value)

(Title of class)

 

## **1.1          Stock Purchase Rights**

(Title of class)

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes ýNo o

 

Indicate by check mark if theregistrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o Noý

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes ýNo o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. 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 large accelerated filer” in Rule 12b-2 of theExchange Act.  (Check one):

Large accelerated filer ý         Acceleratedfiler o              Non-acceleratedfiler  

 

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

 

At June 30, 2005,the last business day of registrant’s most recently completed second fiscalquarter, the aggregate market value of shares of common stock held bynon-affiliates of registrant (1) (including fiduciary accounts administeredby affiliates) was $4,091,276,550 based on the last sale price on the NasdaqNational Market on June 30, 2005.

 

As of March 9, 2006,123,296,036 shares of common stock were outstanding.

 

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 (1) Excludes 3,879,543 shares of common stockheld by directors, executive officers, and shares held in fiduciary accounts bythe Registrant and subsidiaries of the registrant with discretionary power tovote or dispose of such shares as of June 30, 2005.  Exclusion ofshares held by any person should not be construed to indicate that such personpossesses the power, direct or indirect, to direct or cause the direction ofthe management or policies of the registrant, or that such person is controlledby or under common control with the registrant.

 

Documents Incorporated byReference:  Portions ofthe registrant’s Definitive Proxy Statement of Registrant to be filed with theSecurities and Exchange Commission under Regulation 14A within 120 days afterthe end of the Registrant’s fiscal year covered by this Annual Report on Form 10-Kare incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

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**2005ANNUAL REPORT ON FORM 10-K**

**TABLE OFCONTENTS**

 
| ** **    |                                                                        | ** ** |
|---------------|-----------------------------------------------------------------------------|------------|
|          |                                                                        |       |
| PART I   |                                                                        |
|          |                                                                        |       |
| Item 1.       | Business                                                                    |       |
| Item 1A.      | Risk Factors                                                                |       |
| Item 1B.      | Unresolved Staff Comments                                                   |       |
| Item 2.       | Properties                                                                  |       |
| Item 3.       | Legal Proceedings                                                           |       |
| Item 4.       | Submission of Matters to a  Vote of Security Holders                        |       |
|          |                                                                        |       |
| PART II  |                                                                        |
|          |                                                                        |       |
| Item 5.       | Market for the Registrant’s  Common Stock, Related Stockholder Matters |       |
|          | and Issuer Purchases of  Equity Securities                                  |       |
| Item 6.       | Selected Financial Data                                                     |       |
| Item 7.       | Management’s Discussion and  Analysis of Financial Condition and       |       |
|          | Results of Operations                                                       |       |
| Item 7A.      | Quantitative  and Qualitative Disclosures About Market Risk                 |       |
| Item 8.       | Financial  Statements and Supplementary Data                                |       |
| Item 9.       | Changes in  and Disagreements with Accountants on Accounting and            |       |
|          | Financial  Disclosure                                                       |       |
| Item 9A.      | Controls and  Procedures                                                    |       |
| Item 9B.      | Other Information                                                           |       |
|          |                                                                        |       |
| PART III |                                                                        |
|          |                                                                        |       |
| Item 10.      | Directors  and Executive Officers of the Registrant                         |       |
| Item 11.      | Executive  Compensation                                                     |       |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management             |       |
|          | and Related  Stockholder Matters                                            |       |
| Item 13.      | Certain  Relationships and Related Transactions                             |       |
| Item 14.      | Principal  Accounting Fees and Services                                     |       |
|          |                                                                        |       |
| PART IV  |                                                                        |
|          |                                                                        |       |
| Item 15.      | Exhibits,  Financial Statement Schedules                                    |       |
|          |                                                                        |       |
| Signatures    |                                                                        |       |

 

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**PART I**

 

ITEM 1.  BUSINESS 

 

**General**

 

Mercantile BanksharesCorporation, with $16.4 billion in assets for the year ended December 31,2005, is a regional multibank holding company with headquarters in Baltimore,Maryland.  It is comprised of 11 banks(the “Banks”) and a mortgage banking company. Eight banks are headquartered in Maryland, two are in Virginia and oneis in Delaware.  At December 31,2005, Bankshares’ largest bank, Mercantile-Safe Deposit and Trust Company (“MSD&T”),represented approximately 45% of total assets and operated 40 offices inMaryland, 13 in Virginia, two in Washington, D.C. and one in Pennsylvania.MSD&T provides nearly all of Bankshares’ substantial wealth managementoperations and specialized corporate banking services.  Mercantile Bankshares Corporation wasincorporated under the laws of Maryland on May 27, 1969.  Mercantile Bankshares Corporation along withits consolidated subsidiaries is referred to in this report as “Bankshares,” “we”or “Registrant.”

 

**Washington Expansion andAffiliate Consolidation**

 

In 2004, Bankshares initiated a significant reorganization within itsBanking network.  In a move designed tocreate banks of sufficient size and depth to compete more effectively today andin the future, Bankshares combined 11 affiliate banks to create four neworganizations, all with a more prominent Mercantile identity. Thisreorganization has enabled Bankshares to operate more effectively andefficiently in the face of increased competitive and regulatory pressures.  Fewer, larger banks allow better leverage ofour branch network, reduce administrative and operational redundancies andincrease the breadth and depth of expertise within our banks. All banks thatwere combined are geographically contiguous, share increasingly common marketdynamics and offer the opportunity to create scale efficiencies.

 

To capitalize on thepotential in affluent, fast growing metropolitan Washington, D.C., in 2004Bankshares consolidated most of its retail and small business, commerciallending and real estate operations in the Washington region into its affiliatebank headquartered in Montgomery County, Maryland, and renamed the bankMercantile Potomac Bank (“Mercantile Potomac”). In the second quarter of 2005,Bankshares consolidated Fidelity Bank, its bank subsidiary in western Maryland,into Farmers & Mechanics Bank (“Farmers”), its subsidiary bank basedin Frederick, Maryland. The consolidation of these banks enables the survivingbank to serve its local customers with greater scale and expertise. Also, inthe second quarter of 2005, Mercantile Potomac merged into MSD&T, andcontinues to do business in the Washington metropolitan region as a division ofMSD&T under the Mercantile Potomac Bank name. This combination enablesBankshares to provide the capital resources necessary for greater expansioninto the Washington, D.C. and Northern Virginia markets.

 

On May 18, 2005,Bankshares completed its acquisition of Community Bank of Northern Virginia (“CBNV”),a bank headquartered in Sterling, Virginia, which was merged into MSD&T andbecame part of MSD&T’s Mercantile Potomac Bank.  CBNV operated 14 branch offices in theNorthern Virginia metropolitan market at the time of the acquisition. Theprimary reason for the merger with CBNV was to expand Bankshares’ distributionnetwork in Northern Virginia, a higher growth market. The total considerationpaid to CBNV shareholders in connection with the acquisition was $82.9 millionin cash and 3.7 million shares of Bankshares’ common stock, which reflects theadjustment for the three-for-two stock split announced by Bankshares on January10, 2006.  CBNV transactions have beenincluded in Bankshares’ financial results subsequent to May 18, 2005.  The assets and liabilities of CBNV wererecorded on the Consolidated Balance Sheet at their respective fair values. Thefair values have been determined as of May 18, 2005 and are subject torefinement, as further information becomes available. The transaction resultedin total assets acquired as of May 18, 2005 of $888.2 million, including$671.0 million of loans and leases; liabilities assumed were $842.3 million,including $626.9 million of deposits.

 

**Affiliate Bank Network**

Bankshares placesparticular emphasis on long-term customer relationships by providingvalue-added services through its extensive affiliate bank network.  Each of its affiliate Banks has its ownidentity, management team and board of directors.  Perhaps most importantly, each Bank hasstrong historical ties to the families and businesses in the community itserves.  Through its association withBankshares, each Bank is able to provide its customers with the sophisticatedbanking services and financial resources of a major banking organization.

 

1

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Bankshares directly ownsall of the outstanding stock of the Banks and directly or indirectly owns allof the outstanding stock of certain other affiliates. The principal componentsof our banking and nonbanking network are listed below.

 

*Lead Bank and Affiliates*

 

Mercantile-Safe Depositand Trust Company

 

Mercantile MortgageCorporation (“MMC”)

 

Mercantile Mortgage, LLC(49.9% owned by MMC)

 

Columbia National RealEstate Finance LLC (60% owned by MMC)

 

West River LLC

 

HarborPoint Capital, GPLLC

 

HarborPoint Capital LP(75% owned by MMC)

 

Mercantile BrokerageServices Holdings, LLC

 

Mercantile BrokerageServices, Inc.

 

Mercantile CapitalAdvisors, Inc.

 

Mercantile/Cleveland, LLC

 

Boyd Watterson AssetManagement, LLC

 

MBC Agency, Inc.

 

Mercantile Life InsuranceCompany

 

*Community Banks*

 
| The Annapolis Banking  and Trust Company   |   | Annapolis, Maryland       |
|--------------------------------------------|--------|---------------------------|
|                                       |   |                      |
| The Citizens National  Bank                |   | Laurel, Maryland          |
|                                       |   |                      |
| Farmers &  Mechanics Bank         |   | Frederick, Maryland       |
|                                       |   |                      |
| Keller  Stonebraker Insurance, Inc.   |   | Hagerstown, Maryland      |
|                                       |   |                      |
| Potomac  Basin Group Associates, Inc. |   | Beltsville, Maryland      |
|                                       |   |                      |
| Marshall National Bank  and Trust Company  |   | Marshall, Virginia        |
|                                       |   |                      |
| Mercantile County Bank                     |   | Elkton, Maryland          |
|                                       |   |                      |
| Mercantile Eastern  Shore Bank             |   | Chestertown, Maryland     |
|                                       |   |                      |
| Mercantile Peninsula  Bank                 |   | Selbyville, Delaware      |
|                                       |   |                      |
| Mercantile Southern  Maryland Bank         |   | Leonardtown, Maryland     |
|                                       |   |                      |
| The National Bank of  Fredericksburg       |   | Fredericksburg,  Virginia |
|                                       |   |                      |
| Westminster Union Bank                     |   | Westminster, Maryland     |

 

2

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For purposes of segmentreporting, two operating components have been identified: Banking andInvestment & Wealth Management. For segment reporting information, seeNote No. 16 (Segment Reporting) to the financial statements in Item 8 ofthis Annual Report and information under the heading “Segment Reporting” in thesections captioned “Analysis of Operating Results for 2005 to 2004” and “Reviewof Earnings and Balance Sheet for 2004 to 2003,” in Item 7 of this AnnualReport. Bankshares periodically reviews and considers possible acquisitions ofbanks and other entities performing related activities and discusses suchpossible acquisitions with management of the subject companies, and suchacquisitions, which may be material, may be made from time to time.  Acquisitions are normally subject toregulatory approval.

 

**Banking Services**

 

***RetailBanking***

The Banks offer numerousservices to meet the checking, savings, investment and credit needs ofindividuals in their communities.  Retailbanking services include checking, savings and money market accounts,Individual Retirement Accounts, and time deposits.    The Banks offer home equity loans and linesof credit,  installment loans and linesof credit, and equipment and transportation (auto, marine, recreationalvehicles, aircraft) loans to meet a variety of borrowing needs.

 

Through the affiliatebank network, customers have no-fee access to their accounts at 250 Mercantile BANKING TWENTY-FOURSM ATMs, and theycan perform many routine transactions at any of the 240 affiliate-banking offices.  For added convenience, substantially all ofBankshares affiliates provide customers with toll-free telephone access to acentralized Customer Service Center and a voice-response account informationsystem.  BANKINGTWENTY-FOUR ONLINE® enables customers to access their personalaccounts online to pay bills, verify account balances, track recent accountactivity and perform selected transactions. BANKING TWENTY-FOUR ONLINE offers sole proprietorssimilar capabilities specifically tailored to meet small business needs.

 

***SmallBusiness Banking***

The Banks offer numerousservices to meet the deposit, credit and service needs of businesses withannual****revenues up to $3.0 million or creditneeds up to $750.0 thousand. Each Bank works closely with customers to providecash management services and extend credit for such purposes as receivables andinventory financing, equipment leases and real estate financing.******Where appropriate, the Banks areadept at employing government guarantee programs, such as those available fromthe Small Business Administration.

 

***CommercialBanking***

Commercial bankingservices include commercial deposit, lending and commercial real estatesolutions provided to businesses with annual revenues between $4.0 million and$50.0 million.

 

Cash management serviceshelp business customers collect, transfer and invest their cash.  Through a variety of electronic payment andaccount management tools, customers are able to monitor and manage cash flowsconveniently and efficiently.

 

With their local knowledgeand focus, our Banks are well suited to meet the traditional credit needs ofbusinesses in their market areas.  EachBank works closely with customers to extend credit for general businesspurposes, such as working capital, plant expansion or equipment purchases, andfor financing industrial and commercial real estate.  When local commercial customers do notqualify for traditional financing, we can help them convert the value of theiraccounts receivable, inventory and equipment into cash for operations.Additionally, we can arrange more sophisticated financing in the areas ofacquisitions and management buyouts. We provide land acquisition anddevelopment, construction and interim financing to commercial real estateinvestors and developers.

 

In addition to extending creditto the businesses in its own market area, MSD&T works in collaboration withother affiliates when their customers’ credit needs exceed the affiliate bank’slending limit or when there is a more specialized commercial banking need. Tosupplement traditional credit products, the Banks offer capital market productssuch as municipal bond underwriting, interest rate risk management andfinancial advisory services through the MSD&T Capital Markets Group. Theseservices include underwriting and remarketing tax-exempt and taxable municipalvariable-rate demand bonds for nonprofit organizations such as senior livingand health care providers, private schools, health and social welfareorganizations and cultural institutions. By working directly with borrowers, wecan evaluate and recommend financing and interest rate risk managementstrategies, which include interest rate swaps, caps and collars.

 

3

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***MortgageBanking***

Residential mortgages areprovided through Mercantile Mortgage, LLC, a joint venture between MercantileMortgage Corporation (“Mercantile Mortgage”), a subsidiary of MSD&T, andWells Fargo Ventures, LLC.  A widevariety of competitively priced fixed- and variable-rate products areavailable, including jumbo loans. Residential mortgage loans also are available through the Banks.Mercantile Mortgage also makes loans for land acquisition, development andconstruction of single-family and multifamily housing.

 

Risks associated with residentialmortgage lending include interest rate risk, which is mitigated through thesale of the majority of all conforming fixed-rate loans, and default risk bythe borrower, which is mitigated through underwriting procedures and creditquality standards, among other things.

 

Permanent financing formultifamily projects and long-term, nonrecourse financing for commercial realestate are provided through Columbia National Real Estate Finance, LLC (“CNREF”),a joint venture, the majority of which is owned by Mercantile Mortgage.  CNREF is a Freddie Mac Program Plus SellerServicer and is a MAP (Multifamily Accelerated Processing) approved lender forHUD.  It has correspondent relationshipswith approximately 12 life insurance companies and services a loan portfolio inexcess of $6.1 billion. Permanent financing for multifamily projects nationwideis also provided through HarborPoint Capital, LP, a joint venture, the majorityof which is owned by Mercantile Mortgage. HarborPoint Capital, LP, headquartered in Dallas, Texas, is one of thenation’s few Fannie Mae DUS (Delegated Underwriting and Servicing) lenders.

 

**Insurance Products**

 

Keller StonebrakerInsurance, Inc., an independent, wholly owned subsidiary of Farmers &Mechanics Bank, arranges a full line of consumer insurance products throughoffices in Hagerstown and Cumberland, Maryland, and Keyser, West Virginia.  Consumer insurance products includeannuities, homeowners, automobile, life and personal umbrellas.  MBC Agency, Inc. provides as agent,under group policies, credit life insurance in connection with extensions ofcredit by the Banks.  Mercantile LifeInsurance Company reinsures the insurance provided by MBC Agency, Inc.

 

Potomac Basin GroupAssociates, Inc. operates as an independent, wholly owned subsidiary ofFarmers & Mechanics Bank and is an independent insurance agencyspecializing in corporate employee benefit plans through its offices inBeltsville and Ellicott City, Maryland. Keller Stonebraker provides commercialproducts that include property and casualty packages, workers’ compensation,professional liability and umbrella coverage, bonds and 401(k) and otherbenefit plans.

 

**Investment and Wealth ManagementServices**

 

Bankshares offersinvestment and wealth management services through the Investment &Wealth Management division (“IWM”) of MSD&T.  IWM continues to build on a more than 140-yeartradition of providing investment and wealth management services to privateindividuals, family groups and institutions.

 

Today, Banksharesprovides a range of wealth management services. Over the past several years, IWM has developed risk management and assetallocation analyses to complement the investment advice we offer.  An open architecture platform enablesBankshares to offer an array of proprietary investment products and carefullyselected outside managers in a range of asset classes, including equity,fixed-income and alternative investment products.  Bankshares’ investment platform provides arange of investment vehicles, from separate account management to mutualfunds.  Investment and wealth managementservices are available through professional advisors at MSD&T, through theaffiliate bank network and through Baltimore-based Mercantile Brokerage Services, Inc.(“MBSI”).  Asset allocation and riskmanagement capabilities, coupled with a range of proprietary and nonproprietaryinvestment alternatives and investment vehicles, enable Bankshares to providehigh quality, advice-driven, risk-managed solutions to meet clients’ investmentobjectives.  At December 31, 2005,Bankshares had $20.6 billion of discretionary assets under management and $46.5billion in assets under administration.

 

***RetailBrokerage Services***

On November 12,2004, Mercantile consolidated its brokerage activities by merging MercantileSecurities, Inc., into Peremel & Company, Inc.  The resulting entity is Mercantile BrokerageServices, Inc., a general securities broker-dealer that offersfull-service, discount and online brokerage capabilities and account services.Our customers can choose from investments in stocks, bonds, proprietary andnonproprietary mutual funds, and fixed or variable annuities.

 

4

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***PrivateWealth Management Services***

When managing a client’sassets as part of an investment management or trustee relationship, Banksharesfocuses on consistent investment performance and an asset allocation that isindividually designed to meet each client’s risk/return parameters andinvestment objectives.  Professionaladvisors, working in partnership with our clients, provide access toproprietary and third-party separate account management, the family ofMercantile Funds, nonproprietary mutual funds and a variety of alternativeinvestments.  In addition, IWM provides awide range of sophisticated fiduciary and client administrative services,including trust administration, protection and continuity of trust structures,estate settlement, estate advice and planning, tax advice and planning andcharitable giving programs. IWM also acts in a custodial capacity for itsclients, providing safekeeping of assets, transaction execution, incomecollection, preparation of tax returns and recordkeeping. IWM also specializesin services designed to meet the unique needs of families with substantialwealth. We provide a full range of services required to manage seamlessly ourclient’s complex, multigenerational financial circumstances. We also provideguidance in more sophisticated investment strategies, incorporatingnontraditional asset classes such as private equity, real estate and hedge fundinvesting.

 

***PrivateBanking Services***

The Private Banking Groupprovides one point of contact for its clients’ deposit, investment and creditneeds, ensuring that these services are delivered within an overall assetmanagement plan.  Private bankers cancoordinate cash flows, arrange investment of short- and long-term funds andstructure credit arrangements to meet short- to long-term needs. In the fourthquarter of 2005, the Private Banking Group of MSD&T was consolidated intothe Private Banking Group of IWM. This organizational change will provideprivate banking customers with Bankshares’ full range of financial services.

 

***InstitutionalInvestment Management***

Bankshares, through IWM,the Banks and Boyd Watterson Asset Management, LLC, works to provide businessesand charitable organizations with investment management and administrativeservices for their employee retirement plans, profit sharing plans andendowments.  Clients include state andlocal government entities, unions, charitable organizations and militaryinstitutions.  For example, IWM istrustee for a group trust that focuses on commercial real estate investmentsfor Taft-Hartley pension plans. IWM also can help nonprofit organizations, suchas charitable and philanthropic groups, with annual giving and capitalcampaigns, pooled income funds, gift annuities and charitable remaindertrusts.  Bankshares offers corporations401(k) programs tailored to their specific needs.

 

***MercantileFunds***

Weoffer a full spectrum of mutual funds - from equity funds designed to grow clients’money over time, to taxable and tax-exempt bond funds designed to offer regularincome payments, to money market funds designed to help clients build a cashreserve. The Mercantile Funds help clients create well-rounded portfoliosaround their goals - with the level of risk and potential for return that makesthe most sense for them.

 

Managedby Mercantile Capital Advisors, Inc., an affiliate of MSD&T,Mercantile Funds utilize the same investment foundation that has broughtMercantile regional prominence: risk management, in-depth fundamental researchand a product line designed to meet clients’ needs.

 

**Private Equity**

 

Bankshares, inpartnership with MSD&T, began a focused private equity investmentinitiative in 2000 with two objectives: provide an alternative method offunding to develop additional long-term client relationships with emergingcompanies in Bankshares’ market area and provide an alternative use of capitalto generate long-term returns.  Theprimary investments are private equity limited partnerships located, or seekinginvestment opportunities, within Bankshares’ geographic trade area and, to alesser extent, direct investments in privately held companies within theregion. The private equity funds include small- and middle-market buyout funds,mezzanine funds and late-stage venture funds in which the target investments ofthe funds are or have the potential to become Bankshares customers.  For more information on private equityinvestments, see Notes No. 1, 6 and 10 of the financial statements.

 

5

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** **

**Statistical Information**

 

The statisticalinformation required in this Item 1 is set forth in Items 6, 7 and 8 of thisAnnual Report on Form 10-K, as follows.

 
| **Disclosure Required by Guide 3** | ** ** | **Reference to Caption in Item 6  or 7, or Note in Item 8** |
|------------------------------------|------------|-------------------------------------------------------------|
| (I)                                |       | Distribution  of Assets,                                    |   |   |
|                               |       | Liabilities  and Stockholders                               |   |   |
|                               |       | Equity;  Interest Rates and                                 |   |   |
|                               |       | Interest  Differentials                                     |   | Analysis  of Interest Rates and Interest Differentials (Item 7) |
|                               |       |                                                        |   | Rate/Volume  Analysis (Item 7) |
|                               |       |                                                        |   | Nonperforming  Assets (Item 7) |
| (II)                               |       | Investment  Portfolio                                       |   | Bond  Investment Portfolio (Item 7) |
|                               |       |                                                        |   | Notes  to Financial Statement, Note No. 3, Investment Securities |
| (III)                              |       | Loan  Portfolio                                             |   | Year-End  Loan Data (Item 6) |
|                               |       |                                                        |   | Loan  Maturity Schedule (Item 7) |
|                               |       |                                                        |   | Interest  Rate Risk (Item 7) |
|                               |       |                                                        |   | Nonperforming  Assets (Item 7) |
| (IV)                               |       | Summary  of Loan Loss                                       |   |   |
|                               |       | Experience                                                  |   | Allowance  for Loan Losses (Item 7) |
|                               |       |                                                        |   | Credit  Risk Analysis (Item 7) |
|                               |       |                                                        |   | Allocation  of Allowance for Loan Losses (Item 7) |
| (V)                                |       | Deposits                                                    |   | Analysis  of Interest Rates and Interest Differentials (Item 7) |
|                               |       |                                                        |   | Notes  to Financial Statements, Note No. 7, Deposits |
| (VI)                               |       | Return  on Equity and Assets                                |   | Return  on Equity and Assets (Item 6) |
| (VII)                              |       | Short-Term  Borrowings                                      |   | Notes  to Financial Statements, Note No. 8, Short-Term Borrowings |

 

**Employees**

 

At December 31, 2005, Bankshares and itsaffiliates had approximately 3,606 employees.

 

#### **Competition**

#### ** **

Thebanking business is highly competitive.  Withintheir service areas, the Banks compete with commercial banks (including localbanks and branches or affiliates of other larger banks), savings and loanassociations and credit unions for loans and deposits, and with insurancecompanies and other financial institutions for various types of loans.  There is also competition for commercial andretail banking business from banks and financial institutions located outsideour service areas.  Interstate banking isan established part of the competitive environment.  Bankshares is a financial holding company andis the largest independent bank holding company headquartered in Maryland.  Measured in terms of assets under managementand administration, MSD&T believes it is one of the largest trustinstitutions in the mid-Atlantic region of the United States.  MSD&T and its subsidiaries (i.e., BoydWatterson & Mercantile Capital Advisors, Inc.) compete forvarious classes of fiduciary and investment advisory business with other banksand trust companies, insurance companies, investment counseling firms, mutualfunds and others.  Mercantile Mortgage isone of many competitors in its area of activity.  MBC Agency, Inc. is limited to providinglife, health and accident insurance in connection with credit extended by theBanks.

 

TheBanks ranged in asset size from approximately $178.7 million to $7.2 billion,at December 31, 2005.  They facecompetition in their own local service areas as well as from the largercompetitors mentioned above.

 

6

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#### **Supervision and Regulation**

#### ** **

***Bankshares***

Bankshares,as a registered bank holding company, is subject to regulation and examinationby the Board of Governors of the Federal Reserve System (the “Federal ReserveBoard”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”)and is required to file with the Federal Reserve Board quarterly and annualreports and such additional information as the Federal Reserve Board mayrequire pursuant to the BHC Act.  Amongother provisions, the BHC Act and regulations promulgated thereunder requireprior approval of the Federal Reserve Board of the acquisition by Bankshares ofmore than 5% of any class of the voting shares of any bank holding company,bank, or savings association.

 

*Capital Adequacy*.  The Banks include seven banks chartered bythe state of Maryland (two of which are members of the Federal Reserve System),a Delaware-chartered bank, and three national banks (additional informationabout the chartering of the Banks is contained in *The Banks*,below).  The Federal Reserve Board,regulator of bank holding companies and state-chartered banks that are membersof the Federal Reserve System, the Office of the Comptroller of the Currency (the“OCC”), the federal regulator of national banks, and the Federal DepositInsurance Corporation (the “FDIC”), federal regulator of state-chartered banksthat are not members of the Federal Reserve System and insurer of the depositsof all U.S. commercial banks, have issued substantially similar risk-based andleverage capital guidelines applicable to United States bankingorganizations.  In addition, theseregulatory agencies may from time to time require that a banking organization maintaincapital above the minimum levels, whether because of its financial condition oractual or anticipated growth.

 

TheFederal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), amongother things, identifies five capital categories for insured depositoryinstitutions (well capitalized, adequately capitalized, undercapitalized,significantly undercapitalized and critically undercapitalized) and requiresthe respective federal regulatory agencies to implement systems for “promptcorrective action” for insured depository institutions that do not meet minimumcapital requirements within such categories.  FDICIA imposes progressively more restrictiveconstraints on operations, management and capital distributions, depending onthe category in which an institution is classified.  Failure to meet the capital guidelines couldalso subject a banking institution to requirements to raise capital.

 

Thevarious regulatory agencies have adopted substantially similar regulations thatdefine the five capital categories identified by FDICIA, using the totalrisk-based capital, Tier 1 risk-based capital and leverage capital ratios asthe relevant capital measures.  Suchregulations establish various degrees of corrective action to be taken when aninstitution is considered undercapitalized.  Under the regulations, a “well capitalized”institution must have a Tier 1 risk-based capital ratio of at least sixpercent, a total risk-based capital ratio of at least ten percent and aleverage ratio of at least five percent and not be subject to a capital directiveorder.  As of December 31, 2005, themost recent notification from the primary regulators for each of Bankshares’subsidiary banks categorized them as “well capitalized” under the promptcorrective action regulations. 

 

Changes to the risk-based capital regime for banking organizations areproposed or implemented from time to time. The minimum risk-based capitalrequirements that are currently in effect for U.S. banking organizations followthe Capital Accord issued in 1988 by the Basel Committee on BankingSupervision, which is comprised of bank supervisors and central banks from themajor industrialized countries, including the United States.  The Basel Committee issued a proposedreplacement for the 1988 Capital Accord in 2001 (“Basel II”), and work hascontinued on the details of Basel II and the timing of its implementation sincethat time.  What form any changes to therisk-based capital requirements may take, the extent of their applicability toa bank holding company such as Bankshares, and the impact they might have onBankshares and its subsidiaries cannot be determined at this time.  Additional information regarding capitalrequirements for bank Additional information regarding capital requirements forbank holding companies and tables reflecting Bankshares’ regulatory capitalposition at December 31, 2005 can be found in Note No. 11 (Shareholders’Equity) to the financial statements in Item 8 of this Annual Report.

 

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*TheGramm-Leach-Bliley Act*.  TheGramm-Leach-Bliley Act of 1999 (the “GLB Act”) was adopted on November 12,1999 and amended several of the federal banking laws, including the BHC Act andthe Banking Act of 1933 (generally known as “Glass-Steagall”), that affectBankshares and its subsidiaries.  Priorto the adoption of the GLB Act, the activities of bank holding companies andtheir subsidiaries were restricted to banking, the business of managing andcontrolling banks, and other activities that the Federal Reserve Board had determinedwere so closely related to banking or managing or controlling banks as to be aproper incident thereto.  In particular,Glass-Steagall and the BHC Act imposed important restrictions on the ability ofbank holding companies or their subsidiaries to engage in the securities orinsurance business.

 

The GLBAct repealed the provisions of Glass-Steagall and restrictions in the BHC Actthat limited affiliations among, and overlapping business activities betweenthe banking business and, respectively, the securities and insuranceindustries.  With the adoption of the GLBAct, a bank holding company that makes an effective election to become a “financialholding company” may, within a holding company system, (a) engage inbanking, or managing or controlling banks; (b) perform certain servicingactivities for subsidiaries; and (c) engage in any activity, or acquireand retain the shares of any company engaged in any activity that is either (i) financialin nature or incidental to such financial activity, as determined by theFederal Reserve Board in consultation with the Secretary of the Treasury or (ii) complementaryto a financial activity and that does not pose a substantial risk to the safetyand soundness of depository institutions or the financial system generally, asdetermined by the Federal Reserve Board. Activities that are “financial in nature” include activities specifiedin the GLB Act and those activities that the Federal Reserve Board haddetermined, by order or regulation in effect prior to enactment of the GLB Act,to be so closely related to banking or managing or controlling banks as to be aproper incident thereto.  Thus, afinancial holding company may engage in a full range of banking, securities andinsurance activities, including securities and insurance underwriting, as wellas, subject to certain restrictions, merchant banking activities.  The election to become a financial holdingcompany is only available to bank holding companies whose bank and thriftsubsidiaries are well capitalized, well managed, and have satisfactoryCommunity Reinvestment Act ratings.

 

Withexceptions for insurance underwriting, merchant banking and real estateinvestment and development, the GLB Act also permits comparable expansion ofnational bank activities by banks meeting similar criteria, together withcertain additional firewalls and other requirements, through “financialsubsidiaries” of national banks. Similarly, as a matter of Federal law, but still subject to State law,the GLB Act expands the potential financial activities of subsidiaries of Statebanks.  Bankshares filed an election and,on December 20, 2002, became a financial holding company.

 

The GLBAct also imposed a general scheme of functional regulation with respect to theactivities of bank holding companies and their bank and nonbank subsidiaries toensure that banking activities are regulated by bank regulators, securitiesactivities are regulated by securities regulators, and insurance activities areregulated by insurance regulators, although the Federal Reserve Board retainsits role as the umbrella supervisor for bank holding companies.  Consequently, various securities activitiesof bank subsidiaries of Bankshares are now subject to regulation by theSecurities and Exchange Commission and the National Association of SecuritiesDealers, Inc.  The functionalregulation of the securities brokerage activities of banks is not yet fullyimplemented.

 

As aresult of the functional regulation imposed by the GLB Act, the Banks havemoved certain securities activities that have become subject to Securities andExchange Commission regulation into separate securities subsidiaries oraffiliates.  For example, MSD&T hastwo subsidiaries that engage in securities activities:  Mercantile Capital Advisors, Inc., aregistered investment adviser that advises the Mercantile family of mutualfunds and certain other institutional accounts; and Mercantile BrokerageServices, Inc. (formerly Mercantile Securities, Inc. or Hopkins PlazaSecurities, Inc.), a registered broker-dealer that facilitates thepurchase of shares of mutual funds by bank customers and may engage in certainother activities in the future.

 

The GLBAct also implements a number of requirements designed to protect the privacy ofcustomer information. A financial institution must inform its customers at theoutset of the customer relationship, and at least annually thereafter, of theinstitution’s privacy policies and procedures with respect to the customer’snonpublic personal financial information. With certain exceptions, an institution may not provide any nonpublicpersonal information to unaffiliated third parties unless the customer has beeninformed that such information may be so provided and the customer has beengiven the opportunity to opt out. Furthermore, the GLB Act limits a financial institution’s use of acustomer’s account information for marketing purposes and imposes criminalpenalties for the use of fraudulent or deceptive means to obtain personalcustomer financial information.  The GLBAct permits states to adopt more rigorous laws with respect to privacy ofcustomer information.

 

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*The FairCredit Reporting Act and the Fair and Accurate Transactions Act of 2003*. The Fair Credit Reporting Act (“FCRA”), among other provisions,restricts any bank from sharing with its affiliates certain informationrelating to its individual customers’ creditworthiness and certain othermatters with various exceptions.   FCRA preempts state laws that purport torestrict further such information sharing among affiliated institutions.  The Fair and Accurate Transactions Act of2003 (the “FACT Act”), which was signed into law on December 4, 2003, amendedFCRA in various respects, including to enhance the ability of consumers tocombat identity theft, increase the accuracy of consumer credit reports, andallow consumers to exercise greater control over the type and amount ofmarketing solicitations that they receive. The new marketing restrictions, with some exceptions, would preventbanks from using certain information received from an affiliate for marketingto a consumer unless the consumer was given notice and an opportunity to optout.  The FACT Act also restricts thesharing of certain types of consumer medical information among affiliates.  These new restrictions on sharing or usinginformation shared among affiliates must be implemented by regulations, whichwere issued for public comment but have not yet been finalized.  More generally, the Federal Reserve Board andthe Federal Trade Commission issued joint final rules establishing December 1,2004 as the effective date for many of the provisions of the FACT.

 

In December 2004, implementing section 216 of the FACT Act,the federal bank regulatory agencies announced interagency final rules torequire financial institutions to adopt measures for properly disposing of “consumerinformation” derived from credit reports. Federal banking law requires financial institutions to protect customerinformation by implementing information security programs.  The rules adopted by the bankingagencies require institutions to make certain adjustments to their informationsecurity programs to include measures for the proper disposal of consumerinformation.  The rules define “consumerinformation” to mean “any record about an individual, whether in paper,electronic, or other form, that is a consumer report or is derived from aconsumer report and that is maintained or otherwise possessed by or on behalfof the [institution] for a business purpose,” and include a compilation of suchrecords, but exclude any record that does not identify an individual.  The rules took effect on July 1,2005.  Federal regulators have pursuedenforcement action against U.S. banks and other entities for failing toproperly safeguard customers’ information.

 

*The USAPATRIOT ACT*.  Congress adopted the USA PATRIOT ACT (the “PatriotAct”) on October 26, 2001 in response to the terrorist attacks thatoccurred on September 11, 2001. Under the Patriot Act, banks are required to maintain and prepareadditional records and reports that are designed to assist the government’sefforts to combat terrorism.  The PatriotAct includes sweeping anti-money laundering and financial transparency laws andrequired additional regulations, including, among other things, standards forverifying client identification when opening an account and rules topromote cooperation among financial institutions, regulators and lawenforcement entities in identifying parties that may be involved in terrorismor money laundering.  Specifically, thecustomer identification program (“CIP”) regulation issued under the Patriot Actrequires each bank to implement a written CIP appropriate for its size and typeof business that includes certain minimum requirements. The CIP must beincorporated into the bank’s anti-money laundering compliance program, which issubject to approval by the bank’s board of directors.  The regulation applies to all federallyregulated banks and savings associations, credit unions, and non-federallyregulated private banks, trust companies, and credit unions. All banks wererequired to comply with the CIP regulation for all accounts established on orafter October 1, 2003.

 

*InterstateBanking.   *Pursuant to the Riegle-Neal Interstate Banking andBranching Efficiency Act of 1994 (the “Interstate Banking and Branching Act”),a bank holding company may acquire banks located in states other than its homestate without regard to the permissibility of such acquisitions under statelaw, but subject to any state requirement that the bank has been organized andoperating for a minimum period of time, not to exceed five years, and therequirement that the bank holding company, after the proposed acquisition,controls no more than 10%  of the totalamount of deposits of insured depository institutions in the United States andno more than 30%  or such lesser orgreater amount set by state law of such deposits in that state.

 

Subjectto certain restrictions, the Interstate Banking and Branching Act alsoauthorizes banks to merge across state lines to create interstate banks.  The Interstate Banking and Branching Act alsopermits a bank to open new branches in a state in which it does not alreadyhave banking operations if such state enacts a law permitting de novobranching.

 

*Other Regulatory Matters*.  Bankshares is a separate and distinct legalentity from its subsidiaries.  Itreceives substantially all of its revenue from dividends from its subsidiariesand interest payments from the Banks on subordinated debt. These dividends arethe principal source of funds to pay dividends on Bankshares’ common stock andinterest on its debt. The payment of dividends by a bank is subject to federallaw restrictions as well as to the laws of its state of incorporation in thecase of a state-chartered bank. Also, a parent company’s right to participatein a distribution of assets upon a subsidiary’s

 

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liquidation or reorganization is subject to the prior claims of thesubsidiary’s creditors.  It is FederalReserve Board policy that a bank holding company should serve as a source offinancial and managerial strength for, and commit resources to support each, ofits subsidiary banks even in circumstances in which it might not do so (or maynot legally be required or financially able to do so) absent such a policy.

 

Changes in control of Bankshares and the Banks are regulated under theBHC Act, the Change in Bank Control Act of 1978 and various state laws.

 

 In addition to the specific laws andregulations discussed above, there are numerous federal and state laws andregulations which regulate the activities of Bankshares and the Banks,including requirements and limitations relating to reserves, permissibleinvestments and lines of business, transactions with officers, directors andaffiliates, loan limits, consumer protection laws, privacy of financialinformation, predatory lending, fair lending, mergers and acquisitions,issuances of securities, dividend payments, inter-affiliate liabilities,extensions of credit and branch banking. The BHC Act and the Federal Reserve Board’s regulations limit theability of bank subsidiaries of bank holding companies to engage in certaintie-in arrangements with bank holding companies and their nonbank subsidiariesin connection with any extension of credit or provision of any property orservices, subject to various exceptions.

 

The lawsand regulations to which Bankshares is subject are constantly under review byCongress, regulatory agencies and state legislatures.  The likelihood and timing of any bank-relatedproposals or legislation and the impact they might have on Bankshares and itssubsidiaries cannot be determined at this time.

 

As a general matter, the recent regulatory environment for bankingorganizations has included significant enforcement actions by bankingregulators and other federal and state agencies, involving such matters asalleged shortcomings in anti-money laundering policies and procedures,inadequate protection of confidential customer information, and violations ofsecurities or other laws.  As a result ofthis regulatory environment, banking organizations may experience increases incompliance requirements and associated costs.

 

***The Banks***

 

All theBanks, with the exception of The Citizens National Bank, The National Bank ofFredericksburg, Marshall National Bank and Trust Company and MercantilePeninsula Bank are Maryland banks, subject to the banking laws of Maryland andto regulations issued by the Commissioner of Financial Regulation of Maryland,who is required by statute to make at least one examination in each calendaryear (or at 18-month intervals if the Commissioner determines that anexamination is unnecessary in a particular calendar year).  Their deposits are insured by, and they aresubject to certain provisions of federal law and regulations and examinationby, the FDIC.

 

Inaddition, The Annapolis Banking and Trust Company and Farmers &Mechanics Bank are members of the Federal Reserve System and are therebysubject to regulation by the Federal Reserve Board.

 

TheCitizens National Bank, The National Bank of Fredericksburg and MarshallNational Bank and Trust Company are national banks subject to regulation andregular examination by the OCC in addition to regulation and examination by theFDIC, which insures their deposits.

 

MercantilePeninsula Bank is a Delaware bank, subject to the banking laws of Delaware andto regulation by the Delaware State Bank Commissioner, who is required bystatute to make periodic examinations. Its deposits are insured by, and it is subject to certain provisions offederal law and regulation and examination by, the FDIC.

 

Bankshares and itsaffiliates are subject to the provisions of Section 23A and Section 23Bof the Federal Reserve Act and the Federal Reserve Board’s Regulation W, whichimplements Sections 23A and 23B.  Section 23A,among other things, limits the amount of loans or extensions of credit by theBanks to, and their investments in, Bankshares and the nonbank affiliates ofthe Banks, while Section 23B generally requires that transactions betweenthe Banks and Bankshares and its nonbank affiliates be on terms and under****circumstances that are substantially the same as withnon-affiliates.  Under thecross-guarantee provisions of the Federal Deposit Insurance Act, in the eventof a loss suffered or anticipated by the FDIC either as a result of default ofa bank subsidiary or related to FDIC assistance provided to a bank subsidiaryin danger of default the Banks may be assessed for the FDIC’s loss,subject to certain exceptions.

 

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***Other Affiliates***

Asaffiliates of Bankshares, the nonbank affiliates are subject to examination bythe Federal Reserve Board and, as affiliates of the Banks, they are subject toexamination by the FDIC, the Commissioner of Financial Regulation of Marylandand the OCC, as the case may be.  Inaddition, MBC Agency, Inc. and Mercantile Life Insurance Company are subjectto licensing and regulation by state insurance authorities.  Mercantile Capital Advisors, Inc., BoydWatterson and Mercantile Brokerage Services, Inc. are subject toregulation by the Securities and Exchange Commission and state securities lawauthorities, and Mercantile Brokerage Services, Inc. is also subject toregulation by the National Association of Securities Dealers, Inc.  Retail sales of insurance and securitiesproducts by Mercantile Brokerage Services, Inc. are also subject to therequirements of the Interagency Statement on Retail Sales of NondepositInvestment Products promulgated in 1994 by the FDIC, the Federal Reserve Board,the Comptroller of the Currency and the Office of Thrift Supervision.

 

***Effects of Monetary Policy***

Allcommercial banking operations are affected by the Federal Reserve System’sconduct of monetary policy and its policies change from time to time based onchanging circumstances.  The FederalReserve Board effectively controls the supply of bank credit in order to achieveeconomic results it deems appropriate, including efforts to combatunemployment, recession or inflationary pressures.  Among the instruments of monetary policy usedto advance these objectives are open market operations in the purchase and saleof U.S. Government securities, changes in the discount rate charged on bankborrowings and changes in reserve requirements against bank deposits.  These means are used in varying combinationsto influence the general level of interest rates and the general availabilityof credit.  More specifically, actions bythe Federal Reserve Board influence the levels of interest rates paid ondeposits and other bank funding sources and charged on bank loans as well asthe availability of bank funds with which loans and investments can be made.

 

**Cautionary Statement**

 

This Annual Report on Form 10-Kcontains forward-looking statements, within the meaning of and pursuant to thesafe harbor provisions of the Private Securities Litigation Reform Act of1995.  A forward-looking statementencompasses any estimate, prediction, opinion or statement of belief containedin this report and the underlying management assumptions.  These “forward-looking statements” includesuch words as “believes,” “expects,” “anticipates,” “intends” and similarexpressions.  Examples of forward-lookingstatements in this Annual Report on Form 10-K are statements concerningcompetitive conditions, effects of monetary policy, the potential impact oflegislation, identification of trends, loan growth, customer borrowing trends,anticipated levels of interest rates, business strategies and services,continuation or development of specified lending and other activities, creditquality, predictions or assessments related to the determination and adequacyof loan loss allowances, monitored loans, internal controls, tax accounting,importance and effects of capital levels, effects of asset sensitivity andinterest rates, earnings simulation model projections, efforts to mitigatemarket and liquidity risks, dividend payments and impact of FASBpronouncements. These statements are based on current expectations andassessments of potential developments affecting market conditions, interestrates and other economic conditions, and results may ultimately vary from the statementsmade in this report.  The followingfactors, among others, could cause actual results to differ materially from theanticipated results or other expectations expressed in the forward-lookingstatements: (1) the interest rate environment may further compress marginsand adversely affect net interest income; (2) results may be adverselyaffected by continued diversification of assets and adverse changes in creditquality; (3) economic slowdown could adversely affect credit quality andloan originations; (4) loan growth may not improve to a degree that wouldhelp offset continuing pressure on net interest margin; (5) adversegovernmental or regulatory policies may be enacted; (6) the expectedgrowth opportunities or cost savings from our merger with Community Bank ofNorthern Virginia may not be fully realized or may take longer to realize thanexpected;  (7) Community Bank ofNorthern Virginia’s actual earnings may not be as strong as initially projected;(8) declines in equity and bond markets may adversely affect IWM revenues;and (9) the inability to manage adequately the spread between yields onearning assets and cost of funds could adversely affect results.

 

**WebsiteAccess To Information**

 

Bankshares’ annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K and allamendments to those reports may be accessed through Bankshares’ website as soonas reasonably practicable after such material is electronically filed with orfurnished to the Securities and Exchange Commission.  Bankshares’ website is www.mercantile.com.

 

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ITEM 1A.  RISKFACTORS

 

The following is asummary of the risk factors that we believe are most relevant to ourbusiness.  These are factors that,individually or in the aggregate, we think could cause our actual results todiffer significantly from anticipated or historical results.  You should understand that it is not possibleto predict or identify all such factors. Consequently, you should not consider the following to be a completediscussion of all potential risks or uncertainties.  We undertake no obligation to publicly updateforward-looking statements, whether as a result of new information, futureevents, or otherwise.  You are advised,however, to consult any further disclosure we make on related subjects in ourreports on forms 10-Q and 8-K filed with the SEC.

 

***Bankshares IsSubject To Interest Rate Risk***

Our earnings dependlargely on the relationship between the yield on our interest-earning assetsand our cost of funds.  Thisrelationship, known as the interest rate spread, is subject to fluctuation andis affected by economic and competitive factors which influence market interestrates, the volume and mix of interest-earning assets and interest-bearingliabilities, and the level of non-performing assets.  Fluctuations in market interest rates alsoaffect our customers’ demand for our products and services.  See the sections entitled “Net InterestIncome and Net Interest Margin” and “Interest Rate Risk” in Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”located elsewhere in this report for further discussion related to Bankshares’management of interest rate risk.

 

***Bankshares IsSubject To Lending Risk***

There are inherent risksassociated with Bankshares’ lending activities.  These risks include, among other things, theimpact of changes in interest rates and changes in the economic conditions inthe markets in which Bankshares operates. Increases in interest rates and/or weakening economic conditions couldadversely affect the ability of borrowers to repay outstanding loans or thevalue of the collateral securing these loans.  Commercial loans, including commercial realestate loans are typically subject to a higher credit risk than other types ofloans, including residential real estate or consumer loans, because theyusually involve larger loan balances to a single borrower and are moresusceptible to a risk of default during an economic downturn.  Because Bankshares’ loan portfolio contains asignificant number of commercial and industrial, construction and commercialreal estate loans with relatively large balances, the deterioration of one or afew of these loans could cause a significant increase in nonperforming loans.  These types of loans are also typically largerthan residential real estate loans and consumer loans.   An increase in nonperforming loans couldresult in a net loss of earnings from these loans, an increase in the provisionfor possible loan losses and an increase in loan charge offs, all of whichcould have a material adverse effect on Bankshares’ financial condition andresults of operations.  See the section captioned“Loans” in Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations located elsewhere in this report for furtherdiscussion related to commercial and industrial, construction and commercialreal estate loans.

 

***Bankshares’Allowance For Possible Loan Losses May Be Insufficient***

In an attempt to mitigateour loan and lease losses, we maintain an allowance for loan and lease lossesbased on, among other things, national and regional economic conditions,historical loss experience and delinquency trends.  However, we cannot predict loan and leaselosses with certainty, and we cannot assure you that charge-offs in futureperiods will not exceed the allowance for loan and lease losses.  If our allowance for loan and lease losseswere not sufficient to cover actual loan and lease losses, our earnings woulddecrease.  In addition, regulatoryagencies, as an integral part of their examination process, review ourallowance for loan and lease losses and may require additions to the allowancebased on their judgment about information available to them at the time oftheir examination.  Factors that requirean increase in our allowance for loan and lease losses could reduce ourearnings.

 

***Bankshares’Profitability Depends Significantly On Economic Conditions***

The economic impact ofthe United States’ military operations in Iraq, as well as the war on terrorismand the possibility of any terrorist attacks in response to these operations,is uncertain but could have a material effect on general economic conditions,consumer confidence and market liquidity.  Further, the geographic concentration of ourbusiness in the vicinity of the nation’s capital may place our business atgreater risk of terrorist activity.  Adeterioration in economic conditions in the Washington-Baltimore metropolitanarea could have a material adverse effect on the quality of our loan portfolioand the

 

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demand for our productsand services, and, accordingly, on our results of operations.  No assurance can be given as to the effect ofthese events on the performance of our business.  Furthermore, a significant decline in generaleconomic conditions, caused by inflation, recession, unemployment, changes insecurities markets or other factors could impact local economic conditions and,in turn, have a material adverse effect on Bankshares’ financial condition andresults of operations.

 

***BanksharesOperates In A Highly Competitive Industry and Market Area***

Bankshares facessubstantial competition in all areas of its operations from a variety ofcompetitors, many of which are larger and may have more financialresources.  Such competitors primarilyinclude national, regional, and community banks within the various markets inwhich Bankshares operates.  Banksharesalso faces competition from many other types of financial institutions,including, without limitation, savings and loans, credit unions, financecompanies, brokerage firms, insurance companies, factoring companies and otherfinancial intermediaries.  The financialservices industry could become even more competitive as a result oflegislative, regulatory and technological changes and continued consolidation.  Banks, securities firms and insurancecompanies can merge under the umbrella of a financial holding company, whichcan offer virtually any type of financial service, including banking,securities underwriting, insurance (both agency and underwriting) and merchantbanking.  Also, technology has loweredbarriers to entry and made it possible for nonbanks to offer products and servicestraditionally provided by banks, such as automatic funds transfer and automaticpayment systems.  Many of Bankshares’competitors have fewer regulatory constraints and may have lower coststructures. Additionally, due to their size, many competitors may be able toachieve economies of scale and, as a result, may offer a broader range ofproducts and services as well as better pricing for those products and servicesthan Bankshares can. Bankshares’ ability to compete successfully depends on anumber of factors, including, among other things:

 

•                  Theability to develop, maintain and build upon long-term customer relationshipsbased on top quality service, high ethical standards and safe, sound assets.

•                  Theability to expand Bankshares’ market position.

•                  Thescope, relevance and pricing of products and services offered to meet customerneeds and demands.

•                  Therate at which Bankshares introduces new products and services relative to itscompetitors.

•                  Customersatisfaction with Bankshares’ level of service.

•                  Industryand general economic trends.

 

Failure to perform in anyof these areas could significantly weaken Bankshares’ competitive position,which could adversely affect Bankshares’ growth and profitability, which, inturn, could have a material adverse effect on Bankshares’ financial conditionand results of operations.

 

***Bankshares IsSubject To Extensive Government Regulation and Supervision***

Financial institutionregulation has been the subject of significant legislation in recent years andmay be the subject of further significant legislation in the future, none ofwhich is within our control.  Significantnew laws or changes in, or repeals of, existing laws, including with respect tofederal and state taxation, may cause our results of operations to differmaterially.  Further, federal monetarypolicy, particularly as implemented through the Federal Reserve, significantlyaffects credit conditions for our affiliated banks, primarily through openmarket operations in U.S. government securities and the discount rate for bankborrowings and reserve requirements.  Amaterial change in any of these conditions would have a material impact on ourresults of operations.  Furthermore,failure to comply with laws, regulations or policies could result in sanctionsby regulatory agencies, civil money penalties and/or reputation damage, whichcould have a material adverse effect on Bankshares’ business, financialcondition and results of operations.  WhileBankshares has policies and procedures designed to prevent any such violations,there can be no assurance that such violations will not occur. See the section captioned“Supervision and Regulation” in Item 1 “Business” located elsewhere in thisreport.

 

***Bankshares’Controls And Procedures May Fail Or Be Circumvented***

Management regularlyreviews and updates Bankshares’ internal controls, disclosure controls andprocedures, and corporate governance policies and procedures.  Any system of controls, however well designedand operated, is based in part on certain assumptions and can provide onlyreasonable, not absolute, assurances that the objectives of the system will be met. Any failure or circumvention ofBankshares’ controls and procedures or failure to comply with regulationsrelated to controls and procedures could have a material adverse effect onBankshares’ business, results of operations and financial condition.

 

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***PotentialAcquisitions May Disrupt Bankshares’ Business And Dilute Stockholder Value***

Bankshares seeks mergeror acquisition partners that are culturally similar and have experiencedmanagement and possess either significant market presence or have potential forimproved profitability through financial management, economies of scale orexpanded services.  Acquiring otherbanks, businesses, or branches involves various risks commonly associated withacquisitions, including, among other things:

 

•                  Potentialexposure to unknown or contingent liabilities of the target company.

•                  Exposureto potential asset quality issues of the target company.

•                  Difficultyand expense of integrating the operations and personnel of the target company.

•                  Potentialdisruption to Bankshares’ business.

•                  Potentialdiversion of Bankshares’ management’s time and attention.

•                  Thepossible loss of key employees and customers of the target company.

•                  Difficultyin estimating the value of the target company.

•                  Potentialchanges in banking or tax laws or regulations that may affect the targetcompany.

 

Bankshares regularlyevaluates merger and acquisition opportunities and conducts due diligenceactivities related to possible transactions with other financial institutionsand financial services companies.  As aresult, merger or acquisition discussions and, in some cases, negotiations maytake place and future mergers or acquisitions involving cash, debt or equitysecurities may occur at any time.  Acquisitions typically involve the payment ofa premium over book and market values and, therefore, some dilution ofBankshares’ tangible book value and net income per common share may occur inconnection with any future transaction.

 

Furthermore, failure torealize the expected revenue increases, cost savings, increases in geographicor product presence, and/or other projected benefits from an acquisition couldhave a material adverse effect on Bankshares’ financial condition and resultsof operations.  See Note No. 2 “BusinessCombinations” in the notes to consolidated financial statements included inItem 8. Financial Statements and Supplementary Data, which is located elsewherein this report.

 

***Bankshares May NotBe Able To Attract And Retain Skilled People***

Bankshares’ successdepends, in large part, on its ability to attract and retain key people.  Competition for the best people in the businessconducted by Bankshares can be intense and Bankshares may not be able to hirepeople or to retain them. The unexpected loss of services of one or more ofBankshares’ key personnel could have a material adverse impact on Bankshares’business because of their skills, knowledge of Bankshares’ market, years ofindustry experience and the difficulty of promptly finding qualifiedreplacement personnel.

 

***Bankshares’Information Systems May Experience An Interruption Or Breach In Security***

Bankshares relies heavilyon communications and information systems to conduct its business.  Any failure, interruption or breach insecurity of these systems could result in failures or disruptions in Bankshares’customer relationship management, general ledger, deposit, loan and othersystems.  While Bankshares has policiesand procedures designed to prevent or limit the effect of the failure,interruption or security breach of its information systems, there can be noassurance that any such failures, interruptions or security breaches will notoccur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptionsor security breaches of Bankshares’ information systems could damage Bankshares’reputation, result in a loss of business, subject Bankshares to additionalregulatory scrutiny, or expose Bankshares to civil litigation and possiblefinancial liability, any of which could have a material adverse effect onBankshares’ financial condition and results of operations.

 

***Bankshares ContinuallyEncounters Technological Change***

The financial servicesindustry is continually undergoing rapid technological change with frequentintroductions of new technology driven products and services.  The effective use of technology increasesefficiency and enables financial institutions to serve customers better and toreduce costs.  Bankshares’ future successdepends, in part, upon its ability to address the needs of its customers byusing technology to provide products and services that will satisfy customerdemands, as well as to create additional efficiencies in Bankshares’operations.  Many of Bankshares’competitors have substantially greater resources to invest in technologicalimprovements.  Bankshares may not be ableto effectively implement new technology driven products and services or besuccessful in marketing these products and services to its customers.  Failure to keep pace successfully withtechnological change affecting the financial services industry could have amaterial adverse impact on Bankshares’ business and, in turn, Bankshares’financial condition and results of operations.

 

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***Bankshares IsSubject To Claims and Litigation Pertaining To Fiduciary Responsibility***

From time to time, customersmake claims and take legal action pertaining to Bankshares’ performance of itsfiduciary responsibilities.  Whethercustomer claims and legal action related to Bankshares’ performance of itsfiduciary responsibilities are founded or unfounded, if such claims and legalactions are not resolved in a manner favorable to Bankshares they may result insignificant financial liability and/or adversely affect the market perceptionof Bankshares and its products and services as well as affect customer demandfor those products and services.  Anyfinancial liability or reputation damage could have a material adverse effecton Bankshares’ business, which, in turn, could have a material adverse effecton Bankshares’ financial condition and results of operations.

 

***Severe Weather,Natural Disasters, Acts Of War Or Terrorism And Other External Events CouldSignificantly Impact Bankshares’ Business***

Severe weather, naturaldisasters, acts of war or terrorism and other adverse external events couldhave a significant impact on Bankshares’ ability to conduct business.  Such events could affect the stability ofBankshares’ deposit base, impair the ability of borrowers to repay outstandingloans, impair the value of collateral securing loans, cause significantproperty damage, result in loss of revenue and/or cause Bankshares to incuradditional expenses.  Although managementhas established disaster recovery policies and procedures, the occurrence ofany such event could have a material adverse effect on Bankshares’ business,which, in turn, could have a material adverse effect on Bankshares’ financialcondition and results of operations.

 

***BanksharesRelies On Dividends From Its Subsidiaries For Most Of Its Revenue***

We are a financialholding company and a bank holding company and as a result, much of our income consistsof dividends received from our affiliated banks.  This means we rely primarily upon dividendsfrom our affiliated banks to pay dividends to Bankshares’ commonstockholders.  Federal and state bankregulations restrict the amounts when our affiliated banks pay dividendsdirectly or indirectly to us, when making any extensions of credit to us, whentransferring assets to us and when investing in our stock or securities.  These regulations also prevent us from borrowingfrom our affiliated banks unless the loans are secured by collateral.  In addition, we cannot assure that ouraffiliated banks will be able to continue to pay dividends to us at pastlevels, if at all.  If we do not receivesufficient cash dividends or borrowings from our affiliate banks, we may nothave sufficient funds to pay dividends on common stock.

 

ITEM 1B.  UNRESOLVED STAFF COMMENTS

 

There were no unresolved staff comments as of December 31,2005.

 

ITEM 2.  PROPERTIES

 

Themain offices of Bankshares and MSD&T are located in a 21-story building atTwo Hopkins Plaza in Baltimore, Maryland, which is owned by MBC Realty, LLC, awholly owned subsidiary of Harbor Group International, L.L.C.  Pursuant to a lease agreement by and betweenMBC Realty, LLC (which was previously owned by Bankshares) and MSD&T,effective as of December 13, 2004, MSD&T agreed to lease up toapproximately 179,000 square feet of prime office space and approximately27,000 square feet ofback-office and storage space at Two Hopkins Plaza, for a term of tenyears.  At December 31, 2005,MSD&T and Bankshares occupied approximately 206,000 square feet.  The lease agreement contains two five-yearrenewal options.  The lease agreementrequires aggregate annual rent of approximately $3.9 million in 2005.  At December 31, 2005, Bankshares alsooccupied approximately 132,000 square feet of leased space in a buildinglocated in Linthicum, Maryland, in which its operations and certain otherdepartments are located, and a 7,000 square foot call center facility inFederalsburg, Maryland.  The Linthicumand Federalsburg properties are owned by Bankshares.  Of the 240 banking offices, 112 are owned infee, 33 are owned subject to ground leases and 95 are leased, with aggregateannual rentals, not including the branch located at Two Hopkins Plaza, ofapproximately $10.6 million as of December 31, 2005.

 

15

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ITEM 3.  LEGAL PROCEEDINGS

 

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

 

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

 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

Nomatter was submitted during the fourth quarter of the fiscal year covered bythis Report to a vote of security holders, which is required to be disclosedpursuant to the instructions contained in the form for this Report.

 

SPECIAL ITEM: EXECUTIVEOFFICERS OF THE REGISTRANT

 

The Bankshares’ officerswho file reports under Section 16 of the Securities Exchange Act of 1934are: 

 
| **Name**                      | ** ** | **Position**                                                  | ** ** | **Age** |
|-------------------------------|------------|---------------------------------------------------------------|------------|---------|
|                          |       |                                                          |       |    |
| Edward J.  Kelly, III    |       | Chairman of the Board,  President and Chief Executive Officer |       | 52      |
|                          |       |                                                          |       |    |
| Alexander T. Mason            |       | Vice Chairman and Chief  Operating Officer                    |       | 54      |
|                          |       |                                                          |       |    |
| Jay M. Wilson                 |       | Vice Chairman and  Chairman and Chief Executive Officer,      |       |    |
|                          |       | Investment &  Wealth Management                      |       | 59      |
|                          |       |                                                          |       |    |
| J. Marshall Reid              |       | Executive Vice  President, Banking                            |       | 60      |
|                          |       |                                                          |       |    |
| Peter W.  Floeckher, Jr. |       | Executive Vice  President, Affiliate Management               |       | 56      |
|                          |       |                                                          |       |    |
| Terry L. Troupe               |       | Executive Vice  President and Chief Financial Officer         |       | 58      |
|                          |       |                                                          |       |    |
| John L. Unger                 |       | Executive Vice  President, General Counsel and Secretary      |       | 52      |
|                          |       |                                                          |       |    |
| Michael M. Paese              |       | Executive Vice  President, Chief Administrative Officer,      |       |    |
|                          |       | Chief Risk Officer and  Deputy General Counsel                |       | 38      |
|                          |       |                                                          |       |    |
| Deborah A. Kakaris            |       | Executive Vice  President, Operations and Technology Services |       | 42      |
|                          |       |                                                          |       |    |
| Kaye A. Simmons               |       | Senior Vice President  and Treasurer, Bankshares              |       | 50      |
|                          |       |                                                          |       |    |
| William T.  Skinner, Jr. |       | Senior Vice President  and Controller                         |       | 58      |

 

16

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No family relationships,as defined by the rules and regulations of the Securities and ExchangeCommission, exist

among any of theExecutive Officers. All officers are elected annually by the Board of Directorsand hold office at the pleasure of the Board. 

 

Effective March 1,2001, Mr. Kelly became President and Chief Executive of Bankshares andChairman of the Board and Chief Executive Officer of MSD&T.  In addition, effective March 1, 2003 Mr. Kellybecame Chairman of Bankshares. Mr. Kelly served as Managing Director, Headof Global Financial Institutions, and as Co-Head of Investment Banking ClientManagement of J. P. Morgan, Chase & Co. during January 2001.  Prior thereto, he was a Managing Director of J.P. Morgan & Co. Incorporated and held the following additionalpositions with that Company: Head, Global Financial Institutions from February,2000 through December, 2000; Co-Head, Global Financial Institutions and Head,Latin America Investment Banking from December 1997 through February 2000;Member, Global Investment Banking Committee from December 1997 through December 2000;and Co-Head, Financial Institutions (Americas) from February 1996 through December 1997.

 

Mr. Mason joinedBankshares in November 2003, and is Vice Chairman of Bankshares.  Effective January 2, 2004, he was namedBankshares’ Chief Operating Officer. Prior to joining Bankshares, he was ViceChairman of Deutsche Bank in the Americas and Managing Director of DeutscheBank Securities.  He also served as chiefoperating officer of the firm’s Global Corporate Finance Department and headedup the firm’s Global Industry Group practice. He was elected a director of MSD&T in January 2005, and adirector of Bankshares in January 2005.

 

Mr. Wilson has beena Vice Chairman of Bankshares and Chief Executive Officer of the Investment andWealth Management Division of MSD&T since January 2005.  From September 1998 until December 2004,he was General Partner of Spring Capital Partners, L.P., a private equity fundproviding expansion and acquisition capital to emerging growth companies. Hewas elected a director of MSD&T in January 2005, and a director ofBankshares in January 2005.

 

Mr. Reid was electedPresident and Chief Operating Officer of MSD&T in September 1997. Hejoined MSD&T as a Senior Vice President in 1993 and served as an ExecutiveVice President from 1994 until September 1997.

 

Mr. Floeckher wasappointed Executive Vice President and Head of the Affiliates for Bankshares inNovember 2003.  He served as Presidentand Chief Executive Officer of Citizens National Bank from 1995 until November 2003.

Mr. Floeckher isresponsible for oversight of the Banks, which includes risk management,compliance and enhanced performance through coordinated sharing of best practices.

 

Mr. Troupe has beenChief Financial Officer of Bankshares and MSD&T since he joined the Bank inSeptember 1996.

 

Mr. Unger becameGeneral Counsel on March 23, 2002 and was elected Secretary of Banksharesand MSD&T on July 1, 2002. Prior to joining Bankshares, Mr. Unger was General Counsel to IMIResort Holdings, Inc., a privately held real estate company in Greenville,South Carolina.

 

Mr. Paese was namedChief Administrative Officer of Bankshares in November 2004 and becameChief Risk Officer on January 2, 2005. He joined MSD&T as a Senior Vice President and Deputy GeneralCounsel in January 2003.  Beforejoining Mercantile, Mr. Paese was Senior Counsel to the Financial ServicesCommittee of the U.S. House of Representatives (minority).  Mr. Paese advised the Committee on legaland policy issues relating to U.S. capital markets and corporategovernance.  Prior thereto, Mr. Paesewas a Vice President in equity capital markets, at J .P. Morgan & Co.Incorporated.  Prior thereto, Mr. Paesewas an associate at Davis Polk & Wardwell.

 

Mrs. Kakaris hasbeen an Executive Vice President of Bankshares and MSD&T since 2002.  She is responsible for Operations andTechnology Services.  Mrs. Kakarisjoined the bank in 1988 and served as a Senior Vice President from 1997 until March 2002.

 

Ms. Simmons joinedBankshares in 2003, after the merger with F&M Bancorp.  She had been Treasurer of F&M Bancorpsince 2000 and Executive Vice President and Chief Financial Officer of Farmers &Mechanics Bank since 2000. Prior to that time, Ms. Simmons served asSenior Vice President of Finance and Treasurer of Citizens Bancorp from 1989 to1997.

 

Mr. Skinner has beenSenior Vice President and Controller of Bankshares since 1998.  He served as Controller of MSD&T since1996.  Mr. Skinner joined MSD&Tin 1979.

 

17

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**PART II**

 

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY,RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES

 

For information regarding market prices, dividends onBankshares common stock, and the number of Bankshares stockholders, see theinformation set forth under the captions “Dividends” and “Recent Common StockPrices” in Item 7 of this Annual Report.

 

18

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Item6.  Selected Financial Data

 

Five-YearSelected Financial Data

 
| **Years Ended December 31,**                                                  | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ***(Dollars in thousands, except per share data)***                                | ** ** | **2005**       | ** **     | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
| **OPERATING  RESULTS**                                                             |       |           | ** **     |       |       |       |       |       |       |       |       |
| Net interest  income                                                               | ** ** | **$**          | **617,126**    | ** ** | $          | 545,781    |       | $          | 472,349    |       | $          | 441,035 |   | $ | 417,327 |   |
| Net interest  income - taxable equivalent                                          | ** ** | **623,973**    | ** **     | 552,525    |       | 479,109    |       | 447,228    |       | 423,751    |       |
| Provision for  loan losses                                                         | ** ** | **1,576**      | ** **     | 7,221      |       | 12,105     |       | 16,378     |       | 13,434     |       |
| Noninterest  income                                                                | ** ** | **243,120**    | ** **     | 213,929    |       | 183,572    |       | 144,519    |       | 146,404    |       |
| Noninterest  expense                                                               | ** ** | **420,821**    | ** **     | 391,958    |       | 337,447    |       | 272,608    |       | 263,959    |       |
| Net income                                                                         | ** ** | **276,319**    | ** **     | 229,407    |       | 196,814    |       | 190,238    |       | 181,295    |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| **PER  COMMON SHARE DATA (1)**                                                     |       |           | ** **     |       |       |       |       |       |       |       |       |
| Basic net income                                                                   | ** ** | **$**          | **2.28**       | ** ** | $          | 1.93       |       | $          | 1.80       |       | $          | 1.82 |   | $ | 1.71 |   |
| Diluted net  income                                                                | ** ** | **2.26**       | ** **     | 1.92       |       | 1.79       |       | 1.81       |       | 1.70       |       |
| Dividends paid                                                                     | ** ** | **0.99**       | ** **     | 0.92       |       | 0.86       |       | 0.79       |       | 0.73       |       |
| Book value at  period end                                                          | ** ** | **17.81**      | ** **     | 16.12      |       | 15.39      |       | 12.83      |       | 11.75      |       |
| Market value at  period end                                                        | ** ** | **37.63**      | ** **     | 34.80      |       | 30.39      |       | 25.73      |       | 28.69      |       |
| Market range:                                                                      |       |           | ** **     |       |       |       |       |       |       |       |       |
| High                                                                               | ** ** | **40.09**      | ** **     | 35.39      |       | 30.63      |       | 30.24      |       | 29.67      |       |
| Low                                                                                | ** ** | **32.27**      | ** **     | 26.87      |       | 20.11      |       | 21.38      |       | 22.42      |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| **BALANCE  SHEET DATA AT PERIOD END**                                              |       |           | ** **     |       |       |       |       |       |       |       |       |
| Total loans                                                                        | ** ** | **$**          | **11,607,845** | ** ** | $          | 10,228,433 |       | $          | 9,272,160  |       | $          | 7,312,027 |   | $ | 6,906,246 |   |
| Total investment  securities                                                       | ** ** | **3,106,287**  | ** **     | 2,928,870  |       | 3,070,645  |       | 2,550,491  |       | 2,327,760  |       |
| Total assets                                                                       | ** ** | **16,421,729** | ** **     | 14,425,690 |       | 13,695,472 |       | 10,790,376 |       | 9,928,786  |       |
| Total deposits                                                                     | ** ** | **12,077,350** | ** **     | 10,799,199 |       | 10,262,553 |       | 8,260,940  |       | 7,447,372  |       |
| Shareholders’  equity                                                         | ** ** | **2,194,722**  | ** **     | 1,917,683  |       | 1,841,441  |       | 1,324,358  |       | 1,230,206  |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| **PROFITABILITY  RATIOS**                                                          |       |           | ** **     |       |       |       |       |       |       |       |       |
| Return on  average assets                                                          | ** ** | **1.78**       | **%**          | 1.64       | %          | 1.64       | %          | 1.88       | %          | 1.96       | %          |
| Return on  average equity                                                          | ** ** | **13.18**      | ** **     | 12.26      |       | 13.15      |       | 15.12      |       | 15.15      |       |
| Return on  average tangible equity                                                 | ** ** | **19.54**      | ** **     | 18.00      |       | 16.55      |       | 16.69      |       | 17.67      |       |
| Net interest  rate spread - taxable equivalent                                     | ** ** | **3.88**       | ** **     | 3.99       |       | 3.92       |       | 4.05       |       | 3.79       |       |
| Net interest  margin on earning assets - taxable equivalent                        | ** ** | **4.44**       | ** **     | 4.35       |       | 4.32       |       | 4.65       |       | 4.83       |       |
| Efficiency ratio                                                                   | ** ** | **48.53**      | ** **     | 51.14      |       | 50.92      |       | 46.07      |       | 46.30      |       |
| Cash operating  efficiency ratio                                                   | ** ** | **47.61**      | ** **     | 49.63      |       | 49.52      |       | 45.80      |       | 45.10      |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| **CAPITAL  RATIOS**                                                                |       |           | ** **     |       |       |       |       |       |       |       |       |
| Average equity  to average assets                                                  | ** ** | **13.51**      | **%**          | 13.38      | %          | 12.51      | %          | 12.43      | %          | 12.97      | %          |
| Average tangible  equity to average tangible assets                                | ** ** | **9.70**       | ** **     | 9.70       |       | 10.34      |       | 11.45      |       | 11.89      |       |
| Dividend payout  ratio (1)                                                         | ** ** | **43.42**      | ** **     | 47.67      |       | 47.78      |       | 43.41      |       | 42.69      |       |
| Risk-based  capital:                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| Tier 1 capital  ratio                                                              | ** ** | **11.82**      | ** **     | 12.33      |       | 12.46      |       | 15.00      |       | 15.41      |       |
| Total capital  ratio                                                               | ** ** | **15.37**      | ** **     | 16.23      |       | 16.63      |       | 16.29      |       | 16.72      |       |
| Leverage ratio                                                                     | ** ** | **9.81**       | ** **     | 10.02      |       | 9.60       |       | 11.20      |       | 11.60      |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| Bank offices                                                                       | ** ** | **240**        | ** **     | 226        |       | 227        |       | 185        |       | 188        |       |
| Employees                                                                          | ** ** | **3,606**      | ** **     | 3,479      |       | 3,565      |       | 2,885      |       | 2,949      |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| **CREDIT  QUALITY DATA AT PERIOD END**                                             |       |           | ** **     |       |       |       |       |       |       |       |       |
| Net charge-offs                                                                    | ** ** | **$**          | **991**        | ** ** | $          | 13,556     |       | $          | 8,574      |       | $          | 19,240 |   | $ | 10,583 |   |
| Nonaccrual loans                                                                   | ** ** | **22,565**     | ** **     | 30,898     |       | 50,352     |       | 33,371     |       | 32,919     |       |
| Other real  estate owned, net                                                      | ** ** | **667**        | ** **     | 212        |       | 191        |       | 132        |       | 181        |       |
| Total  nonperforming assets                                                        | ** ** | **23,232**     | ** **     | 31,110     |       | 50,543     |       | 33,503     |       | 33,100     |       |
|                                                                               |       |           | ** **     |       |       |       |       |       |       |       |       |
| **CREDIT  QUALITY RATIOS**                                                         |       |           | ** **     |       |       |       |       |       |       |       |       |
| Net charge-offs  as a percent of period-end loans                                  | ** ** | **0.01**       | **%**          | 0.13       | %          | 0.09       | %          | 0.26       | %          | 0.15       | %          |
| Allowance for  loan losses as a percent of period-end loans                        | ** ** | **1.35**       | ** **     | 1.46       |       | 1.68       |       | 1.90       |       | 2.05       |       |
| Allowance for  loan losses as a percent of nonperforming loans                     | ** ** | **694.32**     | ** **     | 482.24     |       | 308.50     |       | 415.33     |       | 429.73     |       |
| Nonperforming  assets as a percent of period-end loans and other real estate owned | ** ** | **0.20**       | ** **     | 0.30       |       | 0.55       |       | 0.46       |       | 0.48       |       |

----

(1)           On January 10, 2006, Banksharesannounced a three-for-two stock split on its common stock. Per share amountsand other applicable information have been adjusted to give effect to thesplit.

 

19

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Five-YearSummary of Consolidated Income

 
| **Years Ended December 31,**                    | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ***(Dollars in thousands)***                         | ** ** | **2005**    | ** **  | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
| INTEREST INCOME                                      |       |        |        |       |       |       |       |       |       |       |       |
| Interest and  fees on loans                          | ** ** | **$**       | **700,832** |       | $          | 546,531    |       | $          | 472,943    |       | $          | 468,678 |   | $ | 543,242 |   |
| Interest on  securities                              | ** ** | **112,769** |        | 111,003    |       | 113,254    |       | 112,091    |       | 99,624     |       |
| Other interest  income                               | ** ** | **2,436**   |        | 1,503      |       | 3,397      |       | 4,848      |       | 5,986      |       |
| Total interest  income                               | ** ** | **816,037** |        | 659,037    |       | 589,594    |       | 585,617    |       | 648,852    |       |
| INTEREST EXPENSE                                     |       |        |        |       |       |       |       |       |       |       |       |
| Interest on  deposits                                | ** ** | **139,917** |        | 83,403     |       | 93,190     |       | 122,569    |       | 199,703    |       |
| Interest on  short-term borrowings                   | ** ** | **26,266**  |        | 7,844      |       | 5,604      |       | 11,259     |       | 25,120     |       |
| Interest on  long-term debt                          | ** ** | **32,728**  |        | 22,009     |       | 18,451     |       | 10,754     |       | 6,702      |       |
| Total interest  expense                              | ** ** | **198,911** |        | 113,256    |       | 117,245    |       | 144,582    |       | 231,525    |       |
| NET INTEREST  INCOME                                 | ** ** | **617,126** |        | 545,781    |       | 472,349    |       | 441,035    |       | 417,327    |       |
| Provision for  loan losses                           | ** ** | **1,576**   |        | 7,221      |       | 12,105     |       | 16,378     |       | 13,434     |       |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN LOSSES | ** ** | **615,550** |        | 538,560    |       | 460,244    |       | 424,657    |       | 403,893    |       |
| NONINTEREST  INCOME                                  |       |        |        |       |       |       |       |       |       |       |       |
| Investment and  wealth management                    | ** ** | **95,756**  |        | 90,050     |       | 78,933     |       | 68,435     |       | 69,331     |       |
| Service charges  on deposit accounts                 | ** ** | **43,885**  |        | 44,263     |       | 39,194     |       | 33,539     |       | 30,101     |       |
| Other income                                         | ** ** | **103,479** |        | 79,616     |       | 65,445     |       | 42,545     |       | 46,972     |       |
| Total  noninterest income                            | ** ** | **243,120** |        | 213,929    |       | 183,572    |       | 144,519    |       | 146,404    |       |
| NONINTEREST  EXPENSES                                |       |        |        |       |       |       |       |       |       |       |       |
| Salaries and  employee benefits                      | ** ** | **246,397** |        | 232,297    |       | 198,043    |       | 165,371    |       | 152,887    |       |
| Net occupancy  and equipment expenses                | ** ** | **60,255**  |        | 55,746     |       | 52,366     |       | 40,368     |       | 38,448     |       |
| Amortization of  goodwill                            | ** ** | **—**  |        | —     |       | —     |       | —     |       | 9,072      |       |
| Other expenses                                       | ** ** | **114,169** |        | 103,915    |       | 87,038     |       | 66,869     |       | 63,552     |       |
| Total  noninterest expenses                          | ** ** | **420,821** |        | 391,958    |       | 337,447    |       | 272,608    |       | 263,959    |       |
| Income before  income taxes                          | ** ** | **437,849** |        | 360,531    |       | 306,369    |       | 296,568    |       | 286,338    |       |
| Applicable  income taxes                             | ** ** | **161,530** |        | 131,124    |       | 109,555    |       | 106,330    |       | 105,043    |       |
| NET INCOME                                           | ** ** | **$**       | **276,319** |       | $          | 229,407    |       | $          | 196,814    |       | $          | 190,238 |   | $ | 181,295 |   |

 

20

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Item7.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations

 

I. EXECUTIVE OVERVIEW

 

Mercantile BanksharesCorporation (“Bankshares”) is a regional multibank holding companyheadquartered in Baltimore, Maryland.  AtDecember 31, 2005, Bankshares had $16.4 billion in assets, $11.6 billionin loans and $12.1 billion in deposits. It is the largest bank holding company headquartered in the state ofMaryland.  The two principal lines ofbusiness are Banking and Investment & Wealth Management (“IWM”),delivered through the lead bank Mercantile-Safe Deposit and Trust Company (“MSD&T”)and 10 affiliated banks.  See “SegmentReporting” in section “II. ANALYSIS OF OPERATING RESULTS FOR 2005 TO 2004” for moreinformation.

 

On January 10, 2006,Bankshares announced a three-for-two stock split on its common stock, payablein the form of a stock dividend on January 27, 2006 to stockholders of recordas of the close of business on January 20, 2006.  Certain shares, average shares and per shareamounts have been adjusted to give effect to the split.

 

Bankshares recorded its 30thconsecutive year of increased net income in 2005.  Net income for Bankshares was $276.3 millionfor the year ended December 31, 2005, compared with $229.4 million for theyear 2004, representing a 20.4% increase. Diluted net income per common share for 2005 increased by 17.7% to $2.26compared with $1.92 for 2004.  The mostnoteworthy factors affecting 2005 earnings were the acquisition of CommunityBank of Northern Virginia (“CBNV”), improvement in the net interest margin,growth in loans and improving credit quality.

 

On May 18, 2005,Bankshares completed its acquisition of CBNV, a bank headquartered in Sterling,Virginia, which was merged into MSD&T. CBNV operated 14 branch offices in the Northern Virginia metropolitanmarket at the time of the acquisition.  Theconsideration paid to CBNV shareholders in connection with the acquisition wascomprised of $82.9 million in cash and 3.7 million shares of Bankshares’ commonstock as adjusted to give effect to the stock split.  CBNV transactions have been included inBankshares’ financial results subsequent to May 18, 2005.  The assets and liabilities of CBNV wererecorded on the Consolidated Balance Sheet at their respective fairvalues.  The fair values were determinedas of May 18, 2005, and are subject to refinement as further informationbecomes available.  The transactionresulted in total assets acquired as of May 18, 2005 of $888.2 million,including $671.0 million of loans and leases; liabilities assumed were $842.3million, including $626.9 million of deposits. Bankshares recorded $162.1 million of goodwill and $4.6 million of coredeposit intangible (“CDI”).  CDI issubject to amortization and is being amortized over nine years on astraight-line basis.

 

The Board of Governors ofthe Federal Reserve System (“Federal Reserve Board”) increased short-term ratesby 125 basis points in 2004 and 200 basis points in 2005.  The net interest margin improved 9 basispoints to 4.44% for 2005 from 4.35% for 2004, which compares favorably with theincrease of 3 basis points experienced during 2004.  The net interest margin for 2003 was4.32%.  The 2005 net interest marginincrease was attributable to a 20 basis point increase in the benefit derivedfrom noninterest-bearing sources of funds, which was partially offset by an 11basis point decline in the spread between the yield on earning assets and thecost of interest-bearing liabilities. Competition to gather deposits increased throughout the year andresulted in higher rates paid on these funds. See “Analysis of Interest Rate and Interest Differentials” and thediscussions of “Net Interest Income” and “Interest Rate Risk” found in Item 7of this report.

 

At December 31,2005, loans outstanding were $11.6 billion, an increase of 13.5% over the $10.2billion outstanding at December 31, 2004.  Much of the lending growth was driven bystrong real estate markets for both commercial and residential properties.  Construction loans at December 31, 2005were $1.6 billion, an increase of 26.7% from $1.3 billion at December 31,2004.  Commercial real estate loans were$3.7 billion at December 31, 2005, an increase of 18.6% from $3.1 billionat December 31, 2004.  Commercialand industrial loans grew by 3.2%.

 

Credit quality measuresimproved on both an absolute and relative basis.  Nonperforming loans declined from $30.9million at December 31, 2004 to $22.6 million at December 31,2005.  This is the lowest level reportedat year-end since December 31, 1999. Nonperforming loans as a percent of year-end loans were 0.19% at December 31,2005.  On a relative basis, this is theirlowest level at year-end in more than 20 years. Reflecting these improvements, the provision for loan losses declined by$5.6 million to $1.6 million for the year ended December 31, 2005.

 

In 2005 Banksharesexperienced improvements in return on average assets (“ROA”) and return onaverage shareholders’ equity (“ROE”). The 2005 ROA increased to 1.78% from1.64% in 2004. Bankshares’ 2005 ROE increased to 13.18% from 12.26% in2004.  Average shareholders’ equity toaverage assets was at 13.51% for 2005, an increase from 13.38% for 2004.

 

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.  We believe these non-GAAP measuresprovide information useful to investors in understanding our ongoing corebusiness and operational performance trends. These measures should not be viewed as a substitute for GAAP.  Management believes presentations offinancial measures excluding the impact of certain items provide usefulsupplemental

 

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information and betterreflect its core operating activities. In order to arrive at core business operating results, the effects ofcertain noncore business transactions, such as gains and losses on the sales ofsecurities, amortization of intangibles, restructuring charges andmerger-related expenses, have been excluded. Management reviews these same measures internally.  For instance, the cash operating efficiencyratio, rather than the GAAP basis efficiency ratio, is used to measuremanagement’s success at controlling ongoing, core operating expenses.  We believe these measures are consistent withhow investors and analysts typically evaluate our industry, and by providingthese measures, we facilitate their analysis. Cash operating earnings totaled$279.6 million for 2005, an increase of 18.7% over $235.5 millionfor 2004.

 

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.  For the year 2005, the return on averagetangible assets was 1.89% compared with 1.75% for 2004.  The ratio of average tangible equity toaverage tangible assets was 9.70% for 2005 and 2004.  See “Reconciliation of Non-GAAP Measures” forthe reconciliation of GAAP measures to non-GAAP measures in the section captioned“II. ANALYSIS OF OPERATING RESULTS FOR 2005 TO 2004” elsewhere in Item 7.

 

The remaining sections ofManagement’s Discussion and Analysis of Financial Condition and Results ofOperations will provide a more detailed explanation of the important trends andmaterial changes in components of our consolidated financial statements.  The discussion suggests that sustainingfuture earnings growth comparable to our experience in past years will require,among other things, efficient generation of loan growth in a competitivemarket, while maintaining an adequate spread between yields on earning assetsand the cost of funds.  Our degree ofsuccess in meeting these goals depends on unpredictable factors such aspossible changes in prevailing interest rates, the mix of deposits, creditquality and general economic conditions. This discussion and analysis should be read in conjunction with theconsolidated financial statements and other financial information presented inthis Report.

 
| NET INCOME                            |   | DILUTED EARNINGS PER  SHARE           |
|---------------------------------------|--------|---------------------------------------|
| (Dollars in millions)                 |   | (In dollars)                          |
| Five-Year Compound  Growth Rate: 9.5% |   | Five-Year Compound  Growth Rate: 6.1% |
|                                  |   |                                  |
|                                       |   |                                       |

 
| TOTAL  ASSETS                                 |   | INTEREST YIELDS AND  RATES |
|-----------------------------------------------|--------|----------------------------|
| (Dollars in millions)  December 31, 2005 |   | (Tax-equivalent basis)     |
| Five-Year Compound  Growth Rate: 12.9%        |   |                       |
|                                          |   |                       |
|                                               |   |                            |

 

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**Critical Accounting Policies andRelated Estimates**

Set forth below is adiscussion of the accounting policies and related estimates that managementbelieves are the most critical to understanding Bankshares’ consolidatedfinancial statements, financial condition and results of operations, and whichrequire complex management judgments, uncertainties and/or estimates.  Information regarding Bankshares’ otheraccounting policies is included in Note No. 1 (Significant AccountingPolicies) of the financial statements.

 

*Investment Securities*

Investment securitiesclassified as “held-to-maturity” are acquired with the intent and ability tohold until maturity and are carried at cost. Investment securities classified as “available-for-sale” are acquired tobe held for indefinite periods and may be sold in response to changes ininterest rates and/or prepayment risk or for liquidity managementpurposes.  These securities are carriedat fair value.  Securities may becomeimpaired on an other-than-temporary basis, which involves a degree ofjudgment.  Therefore, an assessment ismade at the end of each quarter to determine whether there have been any eventsor economic circumstances to indicate that a security is impaired on another-than-temporary basis.  Another-than-temporary impairment may develop if, based on all availableevidence, the carrying amount of the investment is not recoverable within areasonable period.  Factors considered inmaking this assessment include among others, the intent and ability to hold theinvestment for a period sufficient for a recovery in value, external creditratings and recent downgrades, market price fluctuations due to factors otherthan interest rates, and the probability of collection of contractual cashflows.  Securities on which there is anunrealized loss deemed to be other-than-temporary are written down to fairvalue, and the adjustment is recorded as a realized loss.

 

*Allowance for Loan Losses*

Arriving at an appropriatelevel of allowance for loan losses involves a high degree of judgment.Bankshares’ allowance for loan losses provides for probable losses based onevaluations of known and inherent risks in the loan portfolio.  Management uses historical quantitative informationto assess the adequacy of the allowance for loan losses as well as qualitativeinformation about the prevailing economic and business environment among otherthings.  The allowance for loan losses iscomprised of specific allocations to impaired loans and general allocations topools of loans not deemed impaired that include an unallocated amount.

 

The specific allowanceallocation is based on an analysis of the loan portfolio.  Each loan with an outstanding balance inexcess of a specified threshold that is either in nonaccrual status or on the Watchlistis evaluated.  The Watchlist representsloans identified and closely followed by management.  They possess certain qualities orcharacteristics that may lead to collection and loss issues.  The identified loans are evaluated forpotential loss in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 114, “Accounting for Creditors for Impairment of a Loan” and SFAS No. 118,“Accounting for Creditors for Impairment of a Loan – Income Recognition andDisclosure” by analyzing current collateral values or present value of cashflows, as well as the capacity of the guarantor, as applicable.

 

The general allowancecalculation begins with segmentation of the remaining (unimpaired) portfolioaccording to loan types. Historical loss factors are maintained for each loantype, providing the starting point of the analysis.  Historical loss factors are applied to allnon-Watchlist loans.  Management iscurrently utilizing the past five-year loss history specific to each majorsegment to perform the allocation. Historical loss factors are adjusted to reflect the point in time thatmanagement initially identified a potential impairment loss in such risk-ratedloans as opposed to when such loss is actually taken as a charge-off againstthe allowance.  This adjustment isnecessary, as Bankshares’ practice has generally been to work with itsborrowers through their economic difficulties and record a charge-off when allrecovery efforts have been exhausted. Accordingly, historical losses may tend to lag the national and regionaleconomic cycles.  Bankshares also hasdeveloped data on probability of default and loss given default, which havebeen incorporated for the higher risk rated credits, which include Watchlistloans that are not currently impaired. Those loss factors are then applied to all loans within the same riskrating.  Qualitative factors that maycause credit losses to deviate from average historical experience are thendeveloped.  These include, but are notlimited to: changes in the volume and severity of past due loans; changes inthe volume of Watchlist loans and nonaccruals; concentrations in a specificindustry or geographic location; administrative risk concerns that includechanges in the loan review and loan grading system; changes in lending policiesand procedures (which include underwriting, collection, charge-off and recoverypractices); changes in management or the staff of any previously mentionedareas; and current economic conditions and indicators.  Both internal and external peer data areutilized as applicable to establish these factors.  Management’s judgment and experience are keyto this process.  These factors arerevised to address current conditions and trends in the portfolio.

 

The allowance amount notallocated represents the differential between the combined specific and generalallocations and the actual allowance recorded on the books.  The unallocated allowance recognizes theimprecision inherent in estimating and measuring loss when allocating theallowance to individual, or pools of, loans. It also takes into consideration the allowance level deemed appropriateby each affiliate based on its local knowledge and input from bank regulatorsand their view from the standpoint of safety and soundness, among otherfactors.

 

For a full discussion ofBankshares’ methodology for assessing the adequacy of the allowance for loanlosses, see “Allowance for Loan Losses” found elsewhere in Item 7 and Note No. 1(Significant Accounting Policies) of the financial statements.

 

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*Loans in NonaccrualStatus or Deemed to Be Impaired*

A loan asset will be classified and placedinto nonaccrual status when the principal or interest payments on any loan(e.g., commercial, mortgage and construction loans) are past due 90 days ormore at the end of a calendar quarter or the payment in full of principal orinterest is not expected.  Any accruedbut uncollected interest is reversed at that time.  Consumer installment loans are charged offwhen they become 90 days past due at the end of the quarter.  Additionally, a loan may be put on nonaccrualstatus sooner than 90 days, if in management’s judgment, the loan or portionthereof is deemed uncollectible. Bankshares ceases to accrue interest income on such loans. Subsequentreceipts on nonaccrual loans are recorded as a reduction of principal, andinterest income is recorded only once principal recovery is reasonablyassured.  Generally, a loan may berestored to accrual status when all past due principal, interest and latecharges have been paid and the Bank expects repayment of the remainingcontractual principal and interest.

 

A loan is considered impaired, based on current information and events,if it is probable that Bankshares will not collect all principal and interestpayments according to the contractual terms of the loan agreement.  Impaired loans do not include large groups ofsmaller balance homogeneous loans that are evaluated collectively forimpairment (e.g., residential mortgages and consumer installment loans).  The impairment of a loan is measured based onthe present value of expected future cash flows discounted at the loan’seffective interest rate, or the fair value of the collateral if the repaymentis expected to be provided predominantly by the underlying collateral.  A majority of Bankshares’ impaired loans aremeasured by reference to the fair value of the collateral.

 

*Income Taxes*

Bankshares recognizes deferredincome tax assets and liabilities for the future tax effects of temporarydifferences, net operating loss carryovers and tax credits.  Deferred tax assets are subject tomanagement’s judgment, based on available evidence, that future realization ismore likely than not.  If management determinesthat Bankshares may be unable to realize all or part of net deferred tax assetsin the future, then Bankshares would be required to record a valuationallowance against such deferred tax asset. In such an event, a direct charge to income tax expense may be requiredto reduce the recorded value of the net deferred tax asset to the expectedrealizable amount.  For more informationregarding Bankshares’ accounting for income taxes, see Note No. 12 (IncomeTaxes) of the financial statements.

 

*Valuation of Goodwill/Intangible Assets andAnalysis for Impairment*

Bankshares has increased its market share, in part, through theacquisition of entire financial institutions accounted for under the purchasemethod of accounting, as well as from the purchase of other financialinstitutions’ branches (not the entire institution). Bankshares is required torecord assets acquired and liabilities assumed at their fair value, whichinvolves an estimate determined by the use of internal or other valuationtechniques.  See Note No. 19(Goodwill and Intangible Assets) of the financial statements for furtherinformation on the accounting for goodwill and other intangible assets.

 

II. ANALYSIS OF OPERATING RESULTS FOR 2005 TO 2004

 

##### **Segment Reporting**

Bankshares reports two distinct business segments, Banking andInvestment & Wealth Management, for which financial information issegregated for use in assessing performance and allocating resources whenreporting to the Board of Directors.  TheBanking segment consists of the group of 11 affiliate banks and mortgage-bankingactivities.  A schedule disclosingthe details of these operating segments can be found in Note No. 16(Segment Reporting) of the financial statements.  Segment financial information is subjectiveand, unlike financial accounting, is not necessarily based on GAAP.  As a result, financial information of thereporting segments is not necessarily comparable with similar informationreported by others and may not be comparable with Bankshares’ consolidatedresults.  Certain expense amounts, suchas operations overhead, have been reclassified from internal financialreporting in order to provide for proper allocation of costs in the reporteddata.

 

In the fourth quarter of 2005, the Private Banking Group of MSD&Twas consolidated into the Private Banking Group of IWM.  The segment results have been reclassified toconform to current presentation for comparability.  Additionally, as loans and deposits are nowbeing reflected in the IWM segment, a funds transfer-pricing model was utilizedto match the duration of the funding and investment of the IWM segment’s assetsand liabilities.

 

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*Banking*

The Banking segment includes the Retail, Small Business, Commercial andMortgage Banking lines of business. Banking products include:

 

•                  *Retail Banking*: Checking, savings and money market accounts, time deposits and IRAs,insurance, equity lines and loans, lines of credit, and equipment andtransportation (auto, recreational vehicle and marine) loans.

•                  *Small Business Banking*: Deposit and credit products and services to businesses with annualrevenues up to $3.0 million or credit needs up to $750.0 thousand, includingreceivables and inventory financing, equipment leases, and real estatefinancing.

•                  *Commercial Banking*: Commercial deposit, lending and commercial real estate solutions tobusinesses typically with annual revenues between $4.0 million and $50.0million, and including commercial loans and lines of credit, letters of credit,asset-based lending, commercial real estate, construction loans, capital marketproducts and insurance.

•                  *Mortgage Banking*: Commercial, multi-family and residential mortgage loan origination andservicing.

 

The following table presents selected Banking segment information forthe three years ended December 31, 2005.

 
| **(Dollars in thousands)** | ** ** | **2005**       | ** **     | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------|------------|----------------|----------------|------------|------------|------------|------------|
| Net interest income        | ** ** | **$**          | **609,758**    | ** ** | $          | 534,468    |       | $ | 469,704 |   |
| Provision for loan losses  | ** ** | **(1,576**     | **)**          | (7,221     | )          | (12,105    | )          |
| Noninterest income         | ** ** | **132,154**    | ** **     | 114,477    |       | 98,426     |       |
| Noninterest expenses       | ** ** | **(341,543**   | **)**          | (318,706   | )          | (268,656   | )          |
| Adjustments                | ** ** | **17,610**     | ** **     | 18,098     |       | 9,941      |       |
| Income before income taxes | ** ** | **416,403**    | ** **     | 341,116    |       | 297,310    |       |
| Income tax expense         | ** ** | **(145,044**   | **)**          | (120,253   | )          | (104,815   | )          |
| Net income                 | ** ** | **$**          | **271,359**    | ** ** | $          | 220,863    |       | $ | 192,495 |   |
| Average loans              | ** ** | **$**          | **10,876,592** | ** ** | $          | 9,591,510  |       | $ | 7,969,464 |   |
| Average earning assets     | ** ** | **13,917,161** | ** **     | 12,576,465 |       | 10,966,978 |       |
| Average assets             | ** ** | **15,235,634** | ** **     | 13,413,992 |       | 11,581,942 |       |
| Average deposits           | ** ** | **11,444,361** | ** **     | 10,323,349 |       | 9,010,069  |       |
| Average equity             | ** ** | **1,891,834**  | ** **     | 1,449,355  |       | 1,280,643  |       |
|                            |            |                |                |            |            |            |            |  |  |  |  |

 

In the second quarter of 2005, Bankshares consolidated Fidelity Bankinto Farmers & Mechanics Bank. The consolidation of these banks enables the surviving bank, Farmers &Mechanics, to serve its local customers with greater size and expertise.  Also in the second quarter of 2005,Mercantile Potomac Bank merged into MSD&T. This combination allows Bankshares to provide the capital resourcesnecessary for expansion into the Washington, D.C. and Northern Virginiamarkets.  Further, the merger of CBNVinto the Mercantile Potomac Division of MSD&T was completed in the secondquarter.  Mercantile Potomac Bank andFidelity Bank will continue to serve their respective markets under their ownnames with local leadership and decision-making.

 

In the third quarter of 2004, Bankshares consolidated 11 affiliatebanks into four banks.  The consolidatedbanks shared common markets.  Theconsolidation of these banks enables the surviving banks to serve their localcustomers with greater size, scale and expertise.  This initiative was not undertaken to reduceoperating costs, although some savings arose out of the consolidation.  The initiative was undertaken to enable thesebanks to streamline operating processes, controls and compliance efforts; recruitseasoned professionals to these markets; and provide a greater breadth ofservices at the local level.  Banksharesis committed to the affiliate bank model, whereby local boards of directorsprovide strong oversight, and bank presidents maintain strong relationshipswithin the community. In 2004, Banking incurred approximately $3.6 million inrestructuring charges related to the consolidations. A majority of these costswas in severance charges and other personnel costs of approximately $2.3million, with $1.1 million in legal and consulting fees.

 

The Banking segment, which contributed 86.0% of total revenue,continued to experience strong loan and deposit growth.  The Banking segment was the primarybeneficiary of the CBNV acquisition.  Theaddition of CBNV during 2005 had an impact on nearly every line of theconsolidated balance sheet and statement of consolidated income, as well as theperformance of the Banking segment, as set forth below.  Net income for Banking for 2005 increased22.9% to $271.4 million from $220.9 million for 2004.  The Banking segment’s operating leverageimproved over the comparative period, with revenue growth of 15.4% and expense growthof 7.8%, which includes the addition of CBNV. Net interest income for Bankingincreased 14.1% to $609.8 million for 2005 from $534.5 million for 2004. Thegrowth in net interest income in 2005 was largely attributable to a 13.4%increase in average loans outstanding, with the CBNV acquisition contributingapproximately 32.1% of this growth.  See theanalysis of net interest income included in the section captioned “NetInterest Income and Net Interest Margin” included elsewhere in this document.

 

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As a reflection of the overall improvement in the Banking creditquality trends, Banking recorded a decrease of $5.6 million in the provisionfor loan losses for 2005.  Bankingrecorded a provision for loan losses of $1.6 million in 2005 compared with $7.2million in 2004.  The allowance as apercentage of loans was 1.35% at year-end 2005 compared with 1.46% at year-end2004.

 

Average loans outstanding increased 13.6% to $10.9 billion for2005.  Commercial loans excluding theleasing portfolio (which is in the process of paying down as Bankshares hasreduced the scope of this business) increased 5.0%, while commercial realestate increased 19.0% from the 2004 average. Construction loans increased 28.7%, while consumer loans increased13.0%, from 2004 levels.  Residentialreal estate loans increased 9.1% from 2004.  The CBNV acquisition contributed approximately32.1% of the average loan growth in 2005.

 

Average deposits for Banking increased 10.9% to $11.4 billion in2005.  All deposit categories increasedfrom the 2004 average outstandings.  Thestrongest year-over-year growth was in certificates of deposit,noninterest-bearing deposits and money market deposit accounts with growthpercentages of 19.9%, 9.3% and 8.5%, respectively.  The CBNV acquisition contributedapproximately 34.8% of this deposit growth.

 

The year-over-year increases in noninterest income and noninterestexpenses from 2004 are primarily attributable to the CBNV acquisition,increased deposit activities and branch expansion.  Noninterest income increased by $17.7 millionin 2005, with gains on sales of bank premises increasing $2.7 million, mortgagebanking fees increasing $3.5 million, nonmarketable investments increasing $2.6million, insurance fees increasing $1.8 million and electronic banking feesincreasing $2.2 million.  These gainswere partially offset by a decrease of $0.6 million in deposit servicecharges.  Noninterest expenses increasedby $22.8 million from 2004.  Thisincrease was partially attributable to the $8.2 million in additional operatingexpenses related to the CBNV acquisition. More than 41.0% of the increase in total noninterest expense is relatedto salaries and benefits, which grew by $11.2 million.  Incentive compensation linked to improvedoperating performance increased $7.7 million and pension expense increased $1.3million.  Occupancy expense increased by$3.6 million and electronic banking costs increased by $2.4 million.

 

*Investment & Wealth Management*

IWMincludes Retail Brokerage Services, Private Wealth Management, InstitutionalInvestment Management, Private Banking and Mercantile Funds.  IWM provides a full line of investmentproducts and retirement, tax and estate planning services. IWM productsinclude:

 

•                  *Retail Brokerage Services*: Stocks, bonds, proprietary andnonproprietary mutual funds, fixed and variable annuities.

•                  *Private Wealth Management Services*: Proprietary andnonproprietary mutual funds, proprietary and nonproprietary separate accountmanagement, customized wealth advisory services, defined benefit and definedcontribution retirement services, family office services, individual andinstitutional trust services and custody services.

•                  *Institutional Investment Management*:  Sophisticated investment management andadministrative services for employee retirement plans, profit-sharing plans andendowments.

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

•                  *Mercantile Funds*: Proprietary stock, taxable and nontaxable fixed income, money marketmutual funds and registered hedge funds of funds.

 

The following table presents selected IWM segment information for thethree years ended December 31, 2005.

 
| **(Dollars in thousands)** | ** ** | **2005**    | ** **  | **2004**   | ** ** | **2003** | ** ** |
|----------------------------|------------|-------------|-------------|------------|------------|----------|------------|
| Net interest income        | ** ** | **$**       | **7,819**   | ** ** | $          | 10,172   |       | $ | 7,803 |   |
| Provision for loan losses  | ** ** | **—**  | ** **  | —     |       | —   |       |
| Noninterest income         | ** ** | **95,958**  | ** **  | 90,516     |       | 78,608   |       |
| Noninterest expenses       | ** ** | **(72,929** | **)**       | (69,575    | )          | (63,870  | )          |
| Adjustments                | ** ** | **(3,885**  | **)**       | (3,603     | )          | (3,483   | )          |
| Income before income taxes | ** ** | **26,963**  | ** **  | 27,510     |       | 19,058   |       |
| Income tax expense         | ** ** | **(10,785** | **)**       | (11,004    | )          | (7,623   | )          |
| Net income                 | ** ** | **$**       | **16,178**  | ** ** | $          | 16,506   |       | $ | 11,435 |   |
| Average loans              | ** ** | **$**       | **152,572** | ** ** | $          | 127,739  |       | $ | 119,285 |   |
| Average earning assets     | ** ** | **152,572** | ** **  | 127,739    |       | 119,285  |       |
| Average assets             | ** ** | **152,941** | ** **  | 127,949    |       | 119,501  |       |
| Average deposits           | ** ** | **199,159** | ** **  | 175,096    |       | 132,575  |       |
| Average equity             | ** ** | **34,354**  | ** **  | 31,219     |       | 28,834   |       |

 

In the fourth quarter of 2005, the Private Banking Group of MSD&Twas consolidated into the Private Banking Group of IWM.  The segment results have been reclassified toconform to current presentation for comparability.  Additionally, as loans and deposits are nowbeing reflected in the IWM segment, a funds transfer-pricing model was utilizedto match the duration of the funding and investment of the IWM’s segment assetsand liabilities.

 

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Ongoingprogress was made in expanding the IWM business and upgrading client services.  Resources related to new business developmentand client service were added.  Productbreadth was enhanced with the expansion of the open architecture platform thatprovides clients with access to a selected group of external separate accountmanagers and mutual funds to complement Bankshares’ proprietary products.  Resources were also added in the DC/Virginiamarket, and Bankshares’ acquisition of CBNV has provided a larger distributionnetwork in Northern Virginia.

 

Netincome in IWM decreased slightly to $16.2 million in 2005, from $16.5 millionin 2004 primarily due to a reduction in net interest income in the PrivateBanking Group.  Net interest incomedeclined due to lower earnings attributed to noninterest-bearing demand depositaccounts due to greater volatility in customer balances during 2005.  Excluding the Private Banking Group, IWM netincome increased $1.3 million, or 11.5%, from the previous year.  Pretax profit margins, prior to corporateoverhead allocation, were 29.9% and 31.1% for 2005 and 2004, respectively.

 

The rise in equity markets immediately following the November 2004election was sustained through most of 2005. While the S&P 500 ended 2005 only 2.8% ahead of December 2004,most months during the year were 4.0% to 6.0% ahead of the comparable month in2004.  Other major indices had mixedresults.  Between December 31, 2004and December 31, 2005, the Dow Jones Industrial Average was down 0.6% andthe Nasdaq was up 1.4%.  In fixed incomemarkets, the Lehman Aggregate Bond Index was down 2.5% for the year.  Given the relatively balanced weighting ofequities and fixed income within Bankshares’ investment asset base, the marketsoverall provided a modest boost in 2005. As of December 31, 2005, 44% of IWM’s managed assets were investedin equities, including real estate. Approximately 38% of IWM’s managed assets were invested in fixed incomesecurities and 18% were invested in cash and other.

 
| ** **                              | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|
| **Market Indices**                      | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dow Jones Industrial Average            | ** ** | **10717**                   |       | 10783 |   | 10454 |   |
| Year-over-Year % Change                 | ** ** | **-0.6**                    |       | 3.1 |   | 25.3 |   |
| S&P 500 Index-period-end            | ** ** | **1248**                    |       | 1214 |   | 1112 |   |
| Year-over-Year % Change                 | ** ** | **2.8**                     |       | 9.0 |   | 26.4 |   |
| Nasdaq                                  | ** ** | **2205**                    |       | 2175 |   | 2003 |   |
| Year-over-Year % Change                 | ** ** | **1.4**                     |       | 8.6 |   | 50.0 |   |
| Lehman Brothers US Aggregate Bond Index | ** ** | **101.9**                   |       | 104.6 |   | 106.0 |   |
| Year-over-Year % Change                 | ** ** | **-2.5**                    |       | -1.3 |   | -1.9 |   |

 

Revenuesincreased $3.1 million, or 3.1%, to $103.8 million in 2005 from $100.7 millionin 2004.  Revenue increases were realizedin Private Wealth Management, Institutional Investment Management, MercantileFunds, and Brokerage.  Revenues declinedin Private Banking despite strong loan and deposit growth.  Growth in IWM revenues was principally due tostronger equity and real estate markets during 2005 compared with 2004,increased new sales in Private Wealth Management and increased brokerageactivity.

 

Private Wealth Management benefited from a modest improvement in theequity markets, 19% growth in annualized revenues from new sales compared withthe prior year and the addition of new assets at higher fees than theprevailing average.  These trends werepartially offset by a decline in income-related fees associated with thecurrent low interest rate environment. The increase in revenues partially reflects a $0.3 billion, or 2.1%,increase in Personal Assets Under Administration to $12.5 billion.  Personal Assets with InvestmentResponsibility increased $0.1 billion, or 1.5%, to $8.7 billion, while Assetswith No Investment Responsibility increased $0.2 billion, or 4.5%,to $3.8 billion.

 

Institutional Investment Management benefited from an increase in realestate pension fees.  This was partiallyoffset by a decline in the revenues of our Boyd Watterson Asset Management (“BoydWatterson”) subsidiary and the loss of one significant account in the custodyarea.  The decline in revenues at BoydWatterson is primarily attributable to a decline in equity assets undermanagement and the spin-off of one part of its business.  Total Institutional Assets Under Administration(including Boyd Watterson) declined $1.6 billion, or 4.5%, to $33.7billion.  Institutional Assets withInvestment Responsibility declined $0.6 billion, or 4.9%, to$11.6 billion.  Assets UnderAdministration with No Investment Responsibility declined $1.0 billion, or4.3%, to $22.1 billion.

 

The Mercantile Funds benefited from higher assets flows into the fundsand improved equity markets.  MercantileFund assets increased $0.1 billion, or 3.2%, to $3.9 billion, driven by an11.0% increase in personal trust assets. Brokerage commissions and income benefited from growth in the number ofaccounts and assets held in accounts. Brokerage assets increased 14.0% to $1.0 billion.  In the table below, Mutual Fund assets andBrokerage assets have been allocated to Personal and Institutional.

 

27

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| ** **                               | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in billions)**                | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| *Personal*                               |       |                             |       |   |   |   |   |
| Assets with Investment Responsibility    | ** ** | **$**                            | **8.7**    |   | $ | 8.7 |   | $ | 8.7 |   |
| Assets with No Investment Responsibility | ** ** | **3.8**                          |       | 3.6 |   | 3.3 |   |
| Total  Personal                          | ** ** | **12.5**                         |       | 12.3 |   | 12.0 |   |
| *Institutional*                          |       |                             |       |   |   |   |   |
| Assets with Investment Responsibility    | ** ** | **11.6**                         |       | 12.2 |   | 12.2 |   |
| Assets with No Investment Responsibility | ** ** | **22.1**                         |       | 23.1 |   | 21.6 |   |
| Total  Institutional                     | ** ** | **33.7**                         |       | 35.3 |   | 33.8 |   |
|                                     | ** ** | ** **                       |       |   |   |   |   |
| *Mutual Funds Not included Above*        | ** ** | **0.3**                          |       | 0.2 |   | 0.2 |   |
| *Total*                                  |       |                             |       |   |   |   |   |
| * *                                 |       |                             |       |   |   |   |   |
| Assets with Investment Responsibility    | ** ** | **20.6**                         |       | 21.1 |   | 21.1 |   |
| Assets with No Investment Responsibility | ** ** | **25.9**                         |       | 26.7 |   | 24.9 |   |
| Total Assets  Under Administration       | ** ** | **$**                            | **46.5**   |   | $ | 47.8 |   | $ | 46.0 |   |

 

At December 31, 2005, Assets Under Administration by IWM were$46.5 billion, a decrease of $1.3 billion, or 2.7%, from the prior year.  Bankshares had investment responsibility for$20.6 billion, down $0.5 billion, or 2.4%, compared with the prior year. Additionalrevenue growth will depend on continued new sales and increased distribution,equity and bond market conditions and acquisitions, if any.

 

In 2005, expenses increased 4.8%, or $3.3 million, to $72.9 million,compared with $69.6 million in 2004. Increases in personnel-related, technologyand occupancy expenses were offset by decreases in professional services,travel and marketing expenses.

 

28

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Bankshares Earnings Performance

 

ANALYSIS OF INTEREST RATES AND INTEREST DIFFERENTIALS

The following table presents the distribution of the averageconsolidated balance sheets, interest income/expense and yields earned andrates paid.

 
| ** **                                              | ** ** | **2005**       | ** **     | **2004**       | ** **  |
|---------------------------------------------------------|------------|----------------|----------------|----------------|-------------|
| ** **                                              | ** ** | **Average**    | ** **     | **Income (1)** | ** **  | **Yield (1)** | ** ** | **Average** | ** ** | **Income (1)** | ** ** | **Yield (1)** | ** ** |
| **(Dollars in thousands)**                              | ** ** | **Balance**    | ** **     | **/ Expense**  | ** **  | **/ Rate** | ** ** | **Balance** | ** ** | **/ Expense** | ** ** | **/ Rate** | ** ** |
| Earning  assets                                         |       |           |           |           |        |   |   |   |   |   |   |   |   |
| Loans: (2)                                              |       |           |           |           |        |   |   |   |   |   |   |   |   |
| Commercial  and leasing                                 | ** ** | **$**          | **2,900,598**  | ** **     | **$**       | **186,462** | ** ** | **6.43** | % | $ | 2,725,452 |   | $ | 145,170 |   | 5.33 | % |
| Commercial  real estate                                 | ** ** | **3,444,921**  | ** **     | **226,356**    | ** **  | **6.57** |   | 2,927,968 |   | 173,626 |   | 5.93 |   |
| Construction                                            | ** ** | **1,473,353**  | ** **     | **102,484**    | ** **  | **6.96** |   | 1,144,044 |   | 62,508 |   | 5.46 |   |
| Residential  real estate                                | ** ** | **1,761,955**  | ** **     | **105,312**    | ** **  | **5.98** |   | 1,643,504 |   | 98,596 |   | 6.00 |   |
| Home equity  lines                                      | ** ** | **507,153**    | ** **     | **30,692**     | ** **  | **6.05** |   | 450,244 |   | 20,222 |   | 4.49 |   |
| Consumer                                                | ** ** | **941,571**    | ** **     | **54,283**     | ** **  | **5.77** |   | 828,197 |   | 50,940 |   | 6.15 |   |
| Total loans                                             | ** ** | **11,029,551** | ** **     | **705,589**    | ** **  | **6.40** |   | 9,719,409 |   | 551,062 |   | 5.67 |   |
| Federal  funds sold, et al                              | ** ** | **51,826**     | ** **     | **2,434**      | ** **  | **4.70** |   | 59,848 |   | 1,501 |   | 2.51 |   |
| Securities:  (3)                                        |       |           |           |           |        |   |   |   |   |   |   |   |   |
| Taxable  securities                                     |       |           |           |           |        |   |   |   |   |   |   |   |   |
| U.S.  Treasury                                          | ** ** | **494,763**    | ** **     | **17,906**     | ** **  | **3.62** |   | 741,127 |   | 28,710 |   | 3.87 |   |
| U.S.  Government agencies                               | ** ** | **922,597**    | ** **     | **30,143**     | ** **  | **3.27** |   | 810,014 |   | 28,554 |   | 3.53 |   |
| Mortgage-backed                                         | ** ** | **1,418,144**  | ** **     | **59,084**     | ** **  | **4.17** |   | 1,250,947 |   | 48,159 |   | 3.85 |   |
| Other  investments                                      | ** ** | **63,067**     | ** **     | **2,497**      | ** **  | **3.96** |   | 57,193 |   | 2,389 |   | 4.18 |   |
| Tax-exempt  securities                                  |       |           |           |           |        |   |   |   |   |   |   |   |   |
| States and  political subdivisions                      | ** ** | **87,992**     | ** **     | **5,229**      | ** **  | **5.94** |   | 94,308 |   | 5,404 |   | 5.73 |   |
| Total  securities                                       | ** ** | **2,986,563**  | ** **     | **114,859**    | ** **  | **3.85** |   | 2,953,589 |   | 113,216 |   | 3.83 |   |
| Interest-bearing  deposits in other banks               | ** ** | **197**        | ** **     | **2**          | ** **  | **1.21** |   | 158 |   | 2 |   | 1.17 |   |
| Total  earning assets                                   | ** ** | **14,068,137** | ** **     | **822,884**    | ** **  | **5.85** |   | 12,733,004 |   | 665,781 |   | 5.23 |   |
| Cash and due  from banks                                | ** ** | **309,646**    |           |           |        |   |   | 291,540 |   |   |   |   |   |
| Bank  premises and equipment, net                       | ** ** | **143,177**    |           |           |        |   |   | 141,368 |   |   |   |   |   |
| Other assets                                            | ** ** | **1,154,561**  |           |           |        |   |   | 985,222 |   |   |   |   |   |
| Less:  allowance for loan losses                        | ** ** | **(154,502**   | )              |           |        |   |   | (158,163 | )  |   |   |   |   |
| Total assets                                            | ** ** | **$**          | **15,521,019** |           |        |   |   |   | $ | 13,992,971 |   |   |   |   |   |
| Interest-bearing  liabilities                           |       |           |           |           |        |   |   |   |   |   |   |   |   |
| Deposits:                                               |       |           |           |           |        |   |   |   |   |   |   |   |   |
| Savings                                                 | ** ** | **$**          | **1,428,445**  | ** **     | **5,545**   | ** ** | **0.39** |   | $ | 1,425,423 |   | 4,197 |   | 0.29 |   |
| Checking  plus interest accounts                        | ** ** | **1,399,215**  | ** **     | **2,367**      | ** **  | **0.17** |   | 1,289,295 |   | 1,899 |   | 0.15 |   |
| Money market                                            | ** ** | **1,651,513**  | ** **     | **23,036**     | ** **  | **1.39** |   | 1,571,462 |   | 9,584 |   | 0.61 |   |
| Time  deposits $100,000 and over                        | ** ** | **1,627,194**  | ** **     | **51,714**     | ** **  | **3.18** |   | 1,314,423 |   | 26,101 |   | 1.99 |   |
| Other time  deposits                                    | ** ** | **2,142,068**  | ** **     | **57,255**     | ** **  | **2.67** |   | 1,933,799 |   | 41,622 |   | 2.15 |   |
| Total  interest-bearing deposits                        | ** ** | **8,248,435**  | ** **     | **139,917**    | ** **  | **1.70** |   | 7,534,402 |   | 83,403 |   | 1.11 |   |
| Short-term  borrowings                                  | ** ** | **1,105,988**  | ** **     | **26,266**     | ** **  | **2.37** |   | 932,493 |   | 7,844 |   | 0.84 |   |
| Long-term  debt                                         | ** ** | **749,196**    | ** **     | **32,728**     | ** **  | **4.37** |   | 645,375 |   | 22,009 |   | 3.41 |   |
| Total interest-bearing  funds                           | ** ** | **10,103,619** | ** **     | **198,911**    | ** **  | **1.97** |   | 9,112,270 |   | 113,256 |   | 1.24 |   |
| Noninterest-bearing  deposits                           | ** ** | **3,165,320**  |           |           |        |   |   | 2,879,290 |   |   |   |   |   |
| Other  liabilities and accrued expenses                 | ** ** | **155,663**    |           |           |        |   |   | 129,741 |   |   |   |   |   |
| Total  liabilities                                      | ** ** | **13,424,602** |           |           |        |   |   | 12,121,301 |   |   |   |   |   |
| Shareholders’  equity                              | ** ** | **2,096,417**  |           |           |        |   |   | 1,871,670 |   |   |   |   |   |
| Total  liabilities & shareholders’ equity | ** ** | **$**          | **15,521,019** |           |        |   |   |   | $ | 13,992,971 |   |   |   |   |   |
| Net interest  rate spread                               | ** ** | ** **     | ** **     | **$**          | **623,973** |   | **3.88** | % |   |   | $ | 552,525 |   | 3.99 | % |
| Effect of  noninterest-bearing funds                    | ** ** | ** **     |           |           |        | **0.56** |   |   |   |   |   | 0.36 |   |
| Net interest  margin on earning assets                  | ** ** | ** **     |           |           |        | **4.44** | % |   |   |   |   | 4.35 | % |
| Tax-equivalent  adjustment included in:                 |       |           |           |           |        |   |   |   |   |   |   |   |   |
| Loan income                                             | ** ** | ** **     |           | **$**          | **4,757**   |   |   |   |   |   | $ | 4,531 |   |   |   |
| Investment  securities income                           | ** ** | ** **     |           | **2,090**      |        |   |   |   |   | 2,213 |   |   |   |
| Total                                                   | ** ** | ** **     |           | **$**          | **6,847**   |   |   |   |   |   | $ | 6,744 |   |   |   |

 

29

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| ** **                                             | ** ** | **2003**    | ** ** | **2002**       | ** ** | **2001**      | ** ** |
|--------------------------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|
| ** **                                             | ** ** | **Average** | ** ** | **Income (1)** | ** ** | **Yield (1)** | ** ** | **Average** | ** ** | **Income (1)** | ** ** | **Yield (1)** | ** ** | **Average** | ** ** | **Income (1)** | ** ** | **Yield (1)** | ** ** |
| **(Dollars  in thousands)**                            | ** ** | **Balance** | ** ** | **/ Expense**  | ** ** | **/ Rate**    | ** ** | **Balance** | ** ** | **/ Expense** | ** ** | **/ Rate** | ** ** | **Balance** | ** ** | **/ Expense** | ** ** | **/ Rate** | ** ** |
| Earning assets                                         |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans: (2)                                             |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and leasing                                 |       | $           | 2,478,707  |           | $          | 135,186       |       | 5.45 | % | $ | 2,367,328 |   | $ | 148,380 |   | 6.27 | % | $ | 2,407,097 |   | $ | 190,143 |   | 7.90 | % |
| Commercial real estate                                 |       | 2,316,627   |       | 142,166        |       | 6.14          |       | 1,915,994 |   | 130,995 |   | 6.84 |   | 1,571,238 |   | 127,848 |   | 8.14 |   |
| Construction                                           |       | 929,939     |       | 50,324         |       | 5.41          |       | 733,237 |   | 44,667 |   | 6.09 |   | 795,931 |   | 63,359 |   | 7.96 |   |
| Residential real estate                                |       | 1,350,034   |       | 88,292         |       | 6.54          |       | 1,247,859 |   | 91,592 |   | 7.34 |   | 1,229,755 |   | 98,464 |   | 8.01 |   |
| Home equity lines                                      |       | 311,037     |       | 13,899         |       | 4.47          |       | 215,411 |   | 11,122 |   | 5.16 |   | 175,549 |   | 13,892 |   | 7.91 |   |
| Consumer                                               |       | 702,638     |       | 47,973         |       | 6.83          |       | 609,015 |   | 46,744 |   | 7.68 |   | 653,286 |   | 54,486 |   | 8.34 |   |
| Total loans                                            |       | 8,088,982   |       | 477,840        |       | 5.91          |       | 7,088,844 |   | 473,500 |   | 6.68 |   | 6,832,856 |   | 548,192 |   | 8.02 |   |
| Federal funds sold, et al                              |       | 250,462     |       | 3,337          |       | 1.33          |       | 178,624 |   | 4,833 |   | 2.71 |   | 141,245 |   | 5,968 |   | 4.38 |   |
| Securities: (3)                                        |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable securities                                     |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                                          |       | 1,021,513   |       | 41,233         |       | 4.04          |       | 1,478,387 |   | 67,531 |   | 4.57 |   | 1,366,245 |   | 73,653 |   | 5.39 |   |
| U.S. Government agencies                               |       | 709,519     |       | 32,399         |       | 4.57          |       | 610,617 |   | 30,072 |   | 4.92 |   | 339,298 |   | 19,812 |   | 5.84 |   |
| Mortgage-backed                                        |       | 927,235     |       | 36,135         |       | 3.90          |       | 216,391 |   | 12,096 |   | 5.59 |   | 48,203 |   | 3,599 |   | 7.47 |   |
| Other investments                                      |       | 20,804      |       | 807            |       | 3.88          |       | 9,131 |   | 628 |   | 6.88 |   | 8,823 |   | 736 |   | 8.34 |   |
| Tax-exempt securities                                  |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions                      |       | 69,888      |       | 4,543          |       | 6.50          |       | 38,799 |   | 3,135 |   | 8.08 |   | 40,359 |   | 3,298 |   | 8.17 |   |
| Total securities                                       |       | 2,748,959   |       | 115,117        |       | 4.19          |       | 2,353,325 |   | 113,462 |   | 4.82 |   | 1,802,928 |   | 101,098 |   | 5.61 |   |
| Interest-bearing deposits in other banks               |       | 9,085       |       | 60             |       | 0.66          |       | 358 |   | 15 |   | 4.12 |   | 365 |   | 18 |   | 4.98 |   |
| Total earning assets                                   |       | 11,097,488  |       | 596,354        |       | 5.37          |       | 9,621,151 |   | 591,810 |   | 6.15 |   | 8,777,394 |   | 655,276 |   | 7.47 |   |
| Cash and due from banks                                |       | 266,173     |       |           |       |          |       | 227,034 |   |   |   |   |   | 215,852 |   |   |   |   |   |
| Bank premises and equipment, net                       |       | 118,071     |       |           |       |          |       | 101,660 |   |   |   |   |   | 102,993 |   |   |   |   |   |
| Other assets                                           |       | 637,461     |       |           |       |          |       | 314,511 |   |   |   |   |   | 273,444 |   |   |   |   |   |
| Less: allowance for loan losses                        |       | (147,612)   |       |           |       |          |       | (140,899 | ) |   |   |   |   | (142,481 | ) |   |   |   |   |
| Total assets                                           |       | $           | 11,971,581 |           |       |          |       |   | $ | 10,123,457 |   |   |   |   |   | $ | 9,227,202 |   |   |   |   |   |
| Interest-bearing liabilities                           |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                              |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                                |       | $           | 1,168,074  |           | 4,702      |          | 0.40       |   | $ | 966,283 |   | 8,405 |   | 0.87 |   | $ | 853,911 |   | 12,899 |   | 1.51 |   |
| Checking plus interest accounts                        |       | 1,071,877   |       | 2,061          |       | 0.19          |       | 873,497 |   | 2,908 |   | 0.33 |   | 771,186 |   | 5,255 |   | 0.68 |   |
| Money market                                           |       | 1,357,234   |       | 9,757          |       | 0.72          |       | 1,096,417 |   | 14,223 |   | 1.30 |   | 846,577 |   | 21,839 |   | 2.58 |   |
| Time deposits $100,000 and over                        |       | 1,272,327   |       | 29,464         |       | 2.32          |       | 1,080,347 |   | 34,671 |   | 3.21 |   | 1,145,569 |   | 62,350 |   | 5.44 |   |
| Other time deposits                                    |       | 1,852,622   |       | 47,206         |       | 2.55          |       | 1,759,160 |   | 62,362 |   | 3.54 |   | 1,812,589 |   | 97,360 |   | 5.37 |   |
| Total interest-bearing deposits                        |       | 6,722,134   |       | 93,190         |       | 1.39          |       | 5,775,704 |   | 122,569 |   | 2.12 |   | 5,429,832 |   | 199,703 |   | 3.68 |   |
| Short-term borrowings                                  |       | 851,348     |       | 5,604          |       | 0.66          |       | 845,938 |   | 11,259 |   | 1.33 |   | 744,907 |   | 25,120 |   | 3.37 |   |
| Long-term debt                                         |       | 517,386     |       | 18,451         |       | 3.57          |       | 279,471 |   | 10,754 |   | 3.85 |   | 117,823 |   | 6,702 |   | 5.69 |   |
| Total interest-bearing funds                           |       | 8,090,868   |       | 117,245        |       | 1.45          |       | 6,901,113 |   | 144,582 |   | 2.10 |   | 6,292,562 |   | 231,525 |   | 3.68 |   |
| Noninterest-bearing deposits                           |       | 2,269,720   |       |           |       |          |       | 1,856,706 |   |   |   |   |   | 1,618,838 |   |   |   |   |   |
| Other liabilities and accrued expenses                 |       | 113,848     |       |           |       |          |       | 107,671 |   |   |   |   |   | 118,744 |   |   |   |   |   |
| Total liabilities                                      |       | 10,474,436  |       |           |       |          |       | 8,865,490 |   |   |   |   |   | 8,030,144 |   |   |   |   |   |
| Shareholders’ equity                              |       | 1,497,145   |       |           |       |          |       | 1,257,967 |   |   |   |   |   | 1,197,058 |   |   |   |   |   |
| Total liabilities & shareholders’ equity |       | $           | 11,971,581 |           |       |          |       |   | $ | 10,123,457 |   |   |   |   |   | $ | 9,227,202 |   |   |   |   |   |
| Net interest rate spread                               |       |        |       | $              | 479,109    |          | 3.92       | % |   |   | $ | 447,228 |   | 4.05 | % |   |   | $ | 423,751 |   | 3.79 | % |
| Effect of noninterest-bearing funds                    |       |        |       |           |       | 0.40          |       |   |   |   |   | 0.60 |   |   |   |   |   | 1.04 |   |
| Net interest margin on earning assets                  |       |        |       |           |       | 4.32          | %          |   |   |   |   | 4.65 | % |   |   |   |   | 4.83 | % |
| Tax-equivalent adjustment included in:                 |       |        |       |           |       |          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loan income                                            |       |        |       | $              | 4,897      |          |       |   |   |   | $ | 4,822 |   |   |   |   |   | $ | 4,950 |   |   |   |
| Investment securities income                           |       |        |       | 1,863          |       |          |       |   |   | 1,371 |   |   |   |   |   | 1,474 |   |   |   |
| Total                                                  |       |        |       | $              | 6,760      |          |       |   |   |   | $ | 6,193 |   |   |   |   |   | $ | 6,424 |   |   |   |

 

----

(1)  Presented on a tax-equivalent basis using the statutoryfederal corporate income tax rate of 35%. See “Reconciliation ofNon-GAAP Measures.”

(2)  Nonaccrual loans are included in the respective averageloan balances.

(3)  Averageinvestment securities are reported at amortized cost and exclude unrealizedgains (losses) on securities available-for-sale.

(4)  Loan fees of $12.4 million, $11.1 million, $9.3 million,$9.7 million and $9.2 million for 2005, 2004, 2003, 2002 and 2001,respectively, are included for rate calculation purposes.

 

30

----

 

**Net Interest Income and Net Interest Margin**

Net interest income represents the largest source of Bankshares’revenue.  Changes in both the level ofinterest rates and the amount and composition of interest-earning assets andinterest-bearing liabilities affect it. Interest rate risk represents one of the more significant risks facingfinancial institutions like Bankshares. See additional discussion under the caption “Interest Rate Risk” in section ”III.ANALYSIS OF FINANCIAL CONDITION.”  It ismeasured in terms of the effect changes in market interest rates have on netinterest income.  Bankshares is slightlyasset sensitive, with assets repricing more quickly than liabilities inresponse to changes in interest rates. In a rising rate environment, Bankshares’ net interest margin (netinterest income expressed as a percent of average earning assets) expands,causing the growth in net interest income to accelerate.  Net interest income, on a fullytax-equivalent basis, was $624.0 million for 2005.  This represents an increase of 12.9%, or$71.4 million, over the prior year’s $552.5 million.  In 2004, fully tax-equivalent net interestincome increased by $73.4 million, or 15.3%, over 2003.  As previously noted, net interest income isaffected by changes in the volume of earning assets and the net interest marginearned thereon.  The “Rate/VolumeAnalysis” table presents further details supporting this discussion.

 

Average earning assets increased by $1.3 billion, or 10.5%, in 2005,due in part to the CBNV acquisition. Average total loans grew $1.3 billion, or 13.5%, during 2005, of whichthe CBNV acquisition contributed approximately 32.1%, compared with an increaseof $1.6 billion, or 14.7% in 2004, which included a full year of the Farmersacquisition.  Average securities, theother major component of earning assets, increased by $33.0 million, or 1.1%,in 2005 compared with an increase of $204.6 million, or 7.4%, in the prioryear.  The slowing growth of theinvestment portfolio in 2005 is attributable to liquidity used to fund additionalloan growth.  See the following section ”III.ANALYSIS OF FINANCIAL CONDITION” for a more in-depth discussion of balancesheet trends.  The overall growth inaverage earning assets added $60.4 million to net interest income in 2005.

 

Also contributing to the increase in net interest income was a 9 basispoint increase in the net interest margin from 4.35% in 2004 to 4.44% in 2005,compared with a 3 basis-point increase from 4.32% in 2003.  The increase was attributable to a 20 basispoint increase in the benefit derived from noninterest-bearing sources offunds, which was partially offset by an 11 basis point decline in the spreadbetween the yield on earning assets and the cost of interest-bearingliabilities.  The benefit fromnoninterest-bearing funds increased due primarily to a $343.8 million increasein net noninterest-bearing funds and the rising rate environment.  The decline in the net interest spreadresulted from intensified competitive pressure on deposit pricing and theflatness of the yield curve, which caused the overall yield on the investmentportfolio to lag the increase in funding costs. The net improvement in the netinterest margin of 9 basis points added $11.0 million to net interest income in2005.

 

During 2005, the Federal Reserve Board raised rates eight times, for atotal increase of 200 basis points, and the yield curve flatteneddramatically.  At December 31, 2004,the spread between the 10-year and two-year Treasury note rates was 115 basispoints, and by December 31, 2005, the spread had inverted to a negative 2basis points.

 

Looking forward to 2006, management anticipates a moderate increase inshort-term interest rates in the near term. Given the current rate environment,the shape of the yield curve and the competitive dynamic, it is difficult topredict how these pressures will affect the net interest margin.  Management feels that Bankshares’ balancesheet is relatively well positioned with respect to Federal Reserve Boardinterest rate changes; however, competition for customers is expected to remainintense.  As Bankshares expands in newmarkets, it is possible that spreads and margins may compress due to loan anddeposit pricing competition and the effort to achieve sensible growth fromsmall existing market positions.  Foradditional information regarding interest rate sensitivity, see the discussionunder “Interest Rate Risk” in “III. ANALYSIS OF FINANCIAL CONDITION.”

 

| SOURCES OF  INCOME     |       | ** **             | USES OF  INCOME |   | ** ** |
|------------------------|------------|------------------------|-----------------|--------|------------|
| (Dollars in  millions) | ** ** | (Dollars in  millions) | ** **      |
|                        | ** ** |                        | ** **      |

 

 

 

31

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RATE/VOLUME ANALYSIS

 

A rate/volume analysis, which demonstrates changes in tax-equivalentinterest income and expense for significant assets and liabilities, appearsbelow.  The calculation of rate andvolume variances is based on a procedure established for banks by theSecurities and Exchange Commission.

 
| ** **                                | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|
| ** **                                | ** ** | **2005 vs. 2004**           | ** ** | **2004 vs. 2003** | ** ** |
| ** **                                | ** ** | **Due to variances in**     | ** ** | **Due to variances in** | ** ** |
| **(Dollars in thousands)**                | ** ** | **Total**                   | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** |
| Interest earned on:                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Loans:                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Commercial  and leasing (1)               |       | $                           | 41,292     |   | $ | 30,033 |   | $ | 11,259 |   | $ | 9,984 |   | $ | (3,159 | ) | $ | 13,143 |   |
| Commercial  real estate (2)               |       | 52,730                      |       | 18,762 |   | 33,968 |   | 31,460 |   | (4,792 | ) | 36,252 |   |
| Construction  (3)                         |       | 39,976                      |       | 17,070 |   | 22,906 |   | 12,184 |   | 486 |   | 11,698 |   |
| Residential  real estate                  |       | 6,716                       |       | (364 | ) | 7,080 |   | 10,304 |   | (7,302 | ) | 17,606 |   |
| Home equity  lines                        |       | 10,470                      |       | 7,026 |   | 3,444 |   | 6,323 |   | 71 |   | 6,252 |   |
| Consumer                                  |       | 3,343                       |       | (3,193 | ) | 6,536 |   | 2,967 |   | (4,756 | ) | 7,723 |   |
| Taxable  securities (4)                   |       | 1,818                       |       | 332 |   | 1,486 |   | (2,762 | ) | (10,200 | ) | 7,438 |   |
| Tax-exempt  securities (4)                |       | (175                        | )          | 200 |   | (375 | ) | 861 |   | (726 | ) | 1,587 |   |
| Federal  funds sold, et al                |       | 933                         |       | 1,310 |   | (377 | ) | (1,836 | ) | 704 |   | (2,540 | ) |
| Interest-bearing  deposits in other banks |       | —                      |       | — |   | — |   | (58 | ) | 1 |   | (59 | ) |
| Total  interest income                    |       | 157,103                     |       | 71,176 |   | 85,927 |   | 69,427 |   | (29,673 | ) | 99,100 |   |
|                                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Interest paid on:                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Savings  deposits                         |       | 1,348                       |       | 1,336 |   | 12 |   | (505 | ) | (1,541 | ) | 1,036 |   |
| Checking  plus interest deposits          |       | 468                         |       | 282 |   | 186 |   | (162 | ) | (580 | ) | 418 |   |
| Money market  accounts                    |       | 13,452                      |       | 12,335 |   | 1,117 |   | (173 | ) | (1,713 | ) | 1,540 |   |
| Time  deposits $100,000 and over          |       | 25,613                      |       | 15,673 |   | 9,940 |   | (3,363 | ) | (4,338 | ) | 975 |   |
| Other time  deposits                      |       | 15,633                      |       | 10,066 |   | 5,567 |   | (5,584 | ) | (7,652 | ) | 2,068 |   |
| Short-term  borrowings                    |       | 18,422                      |       | 14,302 |   | 4,120 |   | 2,240 |   | 1,706 |   | 534 |   |
| Long-term  debt                           |       | 10,719                      |       | 6,184 |   | 4,535 |   | 3,558 |   | (1,006 | ) | 4,564 |   |
| Total  interest expense                   |       | 85,655                      |       | 60,178 |   | 25,477 |   | (3,989 | ) | (15,124 | ) | 11,135 |   |
| Net interest earned                       |       | $                           | 71,448     |   | $ | 10,998 |   | $ | 60,450 |   | $ | 73,416 |   | $ | (14,549 | ) | $ | 87,965 |   |
|                                           |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Tax-equivalent adjustments of $3.1 million for 2005, 2004 and2003 are included in the calculation of commercial loan rate variances.

(2) Tax-equivalent adjustments of $0.6 million for 2005 and $0.5million for both 2004 and 2003 are included in the calculation of commercialreal estate loan rate variances.

(3) Tax-equivalent adjustments of $1.0 million for 2005, $0.9million for 2004 and $1.3 million for 2003 are included in the calculation ofconstruction loan rate variances.

(4) Tax-equivalent adjustments of $2.1 million for 2005, $2.2million for 2004 and $1.9 million for 2003 are included in the calculation ofinvestment securities rate variances.

(5) Changes attributable to mix (rate and volume) are included inthe volume variance.

 

**Interest Income**

Fully tax-equivalent interest income amounted to $822.9 million in2005, an increase of $157.1 million, or 19.1%, from $665.8 million in 2004.  This compares favorably with the $69.4million, or 11.6%, increase in 2004 from 2003. The increase in 2005 was due to growth in average loans and securitiesthat contributed $85.9 million, and an increase in market interest rates,resulting in a $71.2 million increase from the higher yield on earningassets.  During 2004, the $99.1 millionin additional interest income from growth in average loans and securities wasoffset by a decline in market interest rates, resulting in a $29.7 millionreduction in interest income from lower earning assets.

 

At year-end 2005, the prime rate was 7.25%, compared with 5.25% and4.00% at year-end 2004 and 2003, respectively. The average prime rate was 6.19% for 2005, compared with 4.35% for 2004,an increase of 184 basis points.  Theyield on average total loans in 2005 was 6.40%, a 73 basis-point increase from5.67% in 2004.  The commercial,construction and home equity loan portfolios are the most sensitive to changesin short-term interest rates.  Theaverage yield on the construction and home equity loan portfolios increased 150basis points and 156 basis points, respectively, while the commercial loanportfolio yield increased 110 basis points over 2004.

 

32

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The commercial real estate loan portfolio includes both fixed andvariable-rate loans and the average portfolio yield increased 64 basispoints.  The residential real estate andconsumer loan portfolios are affected mostly by intermediate and long-termrates and do not move with the prime rate. The yields on the consumer loan portfolio and the residential realestate portfolios decreased by 38 basis points and 2 basis points,respectively.

 

The yield on investment securities, 3.85% in 2005, increased 2 basispoints, from 3.83% in 2004.  The yield onthe portfolio decreased 36 basis points in 2004 from 4.19% in 2003.  Bankshares has been changing the mix of theportfolio to offset the negative impact on interest income from reinvesting atlower yields.  During 2005 Banksharescontinued to follow a strategy to diversify the portfolio to a mix of U.S.Treasury, U.S. Government agencies and mortgage-backed securities.  This has resulted in a mix of 17.0%, 31.0%and 47.0% of treasury, agency and mortgage-backed securities, respectively, in2005.  The other 5.0% of the investmentsecurities was comprised of 3.0% municipals and 2.0% other investments atyear-end.

 

**Interest Expense**

Total interest expense in 2005 was $198.9 million, an increase of $85.7million, or 75.6%, from $113.3 million in 2004. The increase in interest expense for 2005 was attributable to anincrease in the rate paid on total interest-bearing funds of 73 basis pointsand a 10.9% growth in average balances. Total interest expense in 2004 was $4.0 million less than the $117.2million reported in 2003.  With theexpectation that the Federal Reserve Board will increase short-term rates againin 2006, management anticipates that rates paid on managed-rate deposits (savings,checking plus interest and money market accounts) will increase.  See the discussion under “Interest Rate Risk”in “III. ANALYSIS OF FINANCIAL CONDITION” for further information regardingBankshares’ exposure to changes in interest rates.

 

The rate paid on average total interest-bearing deposits was 1.70% in2005, an increase of 59 basis points from 1.11% for the prior year.  The rate paid on savings, checking plusinterest and money market accounts increased 10 basis points, 2 basis pointsand 78 basis points, respectively. Certificates of deposit of $100,000 and over increased 119 basis points,while the rate paid on other time deposits increased 52 basis points in 2005.

 

The most interest rate sensitive source of funds is short-termborrowings.  This category is comprisedof federal funds purchased, securities sold under agreements to repurchase andcommercial paper.  The duration of thesefunds is very short, with most repricing daily. Reflecting the rateenvironment, the rate paid on short-term borrowings increased 153 basis pointsto 2.37% in 2005, after having increased by 18 basis points in 2004 to0.84%.  The rate paid on long-term debtincreased 96 basis points in 2005, following a decline of 16 basis points inthe prior year.  The increase is relatedprimarily to the increase in interest rate swap costs on Bankshares’ long-termdebt.  The $200.0 million of 10-year debtissued by MSD&T in the fourth quarter of 2001, issued at a fixed rate of5.70%, were converted to a floating rate through an interest rate swap.  The notes reprice quarterly and carried aneffective cost of 4.24% during 2005 versus 2.38% in 2004.  Additionally, Bankshares issued $300.0million of subordinated debt in April 2003.  The notes were issued at a fixed rate of4.63%.  Subsequently, $150.0 million ofthis debt was converted to a floating rate through interest rate swaps.  The effect of the swaps lowered the cost onthe $300.0 million debt to 4.37% during 2005 versus 3.46% in 2004.

 

33

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NONINTEREST INCOME

 

A schedule of noninterest income over the past three years ispresented below:

 
| ** **                            | ** ** | **Year ended December 31,** | ** **  | **% Change** | ** ** |
|---------------------------------------|------------|----------------------------------|-------------|--------------|------------|
| **(Dollars in thousands)**            | ** ** | **2005**                         | ** **  | **2004**     | ** ** | **2003** | ** ** | **2005/2004** | ** ** | **2004/2003** | ** ** |
| Investment and wealth management      | ** ** | **$**                            | **95,756**  |         | $          | 90,050 |   | $ | 78,933 |   | 6.3 | % | 14.1 | % |
| Service charges on deposit accounts   | ** ** | **43,885**                       |        | 44,263       |       | 39,194 |   | (0.9 | ) | 12.9 |   |
| Mortgage banking-related fees:        |       |                             |        |         |       |   |   |   |   |   |   |
| Commercial                            | ** ** | **12,015**                       |        | 8,478        |       | 6,645 |   | 41.7 |   | 27.6 |   |
| Residential                           | ** ** | **3,004**                        |        | 3,017        |       | 4,466 |   | (0.4 | ) | (32.4 | ) |
| Total  mortgage banking-related fees  | ** ** | **15,019**                       |        | 11,495       |       | 11,111 |   | 30.7 |   | 3.5 |   |
| Net investment securities gains       | ** ** | **405**                          |        | 1,239        |       | 7,137 |   | (67.3 | ) | (82.6 | ) |
| Nonmarketable investments:            |       |                             |        |         |       |   |   |   |   |   |   |
| Private  equity and other investments | ** ** | **10,379**                       |        | 2,569        |       | 823 |   | 304.0 |   | 212.2 |   |
| Hedge funds                           | ** ** | **4,720**                        |        | 5,529        |       | 6,385 |   | (14.6 | ) | (13.4 | ) |
| Bank-owned  life insurance            | ** ** | **4,783**                        |        | 3,324        |       | 2,981 |   | 43.9 |   | 11.5 |   |
| Total  nonmarketable investments      | ** ** | **19,882**                       |        | 11,422       |       | 10,189 |   | 74.1 |   | 12.1 |   |
| Other income:                         |       |                             |        |         |       |   |   |   |   |   |   |
| Electronic  banking fees              | ** ** | **23,969**                       |        | 21,766       |       | 16,930 |   | 10.1 |   | 28.6 |   |
| Charges and  fees on loans            | ** ** | **12,664**                       |        | 10,833       |       | 9,549 |   | 16.9 |   | 13.4 |   |
| Insurance                             | ** ** | **15,017**                       |        | 13,358       |       | 4,656 |   | 12.4 |   | 186.9 |   |
| All other  income                     | ** ** | **16,523**                       |        | 9,503        |       | 5,873 |   | 73.9 |   | 61.8 |   |
| Total other  income                   | ** ** | **68,173**                       |        | 55,460       |       | 37,008 |   | 22.9 |   | 49.9 |   |
| Total                                 | ** ** | **$**                            | **243,120** |         | $          | 213,929 |   | $ | 183,572 |   | 13.6 |   | 16.5 |   |
|                                       |            |                                  |             |              |            |  |  |  |  |  |  |  |  |  |  |  |

 

##### **Noninterest Income**

Noninterest income for 2005 increased by $29.2 million, or 13.6%, to$243.1 million compared with $213.9 million for 2004.  The table above shows the major components ofnoninterest income.  IWM revenue includespersonal and institutional fee income related primarily to trust, brokerage andcustody services.  IWM revenuerepresented the largest source of noninterest income at 39.4%.  Revenues increased 6.3% to $95.8 million in2005.  Growth in IWM revenue was dueprincipally to stronger equity markets during 2005 compared with 2004,increased new sales in Private Wealth Management and increased brokerageactivity.  Additional growth will dependon continued new sales and increased distribution, equity and bond marketconditions and further acquisitions, if any. See the preceding discussion in “Segment Reporting” for additionalinformation relating to IWM.

 

Service charges on deposit accounts decreased slightly from 2004.  The decrease was related primarily toincreased earnings credits used to calculate service charges to our businesscustomers, which resulted from the rising interest rate environment.  Overdraft fees increased $1.9 million over2004, partially offsetting the decline in service charges from our businesscustomers.

 

Mortgage bankingfees increased $3.5 million, or 30.7%, over 2004 due to strong performance inthe commercial sector.  Bankshares’mortgage banking-related revenue is comprised of loan origination fees, whichis the largest category, at 65.0%, of total mortgage banking fees; servicingfees; originated mortgage servicing; and net gain on sales of mortgageloans.  Commercial mortgagebanking-related fees increased $3.5 million due to higher origination fees of$2.3 million and increased income of $1.1 million from originated mortgageservicing.  Commercial servicing incomewas nearly flat compared with the prior year. Commercial mortgages are brokered to an investor base with servicingretained.  Residential mortgage bankingfees for 2005 were nearly flat compared with 2004.

 

Investmentsecurities gains in 2005 mostly represent the restructuring of the securitiesportfolio acquired from CBNV.  The gains in2004 represent sales of equity securities, with the balance related to thecontinued restructuring of the investment securities held in theavailable-for-sale portfolios.

 

Nonmarketable investment income represents revenues derived frominvesting in private equities, hedge funds-of-funds (“hedge funds”), FederalReserve Banks and Federal Home Loan Bank securities acquired to meet variousregulatory requirements and bank-owned life insurance (“BOLI”).  In 2005, nonmarketable investment incomeincreased $8.5 million, or 74.1%, over 2004 as a result of better privateequity investment performance and higher income from bank-owned life insurance(“BOLI”).  These increases were partiallyoffset by a decline in hedge fund income. The increase in BOLI revenue was due to better performance and thepurchase of an additional $50.0 million in the third quarter of 2005, bringingtotal investments in BOLI to $152.6 million.

 

34

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Other income includes several categories.  Electronic banking fees consist of merchantcard processing fees, foreign ATM fees and check card fees.  These fees increased by $2.2 million, or10.1%, from 2004 due to higher volumes. Charges and fees on loans consist of letters of credit fees, late feesand other assessed loan fees and increased $1.8 million, primarily due tohigher letters of credit fees.  Insurancerevenues increased $1.7 million and are derived from fee income related to thesale and servicing of insurance products. All other income increased $7.0million over 2004 due primarily to a $2.7 million increase in gains on sales ofbank-owned premises and $3.3 million in higher capital markets-related revenue.

 

NONINTEREST EXPENSES

 

A schedule of noninterest expenses over the past three years ispresented below:

 
| ** **                             | ** ** | **Year ended December 31,** | ** **  | **% Change** | ** ** |
|----------------------------------------|------------|----------------------------------|-------------|--------------|------------|
| **(Dollars in thousands)**             | ** ** | **2005**                         | ** **  | **2004**     | ** ** | **2003** | ** ** | **2005/2004** | ** ** | **2004/2003** | ** ** |
| Salaries                               | ** ** | **$**                            | **200,222** |         | $          | 187,621 |   | $ | 160,326 |   | 6.7 | % | 17.0 | % |
| Employee benefits                      | ** ** | **46,175**                       |        | 44,676       |       | 37,717 |   | 3.4 |   | 18.5 |   |
| Net occupancy expense of bank premises | ** ** | **28,596**                       |        | 24,307       |       | 20,756 |   | 17.6 |   | 17.1 |   |
| Furniture and equipment expenses       | ** ** | **31,659**                       |        | 31,439       |       | 31,610 |   | 0.7 |   | (0.5 | ) |
| Communications and supplies            | ** ** | **16,406**                       |        | 16,904       |       | 15,188 |   | (2.9 | ) | 11.3 |   |
| Other expenses:                        |       |                             |        |         |       |   |   |   |   |   |   |
| Professional  services                 | ** ** | **21,914**                       |        | 25,302       |       | 19,500 |   | (13.4 | ) | 29.8 |   |
| Advertising  and promotional expenses  | ** ** | **9,103**                        |        | 8,418        |       | 9,155 |   | 8.1 |   | (8.1 | ) |
| Electronic  banking expenses           | ** ** | **13,946**                       |        | 11,509       |       | 8,621 |   | 21.2 |   | 33.5 |   |
| Amortization  of intangible assets     | ** ** | **8,773**                        |        | 8,142        |       | 4,943 |   | 7.7 |   | 64.7 |   |
| Outsourcing  expenses                  | ** ** | **11,231**                       |        | 5,342        |       | 4,145 |   | 110.2 |   | 28.9 |   |
| All other  expenses                    | ** ** | **32,796**                       |        | 28,298       |       | 25,486 |   | 15.9 |   | 11.0 |   |
| Total other  expenses                  | ** ** | **97,763**                       |        | 87,011       |       | 71,850 |   | 12.4 |   | 21.1 |   |
| Total                                  | ** ** | **$**                            | **420,821** |         | $          | 391,958 |   | $ | 337,447 |   | 7.4 |   | 16.2 |   |
|                                        |            |                                  |             |              |            |  |  |  |  |  |  |  |  |  |  |  |

 

**Noninterest Expenses**

Noninterest expenses increased $28.9 million, or 7.4%, from 2004.  The table above shows the major components ofnoninterest expenses.  The principalreasons for the year-over-year increase were expenses of approximately $8.0million related to the acquisition of CBNV; higher incentive compensationrelated to improved operating performance; base compensation and staffingincreases; higher occupancy expense due to the December 2004 sale ofBankshares’ headquarters building and the outsourcing of IWM back-office functions.

 

Controlling costs and maintaining operational efficiencies remains aprimary objective for Bankshares.  Aclosely monitored key measure is Bankshares’ overall efficiency ratio.  It is computed by dividing noninterestexpenses by the sum of net interest income on a tax-equivalent basis andnoninterest income.  Bankshares’efficiency ratio was 48.53% for the year ended December 31, 2005 comparedwith 51.14% for the year ended December 31, 2004.  The cash operating efficiency ratio excludesamortization expense for intangibles and nonoperating income and expenses, suchas securities gains and losses and other significant gains, losses or expenses(such as those associated with integrating acquired entities’ operations intoBankshares) unrelated to Bankshares’ core operations.  When calculating certain performance ratios,Bankshares believes that excluding these costs and income helps the investor toevaluate and compare the results of our core, ongoing business operations.  Bankshares’ cash operating efficiency ratiowas 47.61% and 49.63% for the years ended December 31, 2005 and 2004,respectively.  See “Reconciliation ofNon-GAAP Measures” found in Item 7. 

 

Salaries, which include base compensation, commissions, incentivecompensation and stock-based compensation, are the largest component ofnoninterest expense at 47.6%.  Salariesincreased $12.6 million, or 6.7%.  Nearlyone-quarter of this increase, ($3.0 million) was due to the CBNVacquisition.  Also contributing to theincrease were higher incentive compensation expenses of $8.3 million related toimproved operating performance and $6.3 million in merit and staffingincreases.  Stock-based compensation wasnearly flat when compared with 2004. Partially offsetting these increases was a reduction in salaries expenseby $2.5 million based on the deferral of loan origination costs.  Employee benefit expenses increased nearly$1.5 million, or 3.4%.  This increase wasdue primarily to higher payroll taxes and pension expense.  Partially offsetting this increase was a $1.3million rebate from a medical insurance provider due to good claims experience.

 

35

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Net occupancy expense, which includes premises depreciation, rents,maintenance and utilities, increased due to an increase of approximately $5.0million related to the loss of outside tenant income due to the sale ofBankshares’ headquarters building in December 2004.  The net addition of 14 new branches,primarily from the CBNV acquisition, also contributed to the increase.  Furniture and equipment expenses includedepreciation, rental and maintenance expense associated with the upkeep andimprovement of hardware and computer software.

 

Other expensesconsist of professional services, advertising and promotion, electronicbanking, intangible amortization, outsourcing and all other expenses.  Other expenses increased $10.8 million, or12.4%, in 2005.  The CBNV acquisitioncontributed $2.4 million to this increase. Professional fees decreased $3.4 million in 2005 due primarily to a $1.4million reduction in fees related to the implementation of compliance measuresunder The Sarbanes-Oxley Act of 2002 and a decrease of $1.5 million related toa litigation matter in 2004.  Theincrease in electronic banking expense of $2.4 million in 2005 was driven byvolume increases.  This increase was notcompletely offset by increased revenue generated from these services (referredto in the Noninterest Income section).  Amortization of other identifiable intangibles increased to $8.8 millionin 2005, from $8.1 million in 2004, as a direct result of the CBNVacquisition.  The remaining increase inother expenses over 2004 was due primarily to $5.9 million in higher feesrelated to the outsourcing of IWM back-office functions.

 

III. ANALYSIS OF FINANCIAL CONDITION

 

**Investment Securities**

Bankshares’ investment securities portfolio is structured to manageliquidity, interest rate risk and regulatory capital and to take advantage ofmarket conditions that create more economically attractive returns oninvestments.  At December 31, 2005,the total investment securities portfolio was $3.1 billion compared with $2.9billion at December 31, 2004, with net unrealized losses of $52.2 millionand $3.2 million for the same periods. The portfolio consists of short-term and intermediate-term U.S. Treasuryand U.S. Government agency obligations, adjustable-rate mortgage-backedsecurities (ARMs) and intermediate average-life agency collateralized mortgageobligations (CMOs).  More than 99.5% ofthe total investment portfolio is classified as available-for-sale.

 

At year-end 2005, the weighted-average maturity of the debt securitiesavailable-for-sale portfolio was 2.3 years compared with 2.4 years at year-end2004.  Since 50.0% of this portfolio wasmortgage-backed securities, the expected remaining maturity may differ fromcontractual maturity because borrowers may have the right to prepay obligationsbefore the underlying mortgages mature. The fair value of the bond securities available-for-sale portfolio at December 31,2005 was 98.2% of amortized cost, compared with 99.8% at December 31,2004.  The fair value and unrealized losson securities as of December 31, 2005, segregated by those securities thathave been in an unrealized loss position for a year or more, was $2.0 billionand $22.0 million, respectively.  Becausethe declines in fair value were due to changes in interest rates, not inestimated cash flows or credit quality, no charge from an other-than-temporaryimpairment was recorded at December 31, 2005.  The reference point for determining thosesecurities in an unrealized loss position is quarter-end.  As such, it is possible that a security had amarket value that exceeded its amortized cost on other days during the past 12-monthperiod.

 

The estimated effects of a 200 basis point increase or decrease ininterest rates on the fair value and the expected remaining maturity of themortgage-backed securities available-for-sale portfolio are provided in thetable below.

 
| ** **                  | ** ** | **Fair**  | ** ** | **Net   Unrealized** | ** ** | **Remaining Maturity** | ** ** |
|-----------------------------|------------|-----------|------------|----------------------|------------|------------------------|------------|
| **(Dollars in millions)**   | ** ** | **Value** | ** ** | **Gain (Loss)**      | ** ** | **In Years**           | ** ** |
| At December 31, 2005   |       | $         | 1,544      |                 | $          | (37.6                  | )          | 3.09 |   |
|                        |       |      |       |                 |       |                   |       |
| Assuming a 200 basis point: |       |      |       |                 |       |                   |       |
| Increase in  interest rates |       | 1,456.3   |       | (137.7               | )          | 4.09                   |       |
| Decrease in  interest rates |       | 1,613.9   |       | 19.9                 |       | 1.52                   |       |
|                             |            |           |            |                      |            |                        |            |  |  |

 

More information on the investment portfolio is provided in thefollowing table and in Note No. 3 (Investment Securities) of the financialstatements.

 

36

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BOND INVESTMENT PORTFOLIO

 

The following summary shows the maturity distribution and averagetax-equivalent yields for the bond investment portfolio at December 31,2005.

 
| ** **                           | ** ** | **Within 1** | ** ** | **1-5**   | ** ** | **5-10**  | ** ** | **After 10** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|--------------|------------|-----------|------------|-----------|------------|--------------|------------|------------|------------|
| **(Dollars in thousands)**           | ** ** | **Year**     | ** ** | **Years** | ** ** | **Years** | ** ** | **Years**    | ** ** | **Total**  | ** ** |
| Securities available-for-sale (1)    |       |         |       |      |       |      |       |         |       |       |       |
| U.S.  Treasury                       |       |         |       |      |       |      |       |         |       |       |       |
| Fair Value                           |       | $            | 210,216    |      | $          | 221,820   |       | $            | —     |       | $          | — |   | $ | 432,036 |   |
| Yield                                |       | 3.50         | %          | 3.84      | %          | —    | %          | —       | %          | 3.65       | %          |
| U.S.  Government agencies            |       |         |       |      |       |      |       |         |       |       |       |
| Fair Value                           |       | $            | 366,662    |      | $          | 612,613   |       | $            | 33         |       | $          | — |   | $ | 979,308 |   |
| Yield                                |       | 2.89         | %          | 3.74      | %          | 7.54      | %          | —       | %          | 3.42       | %          |
| States and  political subdivisions   |       |         |       |      |       |      |       |         |       |       |       |
| Fair Value                           |       | $            | 5,300      |      | $          | 19,836    |       | $            | 44,999     |       | $          | — |   | $ | 70,135 |   |
| Yield                                |       | 4.53         | %          | 4.87      | %          | 5.72      | %          | —       | %          | 5.39       | %          |
| Mortgage-backed  securities (2)      |       |         |       |      |       |      |       |         |       |       |       |
| Fair Value                           |       | $            | 25,668     |      | $          | 1,381,340 |       | $            | 137,253    |       | $          | — |   | $ | 1,544,261 |   |
| Yield                                |       | 3.84         | %          | 4.23      | %          | 4.54      | %          | —       | %          | 4.26       | %          |
| Other bonds,  notes and debentures   |       |         |       |      |       |      |       |         |       |       |       |
| Fair Value                           |       | $            | 9,741      |      | $          | 9,127     |       | $            | —     |       | $          | — |   | $ | 18,868 |   |
| Yield                                |       | 2.72         | %          | 3.57      | %          | —    | %          | —       | %          | 3.13       | %          |
| Total  securities available-for-sale |       |         |       |      |       |      |       |         |       |       |       |
| Fair Value                           |       | $            | 617,587    |      | $          | 2,244,736 |       | $            | 182,285    |       | $          | — |   | $ | 3,044,608 |   |
| Yield                                |       | 3.14         | %          | 4.06      | %          | 4.83      | %          | —       | %          | 3.92       | %          |
| Securities  held-to-maturity         |       |         |       |      |       |      |       |         |       |       |       |
| States and  political subdivisions   |       |         |       |      |       |      |       |         |       |       |       |
| Amortized  cost                      |       | $            | 2,347      |      | $          | 7,353     |       | $            | 6,959      |       | $          | — |   | $ | 16,659 |   |
| Yield                                |       | 6.20         | %          | 6.50      | %          | 7.85      | %          | —       | %          | 7.02       | %          |
|                                      |            |              |            |           |            |           |            |              |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Investment securities available-for-sale are presented atestimated fair value.  Yields on suchsecurities are based on amortized cost.

(2) Maturities are reflected based on projected maturities at timeof purchase.  Actual maturities will varyas a result of the level of loan prepayments in the underlying mortgage pools.

 

LOAN COMPOSITION AND GROWTH

Average Loans (Dollars in millions)

Five-Year Compound Growth Rate: 12.3%

 

 

 

37

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**Loan Portfolio**

A comparative chart of average loan balances is included below;year-end balances are in Note No. 4 (Loans and Allowance for Loan Losses)of the Financial Statements.

 

Loans totaled $11.6 billion for the year ended December 31, 2005,an increase of 13.5% over the $10.2 billion for the year ended December 31,2004.  Loans averaged $11.0 billion in2005 compared with $9.7 billion in 2004, an increase of 13.5%.  On average in 2005, commercial loans grew6.4%; commercial real estate grew 17.7%; construction grew 28.8%; residentialreal estate loans grew 7.2%; home equity lines grew 12.6%; and consumer loansincreased 13.7% over 2004.  The increasesin the various loan categories resulted from both organic growth and the CBNVacquisition.  On an average basis, thepercentage of commercial real estate loans to total loans increased to 31.2% in2005 from 30.0% in 2004.  Additionally,construction loans increased in 2005 from 2004, while commercial loans declinedto 26.3% in 2005 from 28.1% in 2004. Strong demand continued throughout 2005 for real estate-based loansincluding commercial, residential and home equity loans and lines.

 

COMPOSITION OF LOANS

 
| ** **                 | ** ** | **Average Balances** | ** **     |
|----------------------------|------------|----------------------|----------------|
| **(Dollars in thousands)** | ** ** | **2005**             | ** **     | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Commercial                 | ** ** | **$**                | **2,900,598**  | ** ** | **26.3** | % | $ | 2,725,452 |   | 28.1 | % | $ | 2,478,707 |   | 30.6 | % | $ | 2,367,328 |   | 33.4 | % | $ | 2,407,097 |   | 35.2 | % |
| Commercial real estate     | ** ** | **3,444,921**        | ** **     | **31.2** |   | 2,927,968 |   | 30.1 |   | 2,316,627 |   | 28.6 |   | 1,915,994 |   | 27.0 |   | 1,571,238 |   | 23.0 |   |
| Construction               | ** ** | **1,473,353**        | ** **     | **13.4** |   | 1,144,044 |   | 11.8 |   | 929,939 |   | 11.5 |   | 733,237 |   | 10.3 |   | 795,931 |   | 11.6 |   |
| Residential real estate    | ** ** | **1,761,955**        | ** **     | **16.0** |   | 1,643,504 |   | 16.9 |   | 1,350,034 |   | 16.7 |   | 1,247,859 |   | 17.6 |   | 1,059,798 |   | 15.5 |   |
| Home equity lines          | ** ** | **507,153**          | ** **     | **4.6** |   | 450,244 |   | 4.6 |   | 311,037 |   | 3.9 |   | 215,411 |   | 3.0 |   | 345,506 |   | 5.1 |   |
| Consumer                   | ** ** | **941,571**          | ** **     | **8.5** |   | 828,197 |   | 8.5 |   | 702,638 |   | 8.7 |   | 609,015 |   | 8.7 |   | 653,286 |   | 9.6 |   |
| Total                      | ** ** | **$**                | **11,029,551** | ** ** | **100.0** | % | $ | 9,719,409 |   | 100.0 | % | $ | 8,088,982 |   | 100.0 | % | $ | 7,088,844 |   | 100.0 | % | $ | 6,832,856 |   | 100.0 | % |
|                            |            |                      |                |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Deposits**

Bankshares’ primary source of funding for its investing and lendingactivities is deposits gathered by the 240 branches of its bankingaffiliates.  Average total deposits in2005 were $11.4 billion, representing an increase of $1.0 billion, or 9.6%,over the prior year average of $10.4 billion. The CBNV acquisition accounted for a substantial portion of this growth,contributing 61.5% based on $626.9 million in acquired deposits.  For the year ended December 31, 2005,81.1% of the funding for average earning assets was derived from deposits,compared with 81.8% for the year ended December 31, 2004.  The affiliate-banking model positionsBankshares to compete not only with the large national and regional bankingcompanies in the gathering of these funds, but also with local communitybanks.  Based on historical experience,management believes Bankshares is positioned to retain this core customer base,although pricing pressure is expected to be intense.  Bankshares continues to promote its cashmanagement services to its commercial customers in order to maintain and expandthis key source of funding.  However,should there be an outflow of deposits, a reversal of recent trends, theinvestment portfolio should provide adequate liquidity.

 

In 2005, interest-bearing deposits represented 72.3% of average totaldeposits and were $8.2 billion, reflecting growth of 9.5% from 2004.  Growth in savings accounts slowed as customersdemonstrated a stronger preference for higher yielding money market andcertificates of deposit accounts. Checking plus interest accounts increased 8.5% from 2004 to $1.4billion.  Certificates of deposit$100,000 and over and other time deposits increased 16.0% on average in 2005over 2004 with the CBNV acquisition contributing approximately 51.5% of thegrowth.  Total averagenoninterest-bearing deposits rose from $2.9 billion in 2004 to $3.2 billion in2005, or 9.9%, and represented 27.7% of average deposits.  Demand for this product has been strong amongboth commercial and retail customers throughout 2005.

 

DEPOSIT MIX

 
| ** **                      | ** ** | **Average Balances** | ** **     |
|---------------------------------|------------|----------------------|----------------|
| **(Dollars  in thousands)**     | ** ** | **2005**             | ** **     | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Noninterest-bearing deposits    | ** ** | **$**                | **3,165,320**  | ** ** | **27.7** | % | $ | 2,879,290 |   | 27.6 | % | $ | 2,269,720 |   | 25.2 | % | $ | 1,856,706 |   | 24.3 | % | $ | 1,618,838 |   | 23.0 | % |
| Interest-bearing deposits:      |       |                 |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                         | ** ** | **1,428,445**        | ** **     | **12.5** |   | 1,425,423 |   | 13.7 |   | 1,168,074 |   | 13.0 |   | 966,283 |   | 12.7 |   | 853,911 |   | 12.2 |   |
| Checking plus interest          | ** ** | **1,399,215**        | ** **     | **12.2** |   | 1,289,295 |   | 12.4 |   | 1,071,877 |   | 11.9 |   | 873,497 |   | 11.4 |   | 771,186 |   | 10.9 |   |
| Money market                    | ** ** | **1,651,513**        | ** **     | **14.5** |   | 1,571,462 |   | 15.1 |   | 1,357,234 |   | 15.1 |   | 1,096,417 |   | 14.4 |   | 846,577 |   | 12.0 |   |
| Time deposits $100,000 and over | ** ** | **1,627,194**        | ** **     | **14.3** |   | 1,314,423 |   | 12.6 |   | 1,272,327 |   | 14.2 |   | 1,080,347 |   | 14.2 |   | 1,145,569 |   | 16.2 |   |
| Other time deposits             | ** ** | **2,142,068**        | ** **     | **18.8** |   | 1,933,799 |   | 18.6 |   | 1,852,622 |   | 20.6 |   | 1,759,160 |   | 23.0 |   | 1,812,589 |   | 25.7 |   |
| Total                           | ** ** | **$**                | **11,413,755** | ** ** | **100.0** | % | $ | 10,413,692 |   | 100.0 | % | $ | 8,991,854 |   | 100.0 | % | $ | 7,632,410 |   | 100.0 | % | $ | 7,048,670 |   | 100.0 | % |

 

38

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**Risk Management**

Bankshares hasestablished an integrated risk management structure in which senior managementregularly identifies, measures and manages risks.  The Chief Risk Officer coordinates anddirects the work of several standing management committees charged withmanaging the risks Bankshares faces and provides regular reports to the AuditCommittee.  These committees are listedbelow.

 

*Credit Quality Committee*

The Credit Quality Committee oversees the establishment of consistentcredit quality policies and, among other responsibilities, works withmanagement in determining important financial reporting information, includingthe allowance for loan and lease loss reserve. A centralized loan review function is charged with analyzing the risksand quality of the lending portfolios. Among other things, Loan Review reaffirms or modifies individualloan-risk ratings in accordance with Bankshares’ Loan Policy.  The Committee reports quarterly to the AuditCommittee.  The members of the Committeeinclude the senior vice presidents of Loan Review, the Chief Financial Officer,Chief Administrative/Risk Officer, Vice Chairman/Chief Operating Officer andChief Executive Officer of Bankshares, the senior vice president of CreditPolicy at MSD&T, the executive vice president of Affiliate Administrationand the Bankshares’ Treasurer.

 

*Asset and Liability Committee*

The Asset and Liability Committee (“ALCO”) manages interest rate risk,market risk and liquidity risk.  Theserisks are described in more detail elsewhere in this document. 

 

*Compliance Committee*

The Compliance Committee establishes compliance guidelines and ensuresstrict compliance with all relevant regulatory and statutory requirements forBankshares and its affiliates.  Increating the Compliance Committee, management intended to foster a strongcompliance function, which would establish global compliance guidelines andensure strict compliance for Bankshares and its affiliates with relevantbanking statutes and regulations, including the Bank Secrecy Act, anti-moneylaundering statutes and fair lending statutes. A chief compliance officer oversees compliance with existing regulatoryrequirements and is responsible for developing a comprehensive trainingprogram.

 

Compliance deficiencies are reported to senior management through theGeneral Counsel and the Compliance Committee. As part of its mission, the Committee regularly assesses Bankshares’compliance efforts and maintains a high level of awareness about compliance andits effect on daily activities.  Thechief compliance officer prepares a report, at least quarterly, that includes

(1) the results of compliance monitoring activities and anycompliance concerns identified with recommended corrective action,

(2) regulatory developments related to new and revised regulationsand proposed regulations, (3) compliance training activities,

(4) compliance initiatives, (5) regulatory exams, and (6) customercomplaints.  The Committee’s meetings arechaired by the General Counsel and are held quarterly.  In addition, the chief compliance officerpresents the compliance report to the Audit Committee quarterly.

 

*Disclosure Committee*

The Disclosure Committee is comprised of senior representatives of allof Bankshares’ business lines and is responsible for reviewing Bankshares’periodic filings and disclosures in order to ensure compliance with therequirements of U.S. securities laws.  Inconjunction with the Chief Executive Officer and the Chief Financial Officer,the Disclosure Committee is charged with the design and oversight of internalcontrols over financial reporting.

 

The Committee conducts a systematic analysis of Bankshares’ annual andquarterly filings and reports filed on Form 8-K.  It has established and evaluates thedisclosure policies and procedures relating to the various certificationrequirements of the Chief Executive Officer and the Chief Financial Officer, asrequired by sections 302, 404, and 906 of The Sarbanes-Oxley Act of 2002.  The Committee, at least annually, performs aformal risk assessment of the primary business processes/cycles that supportfinancial reporting.  The Committeereviews important changes in the law related to disclosure requirements withBankshares’ external and internal legal counsel.  The Chief Financial Officer and hissubordinates monitor important changes in accounting standards and evaluatechanges in the organization that may affect internal controls over financialreporting or that may require disclosure, and regularly report to the Committeeon such developments.  The Committeeregularly reports to the Audit Committee.

 

*Technology and Operations Committee*

The Technology and Operations Committee evaluates operational risk onan ongoing basis.  The Committee hasdeveloped an Operational and IT Risk framework, including the evaluation of keyrisk indicators and the integration with existing Bankshares internal controland risk-assessment efforts.  Specifically,the Committee ensures that risk management is a responsibility of all layers ofmanagement, and it monitors the implementation of the various operational andinformation technology risk policies of Bankshares.

 

The Committee ensures that a structure and process exist for thecontinuous identification and evaluation, and subsequent remediation, ofoperational risk.  Membership includeseight individuals from the Operations & Technology Division.  Ad hoc members include representatives fromexecutive management, business units, Internal Audit, Financial Services andCompliance.   The President of MSD&Tand the Chief Risk Officer/Chief Administrative Officer are kept apprised ofthe Committee’s activities.  The Chair ofthe Committee, the executive vice president of Operations & TechnologyServices, reports to the Audit Committee at least annually**.**

 

39

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**Credit Risk Analysis**

Bankshares’ loans and commitments are substantially to borrowerslocated in its immediate region. Bankshares has restricted its participation in multibank credits whereBankshares is not the managing or agent bank. Central to the operation of a sound and successful financial institutionis the balanced management of asset growth and credit quality.  Responsibility for loan underwriting andmonitoring is clearly fixed on key management personnel in each of ouraffiliates and, ultimately, on the board of directors of each affiliate.  These responsibilities are supported at theholding company level by appropriate underwriting guidelines and effectiveongoing loan review.  In addition,Bankshares has set an internal limit for each affiliate bank that is well belowthe regulatory limit on the maximum amount of credit that may be extended to asingle borrower.

 

Bankshares’ loan review function examines each affiliate bank at leastonce every five quarters.  Theseexaminations provide Bankshares’ management with an independent perspective asto overall loan portfolio quality, risk profile, risk trends and creditadministration processes at each affiliate. The Audit Committee receives quarterly reports on the findings.

 

ALLOWANCE AS A PERCENT OF PERIOD-END LOANS; NONPERFORMING LOANS AS APERCENT OF PERIOD-END LOANS

 

 

ALLOWANCE FOR LOAN LOSSES

 
| ** **                                               | ** ** | **Year  Ended December 31,** | ** **     |
|----------------------------------------------------------|------------|-----------------------------------|----------------|
| **(Dollars in thousands)**                               | ** ** | **2005**                          | ** **     | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Allowance balance — beginning                       | ** ** | **$**                             | **149,002**    | ** ** | $ | 155,337 |   | $ | 138,601 |   | $ | 141,463 |   | $ | 138,612 |   |
| Allowance of acquired banks                              | ** ** | **7,086**                         | ** **     | — |   | 13,205 |   | — |   | — |   |
| Charge-offs:                                             |       |                              | ** **     |   |   |   |   |   |   |   |   |
| Commercial and leasing                                   | ** ** | **(3,692**                        | **)**          | (13,433 | ) | (6,916 | ) | (18,193 | ) | (9,585 | ) |
| Commercial real estate                                   | ** ** | **(32**                           | **)**          | (67 | ) | (625 | ) | (471 | ) | (42 | ) |
| Construction                                             | ** ** | **—**                        | ** **     | — |   | (170 | ) | — |   | (90 | ) |
| Residential real estate                                  | ** ** | **(202**                          | **)**          | (427 | ) | (246 | ) | (251 | ) | (104 | ) |
| Home equity lines                                        | ** ** | **(91**                           | **)**          | (7 | ) | (29 | ) | (74 | ) | (125 | ) |
| Consumer                                                 | ** ** | **(3,585**                        | **)**          | (4,446 | ) | (4,338 | ) | (3,232 | ) | (3,382 | ) |
| Total                                                    | ** ** | **(7,602**                        | **)**          | (18,380 | ) | (12,324 | ) | (22,221 | ) | (13,328 | ) |
| Recoveries:                                              |       |                              | ** **     |   |   |   |   |   |   |   |   |
| Commercial and leasing                                   | ** ** | **3,545**                         | ** **     | 1,768 |   | 1,345 |   | 896 |   | 635 |   |
| Commercial real estate                                   | ** ** | **158**                           | ** **     | 118 |   | 174 |   | 161 |   | 160 |   |
| Construction                                             | ** ** | **446**                           | ** **     | 5 |   | 136 |   | 226 |   | 78 |   |
| Residential real estate                                  | ** ** | **238**                           | ** **     | 442 |   | 125 |   | 128 |   | 147 |   |
| Home equity lines                                        | ** ** | **—**                        | ** **     | 38 |   | 44 |   | 83 |   | 41 |   |
| Consumer                                                 | ** ** | **2,224**                         | ** **     | 2,453 |   | 1,926 |   | 1,487 |   | 1,684 |   |
| Total                                                    | ** ** | **6,611**                         | ** **     | 4,824 |   | 3,750 |   | 2,981 |   | 2,745 |   |
| Net charge-offs                                          | ** ** | **(991**                          | **)**          | (13,556 | ) | (8,574 | ) | (19,240 | ) | (10,583 | ) |
| Provision for loan losses                                | ** ** | **1,576**                         | ** **     | 7,221 |   | 12,105 |   | 16,378 |   | 13,434 |   |
| Allowance balance - ending                               | ** ** | **$**                             | **156,673**    | ** ** | $ | 149,002 |   | $ | 155,337 |   | $ | 138,601 |   | $ | 141,463 |   |
| Average loans                                            | ** ** | **$**                             | **11,029,551** | ** ** | $ | 9,719,409 |   | $ | 8,088,982 |   | $ | 7,088,844 |   | $ | 6,832,856 |   |
| Percent of net charge-offs to average loans              | ** ** | **0.01**                          | **%**          | 0.14 | % | 0.11 | % | 0.27 | % | 0.15 | % |
| Period-end loans                                         | ** ** | **$**                             | **11,607,845** | ** ** | $ | 10,228,433 |   | $ | 9,272,160 |   | $ | 7,312,027 |   | $ | 6,906,246 |   |
| Percent of allowance for loan losses to period-end loans | ** ** | **1.35**                          | **%**          | 1.46 | % | 1.68 | % | 1.90 | % | 2.05 | % |
|                                                          |            |                                   |                |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

40

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Bankshares maintains an allowance for loan losses at a level consideredby management to be adequate to absorb potential losses inherent in the loanportfolio.  Each Bankshares affiliate isrequired to maintain an allowance for loan losses adequate to absorb lossesinherent in the loan portfolio. Each affiliate’s reserve is dedicated to thataffiliate only and is not available to absorb losses from another affiliate.The allowance for loan losses is comprised of specific allocations to impairedloans and general allocations to pools of loans not deemed impaired.  It may also include an unallocatedamount.  The portfolio review and thecalculation of the allowance for loan losses are performed on a quarterly basisby Bankshares’ management.  Thecalculation is reviewed by the Bankshares Credit Quality Committee and eachaffiliate bank as to its allowance.  Theaggregate calculation establishes a targeted minimum level for the allowance ateach affiliate, subject to review and input from each affiliate.  Final approval rests with the Credit QualityCommittee.  The final evaluation isreviewed with the Bankshares Audit Committee. All loan loss reserves are subject to annual bank regulatoryexaminations and determinations as to their methodology and adequacy.  Overall, the determinations of the allowancefor loan losses incorporate SFAS No. 114, “Accounting by Creditors forImpairment of a Loan - an amendment of FASB Statements No. 5 and 15,” and SFAS No. 118,“Accounting by Creditors for Impairment of a Loan - Income Recognition andDisclosure.”  Also incorporated indetermination of the allowance is SFAS No. 5, “Accounting for Contingencies”;guidance contained in the Securities and Exchange Commission’s SAB No. 102,“Loan Loss Allowance Methodology and Documentation”; and the Federal FinancialInstitutions Examination Council’s Policy Statement on Allowance for Loan andLease Losses Methodologies and Documentation for Banks and SavingsInstitutions.

 

ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

 

The following table presents the amount of allowance for loan lossesand the percentage distribution of loan amounts in each category, at the dateshown.

 
| ** **                      | ** ** | **Allowance  amount allocated as of December 31,** | ** **  |
|---------------------------------|------------|---------------------------------------------------------|-------------|
| ** **                      | ** ** | **2005**                                                | ** **  | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                      | ** ** | ** **                                              | ** **  | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                      | ** ** | ** **                                              | ** **  | **Total** | ** ** | ** ** | ** ** | **Total** | ** ** | ** ** | ** ** | **Total** | ** ** | ** ** | ** ** | **Total** | ** ** | ** ** | ** ** | **Total** | ** ** |
| **(Dollars in thousands)**      | ** ** | **Amount**                                              | ** **  | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** |
| Allowance  amount allocated to: |       |                                                    |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial  and leasing         | ** ** | **$**                                                   | **55,421**  | ** ** | **25.5** | % | $ | 58,915 |   | 28.0 | % | $ | 94,584 |   | 28.5 | % | $ | 97,472 |   | 32.8 | % | $ | 92,532 |   | 34.4 | % |
| Commercial  real estate         | ** ** | **39,790**                                              | ** **  | **31.9** |   | 32,770 |   | 30.5 |   | 28,237 |   | 29.6 |   | 21,275 |   | 27.6 |   | 13,315 |   | 26.4 |   |
| Construction                    | ** ** | **16,163**                                              | ** **  | **13.8** |   | 11,080 |   | 12.4 |   | 10,806 |   | 11.5 |   | 9,644 |   | 11.1 |   | 7,124 |   | 9.4 |   |
| Residential  real estate        | ** ** | **12,371**                                              | ** **  | **15.5** |   | 10,303 |   | 16.4 |   | 7,263 |   | 16.6 |   | 3,645 |   | 16.9 |   | 2,866 |   | 17.9 |   |
| Home  equity lines              | ** ** | **3,342**                                               | ** **  | **4.4** |   | 5,460 |   | 4.9 |   | 4,710 |   | 4.5 |   | 1,860 |   | 3.3 |   | 1,414 |   | 2.8 |   |
| Consumer                        | ** ** | **10,808**                                              | ** **  | **8.9** |   | 8,787 |   | 7.8 |   | 9,737 |   | 9.3 |   | 4,705 |   | 8.3 |   | 4,735 |   | 9.1 |   |
| Allowance  amount not allocated | ** ** | **18,778**                                              |        |   |   | 21,687 |   |   |   | — |   |   |   | — |   |   |   | 19,477 |   |   |   |
| Total                           | ** ** | **$**                                                   | **156,673** | ** ** | **100.0** | % | $ | 149,002 |   | 100.0 | % | $ | 155,337 |   | 100.0 | % | $ | 138,601 |   | 100.0 | % | $ | 141,463 |   | 100.0 | % |

 

**Allowance for Loan Losses**

The allowance for loan losses is comprised of specific allocations toimpaired loans, general allocations to pools of loans not deemed impaired andan unallocated amount.  Current trendsand economic conditions that affect the collectibility of the loan portfolioare incorporated into the general allocation. These can include, but are not limited to, exposure to an industryexperiencing problems, changes in the nature or volume of the portfolio,delinquency and nonaccrual trends.

 

The specific allowance allocation is based on an analysis of the loanportfolio by each affiliate bank and Loan Review.  Each loan with an outstanding balance inexcess of a specified threshold that is either on nonaccrual status or on theWatchlist is evaluated. The Watchlist represents loans identified and closelyfollowed by management.  They possesscertain qualities or characteristics that may lead to collection and lossissues.  Monitored loans, which areincluded in the Watchlist, display additional risk characteristics suggestingthat they may be classified as nonperforming loans in the near future.  The identified loans are evaluated forpotential loss in accordance with SFAS No. 114 and SFAS No. 118 byanalyzing current collateral values or present values of cash flows, as well asthe capacity of the guarantor, as applicable. The specific allocation resulting from this review decreased 60.4% to$4.2 million from $10.6 million at December 31, 2005 and 2004,respectively, and was related to specific loan balances of $12.0 million and $18.4million.  The decrease was largelyattributable to the payoff of a credit exposure at MSD&T during the fourthquarter of 2005.  Two credit exposures atMSD&T accounted for $3.5 million, based on the fair value of thecollateral, of the specific allocation at December 31, 2005.  See “Nonperforming Assets” in the following section for moredetail.

 

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The general allowance calculation, which is completed on a quarterlybasis, begins with segmentation of the remaining (unimpaired) portfolioaccording to loan types.  Historical lossfactors are maintained for each loan type, providing the starting point of the analysis.Historical loss factors are applied to all non-Watchlist loans.  Management is currently utilizing the pastfive-year loss history specific to each major segment to perform the allocation.  Bankshares also has developed data onprobability of default and loss given default, which have been incorporated forthe higher risk rated credits, which include Watchlist loans that are notcurrently impaired.  Those loss factorsare then applied to all loans within the same risk rating.  Qualitative factors that may cause creditlosses to deviate from average historical experience are then developed.  These include, but are not limited to:changes in the volume and severity of past due loans; changes in the volume ofWatchlist loans and nonaccruals; concentrations in a specific industry orgeographic location; administrative risk concerns that include changes in theloan review and loan grading system; changes in lending policies and procedures(which include underwriting, collection, charge-off and recovery practices);changes in management or the staff of any previously mentioned areas; andcurrent economic conditions and indicators. Both internal and external peer data are utilized as applicable toestablish these factors.  Management’sjudgment and experience are key to this process.  These factors are revised to address currentconditions and trends in the portfolio. The general allowance was $133.7 million and $116.7 million at December 31,2005 and 2004, respectively.

 

The combination of specific and general allowance calculations resultedin $137.9 million being allocated to loan portfolio segments at December 31,2005 compared with $127.3 million at December 31, 2004.  The increase in the allocated allowance isprimarily attributable to the $7.1 million allowance related to the CBNVacquisition.  The allocation to thecommercial and leasing portfolio has continued to decrease as management hasmade significant progress in resolving nonperforming loans in thissegment.  This segment has been the majorbeneficiary of the decrease in the specific allowance.  The increased allocations to the commercialreal estate, construction, residential real estate and consumer loan portfoliosare related to the growth in these portfolios, which include balances added asa result of the CBNV acquisition.  Thedecline in the allocation to the home equity lines portfolio is attributable toimproving credit quality metrics.

 

The allowance amount not allocated represents the differential betweenthe combined specific and general allocations and the actual allowance.  The unallocated allowance recognizes theimprecision inherent in estimating and measuring loss when allocating theallowance to individual, or pools of, loans. It is designed to capture fully probable incurred losses in the loanportfolio after taking into consideration these perspectives.  It takes into consideration the allowancelevel deemed appropriate by each affiliate based on its local knowledge andinput from their regulators, including their view from the standpoint of safetyand soundness, among other factors.  Theamount of this component and its relationship to the total allowance for loanlosses may change from one period to another. At December 31, 2005, the unallocated component of the allowancefor loan losses was $18.8 million, or 12.0%, of the allowance for loan losses.

 

During 2005, management engaged a third-party vendor to begin buildinga migration model to enhance the allocation methodology of the allowance forloan losses.  When completed, this modelwill replace the in-house model currently utilized by management.  In anticipation of this project, during 2004,management completed a project to enhance its risk-rating categories to providemore granularity in assessing the overall risk profile of the loanportfolio.  Management expects to convertto the migration model during 2006.  Inaddition, the model will evaluate draws against committed, unused lines ofcredit and project expected losses related to unused lines of credit.  Any reserve for losses on unfunded lines ofcredit must be accounted for as a liability, separate from the allowance forpossible loan losses.  Management doesnot expect that this refinement of the credit-risk analysis will have amaterial effect on its operating results or its financial position.

 

The allowance for loan losses has been established through provisionsfor loan losses against income.  Loansdeemed uncollectible are charged against the allowance for loan losses and anysubsequent recoveries are credited to the allowance.  The total allowance for loan losses increasedby $7.6 million from year-end 2004 to $156.7 million at December 31, 2005,which reflected the addition of $7.1 million of CBNV’s allowance atconsummation under SOP 03-3, “Accounting for Certain Loans or Debt SecuritiesAcquired in a Transfer.” The allowance for loan losses as a percent of loansdeclined to 1.35% at December 31, 2005 compared with 1.46% at December 31,2004.  This reflects overall improvingcredit quality trends, the disposition of previously mentioned problem creditsand the inclusion of the acquired portfolio, which resulted in a lower requiredallowance as a percentage of loans. During 2005, the provision for loan loss expense was $1.6 millioncompared with $7.2 million in 2004.  Netcharge-offs decreased to $1.0 million during 2005 compared with $13.6 millionduring 2004, mainly due to moderating trends in the level of new nonperformingassets, our strategic decision to actively manage down problem loans and ahigher level of recoveries during the period. The consumer portfolio represented the largest net charge-off amount for2005 at $1.4 million.  Net charge-offs asa percent of average loans were 0.01%, 0.14% and 0.11% for the years ended December 31,2005, 2004 and 2003, respectively. Intensive collection efforts continue after a loan is charged off inorder to maximize the recovery of amounts previously charged off.  Recoveries as a percent of loans charged offwere 86.9% in 2005, 26.3% in 2004 and 30.4% in 2003.  Recoveries in a given year may not relate toloans charged off in that year.  Furtherdetails related to the allowance for loan losses are shown in the tables aboveand in Note No. 4 (Loans and Allowance for Loan Losses) of the financialstatements.

 

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NONPERFORMING ASSETS

 

A five-year comparison of nonperforming assets is presented below.

 
| ** **                                                                         | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**                                                         | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Nonaccrual loans (1)                                                               |       |                  |       |   |   |   |   |   |   |   |   |
| Commercial  and leasing                                                            | ** ** | **$**                 | **15,771** |   | $ | 25,510 |   | $ | 37,393 |   | $ | 19,944 |   | $ | 22,495 |   |
| Commercial  real estate                                                            | ** ** | **4,451**             |       | 1,959 |   | 7,363 |   | 9,322 |   | 5,564 |   |
| Construction                                                                       | ** ** | **376**               |       | 9 |   | 651 |   | 1,365 |   | 2,201 |   |
| Residential  real estate                                                           | ** ** | **1,505**             |       | 2,748 |   | 3,721 |   | 2,479 |   | 2,251 |   |
| Home equity  lines                                                                 | ** ** | **88**                |       | 300 |   | 78 |   | 105 |   | 9 |   |
| Consumer                                                                           | ** ** | **374**               |       | 372 |   | 1,146 |   | 156 |   | 399 |   |
| Total                                                                              | ** ** | **22,565**            |       | 30,898 |   | 50,352 |   | 33,371 |   | 32,919 |   |
| Renegotiated loans (1)                                                             | ** ** | **—**            |       | — |   | — |   | — |   | — |   |
| Loans  contractually past due 90 days or more and still accruing interest          | ** ** | **—**            |       | — |   | — |   | — |   | — |   |
| Total  nonperforming loans                                                         | ** ** | **22,565**            |       | 30,898 |   | 50,352 |   | 33,371 |   | 32,919 |   |
| Other real estate owned                                                            | ** ** | **667**               |       | 212 |   | 191 |   | 132 |   | 181 |   |
| Total  nonperforming assets                                                        | ** ** | **$**                 | **23,232** |   | $ | 31,110 |   | $ | 50,543 |   | $ | 33,503 |   | $ | 33,100 |   |
| Nonperforming  loans as a percent of period-end loans                              | ** ** | **0.19**              | %          | 0.30 | % | 0.54 | % | 0.46 | % | 0.48 | % |
| Nonperforming  assets as a percent of period-end loans and other real estate owned | ** ** | **0.20**              | %          | 0.30 | % | 0.55 | % | 0.46 | % | 0.48 | % |
|                                                                                    |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Aggregate gross interest income of $2.1 million and $2.5million in 2005 and 2004, respectively, on nonaccrual and renegotiated loanswould have been recorded if these loans had been accruing on their originalterms throughout the period or since origination if held for part of theperiod.  The amount of interest income onthe nonaccrual and renegotiated loans that was recorded totaled$0.5 million and $0.8 million in 2005 and 2004, respectively.

 

**Nonperforming Assets**

Nonperforming assets consist of nonaccrual loans, renegotiated loansand other real estate owned (i.e., real estate acquired in foreclosure or inlieu of foreclosure).  With respect tononaccrual loans, our policy is that, regardless of the value of the underlyingcollateral and/or guarantees, no interest is accrued on the entire balance onceeither principal or interest payments on any loan are 90 days past due at theend of a calendar quarter.  All accruedand uncollected interest on such loans is reversed out of interest income andis recognized only as it is collected. If a loan is impaired and has a specific loss allocation based on ananalysis under SFAS No. 114, “Accounting by Creditors for Impairment of aLoan – an amendment of FASB Statements No. 5 and 15,” all payments areapplied against the loan’s principal.  Aloan may be placed on nonaccrual status sooner than this standard if, inmanagement’s judgment, such action is warranted.

 

Nonperforming assets as a percentage of period-end loans and other realestate owned were 0.20% at December 31, 2005 compared with 0.30% in thepreceding year.  At year-end 2005,nonperforming assets were $23.2 million compared with $31.1 million at year-end2004.  Nonperforming loans totaled $22.6million at December 31, 2005 compared with $30.9 million at December 31,2004.  The largest dollar decrease innonperforming loans was $9.7 million in the commercial and leasing category,which accounted for 69.9% of nonperforming loans at December 31,2005.  The decrease in nonperformingloans was due primarily to improvement in credit quality at the lead bank,MSD&T.

 

The level of monitored loans, or loans with characteristics suggestingthat they may be classified as nonperforming in the near future, decreasedduring the year.  At December 31,2005, monitored loans were $2.2 million compared with $6.4 million a yearbefore. Contributing to this decrease was the elimination of the one remainingloan secured by a commercial aircraft. The amount of loans past due 30-89 days increased from $51.5 million at December 31,2004 to $65.2 million at December 31, 2005.  This increase was primarily reflected in theconstruction loan category and in a general increase in loans past due 30days.  At the acquisition date,Bankshares determined that two loans at CBNV were deemed to be impaired andwere subject to SOP 03-3.  These loanshad a $4.9 million contractual balance and a $3.5 million carrying value at December 31,2005 and the estimated cash flows are assessed at each quarter-end.

 

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Other real estate owned was $667 thousand at December 31, 2005compared with $212 thousand at December 31, 2004.  These properties generally are sold within ashort period, therefore, regardless of the amount, the properties generallywill have changed from year to year. Other real estate owned is carried at the lower of cost or fair marketvalue.  Refer to the data in the “NonperformingAssets” table above, which shows the changes in the amounts of variouscategories of nonperforming assets over the last five years and sets forth therelationship between nonperforming loans and total loans.

 

LOAN MATURITY SCHEDULE

 

The following table illustrates loan diversity by maturity distributionfor commercial (including commercial real estate and lease financing) andconstruction loans as of December 31, 2005.

 
| ** **                 | ** ** | **Maturing** | ** ** |
|----------------------------|------------|--------------|------------|
| ** **                 | ** ** | ** **   | ** ** | **Over 1** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **1 year**   | ** ** | **through** | ** ** | **Over 5** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **or less**  | ** ** | **5 years** | ** ** | **years** | ** ** | **Total** | ** ** |
| Commercial                 |       | $            | 2,150,884  |   | $ | 3,482,378 |   | $ | 1,027,336 |   | $ | 6,660,598 |   |
| Construction               |       | 671,557      |       | 812,123 |   | 123,415 |   | 1,607,095 |   |
| Total                      |       | $            | 2,822,441  |   | $ | 4,294,501 |   | $ | 1,150,751 |   | $ | 8,267,693 |   |

 

Of the $5.4 billion in loans maturing after one year, $2.6 billion, or47.3%, have fixed interest rates, and $2.8 billion, or 52.7%, have variable interestrates.

 

**Asset/Liability and Market Risk Management**

Asset/liability management involves the evaluation, monitoring andmanagement of interest rate risk, market risk, liquidity and funding.  The Asset/Liability Management Committee (“ALCO”)oversees policy guidelines and reports periodically to the Board ofDirectors.  This Committee consists ofsenior financial and business executives. Treasury division management and other finance personnel monitor theday-to-day exposure to interest rates in response to loan and deposit flows.

 

**Interest Rate Risk**

Interest rate risk, which potentially can have a significant earningsimpact, is an integral part of being a financial intermediary. Bankshares issubject to interest rate risk due to a variety of factors including:

 

•                  Assets andliabilities may mature or reprice at different times (for example, currentlyour assets reprice slightly faster than our liabilities and if interest ratesfall, earnings will initially decline);

•                  Assets andliabilities may reprice at the same time but by different amounts (for example,when the market level of interest rates is falling, we may reduce rates paid onchecking and savings deposit accounts by an amount that is less than thegeneral decline in market interest rates);

•                  Short-term andlong-term market interest rates may change by different amounts (i.e., theshape of the yield curve may affect new loan and investment yields and fundingcosts differently); or

•                  The remainingmaturity of various assets or liabilities may shorten or lengthen as interestrates change (for example, if long-term mortgage rates fall, mortgage-backedsecurities may prepay significantly earlier than anticipated, which couldreduce portfolio income). In addition, interest rate changes have an indirectimpact on loan demand, credit losses, mortgage originations, the value ofmortgage servicing rights and other sources of earnings.

 

A balance sheet is considered asset-sensitive when its assets (loansand securities) reprice faster or to a greater extent than liabilities(deposits and borrowings).  Anasset-sensitive balance sheet will produce more net interest income when ratesrise and less net interest income when rates fall.  A balance sheet is described asliability-sensitive when its liabilities (deposits or borrowings) reprice morefrequently or to a greater degree than its assets (loans and securities).  A liability-sensitive balance sheet willproduce a lower level of net interest income when interest rates rise and morenet interest income when rates fall. Bankshares’ large and relatively rate- insensitive deposit base funds aportfolio with a large percentage of floating-rate commercial and consumerloans, which creates a bias towards asset sensitivity.

 

To manage this asset sensitivity in our balance sheet, we maintain alarge portfolio of fixed-rate, although short-duration, investments.Periodically, we elect to use derivatives to protect assets and liabilitiesfrom changes in interest rates.  Whendeciding whether to use derivatives instead of cash market instruments toachieve the same goal, we consider a number of factors, such as cost,efficiency, the effect on our liquidity and capital, and our overallstrategy.  The derivatives we use forinterest rate risk management purposes are primarily interest rate swaps.  We fully incorporate the market riskassociated with interest rate risk management derivatives into our

 

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earnings simulation model in the same manner as other on-balance-sheetfinancial instruments.  The credit riskamount and estimated net fair value of these derivatives as of December 31,2005 and 2004 are presented in Note No. 18 (Derivative Instruments andHedging Activities) to the financial statements.   Derivatives are used for asset/liabilitymanagement in three ways:  (1) toconvert long-term fixed-rate debt to floating-rate payments by entering intoreceive-fixed swaps at issuance; (2) to convert the cash flows fromselected asset and/or liability instruments/portfolios from fixed to floatingpayments or vice versa; and (3) to hedge the mortgage origination pipelineby utilizing forward commitments for loans held-for-sale.

 

We assess interest rate risk by comparing projected net interest incomein the current rate environment with various interest rate scenarios thatdiffer in the direction of interest rate changes, the degree of change overtime, the speed of the change and the projected shape of the yield curve.  This analysis incorporated substantially allof Bankshares’ assets and liabilities and off-balance sheet instruments as of December 31,2005.  Through these simulations,management estimates the impact on net interest income of a 200 basis pointupward and a 200 basis point downward change in interest rates.  In analyzing interest rate sensitivity forpolicy measurement, we compare our forecasted net interest income in both “highrate” and “low rate” scenarios to our most likely earnings estimate utilizing a“flat rate” scenario.  The policymeasurement period is 12 months in length, beginning with the first month ofthe forecast.  Our objective is to manageprudently the interest-bearing assets and liabilities on our balance sheet inways that minimize our exposure to changes in interest rates.  Our “high rate” and “low rate” scenariosassume gradual 100 and 200 basis point increases or decreases in the federalfunds rate relative to the “flat rate” scenario.  Our standard approach evaluates expected netinterest income in a 200 basis point range both above and below the “flat rate”scenario.  However, due to the lowabsolute levels of interest rates in 2004, we modified the “low rate” scenarioto measure a decline of 100 basis points. To capture the impact of yield curve-related risk, we simultaneouslymeasure the impact of nonparallel shifts in rates.  A parallel shift would move all points on theyield curve by the same increments.  Anonparallel shift would consist of a 100 basis point increase in short-termrates, while long-term rates would increase by a different amount.  A rate shift in which short-term rates riseto a greater extent than long-term rates is referred to as a “flattening” ofthe yield curve.  Conversely, long-termrates rising to a greater extent than short-term rates would lead to a “steepening”of the yield curve.

 

The Federal Reserve Board began tightening monetary policy in June 30,2004.  By December 31, 2005, theFederal Reserve Board had raised interest rates by 325 basis points.  As a result, the historically steep yieldcurve environment that persisted in 2004 began to shift to a flatter yieldcurve environment.  Accordingly,throughout 2005 we evaluated rate shifts that included a flattening of theyield curve.  Interest rate riskmanagement decisions are made based on a composite view of both parallel andnonparallel shifts.

 

EARNINGS SENSITIVITY

The following table summarizes the effect a positive 100 and 200 basispoint change and a negative 100 and 200 basis point change in interest rateswould have on Bankshares’ net interest income over the next 12 months.

 
| ** **                   | ** ** | **Calculated increase /  (decrease) in** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **projected net interest income**        | ** ** |
| **Change in interest rates** | ** ** | **As of December 31,**              | ** ** |
| **(basis points)**           | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| +200                         | ** ** | **2.3**                                  | **%**      | 5.5 | % |
| +100                         | ** ** | **1.3**                                  | **%**      | 2.8 | % |
| -100                         | ** ** | **(1.8**                                 | **)%**     | (3.0 | )% |
| -200                         | ** ** | **(4.6**                                 | **)%**     | N/A | % |

 

As seen in the “Earnings Sensitivity” table above, within a one-yearhorizon, the earnings sensitivity model forecasts that, compared with the netinterest income projection under stable rates, net interest income wouldincrease by 1.3% and 2.3% if interest rates increased by 100 and 200 basispoints, respectively.  Inversely, ifinterest rates decreased by 100 and 200 basis points, net interest income woulddecrease by 1.8% and 4.6%, respectively. Bankshares manages the interest rate risk profile within policy limitsof +/- 5.0% change in net interest income on a +/- 200 basis point change ininterest rates and at December 31, 2005 was within the risk limitsestablished.  These results are notnecessarily indicative of future actual results, nor do they take into accountcertain actions that management may undertake in response to future changes ininterest rates.

 

Bankshares’ Consolidated Balance Sheet had been positioned for a raterise, and the increase in 2005 in net interest income reflects some of thebenefit of the Federal Reserve Board rate increases.  In response to action by the Federal ReserveBoard, Bankshares prime interest rate continued to rise. Bankshares hasapproximately $4.7 billion in loans that will reprice within the next quarter.Additionally, in 2005 we continued our investment strategy of shifting theportfolio mix into a higher percentage of mortgage-backed securities.  We use mortgage-backed securities as a hedgeagainst both rising and falling interest rates, depending on their purchaseprice, which has a significant impact on their yield in different rateenvironments.  We selectively includecurrent coupon mortgage securities in our portfolio as a hedge against acontinued low rate environment.  Mortgagesecurities purchased at a discount are used to hedge against decliningrates.  The effects of a rising rateenvironment on interest expense are less predictable due to customer behaviorand intense price competition that may shift the mix of deposit products.  Approximately $1.6 billion in short andlong-term debt will also be subject to rate increases in the near term.  Given the current rate environment, the shapeof the yield curve and the competitive dynamic, we anticipate the net interestmargin will be under greater pressure in 2006.

 

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MARKET VALUE OF EQUITY MODELING

 

Bankshares alsoutilizes the market value of equity as a measurement tool in managing interestrate sensitivity.  The market value ofequity measures the degree to which the market values of Bankshares’ assets andliabilities and off-balance sheet instruments will change given a change ininterest rates.  ALCO guidelines limitthe change in market value of equity in a 200 basis point parallel rate shockto 25% of the market value of equity assuming interest rates at December 31,2005.  The up 200 basis point scenarioresulted in a 2.9% decrease at December 31, 2005 and a 2.2% increase at December 31,2004.  The down 200 basis point scenarioresulted in a 3.9% decrease at December 31, 2005 and an 8.6% decrease at December 31,2004.  At December 31, 2005 and2004, Bankshares was within its policy guidelines.

 

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

 

##### **Market Risk**

Market risk is defined as the constraint imposed by lower market valuesof assets and liabilities as interest rates and equity markets fluctuate.  Changes in market values also affect the feeincome earned by IWM, where a significant portion of the fee schedule istied to current asset values under management or administration.  Bankshares has designated substantially allof its investment portfolio as available-for-sale, and in accordance withfinancial reporting standards, this portfolio is reported at fair value.  Changes in fair value, net of tax, arereflected as a component of shareholders’ equity.

 

*Trading Activities*

Bankshares provides capital market products to its customers.  From a market risk perspective, Bankshares’net income is exposed to changes in interest rates, credit spreads, andequities and their implied volatilities. The primary purpose of Bankshares’ trading business is to accommodatecustomers in the management of their market price risks.  Derivative transactions executed withcustomers are simultaneously hedged in the capital markets.  All derivatives transacted with customersused to hedge capital market transactions with customers are carried at fairvalue.  The ALCO establishes and monitorscounterparty risk limits.  The notionalamount, exposure amount and estimated net fair value of all customeraccommodation derivatives at December 31, 2005 are included in Note No. 18(Derivative Instruments and Hedging Activities) to the financial statements.

 

*Equity Markets*

Bankshares isdirectly and indirectly affected by changes in the equity markets.  Bankshares has made investments in privateequities and hedge funds.  These privateequity investments are made within capital allocations approved by Bankshares’management. Management reviews these investments at least quarterly andassesses them for possible other-than-temporary impairment.  For nonmarketable investments, the analysisis based on the facts and circumstances of each individual investment and theexpectations for that investment’s cash flows and capital needs, the viabilityof the business model and an appropriate exit strategy.  Private equity investments totaled $20.7million at December 31, 2005 and $24.7 million at December 31,2004.  Hedge funds investment totaled$62.8 million at December 31, 2005 and $77.5 million at December 31,2004.

 

Changes in equitymarket prices may also indirectly affect Bankshares’ net income (1) byaffecting the value of third-party assets under management or administrationwithin IWM and, hence, fee income; (2) by affecting particular borrowers,whose ability to repay principal and/or interest may be affected by the stockmarket; or (3) by affecting brokerage activity, related commission incomeand other business activities.

 

Bankshares’maintenance of capital ratios well above regulatory requirements (see “CapitalResources and Adequacy”) provides management with the flexibility to utilizethe available-for-sale portfolio for liquidity and interest rate riskmanagement needs, even during a period when valuations are depressed.  Maintaining a fairly short duration in theportfolio also mitigates market risk.

 

**Liquidity Risk**

Liquidity risk is the possibility that Bankshares will not be able tofund present and future financial obligations. The objective of liquidity management is to maintain the ability to meetcommitments to fund loans, purchase securities and repay deposits and otherliabilities in accordance with their terms. To achieve this objective, the ALCO establishes and monitors liquidityguidelines that require sufficient asset-based liquidity to cover potentialfunding requirements and to avoid over-reliance on volatile, less reliablefunding markets.  Debt securities in theavailable-for-sale portfolio provide liquidity, in addition to the immediatelyliquid resources of cash and due from banks and federal funds sold andsecurities purchased under resale agreements. By limiting the maturity of securities and maintaining a conservativeinvestment posture, management can rely on the investment portfolio to helpmeet any short-term funding needs. U.S. Treasury and agency securities, whichprovide the greatest liquidity, averaged $1.4 billion in 2005, an 8.6% decreasefrom the average of $1.6 billion in 2004.

 

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Core customer deposits historically have provided a substantial sourceof relatively stable, low-cost funds. During 2005, core deposits (total deposits less certificates of depositof $100,000 and over), averaged $9.8 billion compared with $9.1 billion during2004.  Although not viewed as coredeposits, a substantial portion of short-term borrowings comprised ofsecurities sold under agreements to repurchase and commercial paper originatefrom core deposit relationships tied to the overnight cash management programoffered to customers.  Short-termborrowings averaged $1.1 billion during 2005, an 18.1% increase from the 2004level.

 

In addition to these sources, Bankshares has access to national marketsfor certificates of deposit, commercial paper and debt financing.  Should Bankshares need to supplement itsliquidity, it also has $2.1 billion in lines with the Federal Home Loan Bank ofAtlanta (“FHLB”) and back-up commercial paper lines of $40.0 million withcommercial banks.  Bankshares is requiredto obtain approval from holders of Bankshares’ 6.72% and 6.80% unsecured seniornotes if Bankshares incrementally borrows in excess of $150.0 million under theFHLB lines.

 

Long-term debt increased to $742.2 million at December 31, 2005from $690.1 million at December 31, 2004, primarily due to the $116.2million of additional FHLB advances and subordinated debt assumed in the CBNVacquisition.  During 2005, $118.5 millionwas repaid on long-term debt.  Banksharescan access the capital markets for long-term funding by issuing registered debtand private placements.  In September 2005,Moody’s Investors Service affirmed Mercantile Bankshares Corporation’scommercial paper rating of “P-1” and Bankshares’ subordinated debt rating of “A2.”  Also in September 2005, Standard &Poor’s Ratings Service affirmed Bankshares’ rating of “A+/Stable/A-1” andcounterparty rating of “A+/Stable/A-1.” Rating agencies base their ratings on many quantitative and qualitativefactors, including capital adequacy, liquidity, asset quality, quality of themanagement team, business mix and the level and quality of earnings.

 
| TIER I CAPITAL RATIO*                                                              |   | DIVIDENDS PER SHARE                  |
|------------------------------------------------------------------------------------|--------|--------------------------------------|
| Regulatory Tier I Minimum: 4.0%                                                    |   | Five-Year Compound Growth Rate: 7.8% |
| * Tier I  equity as percentages of risk-adjusted total assets at December 31, |   |                                 |

 
|  |   |  |
|--|--------|--|

 

**Capital Resources and Adequacy**

Bankshares has consistently maintained a capital to asset ratio higherthan its peers, as reported in data furnished by its regulators. Shareholders’equity averaged $2.1 billion during 2005, which represented an increase of$224.7 million, or 12.0%, over the prior year’s average.  This increase reflected the shares issued inthe CBNV acquisition that were valued at $124.3 million.

 

Maintenance of capital strength has long been a guiding principle ofBankshares.  Ample capital is necessaryto sustain growth, to provide a measure of protection against unanticipateddeclines in asset values and to safeguard the funds of depositors.  Capital also provides a source of funds tomeet loan demand and enables Bankshares to manage its assets and liabilitieseffectively.

 

Shareholders’ equity increased 14.4% to $2.2 billion at year-end 2005from $1.9 billion at year-end 2004. The increase was attributable primarily toearnings growth and the CBNV acquisition offset by increased cash dividendpayments.  Book value per share was $17.81at December 31, 2005 compared with $16.12 at December 31, 2004.  The ratio of average equity to average assetswas 13.51% in 2005 and 13.38% in 2004, ranking Bankshares among the moststrongly capitalized banks in the industry. Excluding intangible assets, average tangible equity to average tangibleassets was 9.70% in both 2005 and 2004. Bankshares believes that excluding intangible assets helps the investorunderstand the effects of acquisition activities on its results and moreclosely approximates the basis for measuring the adequacy of capital forregulatory purposes.

 

While maintaining exceptional capital strength and financing the growthof the corporation, Bankshares also has pursued a share repurchaseprogram.  In 2001, the Board of Directorsauthorized the repurchase of shares of common stock under these programs.  At December 31, 2005, there remained 476,327shares of common stock authorized for repurchase.  The share repurchase program has supportedmanagement’s strategy to enhance shareholder value.  Management has repurchased shares in openmarket and privately negotiated transactions during periods when capitalaccumulates at a rate in excess of that required to support the growth ofearning assets.  See Note No. 11(Shareholders’ Equity) of the financial statements and the “Statements ofChanges in Consolidated Shareholders’ Equity” found elsewhere in this documentfor details related to the share repurchase program.

 

47

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Various bank regulatory agencies have implemented capital guidelines,which are directly related to a bank’s risk-based capital ratios. By regulatorydefinition, a well capitalized institution, such as Bankshares, faces fewerregulatory constraints on its operations than institutions classified asundercapitalized.  For example, only wellcapitalized banks can accept brokered deposits without advance regulatory approval.  In addition, FDIC deposit insurance premiumrates are significantly lower for banks with higher capital levels. The “Tier ICapital Ratio” graph above shows that Bankshares has maintained capital levelswell in excess of the regulatory minimum over each of the last five years.  For a further discussion of the regulatorycapital requirements that apply to Bankshares, see Note No. 11(Shareholders’ Equity) of the financial statements.  Bank regulatory agencies also impose certainrestrictions on transactions among and between subsidiaries of bank holdingcompanies, including extensions of credit, transfers of assets and payments ofdividends.  Historically, the dividendrestrictions have not limited dividend payments at Bankshares and it is notanticipated that they will have a constraining effect in the future.  In addition to dividend restrictions, capitalrequirements also are affected by off-balance sheet risks.  These include such items as letters of creditand commitments to extend credit. Refer to Note No. 10 (Commitments andContingencies) of the financial statements for information regarding Bankshares’commitments.

 

DIVIDENDS

 
| ** **       | ** ** | **2005** | ** ** | **2004**   | ** ** |
|------------------|------------|----------|------------|------------|------------|
| **Quarter**      | ** ** | **4th**  | ** ** | **3rd**    | ** ** | **2nd** | ** ** | **1st** | ** ** | **4****th** | ** ** | **3rd** | ** ** | **2nd** | ** ** | **1st** | ** ** |
| Common dividends | ** ** | **$**    | **0.25**   | ** ** | **$**      | **0.25** | ** ** | **$** | **0.25** | ** ** | **$** | **0.23** |   | $ | 0.23 |   | $ | 0.23 |   | $ | 0.23 |   | $ | 0.22 |   |
|                  |            |          |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Bankshares has paid quarterly cash dividends on its common stock since September 1970when such stock was first issued. Bankshares intends to consider quarterlypayment of dividends on its common stock, but such payment is necessarilydependent on many factors, including the future earnings and financialrequirements of Bankshares and its affiliates.

 

On January 10, 2006, Bankshares’ Board of Directors announced athree-for-two stock split on its common stock. In addition, the Board statedits intention to raise the indicated quarterly per share dividend rate,adjusted for the stock split, to $0.26 per share.

 

For the 29th consecutive year, the annual dividend paid on common stockexceeded the prior year’s level.  Effectivewith the June 2005 dividend, the quarterly cash dividend, adjusted for thestock split, was increased 8.7% to $0.25 from $0.23 per share.  Over the last five years, dividends haveincreased at a compound growth rate of 7.8 %. Management periodically will evaluate the dividend rate in light ofBankshares’ capital strength, profitability and conditions prevailing in theeconomy in general and the banking industry in particular.  The annual dividends paid per common sharewere $0.99 in 2005 and $0.92 in 2004. Total cash dividends paid were $120.2 million in 2005 and $109.3 millionin 2004.  The “Dividends” table abovepresents quarterly dividends paid over the last two years.

 

RECENT COMMON STOCK PRICES

Market Prices (1)

 
| ** **  | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|-------------|------------|-----------|------------|------------|------------|
| **Quarter** | ** ** | **4th**   | ** ** | **3rd**    | ** ** | **2nd** | ** ** | **1st** | ** ** | **4****th** | ** ** | **3rd** | ** ** | **2nd** | ** ** | **1st** | ** ** |
| High        | ** ** | **$**     | **40.09**  | ** ** | **$**      | **37.46** | ** ** | **$** | **35.20** | ** ** | **$** | **34.90** |   | $ | 35.39 |   | $ | 32.89 |   | $ | 31.95 |   | $ | 30.67 |   |
| Low         | ** ** | **34.11** | ** ** | **34.13**  | ** ** | **32.39** | ** ** | **32.27** |   | 31.38 |   | 29.45 |   | 26.87 |   | 27.67 |   |
|             |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) The stock of Mercantile Bankshares Corporation is traded onthe NASDAQ National Market under the symbol MRBK. The quotations representactual transactions.

 

As of January 31, 2006, there were 10,996 shareholders of record.

 

**Off-Balance Sheet Arrangements andContractual Obligations**

 

*Off-Balance Sheet Arrangements*

Bankshares consolidates majority-owned subsidiaries that itcontrols.  Other affiliates, includingcertain joint ventures in which there is less than 20% ownership, generally arecarried at the lower of cost or fair market value.  Bankshares does not dispose of troubled loansor problem assets by means of unconsolidated special purpose entities.

 

One of Bankshares’ mortgage banking subsidiaries, as a Fannie MaeDelegated Underwriting and Servicing lender, has a loss sharing arrangement forloans originated on behalf of and sold to Fannie Mae.  In the ordinary course of business,Bankshares routinely originates and sells mortgage loans on the secondarymarket.  Typically, these loans are soldunder forward commitments.  Refer to NoteNo. 10 (Commitments and Contingencies) of the financial statements foradditional information regarding commitments relating to mortgage banking.

 

48

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*Contractual Obligations and Other Commitments*

Through the normal course of business, Bankshares enters into certaincontractual obligations and other commitments. Such obligations generally relate to funding operations through debtarrangements as well as leases of premises and equipment.  It is estimated that approximately $36.0 millionof capital expenditures for new and existing banking offices and replacement offurniture, equipment and technology will occur in 2006.  While these items have been included in thebudget for 2006, they are subject to a review and approval process prior tofunding.  For further information oncommitments, see Notes No. 5, 9 and 10 of the financial statements.

 

As a financial services provider, Bankshares routinely enters intocommitments to extend credit, including loan commitments, standby letters of creditand financial guarantees.  Guarantees arecontracts that contingently require us to make payments to a guaranteed partybased on an event or changes in an underlying asset, liability, rate or index.  While contractual obligations representfuture cash requirements of Bankshares, a significant portion of commitments toextend credit are likely to expire without being drawn upon.  Such commitments are subject to the samecredit policies and approval processes accorded to loans made by Bankshares.

 

Additionally, Bankshares has committed to invest funds in third-partyprivate equity investments.

 

The table below summarizes significant contractual obligations andother commitments:

 
| ** **                                         | ** **   | **1 Year**  | ** ** | **1-3**   | ** ** | **3-5**   | ** ** | **After 5** | ** ** | ** ** | ** ** |
|----------------------------------------------------|--------------|-------------|------------|-----------|------------|-----------|------------|-------------|------------|------------|------------|
| **(Dollars in thousands)**                         | *** *** | **or less** | ** ** | **years** | ** ** | **years** | ** ** | **years**   | ** ** | **Total**  | ** ** |
| Contractual obligations                            |         |        |       |      |       |      |       |        |       |       |       |
| Long-term debt (1)                                 |         | $           | 88,028     |      | $          | 45,911    |       | $           | 27,823     |       | $          | 580,401 |   | $ | 742,163 |   |
| Operating leases                                   |         | 16,758      |       | 29,094    |       | 17,919    |       | 43,667      |       | 107,438    |       |
| Purchase obligations                               |         | 5,000       |       | 10,000    |       | 10,000    |       | 5,000       |       | 30,000     |       |
| Total contractual obligations by period            |         | $           | 109,786    |      | $          | 85,005    |       | $           | 55,742     |       | $          | 629,068 |   | $ | 879,601 |   |
| Other commitments                                  |         |        |       |      |       |      |       |        |       |       |       |
| Commitments to extend credit                       |         |        |       |      |       |      |       |        |       | $          | 4,782,574  |   |
| Standby letters of credit and financial guarantees |         |        |       |      |       |      |       |        |       | 540,567    |       |
| Unfunded third-party private equity investments    |         |        |       |      |       |      |       |        |       | 26,641     |       |
| Total other commitments                            |         |        |       |      |       |      |       |        |       | $          | 5,349,782  |   |

 

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##### **(1) Includes$49.3 million in financing resulting from the sale of the Hopkins PlazaBuilding. Includes principal payments only.**

 

49

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REVIEW OF EARNINGS ANDBALANCE SHEET FOR 2004 TO 2003

 

**Performance & OperatingAnalysis**

 

In the third quarter of2004, Bankshares consolidated 11 affiliate banks into four banks.  The consolidated banks shared commonmarkets.  The consolidation of these banksenables the surviving banks to serve their local customers with greater size,scale and expertise.  This initiative wasnot undertaken to reduce operating costs, although some savings arose out ofthe consolidation.  It was to enablethese banks to streamline operating processes, controls and compliance efforts;recruit seasoned professionals to these markets; and provide a greater breadthof services at the local level. Bankshares is committed to the affiliate bank model, whereby localboards of directors provide strong oversight, and bank presidents maintainstrong relationships within the community. As with any strategic initiative,costs are involved.  In 2004, Bankingincurred approximately $3.6 million in restructuring charges related to theconsolidations.  A majority of thesecosts were in severance charges and other personnel costs of approximately $2.3million with $1.1 million in legal and consulting fees.

 

Net income in 2004 was$229.4 million compared with $196.8 million in 2003, a 16.6% increase.  Diluted net income per common share was $1.92in 2004 compared with $1.79 in 2003, an increase of 7.3%.  Return on average assets was 1.64%, andreturn on average equity was 12.26% in 2004 compared with 1.64% and 13.15%,respectively, in 2003.  The decrease inreturn on average equity was due primarily to equity issued in the Farmers acquisition.  Average assets increased 16.9% to $14.0billion; average deposits increased 15.8% to $10.4 billion; and average loansincreased 20.2% to $9.7 billion for the year ended December 31, 2004compared with the prior year.

 

Net interest income, on afully tax-equivalent basis, was $552.5 million in 2004 compared with $479.1million in 2003.  Both changes in thelevel of interest rates and changes in the amount and composition ofinterest-earning assets and interest-bearing liabilities affected net interestincome.  In response to the improvingeconomy, the Board of Governors of the Federal Reserve System (“Federal ReserveBoard”) began increasing short-term interest rates.  After reducing short-term rates by 50 basispoints in 2002 and 25 basis points in 2003, the Federal Reserve Board increasedshort-term rates 125 basis points in 2004. By year-end 2004, the benchmark targeted overnight federal funds ratehad risen from 1.00% to 2.25%.  Althoughthe net interest margin improved only 3 basis points to 4.35% for 2004from 4.32% for 2003, this compared very favorably with the 33 basis pointdecline experienced during 2003.

 

Noninterest income for2004 increased by $30.4 million, or 16.5%, to $213.9 million compared with$183.6 million for 2003. The increases over 2003 were significantly affected innearly every category by the inclusion of Farmers for a full year, which wasacquired on August 12, 2003. Stronger equity markets on average during 2004 fueled the $90.1 million,or 14.1%, increase in IWM revenues over 2003. Additionally, the investment in nonmarketable investments (privateequity, hedge funds and other investments) improved with the stronger equitymarkets.  Income from private equity andother investments increased $1.7 million, or 212.2%, in 2004, offset slightlyby a decline in income from hedge funds of $0.9 million, or 13.4%, in 2004.

 

Noninterest expensesincreased $54.5 million, or 16.2%, from 2003. The principal reasons for the year-over-year increase were the full-yearinclusion of Farmers, Boyd Watterson and Peremel; costs related to theconsolidation of 11 bank affiliates into four; costs related to conversion andoutsourcing the IWM back-office to SunGard; and increased professional servicesrelated to compliance costs.  Salariesincreased $27.3 million, or 17.0%. Nearly one-third of this increase ($9.2 million) was due to Farmers,Boyd Watterson and Peremel included in 2004 for a full year.

 

Net occupancy expenseincreased by $3.6 million, or 17.1%, during 2004 due to inclusion for a fullyear of 39 net additional branch locations as well as three corporate officesrelated to acquisitions.  Mitigating aportion of this expense was $1.2 million related to the termination of certainBanking lease agreements, due primarily to the Farmers integration concluded in2004.

 

Professional feesincreased $5.8 million in 2004.  Professionalservices increased with costs incurred in connection with the investigation ofpotential acquisitions of $1.0 million, legal costs related to investigatoryand litigation matters that, in management’s view, were not normal recurringexpenses of $2.5 million, and compliance implementation costs of $2.5 millionrelated to Section 404 of The Sarbanes-Oxley Act of 2002.

 

50

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**Segment Reporting**

 

In the fourth quarter of2005, the Private Banking Group of MSD&T was consolidated into the Private BankingGroup of IWM. The segment results have been reclassified to conform to currentpresentation for comparability.

 

*Banking*

Net income in 2004 was $220.9million compared with $192.5 million in 2003, a 14.7% increase.  For the year ended December 31, 2004,average assets increased 15.8% to $13.4 billion; average deposits increased 14.6%to $10.3 billion; and average loans increased 20.4% to $9.6 billion.

 

Net interest income, on afully tax-equivalent basis, was $539.0 million in 2004 compared with $474.6million in 2003.  The increase in netinterest income was attributable to a 14.7% increase in average earning assets,which more than offset a decline of 4 basis points in the net interest margin.Contributing to the net interest margin decline was the capital restructuringof the banks during the third quarter of 2003. Subordinated debt totaling $300 million, issued by Bankshares in April 2003,and used in part to fund the cash portion of the Farmers acquisition, wasinvested in a like amount of subordinated debt issued by the banks.  Excess equity capital was paid to Banksharesin the form of a special cash dividend.

 

The year-over-yearincreases in noninterest income and noninterest expenses from 2003 were attributableprimarily to the inclusion of Farmers for a full year and the branch expansionprograms.  Noninterest income increasedto $114.5 million in 2004 from $98.4 million in 2003 with deposit servicecharges increasing by $5.1 million, insurance fees increasing by $8.7 millionand electronic banking fees increasing by $4.8 million, accounting for thelargest gains.  These gains werepartially offset by a decrease of $6.8 million in net gains on investmentsecurities sold.  Noninterest expensesincreased to $318.7 million in 2004 from $268.7 million in 2003.  More than 72% of this increase was related tosalaries and benefits, which grew by $32.7 million.  Severance costs related to the affiliate bankconsolidations were approximately $2.3 million. Occupancy expense increased by $3.1 million, and amortization ofintangible assets increased by $2.6 million, while furniture and equipmentexpenses decreased by $1.3 million.

 

*IWM*

On November 12,2004, Bankshares consolidated its brokerage activities by merging MercantileSecurities, Inc. into Peremel. The resulting entity, Mercantile BrokerageServices, Inc., is a general securities broker-dealer that offersfull-service, discount and online brokerage services.

 

Net income in 2004 was$16.5 million compared with $11.4 million in 2003.  Pretax profit margins, prior to corporateoverhead allocations, were 31.1% and 26.3% for 2004 and 2003,respectively.  At December 31, 2004,assets under administration by IWM were $47.8 billion, an increase of $1.8billion from the prior year.  Bankshareshad investment management responsibility for $21.1 billion at December 31,2004 and 2003.

 

Revenues increased $14.3million, or 16.5%, to $100.7 million in 2004 from $86.4 million in 2003.  Revenue increases were achieved in the threeprincipal client segments:  privatewealth, institutional and brokerage. Growth in IWM revenues was due principally to stronger markets during2004 than 2003, new business development efforts and the inclusion of a fullyear’s results for Boyd Watterson and Peremel, which were acquired on March 1,2003 and April 1, 2003, respectively. Together, these acquisitions accounted for $2.4 million of the increasein revenues.

 

Expenses increased 8.9%to $69.6 million in 2004.  Increases inlegal and professional service expenses were offset largely by decreases inpersonnel-related and technology expenses. Also contributing to the increase was the inclusion of a full year’sresults for Boyd Watterson and Peremel. Expenses for 2003 included $3.6 million of severance and $0.5 millionpaid to terminate a technology equipment lease.

 

During the first quarterof 2004, Bankshares entered into a seven-year service contract with SunGardWealth Management Services (“SunGard”) to provide a new core accounting systemand back-office operations beginning in January 2005.  In 2004, IWM incurred approximately $0.9million in restructuring charges related to the conversion to SunGard’sAddVantage trust accounting system.  Amajority of these costs were severance charges of approximately $0.6million.  Conversion costs ofapproximately $1.8 million that were incurred in 2004 are being amortized overthe life of the contract.

 

**Credit Quality Measures**

Provision for loan losseswas $7.2 million in 2004 compared with $12.1 million in 2003.  Net charge-offs in 2004 were $13.6 million,or 0.14% of average total loans compared with $8.6 million, or 0.11%, in2003.  The allowance for loan losses was$149.0 million, or 1.46% of total loans, at December 31, 2004 comparedwith $155.3 million, or 1.68%, at December 31, 2003.

 

At December 31,2004, total nonperforming assets were $31.1 million, or 0.30% of total loans,compared with $50.4 million, or 0.55%, at December 31, 2003.  The decline primarily relates to acceptanceof payment and charge-off of a nonperforming loan in the fourth quarter of2004.  The restoration of one customer tofull accrual status accounted for $2.5 million of the $5.4 million decrease incommercial real estate nonaccrual loans.

 

51

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**Capital Ratios**

The ratio of averageshareholders’ equity to average total assets was 13.38% for 2004 and 12.51% for2003.  Bankshares’ total risk-basedcapital ratio at December 31, 2004 was 16.23%, and Tier I capital ratiowas 12.33%, exceeding the minimum regulatory guidelines of 8.0% and 4.0%,respectively.  Bankshares’ leverageratios were 10.02% and 9.60% at December 31, 2004 and 2003, respectively,exceeding the minimum regulatory guideline of 4.0%.  As of December 31, 2004, all ofBankshares’ bank affiliates exceeded all capital adequacy requirements necessaryto be considered “well capitalized.”  Foradditional information on Bankshares’ risk-based capital ratios, see Note No. 11(Shareholders’ Equity) of the financial statements.

 

QUARTERLY RESULTS OFOPERATIONS

 

The following is asummary of the quarterly results of operations.

 
| ** **                                                                                | ** ** | **Three months ended** | ** **  |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|
| **2005 (Dollars in thousands, except per share data)** | ** ** | **Dec. 31**                 | ** **  | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| Net interest income                                                                       | ** ** | **$**                            | **162,434** | ** ** | **$** | **159,242** | ** ** | **$** | **152,367** | ** ** | **$** | **143,083** | ** ** |
| Provision for loan losses                                                                 | ** ** | **—**                       | ** **  | **820** | ** ** | **—** | ** ** | **756** | ** ** |
| Net income                                                                                | ** ** | **74,863**                       | ** **  | **70,956** | ** ** | **67,873** | ** ** | **62,627** | ** ** |
| Per share of common stock:                                                                | ** ** | ** **                       | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                     | ** ** | **0.61**                         | ** **  | **0.58** | ** ** | **0.56** | ** ** | **0.53** | ** ** |
| Diluted                                                                                   | ** ** | **0.60**                         | ** **  | **0.57** | ** ** | **0.56** | ** ** | **0.52** | ** ** |
|                                                                                           |            |                                  |             |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                                | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **2004 (Dollars in thousands, except per share data)** | ** ** | **Dec. 31**                 | ** ** | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| Net interest income                                                                       |       | $                                | 143,710    |   | $ | 138,182 |   | $ | 133,484 |   | $ | 130,405 |   |
| Provision for loan losses                                                                 |       | —                           |       | 2,442 |   | 2,353 |   | 2,426 |   |
| Net income                                                                                |       | 60,612                           |       | 56,785 |   | 56,313 |   | 55,697 |   |
| Per share of common stock:                                                                |       |                             |       |   |   |   |   |   |   |
| Basic                                                                                     |       | 0.51                             |       | 0.48 |   | 0.47 |   | 0.47 |   |
| Diluted                                                                                   |       | 0.51                             |       | 0.48 |   | 0.47 |   | 0.46 |   |
|                                                                                           |            |                                  |            |  |  |  |  |  |  |  |  |  |  |

 

52

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RECONCILIATION OF NON-GAAPMEASURES

 

We believe the non-GAAPmeasures we use provide information useful to investors in understanding ourongoing core business and operational performance trends.  These measures should not be viewed as asubstitute 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 corebusiness operations results, the effects of certain non-core businesstransactions such as gains and losses on the sales of securities, amortizationof intangibles, restructuring charges and merger-related expenses, have beenexcluded.  Management reviews these samemeasures internally.  For instance, thecash operating efficiency ratio, rather than the GAAP basis efficiency ratio,is used to measure management’s success at controlling ongoing, core operatingexpenses.  Additionally, managementbelieves that reporting several key measures based on tangible assets (totalassets less intangible assets) and tangible equity (total equity less intangibleassets) is important as this more closely approximates the basis for measuringthe adequacy of capital for regulatory purposes.

 
| ** **                 | ** ** | **For the twelve months ended  December 31,** | ** ** | **For the quarter ended  December 31,** | ** ** |
|----------------------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **2005**                                                               | ** ** | **2004**                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                            |            |                                                                        |            |                                                             |            |  |  |  |  |

 

(1) The net interestmargin and efficiency ratios are presented on a fully taxable-equivalent (FTE)and annualized basis.  The FTE basisadjusts for the tax-favored status of income from certain loans andinvestments.  Management believes thismeasure to be the preferred industry measurement of net interest income andprovides a relevant comparison between taxable and nontaxable investments.  

 
| Net  interest income (GAAP basis)         | ** ** | **$**     | **617,126** |   | $          | 545,781   | ** ** | **$** | **162,434** |   | $ | 143,710 |   |
|-------------------------------------------|------------|-----------|-------------|--------|------------|-----------|------------|-------|-------------|--------|---|---------|--------|
| Taxable-equivalent  adjustment            | ** ** | **6,847** |        | 6,744  | ** ** | **1,833** |       | 1,660 |        |
| Net  interest income - taxable equivalent | ** ** | **$**     | **623,973** |   | $          | 552,525   | ** ** | **$** | **164,267** |   | $ | 145,370 |   |

 

(2) Managementexcludes the balance of intangible assets and their related amortizationexpense from its calculation of return on

average tangible equityand average tangible equity to average tangible assets.  This adjustment allows management to reviewthe

core operating resultsand core capital position of Bankshares. This is consistent with the treatment by the bank regulatory agencies

that excludes goodwilland other intangible assets from their calculation of risk-based capitalratios.

 
| Return  on average equity (GAAP basis)                          | ** ** | **13.18** | **%**      | 12.26  | %      | **13.44** | **%**      | 12.62  | %      |
|-----------------------------------------------------------------|------------|-----------|------------|--------|--------|-----------|------------|--------|--------|
| Impact  of excluding average intangible assets and amortization | ** ** | **6.36**  | ** ** | 5.74   |   | **6.82**  | ** ** | 5.54   |   |
| Return  on average tangible equity                              | ** ** | **19.54** | **%**      | 18.00  | %      | **20.26** | **%**      | 18.16  | %      |
|                                                            |       |      | ** ** |   |   |      | ** ** |   |   |
| Average  equity to average assets (GAAP basis)                  | ** ** | **13.51** | **%**      | 13.38  | %      | **13.59** | **%**      | 13.35  | %      |
| Impact  of excluding average intangible assets and amortization | ** ** | **(3.81** | **)**      | (3.68  | )      | **(3.98** | **)**      | (3.51  | )      |
| Average  tangible equity to average tangible assets             | ** ** | **9.70**  | **%**      | 9.70   | %      | **9.61**  | **%**      | 9.84   | %      |

 

(3) The efficiencyratio is measured by dividing noninterest expenses by the sum of net interestincome on an FTE basis and

noninterest income.  When computing the cash operating efficiencyratio and cash operating earnings, management excludes the amortization ofintangible assets, restructuring charges, merger-related expenses, and gainsand losses on sales of premises and from sales of investment securities inorder to assess the core operating results of Bankshares and because of theuncertainty as to timing and amount of gain or loss to be recognized.

 
| Efficiency  ratio (GAAP basis)   | ** **                           | **48.53**  | **%**      | 51.14      | %     | **47.87** | **%**      | 52.70      | %      |
|----------------------------------|--------------------------------------|------------|------------|------------|-------|-----------|------------|------------|--------|
| Impact  of excluding:            | Securities gains and  (losses)       |       | **0.03**   | ** ** | 0.08  |      | **(0.01**  | **)**      | 0.18   |   |
|                             | Gains  on sales of premises          | ** ** | **0.24**   | ** ** | 0.11  |      | **—** | ** ** | 0.01   |   |
|                             | Amortization of deposit  intangibles | ** ** | **(0.67**  | **)**      | (0.71 | )         | **(0.66**  | **)**      | (0.68  | ) |
|                             | Amortization of other  intangibles   | ** ** | **(0.35**  | **)**      | (0.35 | )         | **(0.35**  | **)**      | (0.31  |   |
|                             | Restructuring charges                | ** ** | **—** | ** ** | (0.59 | )         | **—** | ** ** | (0.70  | ) |
|                             | Merger-related expenses              | ** ** | **(0.17**  | **)**      | (0.05 | )         | **(0.16**  | **)**      | — |   |
| Cash  operating efficiency ratio | ** **                           | **47.61**  | **%**      | 49.63      | %     | **46.69** | **%**      | 51.20      | %      |

 

(4) Bankshares presents cash operating earnings in order to assess its coreoperating results.

 
| Net  income (GAAP basis)                               | ** ** | **$**      | **276,319** | ** ** | $      | 229,407    |   | **$**  | **74,863** |   | $ | 60,612 |   |
|--------------------------------------------------------|------------|------------|-------------|------------|--------|------------|--------|--------|------------|--------|---|--------|--------|
| Less:  Securities (gains) and losses, net of tax       | ** ** | **(245**   | **)**       | (749       | )      | **32**     |   | (426   | )          |
| Gains  on sales of premises, net of tax                | ** ** | **(2,624** | **)**       | (1,005     | )      | **—** |   | (26    | )          |
| Plus:  Amortization of deposit intangibles, net of tax | ** ** | **3,492**  | ** **  | 3,305      |   | **899**    |   | 826    |       |
| Amortization  of other intangibles, net of tax         | ** ** | **1,812**  | ** **  | 1,616      |   | **486**    |   | 388    |       |
| Restructuring  charges, net of tax                     | ** ** | **—** | ** **  | 2,711      |   | **—** |   | 850    |       |
| Merger-related  expenses, net of tax                   | ** ** | **877**    | ** **  | 248        |   | **216**    |   | — |       |
| Cash  operating earnings                               | ** ** | **$**      | **279,631** | ** ** | $      | 235,533    |   | **$**  | **76,496** |   | $ | 62,224 |   |

 

53

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RECENT FASB PRONOUNCEMENTS

 

In May 2005, theFinancial Accounting Standards Board (“FASB”) issued Statement No. 154 (“SFASNo. 154”), “Accounting Changes and Error Corrections - A Replacement ofAPB Opinion No. 20 and FASB Statement No. 3.”  This new standard replaces AccountingPrinciples Board (“APB”) Opinion No. 20, “Accounting Changes” and FASBStatement No. 3, “Reporting Accounting Changes in Interim FinancialStatements.”  Among other changes, SFAS No. 154requires that a voluntary change in accounting principle be appliedretrospectively with all prior period financial statements presented on the newaccounting principle, unless it is impracticable to do so.  SFAS No. 154 also provides that (1) achange in method of depreciating or amortizing a long-lived non-financial assetbe accounted for as a change in estimate (prospectively) that was effected by achange in accounting principle, and (2) correction of errors in previouslyissued financial statements should be termed a “restatement.”  The new standard is effective for accountingchanges and corrections of errors made in fiscal years beginning after December 15,2005.  Bankshares does not anticipatethis revision will have a material effect on its consolidated financialstatements.

 

In December 2004,the FASB issued Statement No. 123 (Revised 2005) (“SFAS No. 123(R)”),“Share-Based Payment,” which requires that the compensation cost relating toshare-based payment transactions be recognized in financial statements. SFAS No. 123(R)replaces SFAS No. 123, “Accounting for Stock-Based Compensation” andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”  Share-based compensation arrangements includeshare options, restricted share plans, performance-based awards, shareappreciation rights and employee share purchase plans.  SFAS No. 123(R) requires all share-basedpayments to employees to be valued using a fair value method on the date ofgrant and expensed based on that fair value over the applicable vestingperiod.  Bankshares adopted the costrecognition provision of SFAS No. 123 in 1995 and has been expensingcompensation cost related to options. SFAS No. 123(R) also amends SFAS No. 95, “Statement of Cash Flows”requiring the benefits of tax deductions in excess of recognized compensationcost be reported as financing instead of operating cash flows.  The Securities and Exchange Commission issuedStaff Accounting Bulletin No. 107 (“SAB No. 107”) which expresses theSEC’s views regarding the interaction between SFAS No. 123(R) and certainSEC rules and regulations. Additionally, SAB No. 107 provides guidance related to share-basedpayment transactions for public companies.

 

SFAS No. 123(R) alsoprovides requirements for determining the grant date of an award that issubject to the accounting Provisions in SFAS No. 123(R). Specifically,assuming a company meets all of the other criteria in the definition of grantdate in SFAS No. 123(R), a mutual understanding (between the company andthe recipient) of the key terms and conditions of an award is presumed to existat the date the award is approved if:  (1) therecipient does not have the ability to negotiate the key terms and conditionsof the award, and (2) the key terms and conditions of the award areexpected to be communicated to the recipient within a relatively short periodof time after the grant was approved.

 

SFAS No. 123(R)requires a company to calculate the pool of excess tax benefits available toabsorb tax deficiencies recognized subsequent to adopting SFAS No. 123(R)(termed the “APIC Pool”), assuming the company has been following therecognition provisions prescribed by SFAS No. 123, “Accounting forStock-Based Compensation.”  After theadoption of SFAS No. 123(R), for options granted that have a retirementeligibility feature, compensation cost will be recognized immediately forawards granted to retirement eligible employees or over the period from thegrant date to the date retirement eligibility is achieved.

 

Bankshares will adoptSFAS No. 123(R) effective January 1, 2006 under the modified versionof prospective application. Bankshares does not anticipate this revision willhave a material effect on its results of operations or financial condition.

 

On November 3, 2005,the FASB issued FSP Nos. FAS 115-1 and FAS 124-1 to address the determinationas to when an investment is considered impaired, whether that impairment isother than temporary, and the measurement of the impairment loss. An investmentis considered impaired if the fair value of the investment is less than itscost.  If, after consideration of allavailable evidence to evaluate the realizable value of its investment,impairment is determined to be other-than-temporary, then an impairment lossshould be recognized equal to the difference between the investment’s cost andits fair value. The FSP also includes guidance on the accounting subsequent tothe recognition of an other-than-temporary impairment and requires additionaldisclosures about unrealized losses that have not been recognized asother-than-temporary impairments.  Theguidance in this FAS amends FASB Statements No. 115, “Accounting forCertain Investments in Debt and Equity Securities” and No. 124, “Accountingfor Certain Investments Held by Not-for-Profit Organizations” and APB Opinion No. 18,“The Equity Method of Accounting for Investments in Common Stock.”  It also nullifies certain requirements inEITF Issue No. 03-1 and EITF Issue No. 03-1a, “ImplementationGuidance for the Application of Paragraph 16 of EITF Issue No. 03-1,”while retaining the disclosure requirements of EITF 03-1 which were adopted in2003.  The guidance in this FSP shall beapplied to reporting periods beginning after December 15, 2005. Banksharesdoes not anticipate this revision will have a material effect on itsconsolidated financial statements.

 

54

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On December 12,2003, the AICPA issued Statement of Position (“SOP”) 03-3, “Accounting forCertain Loans or Debt Securities Acquired in a Transfer.”  SOP 03-3 addresses accounting for differencesbetween the contractual cash flows of certain loans and debt securities and thecash flows expected to be collected when loans or debt securities are acquiredin a transfer and those cash flow differences are attributable, at least inpart, to credit quality.  As such, SOP03-3 applies to loans and debt securities acquired individually, in pools or aspart of a business combination and does not apply to originated loans.  The application of SOP 03-3 limits theinterest income, including accretion of purchase price discounts, which may berecognized for certain loans and debt securities. Additionally, SOP 03-3 doesnot allow the excess contractual cash flows over cash flows expected to becollected to be recognized as an adjustment to the yield, loss accrual orvaluation allowance, such as the allowance for loan losses.  SOP 03-3 requires that increases in expectedcash flows subsequent to the initial investment be recognized prospectivelythrough adjustment of the yield on the loan or the debt security over itsremaining life.  Decreases in expectedcash flows should be recognized as an impairment.  The adoption of SOP 03-3 on January 1,2005 did not have a material effect on Bankshares’ consolidated financialstatements.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

Market risk refers to therisk of loss arising from adverse changes in interest rates, foreign currencyexchange rates, commodity prices, and other relevant market rates and prices,such as equity prices. The risk of loss can be assessed from the perspective ofadverse changes in fair values, cash flows, and future earnings. Due to thenature of its operations, Bankshares is primarily exposed to interest rate riskand, to a lesser extent, liquidity risk.

 

Refer to Item 1A. RiskFactors and Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations, of this report, along with the cautionary statementsset forth elsewhere in this report for additional information.

 

Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Management’s Report onInternal Control over Financial Reporting

 

Report of IndependentRegistered Public Accounting Firm on the Consolidated Financial Statements ofMercantile Bankshares Corporation and on Mercantile Bankshares Corporation’sinternal control over financial reporting

 

Consolidated FinancialStatements

 

Consolidated BalanceSheets, December 31, 2005 and 2004

 

Statements of ConsolidatedIncome for the years ended December 31, 2005, 2004, and 2003

 

Statements ofConsolidated Cash Flows for the years ended December 31, 2005, 2004 and2003

 

Statements of Changes inConsolidated Shareholders’ Equity for the years ended December 31, 2005,2004 and 2003

 

Notes to ConsolidatedFinancial Statements

 

55

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**Management’s Report on InternalControl over Financial Reporting**

 

Management of MercantileBankshares Corporation, (together with its consolidated subsidiaries, we, us orBankshares), is responsible for establishing and maintaining adequate internalcontrol over financial reporting as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934.  Our internal control over financial reportingis designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.  Our internal control over financial reportingincludes those policies and procedures that:

 

(i)                                     pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of Bankshares;

 

(ii)                                  providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of Bankshares arebeing made only in accordance with authorization of management and directors ofBankshares; and

 

(iii)                               providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of our assets that could have a material effecton the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

 

Management assessed theeffectiveness of our internal control over financial reporting as of December 31,2005. In making this assessment, management used the criteria described in the “InternalControl-Integrated Framework” set forth by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

 

Based on our assessmentand those criteria, management has concluded that, as of December 31,2005, Bankshares’ internal control over financial reporting was effective.  Our independently registered publicaccounting firm has audited management’s assessment of the effectiveness ofBankshares’ internal control over financial reporting as of December 31,2005 as stated in their report that appears on the following page.

 
| /s/ Edward J. Kelly, III                         |   |
|-------------------------------------------------------|--------|
| Edward J. Kelly, III                             |
| Chairman, President and  Chief Executive Officer      |
|                                                  |
| /s/ Terry L. Troupe                                   |   |
| Terry L. Troupe                                       |
| Executive Vice President  and Chief Financial Officer |
|                                                  |
| Mercantile Bankshares  Corporation                    |
| March 10, 2006                                   |

 

56

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**Report of Independent RegisteredPublic Accounting Firm**

 

To the Board of Directorsand Shareholders of Mercantile Bankshares Corporation:

 

We have completedintegrated audits of Mercantile Bankshares Corporation’s 2005 and 2004consolidated financial statements and of its internal control over financialreporting as of December 31, 2005, and an audit of its 2003 consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated financial statements

In our opinion, thefinancial statements listed in the accompanying index present fairly, in allmaterial respects, the financial position of Mercantile Bankshares Corporationand its subsidiaries at December 31, 2005 and 2004, and the results oftheir operations and their cash flows for each of the three years in the periodended December 31, 2005 in conformity with accounting principles generallyaccepted in the United States of America. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

Internal control overfinancial reporting

Also, in ouropinion, management’s assessment, included in the accompanying “Management’sReport on Internal Control over Financial Reporting”, appearing under Item 8, thatthe Company maintained effective internal control over financial reporting asof December 31, 2005 based on criteria established in *InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all materialrespects, effective internal control over financial reporting as of December 31,2005, based on criteria established in *Internal Control -Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is to expressopinions on management’s assessment and on the effectiveness of the Company’sinternal control over financial reporting based on our audit.  We conducted our audit of internal controlover financial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects.  An audit of internal control over financialreporting includes obtaining an understanding of internal control overfinancial reporting, evaluating management’s assessment, testing and evaluatingthe design and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances.  We believe that our audit provides areasonable basis for our opinions.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Acompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 
| /s/  PricewaterhouseCoopers LLP |   |
|---------------------------------|--------|
| Baltimore, Maryland             |
| March 10, 2006             |

 

57

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ConsolidatedBalance Sheets

 

**DECEMBER 31,**

 
| **(Dollars in thousands, except per share data)**                                                                                             | ** ** | **2005**       | ** **     | **2004**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|
| **ASSETS**                                                                                                                                                                  | ** ** | ** **     | ** **     | ** ** | ** ** |
| Cash and due from banks                                                                                                                                                     | ** ** | **$**          | **369,536**    |       | $          | 244,875 |   |
| Interest-bearing deposits in other banks                                                                                                                                    | ** ** | **200**        |           | 158        |       |
| Federal funds sold                                                                                                                                                          | ** ** | **25,104**     |           | 101        |       |
| Total cash and cash equivalents                                                                                                                                             | ** ** | **394,840**    |           | 245,134    |       |
|                                                                                                                                                                        |       |           |           |       |       |
| Investment* *securities* *available*-*for*-*sale*(1),(3)*                                                                                                         | ** ** | **3,089,628**  |           | 2,908,694  |       |
| Investment* *securities* *held*-*to*-*maturity*(1),(3)*fair value of $17,181 (2005) and $21,094 (2004)                                                            | ** ** | **16,659**     |           | 20,176     |       |
|                                                                                                                                                                        |       |           |           |       |       |
| Loans* *held*-*for*-*sale*(1)*                                                                                                                                         | ** ** | **26,263**     |           | 11,000     |       |
|                                                                                                                                                                        |       |           |           |       |       |
| Loans*(4)*                                                                                                                                                                  | ** ** | **11,607,845** |           | 10,228,433 |       |
| Less*:*allowance* *for* *loan* *losses*(1),(4)*                                                                                                              | ** ** | **(156,673**   | **)**          | (149,002   | )          |
| Loans, net                                                                                                                                                                  | ** ** | **11,451,172** |           | 10,079,431 |       |
|                                                                                                                                                                        |       |           |           |       |       |
| Bank* *premises* *and* *equipment*,*net*(1),(5)*                                                                                                             | ** ** | **137,419**    |           | 139,946    |       |
| Other* *real* *estate* *owned*,*net*(1)*                                                                                                                     | ** ** | **667**        |           | 212        |       |
| Goodwill*,*net*(1),(19)*                                                                                                                                                    | ** ** | **670,028**    |           | 507,791    |       |
| Other* *intangible* *assets*,*net*(1),(19)*                                                                                                                       | ** ** | **46,653**     |           | 48,226     |       |
| Other* *assets*(6),(12)*                                                                                                                                               | ** ** | **588,400**    |           | 465,080    |       |
| Total assets                                                                                                                                                                | ** ** | **$**          | **16,421,729** |       | $          | 14,425,690 |   |
|                                                                                                                                                                        |       |           |           |       |       |
| **LIABILITIES**                                                                                                                                                             |       |           |           |       |       |
| Deposits:                                                                                                                                                                   |       |           |           |       |       |
|   Noninterest-bearing deposits                                                                                                                                    | ** ** | **$**          | **3,324,650**  |       | $          | 3,049,031 |   |
|   Interest-bearing deposits                                                                                                                                       | ** ** | **8,752,700**  |           | 7,750,168  |       |
| Total deposits                                                                                                                                                              | ** ** | **12,077,350** |           | 10,799,199 |       |
| Short*-*term* *borrowings*(8)*                                                                                                                                         | ** ** | **1,237,714**  |           | 887,857    |       |
| Accrued* *expenses* *and* *other* *liabilities*(6)*                                                                                                     | ** ** | **169,780**    |           | 129,996    |       |
| Long*-*term* *debt*(9)*                                                                                                                                                | ** ** | **742,163**    |           | 690,955    |       |
| Total liabilities                                                                                                                                                           | ** ** | **14,227,007** |           | 12,508,007 |       |
|                                                                                                                                                                        |       |           |           |       |       |
| **COMMITMENTS* *AND* *CONTINGENCIES* ****(5),(9),(10)*                                                                                                       |       |           |           |       |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                               |       |           |           |       |       |
| Preferred stock, no par value; authorized 2,000,000  shares; issued and outstanding - None                                                                                  |       |           |           |       |       |
| Common stock, $2 par value; authorized 130,000,000  shares; issued shares - 82,165,414 (2005) and 79,300,506 (2004); restricted  shares - 166,060 (2005) and 143,528 (2004) | ** ** | **164,331**    |           | 158,601    |       |
| Capital surplus                                                                                                                                                             | ** ** | **676,830**    |           | 530,705    |       |
| Retained earnings                                                                                                                                                           | ** ** | **1,386,405**  |           | 1,231,102  |       |
| Accumulated other comprehensive loss, net of tax                                                                                                                            | ** ** | **(32,844**    | **)**          | (2,725     | )          |
| Total shareholders’ equity                                                                                                                                             | ** ** | **2,194,722**  |           | 1,917,683  |       |
| Total liabilities and shareholders’ equity                                                                                                                             | ** ** | **$**          | **16,421,729** |       | $          | 14,425,690 |   |

 

See notes to consolidatedfinancial statements.

 

58

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Statementsof Consolidated Income

 

**FOR YEARS ENDED DECEMBER 31,**

 
| **(Dollars in thousands, except per share data)**           | ** ** | **2005**    | ** **  | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------|-------------|----------|------------|----------|------------|
| **INTEREST INCOME**                                                                       |       |        |        |     |       |     |       |
| Interest* *and* *fees* *on* *loans*(1)*                               | ** ** | **$**       | **700,832** |     | $          | 546,531  |       | $ | 472,943 |   |
| Interest and dividends on investment securities:                                          |       |        |        |     |       |     |       |
| Taxable interest income                                                                   | ** ** | **107,133** |        | 105,423  |       | 109,767  |       |
| Tax-exempt interest income                                                                | ** ** | **3,161**   |        | 3,266    |       | 2,746    |       |
| Other investment income                                                                   | ** ** | **2,475**   |        | 2,314    |       | 741      |       |
| Total interest and dividends on investment securities                                     | ** ** | **112,769** |        | 111,003  |       | 113,254  |       |
| Other interest income                                                                     | ** ** | **2,436**   |        | 1,503    |       | 3,397    |       |
| Total interest income                                                                     | ** ** | **816,037** |        | 659,037  |       | 589,594  |       |
| **INTEREST EXPENSE**                                                                      |       |        |        |     |       |     |       |
| Interest* *on* *deposits*(7)*                                                   | ** ** | **139,917** |        | 83,403   |       | 93,190   |       |
| Interest on short-term borrowings                                                         | ** ** | **26,266**  |        | 7,844    |       | 5,604    |       |
| Interest on long-term debt                                                                | ** ** | **32,728**  |        | 22,009   |       | 18,451   |       |
| Total interest expense                                                                    | ** ** | **198,911** |        | 113,256  |       | 117,245  |       |
| **NET INTEREST INCOME**                                                                   | ** ** | **617,126** |        | 545,781  |       | 472,349  |       |
| Provision* *for* *loan* *losses*(1),(4)*                                   | ** ** | **1,576**   |        | 7,221    |       | 12,105   |       |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES**                                  | ** ** | **615,550** |        | 538,560  |       | 460,244  |       |
| **NONINTEREST INCOME**                                                                    |       |        |        |     |       |     |       |
| Investment* *and* *wealth* *management*(1)*                                | ** ** | **95,756**  |        | 90,050   |       | 78,933   |       |
| Service charges on deposit accounts                                                       | ** ** | **43,885**  |        | 44,263   |       | 39,194   |       |
| Mortgage banking-related fees                                                             | ** ** | **15,019**  |        | 11,495   |       | 11,111   |       |
| Investment* *securities* *gains*(3)*                                            | ** ** | **405**     |        | 1,239    |       | 7,137    |       |
| Nonmarketable investments                                                                 | ** ** | **19,882**  |        | 11,422   |       | 10,189   |       |
| Other income                                                                              | ** ** | **68,173**  |        | 55,460   |       | 37,008   |       |
| Total noninterest income                                                                  | ** ** | **243,120** |        | 213,929  |       | 183,572  |       |
| **NONINTEREST EXPENSES**                                                                  |       |        |        |     |       |     |       |
| Salaries                                                                                  | ** ** | **200,222** |        | 187,621  |       | 160,326  |       |
| Employee* *benefits*(14)*                                                            | ** ** | **46,175**  |        | 44,676   |       | 37,717   |       |
| Net* *occupancy* *expense* *of* *bank* *premises*(1),(5)*        | ** ** | **28,596**  |        | 24,307   |       | 20,756   |       |
| Furniture* *and* *equipment* *expenses*(1),(5)*                            | ** ** | **31,659**  |        | 31,439   |       | 31,610   |       |
| Communications and supplies                                                               | ** ** | **16,406**  |        | 16,904   |       | 15,188   |       |
| Other expenses                                                                            | ** ** | **97,763**  |        | 87,011   |       | 71,850   |       |
| Total noninterest expenses                                                                | ** ** | **420,821** |        | 391,958  |       | 337,447  |       |
| Income before income taxes                                                                | ** ** | **437,849** |        | 360,531  |       | 306,369  |       |
| Provision* *for* *income* *taxes*(1),(12)*                                 | ** ** | **161,530** |        | 131,124  |       | 109,555  |       |
| **NET INCOME**                                                                            | ** ** | **$**       | **276,319** |     | $          | 229,407  |       | $ | 196,814 |   |
| **NET* *INCOME* *PER* *SHARE* *OF* *COMMON* *STOCK*(11):*** |       |        |        |     |       |     |       |
| Basic                                                                                     | ** ** | **$**       | **2.28**    |     | $          | 1.93     |       | $ | 1.80 |   |
| Diluted                                                                                   | ** ** | **$**       | **2.26**    |     | $          | 1.92     |       | $ | 1.79 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                                                       | ** ** | **$**       | **0.99**    |     | $          | 0.92     |       | $ | 0.86 |   |

 

See notes to consolidatedfinancial statements.

 

59

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##### **Statements of Changes in Consolidated Shareholders’Equity**

 

**FOR THE YEARS ENDED DECEMBER 31,2005, 2004 AND 2003**

 
| **(Dollars in thousands, except  per share data)**                                                     | ** ** | **Total** | ** **    | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **  | **Accumulated Other  Comprehensive  Income (Loss)** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-------------------|------------|----------------------|------------|------------------------|-------------|----------------------------------------------------------|------------|
| BALANCE,  DECEMBER 31, 2002                                                                       |       | $         | 1,324,358     |              | $          | 137,672              |       | $                      | 120,577     |                                                     | $          | 1,010,248 |   | $ | 55,861 |   |
| Net  income                                                                                            |       | 196,814   |          |              |       |                 |       | 196,814                |        |                                                     |       |
| Unrealized  losses on securities available-for-sale, net of reclassification adjustment,  net of taxes |       | (33,377   | )             |              |       |                 |       |                   |        | (33,377                                                  | )          |
| Comprehensive  income                                                                                  |       | 163,437   |          |              |       |                 |       |                   |        |                                                     |       |
| Cash  dividends paid on common stock ($1.29 per share)                                                 |       | (95,842   | )             |              |       |                 |       | (95,842                | )           |                                                     |       |
| Issuance  of 10,379,710 shares for bank acquisition                                                    |       | 428,059   |          | 20,759            |       | 407,300              |       |                   |        |                                                     |       |
| Fair  value of 322,528 options related to employee stock option plan of acquired  bank                 |       | 5,944     |          |              |       | 5,944                |       |                   |        |                                                     |       |
| Issuance  of 124,268 shares for dividend reinvestment and stock purchase plan                          |       | 4,696     |          | 248               |       | 4,448                |       |                   |        |                                                     |       |
| Issuance  of 23,737 shares for employee stock purchase dividend reinvestment plan                      |       | 929       |          | 47                |       | 882                  |       |                   |        |                                                     |       |
| Issuance  of 312,466 shares for employee stock option plan                                             |       | 5,744     |          | 625               |       | 5,119                |       |                   |        |                                                     |       |
| Restricted  stock awards:                                                                              |       |      |          |              |       |                 |       |                   |        |                                                     |       |
| Issuance  of 101,932 shares                                                                            |       | 3,611     |          | 205               |       | 3,406                |       |                   |        |                                                     |       |
| Deferred  compensation                                                                                 |       | (3,611    | )             |              |       |                 |       | (3,611                 | )           |                                                     |       |
| Amortization                                                                                           |       | 3,139     |          |              |       |                 |       | 3,139                  |        |                                                     |       |
| Purchase  of 5,500 shares under stock repurchase plan                                                  |       | (212      | )             | (11               | )          | (201                 | )          |                   |        |                                                     |       |
| Vested  stock options                                                                                  |       | 1,189     |          | —            |       | 1,189                |       | —                 |        | —                                                   |       |
| BALANCE,  DECEMBER 31, 2003                                                                       |       | 1,841,441 |          | 159,545           |       | 548,664              |       | 1,110,748              |        | 22,484                                                   |       |
| Net  income                                                                                            |       | 229,407   |          |              |       |                 |       | 229,407                |        |                                                     |       |
| Unrealized  losses on securities available-for-sale, net of reclassification adjustment,  net of taxes |       | (25,209   | )             |              |       |                 |       |                   |        | (25,209                                                  | )          |
| Comprehensive  income                                                                                  |       | 204,198   |          |              |       |                 |       |                   |        |                                                     |       |
| Cash  dividends paid on common stock ($1.38 per share)                                                 |       | (109,295  | )             |              |       |                 |       | (109,295               | )           |                                                     |       |
| Issuance  of 117,126 shares for dividend reinvestment and stock purchase plan                          |       | 5,281     |          | 234               |       | 5,047                |       |                   |        |                                                     |       |
| Issuance  of 24,583 shares for employee stock purchase dividend reinvestment plan                      |       | 1,130     |          | 50                |       | 1,080                |       |                   |        |                                                     |       |
| Issuance  of 350,110 shares for employee stock option plan                                             |       | 7,911     |          | 700               |       | 7,211                |       |                   |        |                                                     |       |
| Directors’  deferred compensation plan:                                                           |       |      |          |              |       |                 |       |                   |        |                                                     |       |
| Transfer  opening balance                                                                              |       | 6,406     |          |              |       | 6,406                |       |                   |        |                                                     |       |
| Contribution                                                                                           |       | 787       |          |              |       | 787                  |       |                   |        |                                                     |       |
| Dividend                                                                                               |       | —    |          |              |       | 168                  |       | (168                   | )           |                                                     |       |
| Restricted  stock awards:                                                                              |       |      |          |              |       |                 |       |                   |        |                                                     |       |
| Issuance  of 35,982 shares                                                                             |       | 1,632     |          | 72                |       | 1,560                |       |                   |        |                                                     |       |
| Deferred  compensation                                                                                 |       | (1,632    | )             |              |       |                 |       | (1,632                 | )           |                                                     |       |
| Amortization                                                                                           |       | 2,042     |          |              |       |                 |       | 2,042                  |        |                                                     |       |
| Purchase  of 1,000,000 shares under stock repurchase plan                                              |       | (44,110   | )             | (2,000            | )          | (42,110              | )          |                   |        |                                                     |       |
| Vested  stock options                                                                                  |       | 1,892     |          | —            |       | 1,892                |       | —                 |        | —                                                   |       |
| BALANCE,  DECEMBER 31, 2004                                                                       |       | 1,917,683 |          | 158,601           |       | 530,705              |       | 1,231,102              |        | (2,725                                                   | )          |
| Net  income                                                                                            |       | 276,319   |          |              |       |                 |       | 276,319                |        |                                                     |       |
| Unrealized  losses on securities available-for-sale, net of reclassification adjustment,  net of taxes |       | (30,119   | )             |              |       |                 |       |                   |        | (30,119                                                  | )          |
| Comprehensive  income (11)                                                                             |       | 246,200   |          |              |       |                 |       |                   |        |                                                     |       |
| Cash  dividends paid on common stock ($1.49 per share)                                                 |       | (120,167  | )             |              |       |                 |       | (120,167               | )           |                                                     |       |
| Issuance  of 2,460,995 shares for acquisitions                                                         |       | 125,351   |          | 4,922             |       | 120,429              |       |                   |        |                                                     |       |
| Fair  value of 138,764 converted options related to employee stock option plan of  acquired bank       |       | 5,182     |          |              |       | 5,182                |       |                   |        |                                                     |       |
| Issuance  of 108,693 shares for dividend reinvestment and stock purchase plan                          |       | 5,506     |          | 217               |       | 5,289                |       |                   |        |                                                     |       |
| Issuance  of 22,803 shares for employee stock purchase dividend reinvestment plan                      |       | 1,195     |          | 46                |       | 1,149                |       |                   |        |                                                     |       |
| Issuance  of 203,695 shares for employee stock option plan                                             |       | 4,504     |          | 407               |       | 4,097                |       |                   |        |                                                     |       |
| Directors’  deferred compensation plan:                                                           |       |      |          |              |       |                 |       |                   |        |                                                     |       |
| Issuance  of 10,994 shares                                                                             |       | 470       |          | 22                |       | 448                  |       |                   |        |                                                     |       |
| Contribution                                                                                           |       | 1,132     |          |              |       | 1,132                |       |                   |        |                                                     |       |
| Dividend                                                                                               |       | —    |          |              |       | 264                  |       | (264                   | )           |                                                     |       |
| Restricted  stock awards:                                                                              |       |      |          |              |       |                 |       |                   |        |                                                     |       |
| Issuance  of 57,728 shares                                                                             |       | 3,055     |          | 116               |       | 2,939                |       |                   |        |                                                     |       |
| Deferred  compensation                                                                                 |       | (3,222    | )             |              |       |                 |       | (3,222                 | )           |                                                     |       |
| Amortization                                                                                           |       | 2,637     |          |              |       |                 |       | 2,637                  |        |                                                     |       |
| Vested  stock options (15)                                                                             |       | 5,196     |          | —            |       | 5,196                |       | —                 |        | —                                                   |       |
| **BALANCE, DECEMBER 31, 2005**                                                                    | ** ** | **$**     | **2,194,722** | ** **        | **$**      | **164,331**          | ** ** | **$**                  | **676,830** | ** **                                               | **$**      | **1,386,405** | ** ** | **$** | **(32,844** | **)** |

 

See notes to consolidatedfinancial statements.

 

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Statementsof Consolidated Cash Flows

 

**FORYEARS ENDED DECEMBER 31,**

 
| **(Dollars in thousands)**                                               | ** ** | **2005**       | ** **  | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------------------------------|------------|----------------|-------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |           | ** **  |       |       |       |       |
| Net  income                                                                        | ** ** | **$**          | **276,319** | ** ** | $          | 229,407    |       | $ | 196,814 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |           | ** **  |       |       |       |       |
| Provision  for loan losses                                                         | ** ** | **1,576**      | ** **  | 7,221      |       | 12,105     |       |
| Depreciation                                                                       | ** ** | **15,558**     | ** **  | 15,645     |       | 14,251     |       |
| Amortization  of other intangible assets                                           | ** ** | **8,773**      | ** **  | 8,142      |       | 4,943      |       |
| Provision  for deferred tax benefits                                               | ** ** | **(9,263**     | **)**       | (23,749    | )          | (8,993     | )          |
| Write-downs  of other real estate owned                                            | ** ** | **1**          | ** **  | 14         |       | 7          |       |
| Gains  on sales of other real estate owned                                         | ** ** | **(198**       | **)**       | (204       | )          | (366       | )          |
| Gains  on sales of investments securities                                          | ** ** | **(405**       | **)**       | (1,239     | )          | (7,137     | )          |
| Gains  on sales of premises                                                        | ** ** | **(4,341**     | **)**       | (1,664     | )          | (228       | )          |
| Loans  held-for-sale                                                               | ** ** | **(14,974**    | **)**       | 3,925      |       | 31,096     |       |
| Net  (increase) decrease in assets:                                                |       |           | ** **  |       |       |       |       |
| Interest  receivable                                                               | ** ** | **(9,052**     | **)**       | 2,486      |       | 4,741      |       |
| Nonmarketable  investments                                                         | ** ** | **13,100**     | ** **  | (11,297    | )          | (26,969    | )          |
| Other  assets                                                                      | ** ** | **7,360**      | ** **  | 14,349     |       | (7,239     | )          |
| Net  increase (decrease) in liabilities:                                           |       |           | ** **  |       |       |       |       |
| Interest  payable                                                                  | ** ** | **8,373**      | ** **  | (1,113     | )          | 24,132     |       |
| Other  liabilities                                                                 | ** ** | **(1,205**     | **)**       | 7,307      |       | (39,714    | )          |
| Net  cash provided by operating activities                                         | ** ** | **291,622**    | ** **  | 249,230    |       | 197,443    |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |           | ** **  |       |       |       |       |
| Proceeds  from maturities of investment securities held-to-maturity                | ** ** | **3,517**      | ** **  | 8,037      |       | 15,149     |       |
| Proceeds  from maturities of investment securities available-for-sale              | ** ** | **898,334**    | ** **  | 917,216    |       | 961,583    |       |
| Proceeds  from sales of investment securities available-for-sale                   | ** ** | **121,634**    | ** **  | 49,314     |       | 572,615    |       |
| Purchases  of investment securities held-to-maturity                               | ** ** | **—**     | ** **  | —     |       | (2,590     | )          |
| Purchases  of investment securities available-for-sale                             | ** ** | **(1,078,446** | **)**       | (871,948   | )          | (1,488,190 | )          |
| Net  increase in customer loans                                                    | ** ** | **(713,794**   | **)**       | (973,155   | )          | (663,922   | )          |
| Proceeds  from sales of other real estate owned                                    | ** ** | **485**        | ** **  | 533        |       | 959        |       |
| Capital  expenditures                                                              | ** ** | **(10,214**    | **)**       | (10,474    | )          | (17,355    | )          |
| Proceeds  from sales of premises                                                   | ** ** | **7,981**      | ** **  | 3,872      |       | 602        |       |
| Business  acquisitions (net of cash received)                                      | ** ** | **(78,655**    | **)**       | —     |       | (83,689    | )          |
| Purchase  of nonmarketable investments                                             | ** ** | **(58,581**    | **)**       | (9,799     | )          | (4,507     | )          |
| Net  cash used in investing activities                                             | ** ** | **(907,739**   | **)**       | (886,404   | )          | (709,345   | )          |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |           | ** **  |       |       |       |       |
| Net  increase in noninterest-bearing deposits                                      | ** ** | **167,769**    | ** **  | 298,310    |       | 367,640    |       |
| Net  increase (decrease) in interest-bearing deposits                              | ** ** | **485,400**    | ** **  | 238,338    |       | (58,121    | )          |
| Net  increase (decrease) in short-term borrowings                                  | ** ** | **340,151**    | ** **  | 78,836     |       | (187,374   | )          |
| Proceeds  from issuance of long-term debt                                          | ** ** | **—**     | ** **  | 51,250     |       | 300,000    |       |
| Repayment  of long-term debt                                                       | ** ** | **(118,535**   | **)**       | (8,044     | )          | (8,638     | )          |
| Proceeds  from issuance of shares                                                  | ** ** | **11,205**     | ** **  | 14,322     |       | 11,369     |       |
| Repurchase  of common shares                                                       | ** ** | **—**     | ** **  | (44,110    | )          | (212       | )          |
| Dividends  paid                                                                    | ** ** | **(120,167**   | **)**       | (109,295   | )          | (95,842    | )          |
| Net  cash provided by financing activities                                         | ** ** | **765,823**    | ** **  | 519,607    |       | 328,822    |       |
| Net  increase (decrease) in cash and cash equivalents                              | ** ** | **149,706**    | ** **  | (117,567   | )          | (183,080   | )          |
| Cash  and cash equivalents at beginning of period                                  | ** ** | **245,134**    | ** **  | 362,701    |       | 545,781    |       |
| Cash  and cash equivalents at end of period                                        | ** ** | **$**          | **394,840** | ** ** | $          | 245,134    |       | $ | 362,701 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |           | ** **  |       |       |       |       |
| Cash  payments for interest                                                        | ** ** | **$**          | **189,186** | ** ** | $          | 114,370    |       | $ | 115,921 |   |
| Cash  payments for income taxes                                                    | ** ** | **173,306**    | ** **  | 138,832    |       | 115,448    |       |

 

See notes to consolidatedfinancial statements*.*

 

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Notesto Consolidated Financial Statements

 

1. SIGNIFICANT ACCOUNTINGPOLICIES

 

A. Basis of Presentation

Mercantile BanksharesCorporation (“Bankshares”) is a regional multibank holding company headquarteredin Baltimore, Maryland.  At December 31,2005, Bankshares had $16.4 billion in assets, $11.6 billion in loans and $12.1billion in deposits.  It is the largestbank holding company headquartered in the state of Maryland.  The two principal lines of business areBanking and Investment & Wealth Management (“IWM”), delivered throughthe lead bank Mercantile-Safe Deposit and Trust Company (“MSD&T”) and 10affiliated banks.  The consolidatedfinancial statements, which include the accounts of Mercantile BanksharesCorporation (“Bankshares”) (Nasdaq:  MRBK) and all of its affiliates,are prepared in conformity with accounting principles generally accepted in theUnited States of America and follow general practice within the bankingindustry.  All significant intercompanytransactions have been eliminated.  Forpurposes of comparability, certain prior period amounts have been reclassifiedto conform to current period presentation.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andcontingent assets and liabilities at the date of the financial statements andthe disclosure of revenues and expenses during the reporting period.  These estimates and assumptions, such as theaccounting for loan losses, depreciation and pension obligations, are based oninformation available as of the date of the financial statements and coulddiffer from actual results.

 

Assets (other than cashdeposits) held for others under fiduciary and agency relationships are notincluded in the accompanying balance sheets since they are not assets ofBankshares or its affiliates. Acquisitions accounted for as purchases are included in the financialstatements from the respective dates of affiliation.

 

On January 10, 2006,Bankshares announced a three-for-two stock split on its common stock. Certain shares,average shares and per share amounts have been adjusted to give effect to thesplit.

 

B. Investment Securities

Investments areclassified as either “held-to-maturity” or “available-for-sale” or “trading” atthe date of commitment or purchase. The fair value of securities is based onpricing services that rely on quoted market prices, or if quoted market pricesare not available, then the fair value is estimated using quoted market pricesfor similar securities, pricing models or discounted cash flow analysis.  Interest and dividends declared on securitiesare recognized in interest income on an accrual basis.  Premiums and discounts on debt securities areamortized/accreted by the level yield methods adjusted for the effects ofprepayments on the underlying investments. Realized gains and losses are recognized on a specific identificationtrade date basis.  Amortized cost is usedto compute gains or losses on the sales of securities, which are reported inthe Statement of Consolidated Income.

 

Investment securitiesclassified as “held-to-maturity” are acquired with the intent and ability tohold until maturity and are carried at cost, adjusted for amortization ofpremiums and accretion of discounts. Investment securities classified as “available-for-sale” are acquired tobe held for indefinite periods of time and may be sold in response to changesin interest rates and/or prepayment risk or for liquidity managementpurposes.  These securities are carriedat fair value, and any unrealized gain or loss in the market value ofavailable-for-sale securities is reported as accumulated other comprehensiveincome, a separate component of shareholders’ equity, net of applicabletaxes.  Trading securities are acquiredwith the intent to be held for a short period with a subsequent resale.  These securities are carried at fair valuewith realized and unrealized gains and losses recorded in trading accountprofit and losses in the results of operations.

 

An assessment is made atthe end of each quarter to determine whether there have been any events oreconomic circumstances to indicate that a security is impaired on another-than-temporary basis.  Another-than-temporary impairment may develop if, based on all availableevidence, the carrying amount of the investment is not recoverable within areasonable period of time.  Factorsconsidered in making this assessment include, among others, the intent andability to hold the investment for a period of time sufficient for a recoveryin value; external credit ratings and recent downgrades; market pricefluctuations due to factors other than interest rates; and the probability ofcollection of contractual cash flows. Securities on which there is an unrealized loss that is deemed to beother-than-temporary are written down to fair value, and the adjustment isrecorded as a realized loss in securities gains (losses).

 

C. Loans

Interestincome on loans is accrued at the contractual rate on the principal amountoutstanding.  Loan origination andcommitment fees, direct loan acquisition and origination costs, when significant,are deferred and accreted to interest income over the life of the loan or overthe commitment period.  Loansheld-for-sale in conjunction with the mortgage banking business are carried atthe lower of aggregate cost or fair value. Fees related to loans held-for-sale are recognized as a component ofmortgage banking income upon the sale of the loan.  Loans acquired through the completion of atransfer, including loans acquired in a business combination are accounted forin accordance with the American Institute of Certified Public AccountantsStatement of Position (“SOP”) 03-3, “Accounting for Certain Loans or DebtSecurities Acquired in a Transfer.” Under SOP 03-3, loans that fall within the scope of SOP 03-3 areevaluated for evidence of deterioration of credit quality since theirorigination for which it was probable that all contractual payments would notbe collected.  Such loans are carried attheir estimated fair value (as determined by the present value of expectedfuture cash flows) with the estimated cash flows reevaluated on a quarterlybasis.  The difference between theundiscounted cash flows expected at acquisition and the investment in the loan,or the “accretable yield,” is recognized as interest income on a level-yieldmethod over the life of the loan. Contractually required payments for interest and principal that exceed

 

62

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theundiscounted cash flows expected at acquisition, or the “nonacrretabledifference,” are not recognized as a yield adjustment or as a loss accrual or avaluation allowance, but rather are part of the purchase price.  Increases in expected cash flows subsequent tothe initial investment are recognized prospectively through an adjustment ofthe yield on the loan over its remaining life. Decreases in expected cash flowsare recognized as an impairment. Valuation allowances on these impaired loans reflect only lossesincurred after the acquisition (meaning the present value of all cash flowsexpected at acquisition that are ultimately not received) with the estimatedcash flows reevaluated on a quarterly basis. When scheduled principal or interest payments are past due 90 days ormore at quarter-end on any loan, the accrual of interest income isdiscontinued.  Subsequent receipts onthese loans are recorded as a reduction of principal, and interest income isrecorded only once principal recovery is reasonably assured.  Previously accrued but uncollected intereston these loans is charged against interest income.  Generally, a loan may be restored to accruingstatus when all past due principal, interest and late charges have been paidand Bankshares expects repayment of the remaining contractual principal andinterest.

 

Under Statements of Financial Accounting Standards (SFAS) Nos. 114 and118, “Accounting by Creditors for Impairment of a Loan -an amendment of FASBStatements Nos. 5 and 15” a loan is considered impaired, based on currentinformation and events, if it is probable that Bankshares will not collect allprincipal and interest payments according to the contractual terms of the loanagreement.  The impairment of a loan ismeasured based on the present value of expected future cash flows discounted atthe loan’s effective interest rate, or the fair value of the collateral if therepayment is expected to be provided predominantly by the underlyingcollateral. Impaired loans do not include large groups of smaller balancehomogeneous loans that are evaluated collectively for impairment (e.g.,residential mortgages and consumer installment loans).  The allowance for loan losses related tothese loans is included in the allowance for loan losses applicable to otherthan impaired loans. A majority of Bankshares’ impaired loans are measured byreference to the fair value of the collateral.

 

D. Allowance for LoanLosses

The allowance for loanlosses is maintained at a level considered by management to be adequate toabsorb losses inherent in the loan portfolio. Management’s assessment includes the systematic evaluation of severalfactors:  current economic conditions andtheir impact on specific borrowers and industry groups; the level of classifiedand nonperforming loans; the historical loss experience by loan type; theresults of regulatory examinations; and, in specific cases, the estimated valueof underlying collateral.  Theassessments of economic conditions, results of regulatory examinations andother risk elements are primarily determined by management at each affiliateand reviewed by Bankshares.  Indeveloping this assessment, management must rely on estimates and exercisejudgment in assigning credit risk. Depending on changing circumstances, futureassessments of credit risk may yield materially different results from theestimates, which may require an increase or a decrease in the allowance forloan losses.

 

The allowance isincreased by the loan loss provision charged to operating expenses and reducedby loan charge-offs, net of recoveries. The provision for loan losses is based on a continuing review of the loanportfolios, past loss experience and current economic conditions that mayaffect borrowers’ ability to pay.  A loanis charged-off when, in management’s judgement, the collection of the remainingbalance carried is remote.  Consumerloans that are 90 days past due at quarter end, unless well secured and in theprocess of collection, are charged off immediately.

 

E. Loans Held-for-Sale

Bankshares enters intocommitments to sell loans that it has originated.  Generally, these loans are held for a shortterm.  Mortgage loans held for sale arerecorded at the principal amount less deferred fee income, with fee incomesubsequently reflected in earnings when the loan is sold.   The carrying amounts of loans held-for-saleare reported at the lower of cost or fair market value, with the originalprincipal amount adjusted to reflect changes in the loans’ fair value asapplicable through fair value hedge accounting. Pursuant to SFAS No. 133, loans held-for-sale, commitments to sellthe loans, and any commitments to originate loans are recorded on the balancesheet at estimated fair market value. The determination of any write-down to market value on loans held-for -saleincludes consideration of all open positions and outstanding commitments frominvestors.  Declines in the market valueof loans held-for-sale are recorded as a charge in mortgage banking-relatedfees.  Subsequent declines or recoveriesof previous declines in the market value of loans held for sale are recorded inmortgage banking-related fees.  Sales ofloans are recorded when the proceeds are received, and any difference betweenthe proceeds and the carrying amount is recorded as a gain or loss in mortgagebanking-related fees.

 

F. Bank Premises andEquipment

Bank premises andequipment are stated at cost less accumulated depreciation andamortization.  Depreciation andamortization are computed using both the straight-line and accelerated methodsover the estimated useful lives of the properties.  Expenditures for repairs and maintenance arecharged to operating expenses as incurred. Expenditures for improvements that extend the life of an asset arecapitalized and depreciated over the asset’s remaining useful life.  Gains or losses realized on the dispositionof properties are reflected in consolidated income.

 

G. Other Real EstateOwned

Other real estate ownedconsists primarily of real estate obtained through foreclosure or acceptance ofdeeds in lieu of foreclosure. Other real estate owned is held for sale and isstated at the lower of cost or fair value.

 

63

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H. Goodwill andIntangible Assets

Goodwill is the excess ofthe cost of Bankshares’ investment over its equity in the net assets ofpurchased businesses.  Goodwill andidentified intangible assets with indefinite useful lives are not subject toamortization.  Rather they are subject toimpairment testing on an annual basis, or more often if events or circumstancesindicate there may be impairment.

 

Identified intangibleassets that have a finite useful life are amortized over that life in a mannerthat reflects the estimated decline in the economic value of the identifiedintangible asset.  Identified intangibleassets that have a finite useful life are periodically reviewed to determinewhether there have been any events or circumstances to indicate the recordedamount is not recoverable from projected undiscounted net operating cashflows.  If the projected undiscounted netoperating cash flows are less than the carrying amount, a loss is recognized toreduce the carrying amount to fair value, or when appropriate, the amortizationperiod is reduced.

 

Bankshares’ impairmentevaluations for the year ended December 31, 2005, indicated that none ofBankshares’ goodwill or identified intangible assets were impaired with theexception of one small customer relationship intangible where the amortizationperiod required acceleration.

 

Bankshares recognizes asassets the right to service mortgage loans for others.  Market quotes are used to determine the fairvalue of the mortgage servicing rights at the date of the sale.  The capitalized mortgage servicing rights areamortized over the estimated period of net servicing income.  Bankshares analyzes the capitalized mortgageservicing rights for impairment using a discounted cash flow analysis.  A valuation allowance is established througha charge to earnings if the amount of unamortized mortgage servicing rightsexceeds fair value.

 

I. Stock-BasedCompensation

Bankshares’ stock-basedcompensation plans are accounted for in accordance with the provisions of SFAS No. 123,“Accounting for Stock-Based Compensation.” Under this standard, compensation cost for options is determined basedon the fair value of each option and the number of options that are granted andexpected to vest.  Bankshares’ stockoptions typically have an exercise price equal to the fair value of the stockon the date of grant, and vest based on continued service for a specifiedperiod, generally over three to five years. The fair value of the option is measured on the date of grant using theBlack-Scholes option-pricing model with market assumptions.  This amount is amortized on a straight-linebasis over the vesting period.  Optionpricing models require the use of highly subjective assumptions, includingexpected stock price volatility, which if changed can materially affect fairvalue estimates. Compensation expense for restricted stock awards is based onthe closing market value of Bankshares’ stock on the date an award is grantedand is amortized as salaries and employee benefits expense in the results ofoperations in accordance with the applicable vesting schedule, generallystraight-line over one to three years.

 

J. Pension andPostretirement Benefit Obligations

Bankshares offers variouspension plans and postretirement benefit plans to employees.  The calculation of the obligations andrelated expenses under these plans requires the use of actuarial valuationmethods and assumptions.  Actuarialvaluations and assumptions used in the determination of future values of planassets and liabilities are subject to management judgment and may differsignificantly if different assumptions are used.

 

K. Income Taxes

Income taxes are recorded in accordance with SFAS No. 109, “Accountingfor Income Taxes.”  The asset andliability approach underlying SFAS No. 109 requires the recognition of deferredtax liabilities and assets for the expected future tax consequences oftemporary differences between the carrying amounts and tax bases of Bankshares’assets and liabilities.  Deferred taxesare determined using enacted tax rates in effect for the year in which thetemporary difference is expected to reverse. To the extent tax rates or laws change, deferred tax assets andliabilities are adjusted in the period that the tax change is enacted.  Income tax expense includes deferred taxexpense, which represents the net change in the deferred tax asset or liabilitybalance during the year plus any change in a valuation allowance; and currenttax expense, which represents the aggregate amount of tax currently payable toor receivable from tax authorities.

 

L. Earnings Per Share

Basic and dilutedearnings per share (“EPS”) amounts are computed in accordance with theprovisions of SFAS No. 128, “Earnings Per Share.”  Basic EPS is computed by dividing incomeavailable to common shareholders by weighted average common shares outstandingduring the period.  Diluted EPS iscomputed using the same components as in basic EPS with the denominatoradjusted for the dilutive effect of stock options and restricted stock awards.

 

M. Cash Flows

For purposes of reportingcash flows, cash and cash equivalents include cash and due from banks,interest-bearing deposits in other banks, federal funds sold and securitiespurchased under resale agreements. Generally, federal funds are purchased and sold for

one-day periods;securities purchased/sold under resale agreements are purchased/sold forperiods of one to sixty days.

 

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N. Derivatives andHedging Activities

Derivatives are accountedfor in accordance with SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities” as subsequently amended by SFAS No. 137,SFAS No. 138 and SFAS No. 149, which establishes accounting andreporting standards for derivatives and hedging activities.  Under SFAS No. 133, Bankshares maydesignate a derivative as either a hedge of the fair value of a recognizedfixed-rate asset or liability or an unrecognized firm commitment (“fair value” hedge),a hedge of a forecasted transaction or of the variability of future cash flowsof a floating-rate asset or liability (“cash flow” hedge), or a foreigncurrency fair value or cash flow hedge (“foreign currency” hedge).  All derivatives are recorded as other assetsor other liabilities on the balance sheet at their respective fair values withunrealized gains and losses recorded either in other comprehensive income or inthe results of operations, depending on the purpose for which the derivative isheld.  Derivatives that do not meet thecriteria for designation as a hedge under SFAS No. 133 at inception, orfail to meet the criteria thereafter, are included in trading account assets orliabilities.

 

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. To the extent of the effectiveness of a hedge, changes in the fairvalue of a derivative that is designated and qualifies as a cash flow hedge arerecorded in other comprehensive income. For all hedge relationships, ineffectiveness resulting from differencesbetween the changes in fair values or cash flows of the hedged item and changesin fair value of the derivative are recognized as other noninterest income inthe results of operations.  The netinterest settlement on derivatives designated as fair value or cash flow hedgesis treated as an adjustment of the interest income or interest expense of thehedged assets or liabilities.

 

At inception of a hedgetransaction, Bankshares formally documents the hedge, as well as the riskmanagement objective and strategy for undertaking the hedge transactions.  This process includes identification of thehedging instrument, hedged item, risk being hedged and the methodology formeasuring ineffectiveness.  Both atinception and on an ongoing basis, an assessment is made as to whether thederivatives used in hedging transactions have been highly effective inoffsetting changes in the fair value of hedged items and whether thosederivatives may be expected to remain highly effective in future periods.

 

Bankshares discontinueshedge accounting prospectively when either it is determined that the derivativeis no longer highly effective in offsetting changes in the fair value or cashflows of a hedged item; the derivative expires or is sold, terminated orexercised; the derivative is de-designated because it is unlikely that aforecasted transaction will occur; or management determines that designation ofthe derivative as a hedging instrument is no longer appropriate.

 

When hedge accounting isdiscontinued, the derivative is reclassified as a trading account asset orliability.  When a fair value hedge isdiscontinued, the hedged asset or liability is no longer adjusted for changesin fair value, and the existing basis adjustment is amortized or accreted as anadjustment to yield over the remaining life of the asset or liability.  When a cash flow hedge is discontinued butthe hedged cash flows or forecasted transaction are still expected to occur,unrealized gains and losses that were accumulated in other comprehensive incomeare included in the results of operations in the same period when the resultsof operations are also affected by the hedged cash flow.  They are recognized in the results ofoperations immediately if the cash flow hedge was discontinued because a forecastedtransaction is not expected to occur.

 

Under SFAS No. 133,as amended, commitments to purchase loans and certain commitments to sell loansare derivatives.  These commitments canbe designated as a hedge; otherwise, they are recorded as a freestandingderivative and classified as a trading account asset or liability.

 

Bankshares occasionallymay enter into a contract (“host contract”) that contains a derivative that isembedded in the financial instrument.  Ifapplicable, an embedded derivative is separated from the host contract and can bedesignated as a hedge; otherwise, the derivative is recorded as a freestandingderivative and classified as a trading account asset or liability.

 

O. NonmarketableInvestments

Nonmarketable investmentsinclude private equity investments that are not publicly traded, securitiesacquired to meet various regulatory requirements (for example, Federal ReserveBank Stock), bank-owned life insurance and hedge fund investments. Bankshares’reviews typically include an analysis of the facts and circumstances of eachinvestment for fair determination, the expectations for the investments’ cashflows and capital needs, the viability of its business model and our exitstrategy.  Since these private equityinvestments have no readily ascertainable fair value, they are reported atamounts that we have estimated to be fair value. In estimating the fair valueof each investment, we must apply judgment using certain assumptions.  Bankshares believes that an investment’s costis the best indication of its fair value initially, provided that there havebeen no significant positive or negative developments subsequent to itsacquisition that indicate the necessity of an adjustment to a fair valueestimate.  Private equity investments arereviewed at least quarterly for possible other-than-temporary impairment. If,and when, such an event takes place, Bankshares adjusts the investment’s fairvalue by an amount that Bankshares believes reflects the nature of theevent.  Bankshares recognizes anyadjustment to fair value as other noninterest income.  Bank-owned life insurance is carried at cashsurrender value, which approximates fair value. Investments in hedge funds are recorded at fair value.  Changes in fair values are reported asnoninterest income.

 

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2. BUSINESS COMBINATIONS

 

The following providesinformation concerning acquisitions and restructurings completed during thethree years ended December 31, 2005. These acquisitions were accounted for as purchases.  The number of shares issued in the purchaseshave been adjusted for the three-for-two stock split.  The results of operations of theseacquisitions subsequent to the acquisition dates are included in Bankshares’Statements of Consolidated Income. Individually, the results of operations of these acquisitions prior tothe acquisition dates were not material to Bankshares’ results of operations.

 

On November 30,2005, Keller Stonebraker (a subsidiary of Farmers & Mechanics Bank)acquired Select Benefit Services, Inc., an insurance agency headquarteredin Frederick Maryland.  The totalconsideration paid was $1.0 million in the form of 26,003 unregistered sharesof Bankshares’ common stock.

 

On May 18, 2005,Bankshares completed its acquisition of CBNV, a bank headquartered in Sterling,Virginia, which was merged into MSD&T. CBNV operated 14 branch offices in the Northern Virginia metropolitanmarket at the time of the acquisition. The primary reason for the merger with CBNV was to expand Bankshares’distribution network in Northern Virginia, a higher growth market.  The total consideration paid to CBNVshareholders in connection with the acquisition was $82.9 million in cash and 3.7million shares of Bankshares’ common stock. CBNV transactions have been included in Bankshares’ financial resultssubsequent to May 18, 2005.  Theassets and liabilities of CBNV were recorded on the Consolidated Balance Sheetat their respective fair values.  Thefair values were determined as of May 18, 2005 and are subject torefinement as further information becomes available.  The transaction resulted in total assetsacquired as of May 18, 2005 of $888.2 million, including $671.0 million ofloans and leases; liabilities assumed were $842.3 million, including $626.9million of deposits.  Additionally,Bankshares recorded $162.1 million of goodwill and $4.6 million of core depositintangible (“CDI”).  CDI are subject toamortization and are being amortized over nine years on a straight-line basis.

 

As part of theacquisition, Bankshares considered SFAS No. 146 and as such Bankshares’exit costs, referred to herein as “merger-related” costs, are defined toinclude costs for branch closings and related severance, combining operationssuch as systems conversions, and printing/mailing costs incurred by Banksharesprior to and after the merger date and are included in Bankshares’ results ofoperations.  Bankshares expensedmerger-related costs totaling $1.3 million for the year ended December 31,2005.  The costs associated with theseactivities are included in noninterest expenses.  Merger-related expenses incurred consistedlargely of expenses for systems conversion costs, branch closings andintegrations of operations.  Prior to themerger, CBNV recorded exit costs of $9.7 million relating to severance, systemconversions, branch consolidations and costs associated with terminatingcontracts.  Management determined that $224thousand of the estimated $9.7 million in exit costs will not be disbursed andtherefore reversed this amount out of the accrued exit costs.  At December 31, 2005, $371 thousandremained unpaid, which primarily consisted of severance and contractwrite-offs.

 

In the second quarter of2005, Bankshares consolidated Fidelity Bank into Farmers.  The consolidation of these banks allows thesurviving bank to serve its local customers with greater scale andexpertise.  Also in the second quarter of2005, Mercantile Potomac Bank merged into MSD&T.  This combination allows Bankshares to providethe resources necessary for greater expansion into the Washington, D.C. andNorthern Virginia markets.

 

On August 12, 2003,Bankshares completed its acquisition of Farmers, a bank holding companyheadquartered in Frederick, Maryland.  The total consideration paid to Farmers shareholders in connection withthe acquisition was $124.1 million in cash and 15.6 million shares ofBankshares’ common stock.  Farmers’transactions have been included in Bankshares’ financial results since August 13,2003.  Acquired assets on August 12,2003 totaled $2.2 billion, including $1.4 billion of loans and leases;liabilities assumed were $2.0 billion, including $1.7 billion of deposits.  As of December 31, 2003, Banksharesrecorded $385.9 million of goodwill, $36.0 million of core deposit intangible,$5.8 million of mostly client relationship intangibles (relating to the twoinsurance subsidiaries) and $1.1 million in a trademark intangible.  Intangible assets subjected to amortizationare being amortized on a straight-line basis. The weighted average amortization period for the acquired core depositintangible is nine years, and the client relationship identified intangibleranges from three to fifteen years.  On October 24,2003, certain assets and liabilities of Farmers were transferred to otherBankshares affiliates in order to align customers’ accounts with the Banksharesaffiliate serving the geographic area where those customers reside.

 

Farmers, acquiredin a business combination, falls under the guidance of the Emerging Issues TaskForce (“EITF”) in EITF IssueNo. 95-3, “Recognition of Liability in Connection with a Purchase BusinessCombination.”  EITF Issue No. 95-3requires an entity

to recognize aliability for an exit cost on the date that the entity commits itself to anexit plan.  “Exit costs” are defined toinclude those costs recorded by Farmers prior to the merger date and,therefore, are not included in Bankshares’ results of operations.  Prior

to August 12,2003 Farmers recorded exit costs of $33.6 million relating to severance,systems conversion, branch consolidation

and costsassociated with terminating contracts (including leases).  Management has determined that $3.2 millionof the estimated $33.6 million in exit costs will not be disbursed.  This $3.2 million was reversed out of theaccrued exit costs, with corresponding decreases to deferred taxes ($1.2million) and goodwill ($2.0 million).  Asof December 31, 2005, $29.8 million of these exit costs had been paidsince acquisition. Bankshares expensed merger-related costs totaling $8.0million for the year-ended December 31, 2003.  The costs associated with these activitieswere included in noninterest expenses.

 

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In March and April 2003,Bankshares acquired in separate transactions, Boyd Watterson Asset Management,LLC (“Boyd Watterson”), an investment management firm, and Peremel &Company, Inc. (“Peremel”), a directed and discount brokerage company.  In the aggregate, the companies werepurchased for approximately $29.0 million in cash.  The Boyd Watterson acquisition had apotential additional contingent payment of up to $8.6 million that will be paidin the first quarter of 2006 and will be recorded as goodwill.  Bankshares recorded approximately $10.1million of identified intangibles, mostly client relationships, as a result ofthese acquisitions.  These intangiblesare being amortized on a straight-line basis over a range of three to eightyears.  Goodwill recorded on thesetransactions totaled approximately $18.0 million at December 31, 2005.

 

3. INVESTMENTSECURITIES

 

The amortized cost andfair value of investment securities at December 31, 2005 and 2004 were asfollows:

 
| ** **                           | ** ** | **2005**            | ** **    | **2004**                     | ** ** |
|--------------------------------------|------------|---------------------|---------------|------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Amortized  Cost** | ** **    | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Securities held-to-maturity          |       |                |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions    | ** ** | **$**               | **16,659**    | ** **                   | **$**      | **541** | ** ** | **$** | **19** | ** ** | **$** | **17,181** |   | $ | 20,176 |   | $ | 921 |   | $ | 3 |   | $ | 21,094 |   |
| Securities available-for-sale        |       |                |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                        | ** ** | **$**               | **434,893**   | ** **                   | **$**      | **223** | ** ** | **$** | **3,080** | ** ** | **$** | **432,036** |   | $ | 605,505 |   | $ | 4,534 |   | $ | 980 |   | $ | 609,059 |   |
| U.S. Government agencies             | ** ** | **992,040**         | ** **    | **29**                       | ** ** | **12,761** | ** ** | **979,308** |   | 853,930 |   | 3,742 |   | 4,699 |   | 852,973 |   |
| Mortgage-backed securities           | ** ** | **1,581,845**       | ** **    | **685**                      | ** ** | **38,269** | ** ** | **1,544,261** |   | 1,326,056 |   | 4,372 |   | 13,127 |   | 1,317,301 |   |
| States and political subdivisions    | ** ** | **70,017**          | ** **    | **306**                      | ** ** | **188** | ** ** | **70,135** |   | 61,984 |   | 917 |   | 31 |   | 62,870 |   |
| Other bonds, notes and debentures    | ** ** | **19,083**          | ** **    | **—**                   | ** ** | **215** | ** ** | **18,868** |   | 30,387 |   | 28 |   | 126 |   | 30,289 |   |
| Total bonds                          | ** ** | **3,097,878**       | ** **    | **1,243**                    | ** ** | **54,513** | ** ** | **3,044,608** |   | 2,877,862 |   | 13,593 |   | 18,963 |   | 2,872,492 |   |
| Other investments                    | ** ** | **43,980**          | ** **    | **1,236**                    | ** ** | **196** | ** ** | **45,020** |   | 34,936 |   | 1,266 |   | — |   | 36,202 |   |
| Total                                | ** ** | **$**               | **3,141,858** | ** **                   | **$**      | **2,479** | ** ** | **$** | **54,709** | ** ** | **$** | **3,089,628** |   | $ | 2,912,798 |   | $ | 14,859 |   | $ | 18,963 |   | $ | 2,908,694 |   |
|                                      |            |                     |               |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The amortized cost andfair value of the bond investment portfolio by contractual maturity at December 31,2005 and 2004 are shown below.

 
| ** **                    | ** ** | **2005**            | ** **    | **2004**        | ** ** |
|-------------------------------|------------|---------------------|---------------|-----------------|------------|
| **(Dollars  in thousands)**   | ** ** | **Amortized  Cost** | ** **    | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities held-to-maturity   |       |                |          |            |       |   |   |   |   |
| Within 1 year                 | ** ** | **$**               | **2,347**     | ** **      | **$**      | **2,349** |   | $ | 2,812 |   | $ | 2,831 |   |
| 1-5 years                     | ** ** | **7,353**           | ** **    | **7,492**       |       | 9,273 |   | 9,550 |   |
| 5-10 years                    | ** ** | **6,959**           | ** **    | **7,340**       |       | 7,694 |   | 8,281 |   |
| After 10 years                | ** ** | **—**          | ** **    | **—**      |       | 397 |   | 432 |   |
|   Total             | ** ** | **$**               | **16,659**    | ** **      | **$**      | **17,181** |   | $ | 20,176 |   | $ | 21,094 |   |
| Securities available-for-sale |       |                |          |            |       |   |   |   |   |
| Within 1 year                 | ** ** | **$**               | **621,979**   | ** **      | **$**      | **617,587** |   | $ | 571,279 |   | $ | 574,375 |   |
| 1-5 years                     | ** ** | **2,292,959**       | ** **    | **2,244,736**   |       | 2,002,424 |   | 1,993,754 |   |
| 5-10 years                    | ** ** | **182,940**         | ** **    | **182,285**     |       | 278,645 |   | 278,751 |   |
| After 10 years                | ** ** | **—**          | ** **    | **—**      |       | 25,514 |   | 25,612 |   |
|   Total             | ** ** | **$**               | **3,097,878** | ** **      | **$**      | **3,044,608** |   | $ | 2,877,862 |   | $ | 2,872,492 |   |
|                               |            |                     |               |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2005and 2004, no single issue of investment securities exceeded 10.0% ofshareholders’ equity.  At

December 31, 2005and 2004, securities with an amortized cost of $1.3 billion and $1.1 billion,respectively, were pledged

as collateral for certaindeposits as required.

 

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The following table showsthe gross unrealized losses and fair value of Bankshares’ investments withunrealized losses that are not deemed to be other-than-temporarily impaired (inthousands), aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position at December 31,2005 and 2004.

 
| ** **                                            | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**                     | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| **At December 31, 2005  (Dollars in thousands)** | ** ** | **Gross  Unrealized  Losses**          | ** ** | **Fair  Value**                      | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|                                                  |       |                                   |       |                                 |       |                          |       |   |   |   |   |   |   |
| U.S.  Treasury                                        | ** ** | **$**                                  | **1,301**  | ** **                           | **$**      | **334,188**                   | ** ** | **$** | **1,779** | ** ** | **$** | **97,848** | ** ** | **$** | **3,080** | ** ** | **$** | **432,036** | ** ** |
| U.S.  Government agencies                             | ** ** | **4,834**                              | ** ** | **513,169**                          | ** ** | **7,927**                     | ** ** | **466,139** | ** ** | **12,761** | ** ** | **979,308** | ** ** |
| Mortgage-backed  securities                           | ** ** | **15,420**                             | ** ** | **1,026,218**                        | ** ** | **22,848**                    | ** ** | **518,043** | ** ** | **38,269** | ** ** | **1,544,261** | ** ** |
| States  and political subdivisions                    | ** ** | **173**                                | ** ** | **83,626**                           | ** ** | **34**                        | ** ** | **3,690** | ** ** | **207** | ** ** | **87,316** | ** ** |
| Other  bonds, notes and debentures                    | ** ** | **30**                                 | ** ** | **5,129**                            | ** ** | **186**                       | ** ** | **13,739** | ** ** | **215** | ** ** | **18,868** | ** ** |
| Total  bonds                                          | ** ** | **21,758**                             | ** ** | **1,962,330**                        | ** ** | **32,774**                    | ** ** | **1,099,459** | ** ** | **54,532** | ** ** | **3,061,789** | ** ** |
| Other  investments                                    | ** ** | **196**                                | ** ** | **45,020**                           | ** ** | **—**                    | ** ** | **—** | ** ** | **196** | ** ** | **45,020** | ** ** |
| Total                                                 | ** ** | **$**                                  | **21,954** | ** **                           | **$**      | **2,007,350**                 | ** ** | **$** | **32,774** | ** ** | **$** | **1,099,459** | ** ** | **$** | **54 ,728** | ** ** | **$** | **3,106,809** | ** ** |

 
| ** **                                                                | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**                     | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| **At December 31, 2004  (Dollars in thousands)** | ** ** | **Gross  Unrealized  Losses**          | ** ** | **Fair  Value**                      | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|                                                                      |       |                                   |       |                                 |       |                          |       |   |   |   |   |   |   |
| U.S.  Treasury                                                            |       | $                                      | 980        |                                 | $          | 609,059                       |       | $ | — |   | $ | — |   | $ | 980 |   | $ | 609,059 |   |
| U.S.  Government agencies                                                 |       | 4,698                                  |       | 852,922                              |       | 1                             |       | 51 |   | 4,699 |   | 852,973 |   |
| States  and political subdivisions                                        |       | 30                                     |       | 83,590                               |       | 1                             |       | 374 |   | 31 |   | 83,964 |   |
| Mortgage-backed  securities                                               |       | 4,703                                  |       | 1,039,943                            |       | 8,424                         |       | 277,358 |   | 13,127 |   | 1,317,301 |   |
| Other  bonds, notes and debentures                                        |       | 126                                    |       | 30,289                               |       | —                        |       | — |   | 126 |   | 30,289 |   |
| Total  bonds                                                              |       | 10,537                                 |       | 2,615,803                            |       | 8,426                         |       | 277,783 |   | 18,963 |   | 2,893,586 |   |
| Other  investments                                                        |       | —                                 |       | 36,202                               |       | —                        |       | — |   | — |   | 36,202 |   |
| Total                                                                     |       | $                                      | 10,537     |                                 | $          | 2,652,005                     |       | $ | 8,426 |   | $ | 277,783 |   | $ | 18,963 |   | $ | 2,929,788 |   |

 

The unrealized losses onBankshares’ investments in U. S. Treasury obligations and direct obligations ofU. S. Government agencies were caused by interest rate increases.  The contractual terms of those investments donot permit the issuer to settle the securities at a price less than theamortized cost of the investment. Because Bankshares has the ability and intent to hold those investmentsuntil a recovery of fair value, which may be at maturity, Bankshares does notconsider those investments to be other-than-temporarily impaired at December 31,2005.

 

The unrealized losses onBankshares’ investment in federal agency mortgage-backed securities were causedby interest rate increases. Bankshares’ purchased those investments at a modestpremium or discount to their face amount, and the contractual cash flows ofthose investments are guaranteed by an agency of the U.S. Government.  Accordingly, it is expected that thesecurities would not be settled at a price less than the amortized cost ofBankshares’ investment.  Because thedecline in market value is attributable to changes in interest rates and notcredit quality, and because Bankshares has the ability and intent to hold thoseinvestments until a recovery of fair value, which may be at maturity,Bankshares does not consider those investments to be other-than-temporarilyimpaired at December 31, 2005.

 

The unrealized losses onBankshares’ investments in state and political subdivision obligations werecaused by interest rate increases. Credit quality within this portfolioremained strong with 73.0% of the portfolio rated AAA and 99.0% of the portfoliorated investment grade.  The contractualterms of those investments do not permit the issuer to settle the security at aprice less than the amortized cost of the investment.  Because Bankshares has the ability and intentto hold those investments until a recovery of fair value, which may be atmaturity, it does not consider those investments to be other-than-temporarilyimpaired at December 31, 2005.

 

The unrealized losses onBankshares’ investments in other bonds, notes and debentures were caused byinterest rate increases. The credit quality of these bonds has remained strongthroughout 2005 and it is expected that the securities would not be settled at aprice less than the amortized cost of Bankshares’ investment.  Because Bankshares has the ability and intentto hold those investments until a recovery of fair value, which may be atmaturity, it does not consider those investments to be other-than-temporarilyimpaired at December 31, 2005.

 

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Bankshares investments inother investments consist of investments in common stock of other bankingcompanies and a mutual fund that invests in bonds that qualify as CommunityReinvestment Act (“CRA”) investments. The unrealized loss of $196.0 thousand relates to the CRA mutualfund.  Based on the level of theimpairment (less than 1% of the cost) and the duration of the impairment (lessthan 12 months) and Bankshares’ ability and intent to hold this investment fora reasonable period of time sufficient for a forecasted recovery of fair value,Bankshares does not consider this investment to be other-than-temporarilyimpaired at December 31, 2005.

 

The following table showsthe gross realized gains and losses on the sale of securities in theavailable-for-sale portfolio, including marketable equity securities.

 
| ** **                     | ** ** | **2005**                   | ** ** | **2004**                    | ** ** | **2003**                   | ** ** |
|--------------------------------|------------|----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(Dollars in thousands)**     | ** ** | **Gross  Realized  Gains** | ** ** | **Gross  Realized  Losses** | ** ** | **Gross  Realized  Gains** | ** ** | **Gross  Realized  Losses** | ** ** | **Gross  Realized  Gains** | ** ** | **Gross  Realized  Losses** | ** ** |
| Securities  available-for-sale |       |                       |       |                        |       |                       |       |   |   |   |   |   |   |
| Debt                           | ** ** | **$**                      | **293**    | ** **                  | **$**      | **56**                     |       | $ | — |   | $ | 202 |   | $ | — |   | $ | 985 |   |
| Other  Investments             | ** ** | **279**                    | ** ** | **111**                     |       | 1,441                      |       | — |   | 8,122 |   | — |   |
| Total                          | ** ** | **$**                      | **572**    | ** **                  | **$**      | **167**                    |       | $ | 1,441 |   | $ | 202 |   | $ | 8,122 |   | $ | 985 |   |

 

4. LOANS AND ALLOWANCEFOR LOAN LOSSES

 

Loans at December 31,2005 and 2004 were as follows.

 
| **(Dollars in thousands)** | ** ** | **2005**      | ** **     | **2004**  | ** ** |
|--------------------------------------|------------|---------------|----------------|-----------|------------|
| Commercial and leasing               | ** ** | **$**         | **2,957,301**  |      | $          | 2,866,693 |   |
| Commercial real estate               | ** ** | **3,703,297** |           | 3,122,701 |       |
| Construction                         | ** ** | **1,607,095** |           | 1,268,350 |       |
| Residential real estate              | ** ** | **1,802,373** |           | 1,677,932 |       |
| Home equity lines                    | ** ** | **505,508**   |           | 495,462   |       |
| Consumer                             | ** ** | **1,032,271** |           | 797,295   |       |
| Total                                | ** ** | **$**         | **11,607,845** |      | $          | 10,228,433 |   |

 

At December 31, 2005and 2004, $22.6 million and $30.9 million, respectively, were considerednonaccrual loans (loans in which interest income is recognized only ascollected).  Interest income onnonaccrual loans that would have been recorded if accruing

was $2.1 million and $2.5million in 2005 and 2004, respectively. Interest income on nonaccrual loans that was recorded totaled

$0.5 million and $0.8million in 2005 and 2004, respectively. See Note No. 1C (Significant Accounting Policies) for anexplanation of the nonaccrual loan policy.

 

The changes in theallowance for loan losses follow:

 
| **(Dollars in thousands)**   | ** ** | **2005**   | ** **  | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|------------|-------------|----------|------------|----------|------------|
| Allowance balance at beginning of year | ** ** | **$**      | **149,002** |     | $          | 155,337  |       | $ | 138,601 |   |
| Allowance of acquired bank             | ** ** | **7,086**  |        | —   |       | 13,205   |       |
| Charge-offs                            | ** ** | **(7,602** | **)**       | (18,380  | )          | (12,324  | )          |
| Recoveries                             | ** ** | **6,611**  |        | 4,824    |       | 3,750    |       |
| Provision for loan losses              | ** ** | **1,576**  |        | 7,221    |       | 12,105   |       |
| Allowance balance at end of year       | ** ** | **$**      | **156,673** |     | $          | 149,002  |       | $ | 155,337 |   |

 

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Information with respectto impaired loans and the related valuation allowance (if the measure of theimpaired loan is less than the recorded investment) as of December 31,2005 and 2004 is shown below.  Refer to NoteNo. 1C (Significant Accounting Policies) for an expanded discussion onimpaired loans.

 
| **(Dollars in thousands)**                                          | ** ** | **2005**    | ** **  | **2004** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------|-------------|----------|------------|
| Impaired  loans with a specific valuation allowance                           | ** ** | **$**       | **11,512**  |     | $          | 18,695 |   |
| All  other impaired loans                                                     | ** ** | **9,086**   |        | 8,783    |       |
| Total  impaired loans                                                         | ** ** | **$**       | **20,598**  |     | $          | 27,478 |   |
|                                                                          |       |        |        |     |       |
| Specific  allowance for loan losses applicable to impaired loans              | ** ** | **$**       | **4,150**   |     | $          | 10,611 |   |
| General  allowance for loan losses applicable to other than impaired loans    | ** ** | **152,523** |        | 138,391  |       |
| Total  allowance for loan losses                                              | ** ** | **$**       | **156,673** |     | $          | 149,002 |   |
|                                                                          |       |        |        |     |       |
| Year-to-date  interest income on impaired loans recorded on the cash basis    | ** ** | **$**       | **40**      |     | $          | 379 |   |
| Year-to-date  average recorded investment in impaired loans during the period | ** ** | **$**       | **26,703**  |     | $          | 39,025 |   |

 

On May 18, 2005,Bankshares acquired approximately $671.0 million in loans as part of the CBNVacquisition.  At acquisition, CBNV had$7.4 million in an allowance for loan losses of which $7.1 million was carriedover to Bankshares in accordance with SFAS No. 141, “BusinessCombinations,” for those loans that do not fall within the scope of SOP 03-3, “Accountingfor Certain Loans or Debt Securities Acquired in a Transfer.” Banksharesdetermined two commercial real estate loans totaling $4.9 million were withinthe scope of SOP 03-3.  The carryingvalue and accretable yields of these loans as of December 31, 2005 areshown below.

 
| **(Dollars in thousands)** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|
| Commercial  real estate              | ** ** | **$**                       | **4,887**  | ** ** |
| Total                                | ** ** | **$**                       | **4,887**  | ** ** |
| ** **                           | ** ** | ** **                  | ** ** |
| Carrying  amount                     | ** ** | **$**                       | **3,509**  | ** ** |

 
| ** **                                       | ** ** | **Accretable  yield** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| Balance  at May 18, 2005                    | ** ** | **$**                 | **—** | ** ** |
| Additions  - due to acquisition                  | ** ** | **680**               | ** ** |
| Accretions                                       | ** ** | **(227**              | **)**      |
| Reclassifications  from nonaccretable difference | ** ** | **194**               | ** ** |
| Disposals                                        | ** ** | **—**            | ** ** |
| Balance  at December 31, 2005               | ** ** | **$**                 | **647**    | ** ** |

 

5. BANK PREMISES ANDEQUIPMENT

 

Bank premises andequipment at December 31, 2005 and 2004 consisted of the following:

 
| **(Dollars in thousands)**      | ** ** | **2005**     | ** **  | **2004** | ** ** |
|-------------------------------------------|------------|--------------|-------------|----------|------------|
| Land                                      | ** ** | **$**        | **26,670**  |     | $          | 27,590 |   |
| Building and leasehold improvements       | ** ** | **144,200**  |        | 148,119  |       |
| Equipment                                 | ** ** | **113,134**  |        | 106,621  |       |
| Total bank premises and equipment         | ** ** | **284,004**  |        | 282,330  |       |
| Accumulated depreciation and amortization | ** ** | **(146,585** | **)**       | (142,384 | )          |
| Bank premises and equipment, net          | ** ** | **$**        | **137,419** |     | $          | 139,946 |   |

 

Bankshares’ bankaffiliates conduct a part of their branch banking operations from leasedfacilities.  Generally, the initial termsof the leases range from a period of one to fifteen years.  Most of the leases contain options forrenewal at the fair rental value for periods of one to twenty years.  In addition to minimum rentals, certainleases have escalation clauses based on various price indices and includeprovisions for additional payments to cover taxes, insurance and maintenance.

 

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Total rental expense for2005, 2004 and 2003 was:

 
| **(Dollars in thousands)** | ** ** | **2005**  | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Bank premises (1)                    | ** ** | **$**     | **11,185** |     | $          | 9,501    |       | $ | 8,807 |   |
| Equipment / software expense         | ** ** | **6,053** |       | 5,670    |       | 5,984    |       |
| Total rental expense                 | ** ** | **$**     | **17,238** |     | $          | 15,171   |       | $ | 14,791 |   |

 

----

(1) Amounts do not reflectoffset for rental income from outside tenants.

 

The main offices ofBankshares and MSD&T are located in a 21-story building at Two HopkinsPlaza in Baltimore, Maryland, which is owned by MBC Realty, LLC, a wholly ownedsubsidiary of Harbor Group International, L.L.C.  Pursuant to a lease agreement by and betweenMBC Realty, LLC (which was previously ownedby Bankshares) and MSD&T, effective as of December 13, 2004,MSD&T agreed to lease up to approximately 179,000 square feet of primeoffice space and approximately 27,000 square feet ofback-office and storage space at Two Hopkins Plaza, for a term of tenyears.  At December 31, 2005,MSD&T and Bankshares occupied approximately 206,000 square feet.  The lease agreement contains two five-yearrenewal options.  The lease agreement isaccounted for as a lease-financing obligation. See Note No. 9 (Long-termDebt) found elsewhere in this document.

 

At December 31,2005, the aggregate minimum rental commitments under non-cancelable operatingleases were as follows:

2006 - $16.8 million,2007 - $16.0 million, 2008 - $13.1 million, 2009 - $9.9 million, 2010 - $8.0million, thereafter - $43.7 million.

 

6. OTHER ASSETS &LIABILITIES

 

The following tableprovides selected information on Bankshares’ other assets at December 31,2005 and 2004.

 
| **(Dollars in thousands)**             | ** ** | **2005**    | ** **  | **2004** | ** ** |
|--------------------------------------------------|------------|-------------|-------------|----------|------------|
| Nonmarketable investments                        |       |        |        |     |       |
|   Private equity and other investments | ** ** | **$**       | **69,445**  |     | $          | 56,476 |   |
|   Hedge fund of funds                  | ** ** | **62,778**  |        | 74,190   |       |
|   Bank-owned life insurance            | ** ** | **152,613** |        | 83,836   |       |
| Total nonmarketable investments                  | ** ** | **284,836** |        | 214,502  |       |
| Interest receivable                              | ** ** | **90,075**  |        | 62,061   |       |
| Deferred taxes, net                              | ** ** | **79,322**  |        | 47,299   |       |
| Prepaid assets                                   | ** ** | **82,667**  |        | 84,130   |       |
| All other assets                                 | ** ** | **51,500**  |        | 57,088   |       |
| Total other assets                               | ** ** | **$**       | **588,400** |     | $          | 465,080 |   |

 

Net gains from sales orimpairment of private equity and other nonmarketable investments were $10.8million, $2.6 million and $0.8 million in 2005, 2004 and 2003,respectively.  Noninterest income fromhedge funds was $8.4 million, $5.5 million and

$6.4 million in 2005,2004, and 2003, respectively.  In thethird quarter of 2005, Bankshares purchased additional bank-owned lifeinsurance in the amount of $50.0 million and acquired $13.0 million through theCBNV acquisition.  Other noninterestincome from bank-owned life insurance was $4.8 million, $3.3 million and $3.0million in 2005, 2004 and 2003, respectively.

 

The following tableprovides selected information on Bankshares’ other liabilities at December 31,2005 and 2004.

 
| **(Dollars in thousands)** | ** ** | **2005**   | ** **  | **2004** | ** ** |
|--------------------------------------|------------|------------|-------------|----------|------------|
| Accrued expenses                     | ** ** | **$**      | **81,906**  |     | $          | 61,599 |   |
| Interest payable                     | ** ** | **26,276** |        | 16,551   |       |
| All other liabilities                | ** ** | **61,598** |        | 51,846   |       |
| Total other liabilities              | ** ** | **$**      | **169,780** |     | $          | 129,996 |   |

 

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7. DEPOSITS

 

Included in time depositsare certificates of deposit issued in denominations of $100,000 and over, whichtotaled $1.7 billion and $1.4 billion at December 31, 2005 and 2004,respectively. The amount outstanding and maturity distribution of time depositsissued in amounts of $100,000 and over at December 31, 2005 are presentedin the following table.

 
| ** **                           | ** ** | ** ** | ** ** | **Maturing**                  | ** ** |
|--------------------------------------|------------|------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**  | ** ** | **1 year  or less** | ** ** | **Over 1  through  2 years** | ** ** | **Over 2  through  3 years** | ** ** | **Over 3  through  4 years** | ** ** | **Over 4  through  5 years** | ** ** | **Over  5 years** | ** ** |
| Time  deposits $100,000 and over     |       | $          | 1,743,885  |                          | $          | 1,175,410 |   | $ | 286,205 |   | $ | 94,964 |   | $ | 93,606 |   | $ | 90,622 |   | $ | 3,078 |   |
|                                      |            |            |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Deposits at December 31,2005 and 2004 consisted of the following.

 
| **(Dollars in thousands)** | ** ** | **2005**      | ** **     | **2004**  | ** ** |
|--------------------------------------|------------|---------------|----------------|-----------|------------|
| Noninterest-bearing                  | ** ** | **$**         | **3,324,650**  |      | $          | 3,049,031 |   |
| Savings                              | ** ** | **1,339,215** |           | 1,449,313 |       |
| Checking  plus interest              | ** ** | **1,430,524** |           | 1,377,981 |       |
| Money  market                        | ** ** | **1,944,513** |           | 1,588,445 |       |
| Time  - $100,000 and over            | ** ** | **1,743,885** |           | 1,393,907 |       |
| Other  time                          | ** ** | **2,294,563** |           | 1,940,522 |       |
| Total                                | ** ** | **$**         | **12,077,350** |      | $          | 10,799,199 |   |

 

8. SHORT-TERM BORROWINGS

 

The following tableprovides selected information on Bankshares’ short-term borrowings andapplicable weighted average interest rates at December 31, 2005 and 2004.

 
| ** **                                                               | ** ** | **Year-end** | ** **    | **During Year** | ** ** |
|--------------------------------------------------------------------------|------------|--------------|---------------|----------------------|------------|
| **2005 ****(Dollars in thousands)**                       | ** ** | **Amount**   | ** **    | **Rate**             | ** ** | **Highest** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| Federal  funds purchased and securities sold under repurchase agreements | ** ** | **$**        | **1,044,660** | ** **           | **3.04**   | **%** | **$** | **1,084,364** | ** ** | **$** | **928,207** | ** ** | **2.49** | **%** |
| Commercial  paper                                                        | ** ** | **193,054**  | ** **    | **2.37**             | ** ** | **209,355** | ** ** | **177,781** | ** ** | **1.79** | ** ** |
| Other  short-term borrowings                                             | ** ** | **—**   | ** **    | **—**           | ** ** | ** ** | ** ** | **—** | ** ** | **—** | ** ** |
| Total                                                                    | ** ** | **$**        | **1,237,714** | ** **           | **2.93**   | **%** | ** ** | ** ** | **$** | **1,105,988** | ** ** | **2.37** | **%** |
|                                                                          |            |              |               |                      |            |  |  |  |  |  |  |  |  |  |

 
| ** **                                                               | ** ** | **Year-end** | ** ** | **During the Year** | ** ** |
|--------------------------------------------------------------------------|------------|--------------|------------|--------------------------|------------|
| **2004 (Dollars in thousands)**                                          | ** ** | **Amount**   | ** ** | **Rate**                 | ** ** | **Highest** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| Federal  funds purchased and securities sold under repurchase agreements |       | $            | 671,227    |                     | 1.44       | % | $ | 729,315 |   | $ | 726,041 |   | 0.96 | % |
| Commercial  paper                                                        |       | 216,630      |       | 0.80                     |       | 286,844 |   | 206,308 |   | 0.44 |   |
| Other  short-term borrowings                                             |       | —       |       | —                   |       |   |   | 144 |   | 2.19 |   |
| Total                                                                    |       | $            | 887,857    |                     | 1.29       | % |   |   | $ | 932,493 |   | 0.84 | % |
|                                                                          |            |              |            |                          |            |  |  |  |  |  |  |  |  |  |

 

Other short-term borrowingsconsist of borrowings from the Federal Home Loan Bank of Atlanta (“FHLB”).  During 2005 and 2004, commercial paperborrowings were partially supported by back-up lines of credit of $40.0million.  Unused committed lines

of credit at December 31,2005 and 2004 were $40.0 million.  Theselines of credit are paid for quarterly, semiannually or annually

on a fee basis of 0.09%to 0.10%.  In addition, Bankshares alsohas $2.1 billion in lines with the FHLB, although Bankshares’

$50.0 million in seniornotes contain debt covenant restrictions that limit additional FHLB borrowingsto $150.0 million unless Bankshares renegotiates this restriction with existinginvestors.

 

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9. LONG-TERM DEBT

 

Long-term debt at December 31,2005 and 2004 consisted of the following.

 
| **(Dollars in thousands)**             | ** ** | **2005**    | ** **  | **2004** | ** ** |
|--------------------------------------------------|------------|-------------|-------------|----------|------------|
| Senior  notes of Bankshares, unsecured           |       |        |        |     |       |
| Ranging  from 6.72% to 6.80%, due 2006 and 2009  | ** ** | **$**       | **50,000**  |     | $          | 50,000 |   |
| Senior  notes of MSD&T, unsecured (1)        |       |        |        |     |       |
| 5.70%,  due 2011                                 |       |        |        |     |       |
| Book  value                                      | ** ** | **199,739** |        | 199,704  |       |
| Fair  value basis adjustment                     | ** ** | **(866**    | **)**       | 6,147    |       |
| Adjusted  balance                                | ** ** | **198,873** |        | 205,851  |       |
| Subordinated  notes of MSD&T, unsecured (2)  |       |        |        |     |       |
| Floating  rate of LIBOR plus 2.75%, due 2014     |       |        |        |     |       |
| Book  value                                      | ** ** | **9,794**   |        | —   |       |
| Subordinated  notes of Bankshares, unsecured (3) |       |        |        |     |       |
| 4.625%,  due 2013                                |       |        |        |     |       |
| Book  value                                      | ** ** | **299,410** |        | 299,346  |       |
| Fair  value basis adjustment                     | ** ** | **(9,486**  | **)**       | (6,289   | )          |
| Adjusted  balance                                | ** ** | **289,924** |        | 293,057  |       |
| Lease  finance obligation, Hopkins building (4)  |       |        |        |     |       |
| 4.00%,  due 2011                                 | ** ** | **49,288**  |        | 51,186   |       |
| Advances  from Federal Home Loan Bank (5)        |       |        |        |     |       |
| Ranging  from 2.00% to 6.56%, due 2006 to 2018   | ** ** | **144,284** |        | 90,861   |       |
| Total                                            | ** ** | **$**       | **742,163** |     | $          | 690,955 |   |

 

Note: All debt is subjectto interest payments at various intervals. Several of the FHLB advances and the lease-financing obligation aresubject to monthly principal payments.

 

(1) The debt has aface value of $200.0 million, with an unamortized discount of $261 thousandbased on an effective rate of 4.20%. These fixed-rate notes were converted tofloating rates through an interest rate swap. This swap was designed as a hedge of the fair value of the debt;therefore, the debt has been adjusted to reflect the change in the fair valueof the swap.

 

(2) The debt has aface value of $10.0 million, with an unamortized discount of $206 thousandbased on an effective rate of 7.01%.

 

(3) The debt has aface value of $300.0 million, with an unamortized discount of $590 thousandbased on an effective rate of 4.51%. $150.0 million of these fixed-rate noteswere converted to floating rates through interest rate swaps.  These swaps were designed as a hedge of thefair value of the debt; therefore, the debt has been adjusted to reflect the changein the fair value of the swap.

 

(4) Represents theunamortized amount due on the lease of the Hopkins Plaza Building.

 

(5) Of the $144.3million that the Federal Home Loan Bank of Atlanta (“FHLB”) advanced toBankshares as of December 31, 2005, $49.3 million is convertible tothree-month LIBOR at the option of the FHLB. These advances are convertible ona quarterly basis upon written notice from the FHLB. With the exception of$30.2 million in advances, each of these convertible advances is within itsconversion period and may be converted on any quarterly payment date should theFHLB give notice. The $30.2 million in advances has an initial conversion dateof March 20, 2006.

 

The annual maturities onall long-term debt are 2006 - $88.0 million, 2007 - $19.1 million, 2008 - $26.8million, 2009 - $24.4 million, 2010 - $3.4 million, thereafter - $580.4million.

 

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10. COMMITMENTS ANDCONTINGENCIES

 

Bankshares is a party tofinancial instruments that are not reflected in the balance sheet, which includecommitments to extend credit and standby letters of credit. Various commitmentsto extend credit (lines of credit) are made in the normal course of bankingbusiness. 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 $4.8 billion at December 31,2005 and $4.2 billion at December 31, 2004.

 

Letters of credit arecommitments issued to guarantee the performance of a customer to a third party.Outstanding letters of credit were $540.6 million at December 31, 2005 and$379.8 million at December 31, 2004. In accordance with FASB Interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others,” the fees received for issuing letters ofcredit are deferred and amortized over the life of the commitment.  The unamortized fees on letters of credit at December 31,2005 and December 31, 2004 had a carrying value of $1.9 million and $1.3million, 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.  Theunamortized principal balance of the underlying loans totaled $249.8 million atDecember 31, 2005 and $190.7 million at December 31, 2004.  A loss reserve of $60.7 thousand has been establishedfor potential losses on loans originated and sold in the secondary market at December 31,2005.  The mortgage subsidiary also hasoriginated and sold loans with recourse in the event of foreclosure on theunderlying real estate. The unamortized amount of principal balance of loanssold with recourse totaled $1.3 million and $1.7 million at December 31,2005 and 2004, respectively.  Thesemortgages are generally in good standing and are well collateralized, no loss hasensued and no future loss is expected.

 

Bankshares has committedto invest funds in third-party private equity funds. At December 31, 2005and 2004, $26.6 million and $28.9 million, respectively, remained unfunded.

 

Bankshares entered into aseven-year service contract with SunGard Wealth Management Services to providea new core accounting system and back-office operations beginning in January 2005.The annual purchase obligation commitments on this contract are:  2006 - $5.0 million, 2007 - $5.0 million,2008 - $5.0 million, 2009 - $5.0 million, 2010 - $5.0 million, thereafter -$5.0 million. For additional information on other commitments, see Notes Nos. 5,9, and 18.

 

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 the consolidatedfinancial position, earnings or liquidity of Bankshares. If payment associatedwith a claim becomes probable and the cost can be reasonably estimated, acontingent liability would be established based on information currentlyavailable, advice of counsel and available insurance coverage.

 

Between 2001 and2003, on behalf of either individual plaintiffs or a putative class ofplaintiffs, eight separate actions were filed in state and federal courtagainst CBNV and other defendants challenging the validity of second mortgageloans the defendants made to the plaintiffs. All of the cases were either filed in or removed to the federal districtcourt for the Western District of Pennsylvania. In June 2003, the parties to the various actions informed the courtthat they had reached an agreement in principle to settle the variousactions.  On July 17, 2003, thecourt conditionally certified a class for settlement purposes, preliminarilyapproved the class settlement and directed the issuance of notice to the class.

 

Thereafter,certain plaintiffs who had initially opted out of the proposed settlement andother objectors challenged the validity of the settlement in the districtcourt.  The district court denied theirarguments and approved the settlement. These “opt out” plaintiffs and other objectors appealed the districtcourt’s approval of the settlement to the Third Circuit Court of Appeals.  In August 2005, the Third Circuitreversed the district court’s approval of the settlement and remanded the caseto the district court with instructions to consider and address certainspecific issues when re-evaluating the settlement. Certain individuals who wereexcluded from the settlement class have filed two actions on behalf of aputative class of plaintiffs alleging claims similar to those raised in theinitial filing.  These actions recentlywere consolidated in the Western District of Pennsylvania.  Bankshares believes these actions are withoutmerit and intends to defend the actions vigorously.  Based on the information currently available,advice of counsel and established reserves, Bankshares believes that theeventual outcome of these actions will not have a material adverse effect onBankshares’ consolidated financial position or results of operations.

 

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11. SHAREHOLDERS’ EQUITY

 

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. Certain shares, average sharesand per share amounts have been adjusted to give effect to the split.

 

The Board of Directorshas the authority to classify and reclassify any unissued shares of preferredstock by fixing the preferences, rights, voting powers (which may includeseparate class voting on certain matters), restrictions and qualifications,dividends, times and prices of redemption and conversion rights.

 

Bankshares has a DividendReinvestment and Stock Purchase Plan. The Plan allows shareholders to investtheir cash dividends automatically in Bankshares stock at a price that is 5%less than the market price on the dividend payment date. Plan participants alsomay make additional cash payments to purchase stock through the Plan at themarket price. The number of shares of common stock that remain available forissuance under the Plan is 362,766 shares. Bankshares reserves the right toamend, modify, suspend or terminate the Plan at any time at its discretion.

 

Bankshares has anEmployee Stock Purchase Plan.  The Planallows employees (other than executive officers of Bankshares) to purchasestock through payroll deduction and dividend reinvestment at the then currentmarket price for employee purchases and at 95% of market for dividendreinvestment.  The number of shares ofcommon stock that remain available for issuance under the Plan is 1,076,162shares. Bankshares reserves the right to amend, modify, suspend or terminatethe Plan at any time at its discretion.

 

The Board of Directorshas authorized Bankshares to purchase shares of its common stock.  Purchases may be made from time to time,subject to regulatory requirements, in the open market or in privatelynegotiated transactions.  Purchasedshares are retired. The number of shares remaining available for purchase underthe plan was 476,327 shares at December 31, 2005.  During 2005 there were no shares repurchasedunder this plan.  In 2004, Banksharesrepurchased 1,000,000 shares.  In April 2004,Bankshares entered into a privately negotiated agreement for the acceleratedrepurchase of these shares.

 

Pursuant to aShareholders Protection Rights Agreement adopted in June 1999, each shareof outstanding common stock carries a right, initially for the purchase of1/1,000 of a share of preferred stock at an exercise price of $100 (subject toadjustment).  The rights, which do notcarry voting or dividend rights, may be redeemed by Bankshares at $0.005 perright.  The rights expire on September 29,2009 unless sooner exercised, exchanged or redeemed.  The rights will not become exercisable andwill not trade separately from the common stock until the tenth business day(or such other date as the Board of Directors selects) after commencement of atender or exchange offer for, or announcement of the acquisition by a person orgroup of 10.0% or more of the outstanding common stock. Upon exercisability ofthe rights after acquisition by a person or group (acquiring person) of 10.0%or more of the outstanding common stock or upon certain business combinationsor other defined transactions involving Bankshares, each right (except rightsof the acquiring person, which become void) will entitle its holder to acquirecommon stock (or at Bankshares’ discretion, preferred stock) of Bankshares, orcommon stock of the acquiring entity in a business combination or other definedtransaction, with a value of twice the then current exercise price of theright.  In certain such cases, Banksharesmay exchange one share of common stock (or at Bankshares’ discretion, 1/1,000of a share of preferred stock) for each right that has not become void.  The Board of Directors has classified1,600,000 shares of preferred stock as Class A Preferred Stock forpotential issuance on exercise of rights.

 

Cash dividends paid to Bankshares by its consolidated subsidiaries forthe years ended 2005, 2004 and 2003 were $173.0 million, $145.8 million and$310.8 million, respectively.  Inaggregate, our affiliate banks have $379.8 million of capital beyond the levelnecessary to maintain “well capitalized” status at December 31, 2005.  The amount of dividends that Bankshares’ bankand nonbank affiliates could have paid to the holding company without approvalfrom bank regulators at December 31, 2005 was $266.4 million.

 

The Mercantile BanksharesCorporation Stock Retainer and Deferred Compensation Plan for Non-EmployeeDirectors was approved at the 2005 Annual Shareholders’ meeting.  The Plan provides for an annual stockretainer of 750 shares of Bankshares’ common stock to each nonemployee directorof Bankshares.  The Plan permitsnonemployee directors of Bankshares and its affiliates to elect to defervoluntarily their annual stock and cash retainers and some or all of theirfees.  The initial annual stock retainerunder the plan was paid on June 1, 2005 to nonemployee directors.

 

A change to the Directors’Deferred Compensation Plan was approved at the 2004 Annual Shareholders’meeting.  Beginning

April 1, 2004, alldeferred directors’ fees are covered by the Plan.  At April 1, 2004, directors had theoption to leave their deferred balance in the old phantom stock plan or converttheir balance into vested shares under the new plan.  All but 13 directors converted their balancesto the new plan.  This resulted in addingapproximately 223,500 stock equivalents and $6.4 million to capital surplus.These vested shares will be issued after a director retires.

 

75

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*Earnings Per Share*

Basic earnings per share (“EPS”) is computed by dividing incomeavailable to common shareholders by weighted average common shares outstanding,which were 121,348,742 for 2005, 118,830,128 for 2004 and 109,338,614 for 2003.Diluted EPS is computed using the same components as in basic EPS with thedenominator adjusted for the dilutive effect of stock options, restricted stockawards and vested directors’ deferred compensation plan shares. The adjustedweighted average shares were 122,390,007 for 2005, 119,781,506 for 2004 and 110,132,231for 2003. The following tables provide a reconciliation between the computationof basic EPS and diluted EPS for the years ended December 31, 2005, 2004 and2003.

 
| **2005 (In  thousands, except per share data)**          | ** ** | **Net  Income** | ** **  | **Weighted Average  Common Shares** | ** **  | **EPS**    | ** ** |
|----------------------------------------------------------|------------|-----------------|-------------|-------------------------------------|-------------|------------|------------|
| Basic EPS                                                | ** ** | **$**           | **276,319** | ** **                          | **121,349** | ** ** | **$**      | **2.28** | ** ** |
| Dilutive effect of:                                      | ** ** | ** **      | ** **  | ** **                          | ** **  | ** ** | ** ** |
| Stock options and restricted stock awards                | ** ** | ** **      | ** **  | **780**                             | ** **  | ** ** | ** ** |
| Vested directors’ deferred compensation plan shares | ** ** | ** **      | ** **  | **261**                             | ** **  | ** ** | ** ** |
| Diluted EPS                                              | ** ** | **$**           | **276,319** | ** **                          | **122,390** | ** ** | **$**      | **2.26** | ** ** |

 
| **2004 (In  thousands, except per share data)**          | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|-------------------------------------|------------|---------|------------|
| Basic EPS                                                |       | $               | 229,407    |                                | 118,830    |    | $          | 1.93 |   |
| Dilutive effect of:                                      |       |            |       |                                |       |    |       |
| Stock options and restricted stock awards                |       |            |       | 778                                 |       |    |       |
| Vested directors’ deferred compensation plan shares |       |            |       | 174                                 |       |    |       |
| Diluted EPS                                              |       | $               | 229,407    |                                | 119,782    |    | $          | 1.92 |   |

 
| **2003 (In  thousands, except per share data)** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
|-------------------------------------------------|------------|-----------------|------------|-------------------------------------|------------|---------|------------|
| Basic EPS                                       |       | $               | 196,814    |                                | 109,339    |    | $          | 1.80 |   |
| Dilutive effect of:                             |       |            |       |                                |       |    |       |
| Stock options and restricted stock awards       |       |            |       | 793                                 |       |    |       |
| Diluted EPS                                     |       | $               | 196,814    |                                | 110,132    |    | $          | 1.79 |   |

 

76

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*Comprehensive Income*

The two major components of comprehensive income are net income andother comprehensive income. Other comprehensive income includes such items asnet unrealized gains and losses on securities available-for-sale. The followingtable summarizes the market value change and related tax effect of unrealizedgains (losses) on securities available-for-sale for each of the three years inthe period ended December 31, 2005. See the “Statements of Changes inConsolidated Shareholders’ Equity.”

 
| **2005****(Dollars  in thousands)**                                    | ** ** | **Pretax  Amount** | ** ** | **Tax  Benefit** | ** ** | **Net  Amount** | ** **  |
|------------------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|-------------|
| Net Income                                                             | ** ** | ** **         | ** ** | ** **       | ** ** | **$**           | **276,319** | ** ** |
| Other comprehensive income                                             |       |               |       |             |       |            |        |
| Unrealized  holding (losses) gains arising during the period           | ** ** | **(47,718**        | **)**      | **17,844**       | ** ** | **(29,874**     | **)**       |
| Reclassification  adjustment for (gains) losses included in net income | ** ** | **(405**           | **)**      | **160**          | ** ** | **(245**        | **)**       |
| Total other  comprehensive (losses) income                             | ** ** | **(48,123**        | **)**      | **18,004**       | ** ** | **(30,119**     | **)**       |
| Total comprehensive income                                             | ** ** | ** **         | ** ** | ** **       | ** ** | **$**           | **246,200** | ** ** |

 
| **2004 (Dollars in thousands)**                                        | ** ** | **Pretax  Amount** | ** ** | **Tax  Benefit** | ** ** | **Net  Amount** | ** ** |
|------------------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|------------|
| Net Income                                                             |       |               |       |             |       | $               | 229,407    |   |
| Other comprehensive income                                             |       |               |       |             |       |            |       |
| Unrealized  holding (losses) gains arising during the period           |       | (39,156            | )          | 14,696           |       | (24,460         | )          |
| Reclassification  adjustment for (gains) losses included in net income |       | (1,239             | )          | 490              |       | (749            | )          |
| Total other  comprehensive (losses) income                             |       | (40,395            | )          | 15,186           |       | (25,209         | )          |
| Total comprehensive income                                             |       |               |       |             |       | $               | 204,198    |   |

 
| **2003 (Dollars in thousands)**                                        | ** ** | **Pretax  Amount** | ** ** | **Tax  Benefit** | ** ** | **Net  Amount** | ** ** |
|------------------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|------------|
| Net Income                                                             |       |               |       |             |       | $               | 196,814    |   |
| Other comprehensive income                                             |       |               |       |             |       |            |       |
| Unrealized  holding (losses) gains arising during the period           |       | (46,059            | )          | 16,996           |       | (29,063         | )          |
| Reclassification  adjustment for (gains) losses included in net income |       | (7,137             | )          | 2,823            |       | (4,314          | )          |
| Total other  comprehensive (losses) income                             |       | (53,196            | )          | 19,819           |       | (33,377         | )          |
| Total comprehensive income                                             |       |               |       |             |       | $               | 163,437    |   |

 

*Capital Adequacy*

Bankshares and its bank affiliates are subject to various regulatorycapital requirements administered by the federal and state banking agencies.Failure to meet minimum capital requirements can initiate certain mandatory—andpossibly additional discretionary—actions by regulators that, if undertaken,could have a direct material effect on Bankshares’ financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, Bankshares and its bank affiliates must meet specific capitalguidelines that involve quantitative measures of Bankshares’ assets,liabilities and certain off-balance sheet items as calculated under regulatoryaccounting practices. Bankshares’ capital amounts and classification are alsosubject to qualitative judgments by the regulators about components, riskweightings and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require Bankshares and its bank affiliates to maintain.at least theminimum amounts and ratios of Tier I capital (as defined in the regulations) torisk-weighted assets (as defined). Management believes that, as of December 31,2005, Bankshares and its bank affiliates exceeded all capital adequacyrequirements to which they are subject.

 

77

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As of December 31, 2005, the most recent notification from the primaryregulators for each of Bankshares’ affiliate banking institutions categorizedthem as well capitalized under the prompt corrective action regulations. To becategorized as well capitalized, a bank must maintain certain capital ratiosabove minimum levels. These capital ratios include Tier I capital and totalrisk-based capital as percents of net risk-weighted assets and Tier I capitalas a percent of adjusted average total assets (leverage ratio). There are noconditions or events since the last notifications that management believes havechanged the affiliate banks’ category.

 

Actual capital amounts and ratios are presented in the following tablefor Bankshares and its affiliates. The minimum ratios for capital adequacypurposes are 4.00%, 8.00% and 4.00% for the Tier I Capital, Total Capital andLeverage ratios, respectively. To be categorized as well capitalized, a bankmust maintain minimum ratios of 6.00%, 10.00% and 5.00% for its Tier I Capital,Total Capital and Leverage ratios, respectively. Bankshares, as a bank holdingcompany, is not subject to the well capitalized requirement. No deduction fromcapital is required for interest rate risk.

 
| **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 and 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 and 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 and 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                |       |
|                                                 |            |                     |               |                                |            |                                |            |                                     |                |                            |            |                           |            |                     |            |  |  |  |  |

 
| **December 31, 2004 (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                                   |       | $                   | 1,370,112  |                           | $          | 1,802,520                      |       | $                                   | 11,109,137 |                       | $          | 13,674,386                |       | 12.33               | %          | 16.23 | % | 10.02 | % |
| Annapolis Banking  and Trust                 |       | 42,170              |       | 49,516                         |       | 274,303                        |       | 467,607                             |       | 15.37                      |       | 18.05                     |       | 9.02                |       |
| Citizens National  Bank                      |       | 91,078              |       | 139,356                        |       | 1,002,628                      |       | 1,163,721                           |       | 9.08                       |       | 13.90                     |       | 7.83                |       |
| Farmers &  Mechanics Bank                |       | 155,656             |       | 216,901                        |       | 1,282,848                      |       | 1,690,284                           |       | 12.13                      |       | 16.91                     |       | 9.21                |       |
| Marshall National  Bank and Trust            |       | 11,464              |       | 17,821                         |       | 108,120                        |       | 134,203                             |       | 10.60                      |       | 16.48                     |       | 8.54                |       |
| Mercantile County  Bank                      |       | 72,105              |       | 109,669                        |       | 651,245                        |       | 820,186                             |       | 11.07                      |       | 16.84                     |       | 8.79                |       |
| Mercantile  Eastern Shore Bank               |       | 52,642              |       | 84,119                         |       | 473,634                        |       | 594,811                             |       | 11.11                      |       | 17.76                     |       | 8.85                |       |
| Mercantile  Peninsula Bank                   |       | 128,868             |       | 200,736                        |       | 1,207,803                      |       | 1,534,800                           |       | 10.67                      |       | 16.62                     |       | 8.40                |       |
| Mercantile-Safe  Deposit and Trust Company   |       | 484,591             |       | 574,022                        |       | 4,671,752                      |       | 5,457,015                           |       | 10.37                      |       | 12.29                     |       | 8.88                |       |
| Mercantile  Southern Maryland Bank           |       | 94,010              |       | 130,406                        |       | 548,527                        |       | 931,179                             |       | 17.14                      |       | 23.77                     |       | 10.10               |       |
| National Bank of  Fredericksburg             |       | 34,153              |       | 44,842                         |       | 305,234                        |       | 416,813                             |       | 11.19                      |       | 14.69                     |       | 8.19                |       |
| Westminster Union  Bank                      |       | 58,596              |       | 89,677                         |       | 505,819                        |       | 808,495                             |       | 11.58                      |       | 17.73                     |       | 7.25                |       |
|                                              |            |                     |            |                                |            |                                |            |                                     |            |                            |            |                           |            |                     |            |  |  |  |  |

 

78

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12. INCOME TAXES

 

Applicable income taxes on net income for 2005, 2004 and 2003 consistedof the following.

 
| ** **                      | ** ** | **2005**    | ** **  | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------|------------|-------------|-------------|------------|------------|------------|------------|
| **(Dollars in thousands)**      | ** ** | **Federal** | ** **  | **State**  | ** ** | **Total**  | ** ** | **Federal** | ** ** | **State** | ** ** | **Total** | ** ** | **Federal** | ** ** | **State** | ** ** | **Total** | ** ** |
| Current tax expense             | ** ** | **$**       | **151,657** | ** ** | **$**      | **19,136** | ** ** | **$** | **170,793** |   | $ | 140,618 |   | $ | 14,255 |   | $ | 154,873 |   | $ | 107,870 |   | $ | 10,678 |   | $ | 118,548 |   |
| Deferred tax  expense (benefit) | ** ** | **(9,047**  | **)**       | **(216**   | **)**      | **(9,263** | )          | (21,937 | ) | (1,812 | ) | (23,749 | ) | (7,457 | ) | (1,536 | ) | (8,993 | ) |
| Total                           | ** ** | **$**       | **142,610** | ** ** | **$**      | **18,920** | ** ** | **$** | **161,530** |   | $ | 118,681 |   | $ | 12,443 |   | $ | 131,124 |   | $ | 100,413 |   | $ | 9,142 |   | $ | 109,555 |   |
|                                 |            |             |             |            |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Significant components of Bankshares’ deferred tax assets andliabilities as of December 31, 2005 and 2004 were as follows.

 
| **(Dollars in thousands)**                              | ** ** | **2005**    | ** ** | **2004** | ** ** |
|---------------------------------------------------------|------------|-------------|------------|----------|------------|
| Deferred tax  assets:                                   |       |        |       |     |       |
| Allowance for  loan losses                              | ** ** | **$**       | **60,308** |     | $          | 58,322 |   |
| Write-down of  other real estate owned                  | ** ** | **51**      |       | 134      |       |
| Deferred income                                         | ** ** | **35,607**  |       | 35,559   |       |
| Net unrealized  losses on securities available-for-sale | ** ** | **19,388**  |       | 1,382    |       |
| Other                                                   | ** ** | **9,218**   |       | 7,913    |       |
| Total deferred  tax assets                              | ** ** | **124,572** |       | 103,310  |       |
| Deferred tax  liabilities:                              |       |        |       |     |       |
| Purchase  accounting adjustments                        | ** ** | **10,939**  |       | 8,570    |       |
| Depreciation                                            | ** ** | **30,205**  |       | 37,777   |       |
| Accrued employee  benefits                              | ** ** | **4,106**   |       | 9,512    |       |
| Prepaid items                                           | ** ** | **—**  |       | 152      |       |
| Total deferred  tax liabilities                         | ** ** | **45,250**  |       | 56,011   |       |
| Net deferred tax  assets                                | ** ** | **$**       | **79,322** |     | $          | 47,299 |   |

 

A reconciliation between actual tax expense and taxes computed at thestatutory federal rate of 35% for each of the three years in the period endedDecember 31, 2005 follows.

 
| ** **                                             | ** ** | **2005**   | ** **  | **2004**         |       | **2003**   | ** ** |
|--------------------------------------------------------|------------|------------|-------------|------------------|------------|------------|------------|
| ** **                                             | ** ** | ** ** | ** **  | **% of  Pretax** | ** ** | ** ** | ** ** | **% of  Pretax** |   | ** ** | ** ** | **% of  Pretax** | ** ** |
| **(Dollars in thousand)**                              | ** ** | **Amount** | ** **  | **Income**       | ** ** | **Amount** | ** ** | **Income** |   | **Amount** | ** ** | **Income** | ** ** |
| Tax computed at  statutory rate                        | ** ** | **$**      | **153,247** | ** **       | **35.0**   | **%**      | $          | 126,186 |   | 35.0 | % | $ | 107,229 |   | 35.0 | % |
| Increases  (decreases) in tax resulting from:          |       |       |        |             | ** ** |       |       |   |   |   |   |   |   |
| Tax-exempt  interest income                            | ** ** | **(3,658** | **)**       | **(0.8**         | **)**      | (3,567     | )          | (0.9 | ) | (3,581 | ) | (1.2 | ) |
| State income  taxes, net of federal income tax benefit | ** ** | **12,298** | ** **  | **2.8**          | ** ** | 8,088      |       | 2.2 |   | 5,942 |   | 1.9 |   |
| Other, net                                             | ** ** | **(357**   | **)**       | **(0.1**         | **)**      | 417        |       | 0.1 |   | (35 | ) | — |   |
| Actual tax  expense                                    | ** ** | **$**      | **161,530** | ** **       | **36.9**   | **%**      | $          | 131,124 |   | 36.4 | % | $ | 109,555 |   | 35.7 | % |

 

13. RELATED PARTY TRANSACTIONS

 

In the normal course of business, loans are made to officers anddirectors of Bankshares and its affiliates, as well as to their relatedinterests. In the opinion of management, these loans are consistent with soundbanking practices, are within regulatory lending limitations and do not involvemore than the normal risk of collectibility. At December 31, 2005 and 2004,loans to executive officers and directors of Bankshares and its principalaffiliates, including loans to their related interests, totaled $119.1 millionand $129.1 million, respectively. During 2005, loan additions and loan maturitiesand payoffs were $167.3 million and $177.3 million, respectively. 

 

79

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14. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS

 

Bankshares sponsors qualified and nonqualified pension plans and otherpostretirement benefit plans for its employees. With regard to the pensionplans, there is no additional minimum pension liability required to berecognized. Included in the other postretirement benefit plans are health careand life insurance. All Bankshares affiliates have adopted the same health careand life insurance plans, except for one affiliate, which has separate benefitplans. Employees were eligible for company-paid health care benefits if theirage plus length of service was equal to at least 65 as of December 31, 1990. Employeesmay become eligible for company-paid life insurance benefits if they qualify forretirement while working for Bankshares. In addition to the plans disclosed inthe following tables, Bankshares has periodically entered into separatesupplemental retirement agreements with key executives. These are generally unfundedobligations, with an accrued liability of $18.7 million and $18.5 million atDecember 31, 2005 and 2004, respectively.

 

The following table provides a reconciliation of the changes in theplans’ benefit obligations and fair value of assets for each of the two yearsin the period ended December 31, 2005.

 
| ** **                                      | ** ** | **Pension  Benefits** | ** **  | ** **    | ** ** | ** **  | ** ** |
|-------------------------------------------------|------------|-----------------------|-------------|---------------|------------|-------------|------------|
| ** **                                      | ** ** | **2005**              | ** **  | **2004**      | ** ** | ** **  | ** ** |
| ** **                                      | ** ** | ** **            | ** **  | **Non-**      | ** ** | ** **  | ** ** | ** ** | ** ** | **Non-** | ** ** | ** ** | ** ** | **Other  Benefits** | ** ** |
| **(Dollars in thousands)**                      | ** ** | **Qualified**         | ** **  | **qualified** | ** ** | **Total**   | ** ** | **Qualified** | ** ** | **qualified** | ** ** | **Total** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Change  in Benefit Obligations**              |       |                  |        |          |       |        | ** ** |   |   |   |   |   |   |   |   |   |   |
| Benefit  obligation at beginning of year        | ** ** | **$**                 | **198,422** | ** **    | **$**      | **2,910**   | ** ** | **$** | ** 201,332** | ** ** | $ |  168,104 |   | $ | 6,560 |   | $ | 174,664 | ** ** | **$** | **16,910** |   | $ | 15,050 |   |
| Service cost                                    | ** ** | **7,320**             | ** **  | **607**       | ** ** | **7,927**   | ** ** | 5,603 |   | 618 |   | 6,221 | ** ** | **390** |   | 352 |   |
| Interest cost                                   | ** ** | **11,276**            | ** **  | **161**       | ** ** | **11,437**  | ** ** | 10,528 |   | 386 |   | 10,914 | ** ** | **904** |   | 1,028 |   |
| Amendments                                      | ** ** | **—**            | ** **  | **—**    | ** ** | **—**  | ** ** | 4,865 |   | 83 |   | 4,948 | ** ** | **—** | ** ** | — |   |
| Actuarial (gain)  loss                          | ** ** | **2,160**             | ** **  | **955**       | ** ** | **3,115**   | ** ** | 18,276 |   | (4,517 | ) | 13,759 | ** ** | **(1,705** | **)** | 1,589 |   |
| Acquisition                                     | ** ** | **—**            | ** **  | **—**    | ** ** | **—**  | ** ** | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Benefits paid                                   | ** ** | **(9,237**            | **)**       | **(121**      | **)**      | **(9,358**  | **)**      | (8,954 | ) | (220 | ) | (9,174 | ) | **(1,098** | **)** | (1,109 | ) |
| Benefit  obligation at end of year              | ** ** | **209,941**           | ** **  | **4,512**     | ** ** | **214,453** | ** ** | 198,422 |   | 2,910 |   | 201,332 | ** ** | **15,401** | ** ** | 16,910 |   |
|                                            |       |                  |        |          |       |        | ** ** |   |   |   |   |   |   |   | ** ** |   |   |
| **Change  in Plan Assets**                      |       |                  |        |          |       |        | ** ** |   |   |   |   |   |   |   | ** ** |   |   |
| Fair value of  plan assets at beginning of year | ** ** | **211,638**           | ** **  | **—**    | ** ** | **211,638** | ** ** | 197,260 |   | — |   | 197,260 | ** ** | **—** | ** ** | — |   |
| Actual return on  plan assets                   | ** ** | **9,110**             | ** **  | **—**    | ** ** | **9,110**   | ** ** | 23,332 |   | — |   | 23,332 | ** ** | **—** | ** ** | — |   |
| Acquisition                                     | ** ** | **—**            | ** **  | **—**    | ** ** | **—**  | ** ** | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Employer  contribution                          | ** ** | **—**            | ** **  | **121**       | ** ** | **121**     | ** ** | — |   | 220 |   | 220 | ** ** | **1,098** | ** ** | 1,109 |   |
| Plan  participants’ contributions          | ** ** | **—**            | ** **  | **—**    | ** ** | **—**  | ** ** | — |   | — |   | — | ** ** | **1,947** | ** ** | 1,687 |   |
| Benefits paid                                   | ** ** | **(9,237**            | **)**       | **(121**      | **)**      | **(9,358**  | **)**      | (8,954 | ) | (220 | ) | (9,174 | **)** | **(3,045** | **)** | (2,796 | ) |
| Fair value of  plan assets at end of year       | ** ** | **211,511**           | ** **  | **—**    | ** ** | **211,511** | ** ** | 211,638 |   | — |   | 211,638 | ** ** | **—** | ** ** | — |   |
| Funded status                                   | ** ** | **1,570**             | ** **  | **(4,512**    | **)**      | **(2,942**  | **)**      | 13,216 |   | (2,910 | ) | 10,306 | ** ** | **(15,401** | **)** | (16,910 | ) |
| Unrecognized net  actuarial (gain) loss         | ** ** | **44,524**            | ** **  | **(1,453**    | **)**      | **43,071**  | ** ** | 36,362 |   | (2,593 | ) | 33,769 | ** ** | **4,212** | ** ** | 6,190 |   |
| Unrecognized prior  service cost                | ** ** | **8,568**             | ** **  | **226**       | ** ** | **8,794**   | ** ** | 9,738 |   | 249 |   | 9,987 | ** ** | **—** | ** ** | — |   |
| Unrecognized  transition (assets)/obligation    | ** ** | **—**            | ** **  | **—**    | ** ** | **—**  | ** ** | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Prepaid (accrued)  benefit cost                 | ** ** | **$**                 | **54,662**  | ** **    | **$**      | **(5,739**  | **)**      | **$** | **48,923** | ** ** | $ | 59,316 |   | $ | (5,254 | ) | $ | 54,062 | ** ** | **$** | **(11,189** | **)** | $ | (10,720 | ) |

 

Amounts recognized in the consolidated balance sheets consist of:

 
| ** **                              | ** ** | **Pension  Benefits** | ** ** | ** **            | ** ** | ** **          | ** ** |
|-----------------------------------------|------------|-----------------------|------------|-----------------------|------------|---------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2004**              | ** ** | **Other  Benefits** | ** ** |
| **(Dollars in thousands)**              | ** ** | **Qualified**         | ** ** | **Non-****qualified** | ** ** | **Total**           | ** ** | **Qualified** | ** ** | **Non-****qualified** | ** ** | **Total** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Prepaid benefit cost                    | ** ** | **$**                 | **54,662** | ** **            | **$**      | **—**          | ** ** | **$** | **54,662** |   | $ | 59,316 |   | $ | — |   | $ | 59,316 | ** ** | **$** | **—** |   | $ | — |   |
| Accrued benefit cost                    | ** ** | **—**            | ** ** | **(5,739**            | **)**      | **(5,739**          | **)**      | — |   | (5,254 | ) | (5,254 | **)** | **(11,189** | **)** | (10,720 | ) |
| Intangible assets                       | ** ** | **—**            | ** ** | **—**            | ** ** | **—**          | ** ** | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Accumulated other  comprehensive income | ** ** | **—**            | ** ** | **—**            | ** ** | **—**          | ** ** | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Net amount recognized                   | ** ** | **$**                 | **54,662** | ** **            | **$**      | **(5,739**          | **)**      | **$** | **48,923** | ** ** | $ | 59,316 |   | $ | (5,254 | ) | $ | 54,062 | ** ** | **$** | **(11,189** | **)** | $ | (10,720 | ) |

 

80

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The following is a comparison of the projected and accumulated benefitobligation to the fair value of assets for the pension plans.

 
| ** **                     | ** ** | **Pension Benefits at December 31,** | ** **  |
|--------------------------------|------------|--------------------------------------|-------------|
| ** **                     | ** ** | **2005**                             | ** **  | **2004** | ** ** |
| ** **                     | ** ** | **Qualified**                        | ** **  | **Non-  qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** |
| Projected benefit obligation   | ** ** | **$**                                | **209,941** | ** ** | **$** | **4,512** | ** ** | **$** | **214,453** |   | $ | 198,422 |   | $ | 2,910 |   | $ | 201,332 |   |
| Accumulated benefit obligation | ** ** | **202,479**                          | ** **  | **4,512** | ** ** | **206,991** |   | 189,535 |   | 2,910 |   | 192,445 |   |
| Fair value of assets           | ** ** | **211,511**                          | ** **  | **—** | ** ** | **211,511** |   | 211,638 |   | — |   | 211,638 |   |
|                                |            |                                      |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The components of net periodic benefit cost for the pension plans for 2005,2004 and 2003 follow.

 
| ** **                            | ** ** | **Pension  Benefits** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(Dollars in thousands)**            | ** ** | **Qualified**         | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** |
| Service cost                          | ** ** | **$**                 | **7,320**  | ** ** | **$** | **607** | ** ** | **$** | **7,927** |   | $ | 5,603 |   | $ | 618 |   | $ | 6,221 |   | $ | 4,563 |   | $ | 404 |   | $ | 4,967 |   |
| Interest cost                         | ** ** | **11,276**            | ** ** | **161** | ** ** | **11,437** |   | 10,528 |   | 386 |   | 10,914 |   | 9,993 |   | 314 |   | 10,307 |   |
| Expected return  on plan assets       | ** ** | **(16,573**           | **)**      | **—** | ** ** | **(16,573** | **)** | (15,387 | ) | — |   | (15,387 | ) | (12,395 | ) | — |   | (12,395 | ) |
| Amortization of  prior service cost   | ** ** | **1,170**             | ** ** | **23** | ** ** | **1,193** | ** ** | 782 |   | 23 |   | 805 |   | 779 |   | 23 |   | 802 |   |
| Recognized net  actuarial (gain) loss | ** ** | **1,461**             | ** ** | **(185** | **)** | **1,276** |   | 1,052 |   | 92 |   | 1,144 |   | 2,421 |   | 32 |   | 2,453 |   |
| Amortization of  transition asset     | ** ** | **—**            | ** ** | **—** | ** ** | **—** |   | — |   | 94 |   | 94 |   | — |   | 99 |   | 99 |   |
| Net periodic  benefit cost            | ** ** | **$**                 | **4,654**  | ** ** | **$** | **606** | ** ** | **$** | **5,260** |   | $ | 2,578 |   | $ | 1,213 |   | $ | 3,791 |   | $ | 5,361 |   | $ | 872 |   | $ | 6,233 |   |

 

The components of net periodic benefit cost for the otherpost-retirement benefit plans for 2005, 2004 and 2003 follow.

 
| ** **                          | ** ** | **Other Benefits** | ** ** |
|-------------------------------------|------------|--------------------|------------|
| **(Dollars in thousands)**          | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost                        | ** ** | **$**              | **390**    |   | $ | 352 |   | $ | 205 |   |
| Interest cost                       | ** ** | **904**            |       | 1,028 |   | 854 |   |
| Expected return  on plan assets     | ** ** | **—**         |       | — |   | — |   |
| Amortization of  prior service cost | ** ** | **—**         |       | — |   | — |   |
| Recognized net  actuarial loss      | ** ** | **275**            |       | 362 |   | 153 |   |
| Amortization of  transition asset   | ** ** | **—**         |       | — |   | — |   |
| Net periodic  benefit cost          | ** ** | **$**              | **1,569**  |   | $ | 1,742 |   | $ | 1,212 |   |

 

In May 2004, the FASB issued FSP FAS 106-2, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003,” which provides guidance on accounting for theimpact of the Medicare Prescription Drug, Improvement and Modernization Act of2003.  Bankshares has determined that certain benefits covered by itspost-retirement plans are actuarially equivalent to Medicare Part Dbenefits.  The effects of the subsidy reduced the accumulatedpost-retirement benefit obligation by $1.2 million and net periodic benefitcost by $0.1 million.  Thereduction in the projected net periodic benefit cost was recognized inBankshares’ Statements of Consolidated Income in 2005.

 

There was no increase in the minimum liability included in othercomprehensive income relating to pension benefits and other postretirementbenefits for 2005 and 2004.

 

The weighted average assumptions used to determine the benefitobligation are shown in the following table.

 
| ** **                    | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-------------------------------|------------|----------------------|------------|--------------------|------------|
| **As of  December 31,**       | ** ** | **2005**             | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount rate                 | ** ** | **5.75**             | **%**      | 5.75               | %          | **5.75** | **%** | 5.75 | % |
| Rate of compensation increase | ** ** | **4.00**             | **%**      | 4.00               | %          | **4.00** | **%** | 4.00 | % |

 

81

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The weighted average assumptions used to determine the net periodicbenefit cost are shown in the following table.

 
| ** **                               | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|------------------------------------------|------------|----------------------|------------|--------------------|------------|
| **As of  December 31,**                  | ** ** | **2005**             | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount rate                            | ** ** | **5.75**             | **%**      | 6.25               | %          | **5.75** | **%** | 6.25 | % |
| Expected long-term return on plan assets | ** ** | **8.00**             | **%**      | 8.00               | %          | **N/A** | ** ** | N/A |   |
| Rate of compensation increase            | ** ** | **4.00**             | **%**      | 4.00               | %          | **4.00** | **%** | 4.00 | % |

 

In determining pension expense for the qualified pension plan, along-term return on assets of 8% was assumed. This return consists of anaverage return of 10% on equity securities and 5% on debt securities.

 

Assumed health care cost trend rates are shown in the following table.

 
| **As of  December 31,**                                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Health care cost trend rate assumed for next year                                  | ** ** | **10**   | **%**      | 10       | %          |
| Rate to which the cost trend rate is assumed to  decline (the ultimate trend rate) | ** ** | **5**    | **%**      | 5        | %          |
| Year that the rate reaches the ultimate trend rate                                 | ** ** | **2011** |       | 2010     |       |

 

For measurement purposes, a 10% annual rate of increase in the percapita cost of covered health care benefits was assumed for 2006 and assumed todecrease by 1% per annum until the annual rate reaches 5% and to remain levelthereafter. This rate represents Bankshares’ portion of the annual rate ofincrease. Assumed health care cost trend rates have a significant effect on theamounts reported for the health care plans. A 1% change in assumed health carecost trend rates would have the following effects.

 
| ** **                                               | ** ** | **1% Increase** | ** ** | **1% Decrease** | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| Effect on total of service and interest cost  components |       | $               | 106        |            | $          | (92 | ) |
| Effect on postretirement benefit obligation              |       | 1,061           |       | (940            | )          |
|                                                          |            |                 |            |                 |            |  |  |

 

Pension Plan Assets

 

Bankshares’ qualified pension plan weighted average asset allocationsby category are as follows.

 
| ** **          | ** ** | **Plan Assets at December 31,** | ** ** |
|---------------------|------------|---------------------------------|------------|
| **Asset  category** | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Equity  securities  | ** ** | **63**                          | **%**      | 66 | % |
| Debt securities     | ** ** | **34**                          | ** ** | 31 |   |
| Cash                | ** ** | **3**                           | ** ** | 3 |   |
| Total               | ** ** | **100**                         | **%**      | 100 | % |

 

The return objectives for the qualified pension plan are to (1) providea growing and predictable income stream from year to year;

(2) achieve an annual return at least equal to the 8% actuarialassumption rate; (3) preserve the capital value of the pension plan; and (4)achieve growth of capital with comparable pension funds.

 

Asset allocation targets are between 30% to 50% in debt securities and50% to 70% in equity securities. At December 31, 2005, assets of the qualifiedpension plan consisted of 63% equity securities, 34% debt securities, and 3%cash.

 

One final objective of the qualified pension plan is to maintain thefair value of plan assets greater than the plan benefit obligations. AtDecember 31, 2005, the fair value of qualified plan assets was 101% of benefitobligations.

 

The qualified pension plan had no investments in Bankshares’ commonstock as of December 31, 2005 and 2004.

 

82

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Cash Flows

 

Generally, Bankshares makes contributions to the pension plan inamounts permitted under employee benefit and tax laws. Cash contributions aremade after valuations have been finalized for the plan year and prior to thetax return filing date. Bankshares will make a contribution of $15.0 million inthe first quarter of 2006.

 

The following benefit payments, which reflect expected future service,as appropriate, are to be paid.

 
| ** **      | ** ** | **Pension Benefits** | ** ** | ** **        | ** ** |
|-----------------|------------|----------------------|------------|-------------------|------------|
| ** **      | ** ** | **Qualified**        | ** ** | **Non-qualified** | ** ** | **Total** | ** ** | **Other Benefits** | ** ** |
| 2006            |       | $                    | 9,481      |              | $          | — |   | $ | 9,481 |   | $ | 1,640 |   |
| 2007            |       | 9,988                |       | 427               |       | 10,415 |   | 1,617 |   |
| 2008            |       | 10,581               |       | 270               |       | 10,851 |   | 1,525 |   |
| 2009            |       | 11,245               |       | 140               |       | 11,385 |   | 1,555 |   |
| 2010            |       | 11,874               |       | 646               |       | 12,520 |   | 1,654 |   |
| Years 2011-2015 |       | 70,452               |       | 5,022             |       | 75,474 |   | 7,276 |   |
|                 |            |                      |            |                   |            |  |  |  |  |  |  |  |  |

 

15. STOCK PLANS

 

Bankshares adopted the cost recognition provisions of SFAS No. 123 in1995 and has been expensing compensation cost related to options. Bankshareswill be adopting SFAS No. 123(R) effective January 1, 2006 under the modifiedversion of prospective application.

 

Omnibus Stock Plan (1989) 

The Omnibus Stock Plan adopted in 1989 permitted the grant of stockoptions and other stock incentives to key employees of Bankshares and itsaffiliates. The 1989 Plan provided for the issuance of up to 2,902,500 sharesof Bankshares authorized but unissued common stock. Options outstanding weregranted at market value on the grant date and include both stock options whichbecome exercisable cumulatively at the rate of 25.0% a year and those which areexercisable immediately on grant. If certain levels of earnings per share ofBankshares and net income of affiliates are not achieved, all or a portion ofthose options which become exercisable at the rate of 25.0% a year areforfeited and become available for future grants. All options will terminate 10years from date of grant if not exercised. No further grants will be made underthe 1989 Plan.

 

1999 Omnibus Stock Plan

The 1999 Omnibus Stock Plan permits the grant of stock options andother stock incentives, including restricted stock awards, to key employees ofBankshares and its affiliates. The 1999 Plan provides for the issuance of up to4,500,000 shares (as adjusted for the stock split) of Bankshares authorized butunissued common stock. Options outstanding were granted at market value andinclude both performance-based and nonperformance-based options. Options becomeexercisable ratably over three or four years. If certain levels of earnings pershare of Bankshares and net income of affiliates are not achieved, all or aportion of the performance-based options are forfeited and become available forfuture grants. All options will terminate 10 years from date of grant if notexercised. Restricted stock awards outstanding were granted at market value andvest ratably over three years or in total at the end of a specified three-yearperiod. The number of shares of common stock that remain available for futuregrants under the Plan at December 31, 2005 is 1,330,094 shares.

 

83

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The table below summarizes activity under the Omnibus Stock Plan andthe 1999 Omnibus Stock Plan during the three years ended December 31, 2005.

 
| ** **                                                      | ** ** | ** **                          | ** ** | ** **                           | ** ** | **As of December 31,**   | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                                                      | ** ** | **Options issued  and outstanding** | ** ** | **Weighted average  exercise price** | ** ** | **Options  exercisable** | ** ** | **Weighted average  exercise price** | ** ** |
| Balance, December 31, 2002                                      |       | 1,954,634                           |       | $                                    | 16.60      |                     |       |   |   |   |
| Granted                                                         |       | 632,025                             |       | 23.77                                |       |                     |       |   |   |
| Options (at fair value) related to option plan of acquired bank |       | 483,792                             |       | 13.95                                |       |                     |       |   |   |
| Terminated / forfeited                                          |       | (304,217                            | )          | 18.85                                |       |                     |       |   |   |
| Exercised                                                       |       | (499,088                            | )          | 12.93                                |       |                     |       |   |   |
| Balance, December 31, 2003                                      |       | 2,267,146                           |       | 18.54                                |       | 1,348,559                |       | $ | 14.65 |   |
| Granted                                                         |       | 690,858                             |       | 30.41                                |       |                     |       |   |   |
| Terminated / forfeited                                          |       | (69,233                             | )          | 24.88                                |       |                     |       |   |   |
| Exercised                                                       |       | (538,256                            | )          | 12.72                                |       |                     |       |   |   |
| Balance, December 31, 2004                                      |       | 2,350,515                           |       | 23.18                                |       | 1,153,838                |       | 18.11 |   |
| Granted                                                         |       | 436,538                             |       | 34.15                                |       |                     |       |   |   |
| Options (at fair value) related to option plan of acquired bank |       | 208,146                             |       | 8.93                                 |       |                     |       |   |   |
| Terminated / forfeited                                          |       | (5,177                              | )          | 10.08                                |       |                     |       |   |   |
| Exercised                                                       |       | (330,782                            | )          | 14.03                                |       |                     |       |   |   |
| Balance, December 31, 2005                                      | ** ** | **2,659,240**                       | ** ** | **25.01**                            | ** ** | **1,489,397**            | ** ** | **20.80** | ** ** |
|                                                                 |            |                                     |            |                                      |            |                          |            |  |  |  |  |

 

The following table provides selected information on stock optionsoutstanding and exercisable at December 31, 2005.

 
| ** **          | ** **     | **Options Outstanding** | ** ** | **Options Exercisable**                                    | ** ** |
|---------------------|----------------|-------------------------|------------|------------------------------------------------------------|------------|
| **Exercise Prices** | ** **     | **Number  outstanding** | ** ** | **Weighted average  remaining  contractual  life (years)** | ** ** | **Weighted  average  exercise price** | ** ** | **Number  exercisable** | ** ** | **Weighted  Average  exercise price** | ** ** |
| $                   | 6.45 - $12.42  |                    |       | 222,729                                                    |       | 8.30 |   | $ | 8.38 |   | 222,729 |   | $ | 8.38 |   |
| $                   | 13.13 - $17.16 |                    |       | 498,201                                                    |       | 4.43 |   | 16.28 |   | 498,201 |   | 16.28 |   |
| $                   | 19.89 - $26.17 |                    |       | 549,378                                                    |       | 7.07 |   | 23.42 |   | 296,730 |   | 23.13 |   |
| $                   | 28.43 - $34.15 |                    |       | 1,388,932                                                  |       | 8.17 |   | 31.43 |   | 471,737 |   | 29.97 |   |
|                     |                |                         |            |                                                            |            |  |  |  |  |  |  |  |  |  |  |

 

The weighted average fair value of options granted during 2005, 2004and 2003 was $6.36, $4.14 and $4.55, respectively. Compensation expenseassociated with the options granted and expected to vest for 2005, 2004 and 2003was $2.4 million, $2.7 million and $2.0 million, respectively.

 

The weighted average fair value of options granted is estimated as ofthe grant date using the Black-Scholes option-pricing model. The followingweighted average assumptions were used as inputs to the Black-Scholes model forgrants in 2005, 2004 and 2003, respectively:

 

•                  Dividend yield of 2.69%, 2.92% and3.37%

•                  Volatility of 21.85%, 22.32% and26.20%

•                  Risk-free interest rate of 4.12%, 2.66%and 3.28%

•                  Expected term of 4.6, 3.0 and 5.4 years

 

The number of restricted stock awards granted in 2005, 2004 and 2003was 86,592, 53,973 and 152,898, respectively. Total compensation expenseassociated with the restricted stock awards for 2005, 2004 and 2003 was $2.6 million,$2.2 million and $3.0 million, respectively. Compensation expense is recognizedon a straight-line basis over a three-year vesting period. Due to theseparation of personnel from IWM, restricted stock expense of $0.8 million wasaccelerated into the year 2003 that otherwise would have been recognized overfuture periods.

 

84

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In 2004, the Compensation Committee of the Board of Directors approveda performance-based restricted stock program covering seven senior executiveofficers of Bankshares. The maximum potential annual award to any participantis restricted stock with a fair market value equal to 100% of such participant’ssalary as of March 29, 2004. As of December 31, 2005, no awards had been madeunder this program.

 

Another form of stock-based compensation is phantom stock, which isused for a portion of Bankshares’ directors’ deferred compensation plan. Achange in this plan was approved at the annual shareholders’ meeting and waseffective April 1, 2004. This plan provides for the issuance of up to 667,500shares of Bankshares’ authorized but unissued common stock. The Plan requiresall deferred fees to be settled in Bankshares’ stock. The compensation cost forthe phantom stock is included in other expenses.

 

Stock-based compensation amounts for 2005, 2004 and 2003 are summarizedin the following table.

 
| **(Dollars in thousands)**              | ** ** | **2005**  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Stock options  expense                  | ** ** | **$**     | **2,367**  |     | $          | 2,676    |       | $ | 2,045 |   |
| Restricted stock  awards expense        | ** ** | **2,638** |       | 2,191    |       | 2,986    |       |
| Subtotal  included in salaries expense  | ** ** | **5,005** |       | 4,867    |       | 5,031    |       |
|                                    |       |      |       |     |       |     |       |
| Phantom stock  expense                  | ** ** | **310**   |       | 74       |       | 1,581    |       |
| Total  stock-based compensation expense | ** ** | **$**     | **5,315**  |     | $          | 4,941    |       | $ | 6,612 |   |

 

16. SEGMENT REPORTING

 

Operating segments as defined by SFAS No. 131, “Disclosures aboutSegments of an Enterprise and Related Information,” are components of anenterprise with separate financial information. The component engages inbusiness activities from which it derives revenues and incurs expenses and theoperating results of which management relies on for decision-making andperformance assessment. Bankshares has two reportable segments – Banking andInvestment and Wealth Management (“IWM”). The Banking segment is comprised of11 affiliate banks. During 2005, the Private Banking Group of MSD&T wasconsolidated into the Private Banking Group of IWM. The segment results havebeen reclassified to conform to current presentation for comparability. Additionally,as loans and deposits 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 accounting policies of the segments arethe same as those described in Note No. 1 (Significant Accounting Policies) ofthe financial statements. However, the segment data reflect intersegmenttransactions and balances.

 

The following tables present selected segment information for the yearsended December 31, 2005, 2004 and 2003. The components in the “Other” columnconsist of amounts for the nonbank affiliates, unallocated corporate expensesand intercompany eliminations. Certain expense amounts such as operationsoverhead have been reclassified from internal financial reporting in order toprovide for full cost absorption. These reclassifications are shown in the “Adjustments”line. The acquisitions of CBNV and Farmers are included in the “Banking”column, whereas Boyd Watterson and Peremel are included in the “IWM” column.

 
| **2005****(Dollars  in thousands)** | ** ** | **Banking**    | ** **     | **IWM**     | ** ** | **Other**    | ** ** | **Total**      | ** **  |
|-------------------------------------|------------|----------------|----------------|-------------|------------|--------------|------------|----------------|-------------|
| Net interest  income                | ** ** | **$**          | **609,758**    | ** **  | **$**      | **7,819**    | ** ** | **$**          | **(451**    | **)** | **$** | **617,126** | ** ** |
| Provision for  loan losses          | ** ** | **(1,576**     | **)**          | **—**  | ** ** | **—**   | ** ** | **(1,576**     | **)**       |
| Noninterest  income                 | ** ** | **132,154**    | ** **     | **95,958**  | ** ** | **15,008**   | ** ** | **243,120**    | ** **  |
| Noninterest  expenses               | ** ** | **(341,543**   | **)**          | **(72,929** | **)**      | **(6,349**   | **)**      | **(420,821**   | **)**       |
| Adjustments                         | ** ** | **17,610**     | ** **     | **(3,885**  | **)**      | **(13,725**  | **)**      | **—**     | ** **  |
| Income (loss)  before income taxes  | ** ** | **416,403**    | ** **     | **26,963**  | ** ** | **(5,517**   | **)**      | **437,849**    | ** **  |
| Income tax  (expense) benefit       | ** ** | **(145,044**   | **)**          | **(10,785** | **)**      | **(5,701**   | **)**      | **(161,530**   | **)**       |
| Net income  (loss)                  | ** ** | **$**          | **271,359**    | ** **  | **$**      | **16,178**   | ** ** | **$**          | **(11,218** | **)** | **$** | **276,319** | ** ** |
| Average loans                       | ** ** | **$**          | **10,876,592** | ** **  | **$**      | **152,572**  | ** ** | **$**          | **387**     | ** ** | **$** | **11,029,551** | ** ** |
| Average earning  assets             | ** ** | **13,917,161** | ** **     | **152,572** | ** ** | **(1,596**   | **)**      | **14,068,137** | ** **  |
| Average assets                      | ** ** | **15,235,634** | ** **     | **152,941** | ** ** | **132,444**  | ** ** | **15,521,019** | ** **  |
| Average deposits                    | ** ** | **11,444,361** | ** **     | **199,159** | ** ** | **(229,765** | **)**      | **11,413,755** | ** **  |
| Average equity                      | ** ** | **1,891,834**  | ** **     | **34,354**  | ** ** | **170,229**  | ** ** | **2,096,417**  | ** **  |

 

85

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| **2004 (Dollars in thousands)**    | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|------------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest  income               |       | $           | 534,468    |    | $          | 10,172    |       | $          | 1,141      |   | $ | 545,781 |   |
| Provision for  loan losses         |       | (7,221      | )          | —  |       | —    |       | (7,221     | )          |
| Noninterest  income                |       | 114,477     |       | 90,516  |       | 8,936     |       | 213,929    |       |
| Noninterest  expenses              |       | (318,706    | )          | (69,575 | )          | (3,677    | )          | (391,958   | )          |
| Adjustments                        |       | 18,098      |       | (3,603  | )          | (14,495   | )          | —     |       |
| Income (loss)  before income taxes |       | 341,116     |       | 27,510  |       | (8,095    | )          | 360,531    |       |
| Income tax  (expense) benefit      |       | (120,253    | )          | (11,004 | )          | 133       |       | (131,124   | )          |
| Net income  (loss)                 |       | $           | 220,863    |    | $          | 16,506    |       | $          | (7,962     | ) | $ | 229,407 |   |
| Average loans                      |       | $           | 9,591,510  |    | $          | 127,739   |       | $          | 160        |   | $ | 9,719,409 |   |
| Average earning  assets            |       | 12,576,465  |       | 127,739 |       | 28,800    |       | 12,733,004 |       |
| Average assets                     |       | 13,413,992  |       | 127,949 |       | 451,030   |       | 13,992,971 |       |
| Average deposits                   |       | 10,323,349  |       | 175,096 |       | (84,753   | )          | 10,413,692 |       |
| Average equity                     |       | 1,449,355   |       | 31,219  |       | 391,096   |       | 1,871,670  |       |

 
| **2003 (Dollars in thousands)**    | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|------------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest  income               |       | $           | 469,704    |    | $          | 7,803     |       | $          | (5,158     | ) | $ | 472,349 |   |
| Provision for  loan losses         |       | (12,105     | )          | —  |       | —    |       | (12,105    | )          |
| Noninterest  income                |       | 98,426      |       | 78,608  |       | 6,538     |       | 183,572    |       |
| Noninterest  expenses              |       | (268,656    | )          | (63,870 | )          | (4,921    | )          | (337,447   | )          |
| Adjustments                        |       | 9,941       |       | (3,483  | )          | (6,458    | )          | —     |       |
| Income (loss)  before income taxes |       | 297,310     |       | 19,058  |       | (9,999    | )          | 306,369    |       |
| Income tax  (expense) benefit      |       | (104,815    | )          | (7,623  | )          | 2,883     |       | (109,555   | )          |
| Net income  (loss)                 |       | $           | 192,495    |    | $          | 11,435    |       | $          | (7,116     | ) | $ | 196,814 |   |
| Average loans                      |       | $           | 7,969,464  |    | $          | 119,285   |       | $          | 233        |   | $ | 8,088,982 |   |
| Average earning  assets            |       | 10,966,978  |       | 119,285 |       | 11,225    |       | 11,097,488 |       |
| Average assets                     |       | 11,581,942  |       | 119,501 |       | 270,138   |       | 11,971,581 |       |
| Average deposits                   |       | 9,010,069   |       | 132,575 |       | (150,790  | )          | 8,991,854  |       |
| Average equity                     |       | 1,280,643   |       | 28,834  |       | 187,668   |       | 1,497,145  |       |

 

17. FAIR VALUE OF FINANCIAL INSTRUMENTS

 

SFAS No. 107, “Disclosures about the Fair Value of FinancialInstruments,” requires that we disclose estimated fair values for our financialinstruments. This disclosure should be read in conjunction with the financialstatements and Notes to Financial Statements in this Annual Report.

 

We base fair values on estimates or calculations using present valuetechniques when quoted market prices are not available. Because broadly tradedmarkets do not exist for many of our financial instruments, we try toincorporate the current market conditions in the fair value calculation. Thesevaluations are our estimates and are often based on current pricing policy, thecharacteristics of the financial instrument and other such factors. Thesecalculations are subjective, involve uncertainties and rely on managementjudgment. There may be inherent weaknesses in any calculation technique and changesin underlying assumptions used, including discount rates and estimates offuture cash flow that could significantly affect the results.

 

We have not included certain material items in our disclosure, such asthe value of the long-term relationships with our deposit and wealth managementcustomers, since these intangibles are not financial instruments. For all ofthese reasons, the total of the fair value calculations do not represent theunderlying value of Bankshares.

 

86

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The estimated fair values of Bankshares’ financial instruments atDecember 31, 2005 and 2004 were as follows:

 
| ** **                 | ** ** | **2005**        | ** **     | **2004**        | ** ** |
|----------------------------|------------|-----------------|----------------|-----------------|------------|
| **(Dollars in thousands)** | ** ** | **Book  Value** | ** **     | **Fair  Value** | ** ** | **Book  Value** | ** ** | **Fair  Value** | ** ** |
| **Financial Assets**       |       |            |           |            |       |   |   |   |   |
| Loans held-for-sale        | ** ** | **$**           | **26,263**     | ** **      | **$**      | **26,263** |   | $ | 11,000 |   | $ | 11,000 |   |
| Loans                      | ** ** | **11,607,845**  | ** **     | **11,941,754**  |       | 10,228,433 |   | 10,280,155 |   |
| Nonmarketable investments  | ** ** | **284,836**     | ** **     | **284,836**     |       | 214,502 |   | 214,502 |   |
|                       |       |            |           |            |       |   |   |   |   |
| **Financial Liabilities**  |       |            |           |            |       |   |   |   |   |
| Deposits                   | ** ** | **$**           | **12,077,350** | ** **      | **$**      | **11,169,923** |   | $ | 10,799,199 |   | $ | 9,421,832 |   |
| Long-term debt             | ** ** | **742,163**     | ** **     | **736,858**     |       | 690,955 |   | 718,995 |   |

 

The following methods and assumptions were used to estimate the fairvalue disclosures for financial instruments as of

December 31, 2005 and 2004:

 

*Cash and Short-TermInvestments*

The amounts reported in the balance sheet approximate the fair valuesof these assets. Short-term investments include interest-bearing deposits inother banks and federal funds sold.

 

*Investment Securities*

Fair values of investment securities are based on quoted market pricesand are reported in Note No. 3 (Investment Securities).

 

*Loans Held-for-Sale*

Loans held-for-sale are based on what secondary markets are currentlyoffering for portfolios with similar characteristics.

 

*Loans*

The fair value calculation of loans differentiates loans based on theirfinancial characteristics, such as product classification, loan category,pricing features and remaining maturity. Prepayment estimates are evaluated byproduct and loan rate.

 

The fair value of commercial loans, commercial real estate loans andreal estate construction loans is calculated by discounting contractual cashflows using discount rates that are believed to reflect current credit qualityand other related factors.

 

For real estate 1-4 family first and junior lien mortgages, fair valueis calculated by discounting contractual cash flows, adjusted for prepaymentestimates, using discount rates based on current industry pricing for loans ofsimilar size, type, remaining maturity and re-pricing characteristics.

 

For consumer loans, the fair value is calculated by discounting thecontractual cash flows, adjusted for prepayments, based on the current rates weoffer for loans with similar characteristics.

 

Loan commitments and letters of credit not included in the above tablehad contractual values of $4.8 billion and $540.6 million, respectively, atDecember 31, 2005, and $4.2 billion and $379.8 million, respectively, atDecember 31, 2004. These instruments generate ongoing fees at our currentpricing levels. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitments do not necessarily represent futurecash requirements. Unamortized fees on letters of credit totaled $1.9 millionand $1.3 million at December 31, 2005 and 2004, respectively. Carrying costestimates the fair value for these fees.

 

*Nonmarketable Investments*

There are generally restrictions on the sale and/or liquidation ofnonmarketable securities. The carrying value of Federal Reserve Bank stock andFederal Home Loan Bank stock are carried at par, which approximates fair value.Private equity investments, hedge funds and the cash surrender value of BOLIare carried at fair value based on current market valuations.

 

*Deposits*

The fair value of demand deposits, savings accounts and money marketdeposits is the amount payable on demand at the reporting date. The fair valueof fixed-maturity certificates of deposit is estimated using a discounted cashflow calculation that applies interest rates and remaining maturities forcurrently offered certificates of deposit.

 

87

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*Short-Term Borrowings*

The amounts reported in the balance sheet approximate the fair valuesbecause of the short duration of those instruments.

 

*Long-Term Debt*

The fair value of long-term debt associated with interest rate swaps isbased on quoted market prices. For all other long-term debt, fair value isestimated by discounting the future cash flows using estimates of ratescurrently available to Bankshares and its affiliates for debt with similarterms and remaining maturities.

 

*Derivatives*

Fair value for derivatives is determined based on the following:

 

•                  Positionvaluation - 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;

•                  Option valuation- estimated by using standard market models (such as modified Black-Scholesmodel on interest rate options), incorporating quoted market prices and volatilities.

 

The fair value of derivatives at December 31, 2005 and 2004 arereported in Note No. 18 (Derivative Instruments and Hedging Activities).

 

*Limitations*

The valuation techniques employed above involve uncertainties and areaffected by assumptions used and by judgments regarding prepayments, creditrisk, future loss experience, discount rates, cash flows and other factors. Therefore,derived fair values cannot be substantiated by comparison with independentmarkets or with other financial institutions. The reported fair values do notnecessarily represent what Bankshares would realize in immediate sales or otherdispositions. Changes in assumptions could significantly affect the reportedfair values. The information presented is based on fair value calculations andmarket quotes as of December 31, 2005 and 2004. These amounts have not beenupdated since year-end; therefore, the valuation may have changed significantlysince that time.

 

As discussed above, some of our asset and liability financialinstruments are short-term, and therefore, the carrying amounts on theConsolidated Balance Sheet approximate fair value. Other significant assets andliabilities, which are not considered financial assets or liabilities and forwhich fair values have not been determined, include premises and equipment,goodwill and other intangibles, deferred and other liabilities.

 

18. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

Bankshares maintains an overall interest rate risk management strategythat incorporates the use of derivative instruments to minimize significantunplanned fluctuations in earnings that are caused by interest rate volatility.Currently, derivative instruments that are used as part of the interest raterisk management strategy have been restricted to interest rate swaps. Interestrate swaps generally involve the exchange of fixed-rate and variable-rateinterest payments between two parties, based on a common notional principalamount and maturity date. At December 31, 2005, Bankshares had interest rateswaps to convert a portion of its nonprepayable fixed-rate debt tofloating-rate debt.

 

Bankshares also arranges interest rate swaps, caps and swaptions forcommercial 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 of derivative instruments is based on position andoption valuations. The position valuation is estimated by using pricing modelsthat incorporate quoted market prices for swap rates and futures contracts, aswell as market volatility, and assumes all counterparties have the same creditrating. The option valuation is estimated by using standard market models (suchas the modified Black-Sholes model on interest rate options), incorporatingquoted market prices and volatilities. The fair value of derivative instrumentsrelating to hedging activities recorded in other assets was $5.3 million(notional $345.5 million) and $7.1 million (notional $294.5 million) atDecember 31, 2005 and 2004, respectively. The fair value of derivativeinstruments relating to hedging activities recorded in other liabilities was $12.3million (notional $609.1 million) and $6.8 million (notional $136.0 million) atDecember 31, 2005 and 2004, respectively.

 

Changes in the fair value of a derivative that is designated andqualifies as a fair value hedge, along with the gain or loss on the hedgedasset or liability that is attributable to the hedged risk are recorded asother noninterest income in the results of operations. For all hedgerelationships, ineffectiveness resulting from differences between the changesin fair values or cash flows of the hedged item and changes in fair value ofthe derivative are recognized as other noninterest income in the results ofoperations. The net interest settlement on derivatives designated as fair valueor cash flow hedges is treated as an adjustment of the interest income orinterest expense of the hedged assets or liabilities. The fair-value hedges ofnonprepayable fixed-rate debt were effective for the reported periods andqualified for short-cut hedge accounting treatment. The impact of the hedges reducedinterest expense $3.7 million and $10.2 million in 2005 and 2004, respectively.

 

88

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The following tables summarize the gross position of derivativesrelating to hedging activities at December 31, 2005 and 2004.

 
| ** **                          | ** ** | **December 31, 2005**                | ** **  | **December 31, 2004**        | ** ** |
|-------------------------------------|------------|--------------------------------------|-------------|------------------------------|------------|
| **(Dollars in thousands)**          | ** ** | **Notional or  Contractual  Amount** | ** **  | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** | **Notional or  Contractual  Amount** | ** ** | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** |
| *Asset/Liability Management Hedges* |       |                                 |        |                         |       |   |   |   |   |   |   |   |   |
| Interest Rate Contracts:            |       |                                 |        |                         |       |   |   |   |   |   |   |   |   |
| Swaps                               | ** ** | **$**                                | **350,000** | ** **                   | **—** | ** ** | **$** | **(10,349** | **)** | $ | 350,000 |   | $ | 6,297 |   | $ | (143 | ) |
|                                |       |                                 |        |                         |       |   | ** ** |   |   |   |   |   |   |
| *Customer Accommodations*           |       |                                 |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Interest Rate Contracts:            |       |                                 |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Swaps                               | ** ** | **$**                                | **592,934** | ** **                   | **$**      | **5,327** | ** ** | **$** | **3,462** | ** ** | $ | 68,575 |   | $ | 684 |   | $ | 398 |   |
| Swaptions/Caps  Purchased           | ** ** | **5,850**                            | ** **  | **57**                       | ** ** | **57** | ** ** | 5,971 |   | 80 |   | 80 |   |
| Swaptions/Caps  Sold                | ** ** | **5,850**                            | ** **  | **—**                   | ** ** | **(57** | **)** | 5,971 |   | — |   | (80 | ) |
|                                     |            |                                      |             |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Credit risk amounts reflect the replacement cost for thosecontracts in a gain position in the event of nonperformance by allcounterparties.

 

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 $0.2 million at December 31, 2005 and ($1.2) million at December31, 2004.

 

19. GOODWILL AND INTANGIBLE ASSETS

 

Goodwill totaled $670.0 million at December 31, 2005 and $507.8 millionat December 31, 2004. During the second quarter of 2005, Bankshares recordedgoodwill totaling $162.1 million in connection with the CBNV acquisition thatincreased the Banking segment’s goodwill to $630.2 million. See Note No. 2(Business Combinations). The IWM segment goodwill was $39.8 million at December31, 2005 and 2004.

 

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

 
| ** **                  | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**         | ** ** |
|-----------------------------|------------|------------------------------|------------|-------------------------------|------------|
| **(Dollars  in thousands)** | ** ** | **Gross   Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** | **Gross   Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Core deposits               | ** ** | **$**                        | **54,509** | ** **                    | **$**      | **(20,790** | **)** | **$** | **33,719** |   | $ | 49,881 |   | $ | (15,014 | ) | $ | 34,867 |   |
| Mortgage servicing          | ** ** | **2,902**                    | ** ** | **(1,145**                    | **)**      | **1,757** |   | 1,370 |   | (1,013 | ) | 357 |   |
| Customer lists and other    | ** ** | **17,843**                   | ** ** | **(6,666**                    | **)**      | **11,177** |   | 17,010 |   | (4,008 | ) | 13,002 |   |
| Total                       | ** ** | **$**                        | **75,254** | ** **                    | **$**      | **(28,601** | **)** | **$** | **46,653** |   | $ | 68,261 |   | $ | (20,035 | ) | $ | 48,226 |   |

 

Accumulated amortization for total intangible assets was $28.6 millionand $20.0 million at year-end 2005 and 2004, respectively. The projections ofamortization expense shown for mortgage servicing rights are based on assetbalances and the interest rate environment as of December 31, 2005. Futureamortization expense may be significantly different depending on changes in themortgage-servicing portfolio, mortgage interest rates and market conditions.

 

In connection with the CBNV acquisition, Bankshares recorded coredeposit intangibles of $4.6 million. Core deposit intangibles are amortizedbased on estimated lives of nine years, mortgage-servicing intangibles areamortized based on estimated lives ranging from three to ten years and customerlists and other intangibles are amortized based on estimated lives ranging fromfour to fifteen years.

 

89

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The following table shows the current period and estimated futureamortization expense for amortized intangible assets.

 
| **(Dollars  in thousands)**            | ** ** | **Core  Deposits** | ** ** | **Mortgage  Servicing** | ** ** | **Customer Lists  and Other** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------------------|------------|-------------------------------|------------|-----------|------------|
| Year ended December 31, 2005           | ** ** | **$**              | **5,777**  | ** **              | **$**      | **322**                       | ** ** | **$**     | **2,674**  | ** ** | **$** | **8,773** | ** ** |
|                                   |       |               |       |                    |       |                          |       |      |       |
| Estimate for years ended  December 31, |       |               |       |                    |       |                          |       |      |       |
| 2006                                   |       | 5,950              |       | 312                     |       | 2,116                         |       | 8,378     |       |
| 2007                                   |       | 5,747              |       | 264                     |       | 2,039                         |       | 8,050     |       |
| 2008                                   |       | 4,653              |       | 247                     |       | 1,359                         |       | 6,259     |       |
| 2009                                   |       | 4,502              |       | 247                     |       | 624                           |       | 5,373     |       |
| 2010                                   |       | 4,502              |       | 227                     |       | 507                           |       | 5,236     |       |
|                                        |            |                    |            |                         |            |                               |            |           |            |  |  |  |  |

 

90

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**20. MERCANTILE BANKSHARES CORPORATION (PARENTCORPORATION ONLY) FINANCIAL INFORMATION**

 

**BALANCE SHEET**

 
| **December 31,**                                                                      | ** ** | ** **    | ** **    | ** ** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------|---------------|------------|------------|
| **(Dollars in thousands, except  per share data)**                                         | ** ** | **2005**      | ** **    | **2004**   | ** ** |
| **ASSETS**                                                                                 |       |          |          |       |       |
| Cash                                                                                       | ** ** | **$**         | **4,618**     |       | $          | 2,502 |   |
| Interest-bearing  deposits with bank affiliates                                            | ** ** | **237,000**   |          | 176,000    |       |
| Securities  purchased under resale agreements with bank affiliates                         | ** ** | **93,054**    |          | 86,630     |       |
| Cash and cash  equivalents                                                                 | ** ** | **334,672**   |          | 265,132    |       |
| Investment in  bank affiliates                                                             | ** ** | **1,975,302** |          | 1,776,209  |       |
| Investment in  bank-related affiliates                                                     | ** ** | **11,052**    |          | 10,033     |       |
| Loans and  advances to affiliates                                                          | ** ** | **328,074**   |          | 358,076    |       |
| Investment  securities available-for-sale                                                  | ** ** | **18,874**    |          | 18,580     |       |
| Building  premises and equipment, net                                                      | ** ** | **12,717**    |          | 13,629     |       |
| Other assets                                                                               | ** ** | **121,709**   |          | 123,295    |       |
| Total                                                                                      | ** ** | **$**         | **2,802,400** |       | $          | 2,564,954 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                             |       |          |          |       |       |
| Liabilities:                                                                               |       |          |          |       |       |
| Commercial paper                                                                           | ** ** | **$**         | **193,054**   |       | $          | 216,630 |   |
| Accounts payable  and other liabilities                                                    | ** ** | **25,412**    |          | 36,399     |       |
| Long-term debt                                                                             | ** ** | **389,212**   |          | 394,242    |       |
| Total  liabilities                                                                         | ** ** | **607,678**   |          | 647,271    |       |
| Shareholders’  Equity:                                                                |       |          |          |       |       |
| Preferred stock,  no par value; authorized 2,000,000 shares; issued and outstanding - None |       |          |          |       |       |
| Common stock, $2  par value; authorized 130,000,000 shares;                                |       |          |          |       |       |
| Issued 82,165,414  shares in 2005 and 79,300,506 shares in 2004                            | ** ** | **164,331**   |          | 158,601    |       |
| Capital surplus                                                                            | ** ** | **676,830**   |          | 530,705    |       |
| Retained  earnings                                                                         | ** ** | **1,386,405** |          | 1,231,102  |       |
| Accumulated  other comprehensive loss                                                      | ** ** | **(32,844**   | )             | (2,725     | )          |
| Total  shareholders’ equity                                                           | ** ** | **2,194,722** |          | 1,917,683  |       |
| Total                                                                                      | ** ** | **$**         | **2,802,400** |       | $          | 2,564,954 |   |

 

91

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**STATEMENT OF INCOME**

 
| ** **                                                                             | ** ** | **(Dollars in thousands)** | ** **  |
|----------------------------------------------------------------------------------------|------------|----------------------------|-------------|
| **For the Years Ended December  31,**                                                  | ** ** | **2005**                   | ** **  | **2004** | ** ** | **2003** | ** ** |
| **INCOME**                                                                             |       |                       |        |   |   |   |   |
| Dividends from bank affiliates                                                         | ** ** | **$**                      | **172,885** |   | $ | 145,841 |   | $ | 309,980 |   |
| Dividends from bank-related affiliates                                                 | ** ** | **150**                    |        | 767 |   | 863 |   |
| Interest on interest-bearing deposits with bank  affiliates                            | ** ** | **3,681**                  |        | 710 |   | 1,460 |   |
| Interest on securities purchased under resale  agreements with bank affiliates         | ** ** | **1,393**                  |        | 362 |   | 526 |   |
| Interest on loans to affiliates                                                        | ** ** | **15,660**                 |        | 13,685 |   | 5,920 |   |
| Other income                                                                           | ** ** | **13,951**                 |        | 9,467 |   | 6,215 |   |
| Total income                                                                           | ** ** | **207,720**                |        | 170,832 |   | 324,964 |   |
| **EXPENSES**                                                                           |       |                       |        |   |   |   |   |
| Interest on short-term borrowings                                                      | ** ** | **3,181**                  |        | 893 |   | 1,099 |   |
| Interest on long-term debt                                                             | ** ** | **18,563**                 |        | 13,846 |   | 12,128 |   |
| Other expenses                                                                         | ** ** | **4,028**                  |        | 4,984 |   | 6,042 |   |
| Total expenses                                                                         | ** ** | **25,772**                 |        | 19,723 |   | 19,269 |   |
| Income before  income tax benefit and equity in undistributed net income of affiliates | ** ** | **181,948**                |        | 151,109 |   | 305,695 |   |
| Income tax expense (benefit)                                                           | ** ** | **2,427**                  |        | 1,807 |   | (1,959 | ) |
| ** **                                                                             |       | **179,521**                |        | 149,302 |   | 307,654 |   |
| Equity in undistributed net income of:                                                 |       |                       |        |   |   |   |   |
| Bank affiliates                                                                        | ** ** | **95,779**                 |        | 79,637 |   | (110,984 | ) |
| Bank-related  affiliates                                                               | ** ** | **1,019**                  |        | 468 |   | 144 |   |
| **NET  INCOME**                                                                        | ** ** | **$**                      | **276,319** |   | $ | 229,407 |   | $ | 196,814 |   |

 

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**STATEMENT OF CASH FLOWS**

 
| **Increase (decrease) in cash and  cash equivalents**                              | *** *** | **(Dollars in thousands)** | *** *** |
|------------------------------------------------------------------------------------|--------------|----------------------------|--------------|
| **For  the Years Ended December 31,**                                              | ** **   | **2005**                   | ** **   | **2004** | ** ** | **2003** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         |         |                       |         |   |   |   |   |
| Net Income                                                                         | ** **   | **$**                      | **276,319**  | ** ** | $ | 229,407 |   | $ | 196,814 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |         |                       | ** **   |   |   |   |   |
| Equity in  undistributed net income of affiliates                                  | ** **   | **(96,798**                | **)**        | (80,105 | ) | 110,840 |   |
| Depreciation and  amortization                                                     | ** **   | **2,810**                  | ** **   | 102 |   | — |   |
| Investment  securities gains                                                       | ** **   | **—**                 | ** **   | (1,295 | ) | (380 | ) |
| Net (increase)  decrease in other assets                                           | ** **   | **834**                    | ** **   | (8,574 | ) | (6,390 | ) |
| Net increase  (decrease) in liabilities:                                           |         |                       | ** **   |   |   |   |   |
| Interest payable                                                                   | ** **   | **618**                    | ** **   | 478 |   | 3,377 |   |
| Accrued expenses                                                                   | ** **   | **2,638**                  | ** **   | 2,831 |   | 2,424 |   |
| Taxes payable                                                                      | ** **   | **(13,537**                | **)**        | 1,714 |   | (1,615 | ) |
| Net cash  provided by operating activities                                         | ** **   | **172,884**                | ** **   | 144,558 |   | 305,070 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |         |                       | ** **   |   |   |   |   |
| Net decrease  (increase) in loans to affiliates                                    | ** **   | **30,002**                 | ** **   | 1,444 |   | (299,115 | ) |
| Proceeds from  sales of investment securities available-for-sale                   | ** **   | **—**                 | ** **   | 27,224 |   | 2,380 |   |
| Purchases of  investment securities available-for-sale                             | ** **   | **(247**                   | **)**        | (25,933 | ) | (14,995 | ) |
| Capital  expenditures                                                              | ** **   | **—**                 | ** **   | (13,629 | ) | — |   |
| Investment in  affiliates                                                          | ** **   | **(561**                   | **)**        | 63,074 |   | (171,609 | ) |
| Net cash  provided by (used in) investing activities                               | ** **   | **29,194**                 | ** **   | 52,180 |   | (483,339 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |         |                       | ** **   |   |   |   |   |
| Net increase  (decrease) in commercial paper                                       | ** **   | **(23,576**                | **)**        | 25,750 |   | (67,888 | ) |
| Proceeds from  issuance of long-term debt                                          | ** **   | **—**                 | ** **   | 51,250 |   | 300,000 |   |
| Repayment of  long-term debt                                                       | ** **   | **—**                 | ** **   | — |   | (8,400 | ) |
| Proceeds from  issuance of shares                                                  | ** **   | **11,205**                 | ** **   | 14,322 |   | 11,369 |   |
| Repurchase of  common shares                                                       | ** **   | **—**                 | ** **   | (44,110 | ) | (212 | ) |
| Dividends paid                                                                     | ** **   | **(120,167**               | **)**        | (109,295 | ) | (95,842 | ) |
| Net cash (used  in) provided by financing activities                               | ** **   | **(132,538**               | **)**        | (62,083 | ) | 139,027 |   |
| Net increase  (decrease) in cash and cash equivalents                              | ** **   | **69,540**                 | ** **   | 134,655 |   | (39,242 | ) |
| Cash and cash  equivalents at beginning of year                                    | ** **   | **265,132**                | ** **   | 130,477 |   | 169,719 |   |
| Cash and cash  equivalents at end of year                                          | ** **   | **$**                      | **334,672**  | ** ** | $ | 265,132 |   | $ | 130,477 |   |

 

21. SUBSEQUENT EVENT

 

On January 10, 2006, Bankshares announced a three-for-two stock spliton its common stock payable in the form of a stock dividend on January 27, 2006to stockholders of record as of the close of business on January 20, 2006. Inaddition, the Board stated its intention to raise the annualized per sharedividend rate, adjusted for the stock split, from $1.00 to $1.04. After thesplit, the indicated quarterly per share dividend rate will be $0.26 per share.Adjusted for the stock split, basic earnings per share for 2005, 2004 and 2003were $2.28, $1.93 and $1.80, respectively. Adjusted for the stock split,diluted earnings per share for 2005, 2004 and 2003 were $2.26, $1.92 and $1.79,respectively.

 

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ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

Therewas no matter which is required to be disclosed in this Item 9 pursuant to theinstructions contained in the form for this Report.

 

ITEM 9A.CONTROLS AND PROCEDURES

 

We have carried out an evaluation, under the supervision and with theparticipation of our management including our principal executive officer andprincipal financial officer, of the effectiveness of the design and operationof our disclosure controls and procedures, as that term is defined in Rule13a-15(e) under the Securities and Exchange Act of 1934, as amended. Based onthat evaluation, our principal executive officer and principal financialofficer concluded that as of December 31, 2005, which is the end of the periodcovered by this Annual Report on Form 10-K, our disclosure controls andprocedures were effective.

 

There have been no changes in our internal controls over financialreporting in the fiscal quarter ended December 31, 2005 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlsover financial reporting. Management has issued its report on internal controlover financial reporting as of December 31, 2005, which appears in Item 8 ofthis Report. The report of the Independent Registered Public Accounting firm onManagement’s Report on Internal Control over Financial Reporting also appearsin Item 8.

 

ITEM 9B.OTHER INFORMATION

 

There was no information required to be disclosed in a report on Form8-K during the fourth quarter of 2005, but not reported.

 

#### **PART III**

#### ** **

ITEM 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

 

Bankshares has adopted a code of ethics that applies to its chiefexecutive officer, chief financial officer, and controller. The code of ethicsis an exhibit to this Annual Report on Form 10-K. The text of the code isposted on Bankshares’ website at www.mercantile.com. Bankshares will provide toany person, without charge, upon request a copy of the code of ethics. Requestsfor a copy of the code of ethics can be made in writing to: MercantileBankshares Corporation, P.O. Box 1477, Baltimore, MD 21203, Attn: InvestorRelations. Any future amendments to, or waivers from, the provisions of thecode of ethics that require disclosure under applicable rules of the Securitiesand Exchange Commission will be disclosed in a current report on Form 8-K.

 

Theinformation required by this Item 10 with respect to the Executive Officers ofRegistrant appears in Part I of this Annual Report on Form 10-K.

 

Theremaining information required by this Item 10 is incorporated by reference tothe definitive proxy statement of Registrant to be filed with the Securitiesand Exchange Commission under Regulation 14A not later than 120 days after theend of the fiscal year covered by this Annual Report on Form 10-K.

 

ITEM 11.EXECUTIVE COMPENSATION

 

Theinformation required by this Item 11 is incorporated by reference to the definitiveproxy statement of Registrant to be filed with the Securities and ExchangeCommission under Regulation 14A not later than 120 days after the end of thefiscal year covered by this Annual Report on Form 10-K.

 

ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The information required by this Item 12 is incorporated by referenceto the definitive proxy statement of Registrant to be filed with the Securitiesand Exchange Commission under Regulation 14A not later than 120 days after theend of the fiscal year covered by this Annual Report on Form 10-K.

 

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ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

The information required by this Item 13 is incorporated by referenceto the definitive proxy statement of Registrant to be filed with the Securitiesand Exchange Commission under Regulation 14A not later than 120 days after theend of the fiscal year covered by this Annual Report on Form 10-K.

 

ITEM 14.PRINCIPAL ACCOUNTING FEES AND SERVICES

 

The information required by this Item 14 is incorporated by referenceto the definitive proxy statement of Registrant to be filed with the Securitiesand Exchange Commission under Regulation 14A not later than 120 days after theend of the fiscal year covered by this Annual Report on Form 10-K.

 

**PART IV**

 

ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

 

The following documentsare filed or furnished as part of this report, except as indicated.

 

(1)                                  Thefinancial statements filed herewith are listed in the accompanying Index toFinancial Statements.

 

(2)                                  FinancialStatement Schedules are omitted because of the absence of the conditions underwhich they are required or because the information called for is included inthe Consolidated Financial Statements or notes thereto.

 

(3)                                  Exhibitsfiled or furnished herewith or incorporated by reference herein are set forthin the following table prepared in accordance with Item 601 of Regulation S-K.

 

#### **Exhibit Table**

#### ** **

(2)                                  Agreementand Plan of Merger, dated as of January 24, 2005 among Registrant, CommunityBank of Northern Virginia and Mercantile-Safe Deposit and Trust Company(Incorporated by reference to Registrant’s Form 8-K, Filed January 25, 2005,Exhibit 2.1, Commission File No. 0-5127)

 

(3)                                  Charterand by-laws

 

A.                                   (1)                                  Articlesof Incorporation effective May 27, 1969 (Incorporated by reference toRegistrant’s Registration Statement on Form S-1, No. 2-39545, Exhibit 3-A(1)).

 

(2)                                  Articlesof Amendment effective June 6, 1969 (Incorporated by reference to Registrant’sRegistration Statement on Form S-1, No. 2-39545, Exhibit 3-A(2)).

 

(3)                                  ArticlesSupplementary effective August 28, 1970 (Incorporated by reference toRegistrant’s Registration Statement on Form S-1, No. 2-39545, Exhibit 3-A(3)).

 

(4)                                  Articlesof Amendment effective December 14, 1970 (Incorporated by reference toRegistrant’s Registration Statement on Form S-1, No. 2-39545, Exhibit 3-A(4)).

 

(5)                                  ArticlesSupplementary effective May 10, 1971 (Incorporated by reference to Registrant’sRegistration Statement on Form S-1, No. 2-39545, Exhibit 3-A(5)).

 

(6)                                  ArticlesSupplementary effective July 30, 1971 (Incorporated by reference to Registrant’sRegistration Statement on Form S-1, No. 2-41379, Exhibit 3-A(6)).

 

(7)                                  Articlesof Amendment effective May 8, 1986 (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 1993, Exhibit3-A(7), Commission File No. 0-5127).

 

(8)                                  Articlesof Amendment effective April 27, 1988 (Incorporated by reference to Registrant’sAnnual

                

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Reporton Form 10-K for the year ended December 31, 1993, Exhibit 3-A(8), CommissionFile No. 0-5127).

 

(9)                                  ArticlesSupplementary effective September 13, 1989 (Incorporated by reference to Registrant’sForm 8-K filed September 27, 1989, Exhibit B attached to Exhibit 4-A,Commission File No. 0-5127).

 

(10)                            ArticlesSupplementary effective January 3, 1990 (Incorporated by reference toRegistrant’s Form 8-K filed January 9, 1990, Exhibit B attached to Exhibit 4-A,Commission File No. 0-5127).

 

(11)                            Articlesof Amendment effective April 26, 1990 (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 1990, Exhibit3-A(11), Commission File No. 0-5127).

 

(12)                            Articlesof Amendment effective April 30, 1997 (Incorporated by reference to Registrant’sRegistration Statement on Form S-4, No. 333-43651, Exhibit 3(i)(L)).

 

(13)                            ArticlesSupplementary effective June 9, 1999 (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-90307, Exhibit 4.1.M).

 

(14)                            ArticlesSupplementary effective September 30, 1999 (Incorporated by reference toRegistrant’s Registration Statement on Form S-8, No. 333-90307, Exhibit 4.1.N).

 

(15)                            Certificateof Correction effective July 3, 2002, concerning Articles of Amendmenteffective May 8, 1986 (Incorporated by reference to Registrant’s QuarterlyReport for the quarter ended September 30, 2002, Exhibit 3A(15), CommissionFile No. 0-5127).

 

(16)                            Certificateof Correction effective July 3, 2002, concerning Articles of Amendmenteffective April 26, 1990 (Incorporated by reference to Registrant’s QuarterlyReport for the quarter ended September 30, 2002, Exhibit 3A(16), CommissionFile No. 0-5127).

 

B.                                     By-Lawsof the Registrant, as amended to date (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 2004, Exhibit 3.B,Commission File No. 0-5127).

 

(4)                                  Instrumentsdefining the rights of security holders, including indentures.

 

A.                                   RightsAgreement dated as of June 8, 1999 between Registrant and the Rights Agent,including Form of Rights Certificate and Articles Supplementary (Incorporatedby reference to Form 8-K of Registrant filed June 11, 1999, Exhibit 4, CommissionFile No. 0-5127, and to Form 8-A of Registrant filed June 11, 1999, Exhibits 1,2 and 3, Commission File No. 0-5127).

 

B.                                     Indenturebetween Registrant and JP Morgan Chase Bank, as Trustee, dated as of April 15,2003, relating to Subordinated Notes due 2013 (Incorporated by reference toRegistrant’s Registration Statement on Form S-4, No. 333-105238, Exhibit 4.1).

 

C.                                     Formof 4.625% Subordinated Note due 2013, Series B (Incorporated by reference toRegistrant’s Registration Statement on Form S-4, No. 333-105238, Exhibit 4.2).

 

(10)                            Materialcontracts

 

A.                                   MercantileBankshares Corporation and Affiliates Annual Incentive Compensation Plan, asamended and restated through March 12, 2002. (Incorporated by reference toRegistrant’s Definitive Proxy Statement, filed March 22, 2003, Appendix A).

 

B.                                     DividendReinvestment and Stock Purchase Plan of Mercantile Bankshares Corporation(Incorporated by reference to the Plan text included in Registrant’sRegistration Statement on Form S-3, No. 33-44376).

 

C.                                     MercantileBankshares Corporation and Participating Affiliates Unfunded DeferredCompensation Plan for Directors, as amended through March 9, 2004 (Incorporatedby reference to Registrant’s Registration Statement on Form S-8, No.333-115741, Exhibit 4.4).

 

D.                                    MercantileBankshares Corporation Employee Stock Purchase Dividend Reinvestment Plan dated

 

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February 13, 1995(Incorporated by reference to Registrant’s Annual Report on Form 10-K for theyear ended December 31, 1994, Exhibit 10 I, Commission File No. 0-5127).

 

E.                                      MercantileBankshares Corporation (1989) Omnibus Stock Plan (Incorporated by reference toRegistrant’s Quarterly Report on Form 10-Q for the period ended September 30,1997, Exhibit 10 K, Commission File No. 0-5127).

 

F.                                      MercantileBankshares Corporation 1999 Omnibus Stock Plan and First Amendment of MercantileBankshares Corporation 1999 Omnibus Stock Plan (Incorporated by reference toRegistrant’s Definitive Proxy Statement, filed April 8, 2004, Appendix A).

 

G.                                     MercantileBankshares Corporation and Participating Affiliates Supplemental Cash BalanceExecutive Retirement Plan, dated April 27, 1994, effective January 1, 1994(Incorporated by reference to Registrant’s Annual Report on Form 10-K for yearended December 31, 1994, Exhibit 10 R, Commission File No. 0-5127).

 

H.                                    MercantileBankshares Corporation and Participating Affiliates Supplemental 401(k)Executive Retirement Plan, dated December 13, 1994, effective January 1, 1995(Incorporated by reference to Registrant’s Annual Report on Form 10-K for theyear ended December 31, 1994, Exhibit 10 S, Commission File No. 0-5127).

 

I.                                         MercantileBankshares Corporation Stock Retainer and Deferred Compensation Plan ForNon-Employee Directors (Incorporated by reference to Registrant’s Current Reporton Form 8-K, filed May 16, 2005, Exhibit 10.1, Commission File No. 0-5127).

 

J.                                        MercantileBankshares Corporation Option Agreement with J. Marshall Reid, dated August 21,1995 (Incorporated by reference to Registrant’s Annual Report on Form 10-K forthe year ended December 31, 1998, Exhibit 10 R, Commission File No. 0-5127).

 

K.                                    MercantileBankshares Corporation Option Agreement with Terry L. Troupe, dated September10, 1996 (Incorporated by reference to Registrant’s Annual Report on Form 10-Kfor the year ended December 31, 1999, Exhibit 10 S, Commission File No.0-5127).

 

L.                                      ExecutiveEmployment Agreement dated February 2, 2001, among Mercantile BanksharesCorporation, Mercantile-Safe Deposit and Trust Company and Edward J. Kelly, III(Incorporated by reference to Form 8-K of Registrant filed February 13, 2001,Exhibit 10 U, Commission File No. 0-5127), as amended by Agreement effectiveFebruary 21, 2002 (Incorporated by reference to Registrant’s annual report on Form10-K for the year ended December 31, 2001 Exhibit 10R, Commission File No.0-5127).

 

M.                                 ExecutiveSeverance Agreement dated February 2, 2001, among Mercantile BanksharesCorporation, Mercantile-Safe Deposit and Trust Company and Edward J. Kelly, III(Incorporated by reference to Form 8-K of Registrant filed February 13, 2001,Exhibit 10 V, Commission File No. 0-5127), as amended by Agreement effectiveFebruary 21, 2002 (Incorporated by Reference to Registrant’s Annual Report onForm 10-K, for the year ended December 31, 2001, Exhibit 10S, Commission FileNo. 5127).

 

N.                                    SupplementalRetirement Agreement dated February 2, 2001, among Mercantile BanksharesCorporation, Mercantile-Safe Deposit and Trust Company and Edward J. Kelly, III(Incorporated by reference to Form 8-K of Registrant filed February 13, 2001,Exhibit 10 W, Commission File No. 0-5127).

 

O.                                    MercantileBankshares Corporation Option Agreement with Edward J. Kelly, III, dated March2, 2001 (Incorporated by reference to Registrant’s Annual Report on Form 10-Kfor the year ended December 31, 2000, Exhibit 10 X, Commission File No.0-5127).

 

P.                                      Scheduleand Form of Mercantile Bankshares Corporation Option Agreements entered into in2000 with J. Marshall Reid (40,000 shares), and Terry L. Troupe (20,000 shares)(Incorporated by reference to Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2000, Exhibit 10 Y, Commission File No. 0-5127).

 

Q.                                    ExecutiveEmployment Agreement dated March 19, 2002, among Mercantile Bankshares Corporation,Mercantile-Safe Deposit and Trust Company and John L. Unger (incorporated byreference to Registrant’s Form 8-K filed April 3, 2002 Exhibit 10Y, CommissionFile No. 0-5127).

 

R.                                     ExecutiveSeverance Agreement dated March 19, 2002, among Mercantile BanksharesCorporation,

 

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Mercantile-Safe Depositand Trust Company and John L. Unger (incorporated by reference to Registrant’sForm 8-K April 3, 2002, Exhibit 10Z, Commission File No. 0-5127).

 

S.                                      MercantileBankshares Corporation Option Agreement with Edward J. Kelly, III, dated May 7,2002 (incorporated by reference to Registrant’s Quarterly Report for thequarter ended June 30, 2002, Exhibit 10AA, Commission File No. 0-5127).

 

T.                                     MercantileBankshares Corporation Option Agreement with J. Marshall Reid, dated May 7,2002 (incorporated by reference to Registrant’s Quarterly Report for thequarter ended June 30, 2002, Exhibit 10BB, Commission File No. 0-5127).

 

U.                                    MercantileBankshares Corporation Option Agreement with John L. Unger, dated May 7, 2002(incorporated by reference to Registrant’s Quarterly Report for the quarterended June 30, 2002, Exhibit 10DD, Commission File No. 0-5127).

 

V.                                     MercantileBankshares Corporation Option Agreement with Terry L. Troupe, dated May 7, 2002(incorporated by reference to Registrant’s Quarterly Report for the quarterended June 30, 2002, Exhibit 10EE, Commission File No. 0-5127).

 

W.                                MercantileBankshares Corporation Restricted Stock Agreement with Edward J. Kelly, III, datedApril 29, 2002 (incorporated by reference to Registrant’s Quarterly Report forthe quarter ended June 30, 2002, Exhibit 10FF, Commission File No. 0-5127).

 

X.                                    MercantileBankshares Corporation Restricted Stock Agreement with J. Marshall Reid, datedApril 29, 2002 (incorporated by reference to Registrant’s Quarterly Report forthe quarter ended June 30, 2002, Exhibit 10HH, Commission File No. 0-5127).

 

Y.                                     F&MBancorp Restated 1983 Incentive Stock Option Plan (Incorporated by reference toRegistrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit 4.4).

 

Z.                                     F&MBancorp 1995 Stock Option Plan (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.5).

 

AA.                         F&MBancorp 1999 Employee Stock Option Plan (Incorporated by reference toRegistrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit 4.6).

 

BB.                             F&MBancorp 1999 Stock Option Plan for Non-Employee Directors (Incorporated byreference to Registrant’s Registration Statement on Form S-8, No. 333-108123,Exhibit 4.7).

 

CC.                             PatapscoValley Bancshares, Inc. Incentive Stock Option Plan (Incorporated by referenceto Registrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit4.8).

 

DD.                           PatapscoValley Bancshares, Inc. Directors’ Stock Option Plan (Incorporated by referenceto Registrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit4.9).

 

EE.                               PatapscoValley Bancshares, Inc. Employee Stock Purchase Plan (Incorporated by referenceto Registrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit4.10).

 

FF.                               MonocracyBancshares, Inc. 1994 Stock Incentive Plan (Incorporated by reference toRegistrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit 4.11).

 

GG.                             MonocracyBancshares, Inc. 1997 Independent Directors’ Stock Option Plan (Incorporated byreference to Registrant’s Registration Statement on Form S-8, No. 333-108123,Exhibit 4.12).

 

HH.                           ExecutiveEmployment Agreement dated as of February 1, 2002 by and betweenMercantile-Safe Deposit and Trust Company and John J. Pillegi (Incorporated byreference to Registrant’s Annual report on Form 10-K for the year endedDecember 31, 2004, Exhibit 10.UU, Commission File No. 0-5127).

 

II.                                     ExecutiveSeverance Agreement dated as of February 1, 2002 by and between Mercantile-SafeDeposit and Trust Company and John J. Pileggi (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the year ended December 31, 2003,Exhibit 10.VV, Commission File No. 0-5127).

 

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JJ.                                   ExecutiveEmployment Agreement dated as of January 13, 2003 by and betweenMercantile-Safe Deposit and Trust Company and Michael M. Paese (Incorporated byreference to Registrant’s Annual Report on Form 10-K for the year ended December31, 2003, Exhibit 10.WW, Commission File No. 0-5127).

 

KK.                           ExecutiveSeverance Agreement dated as of March 10, 2004 by and between MercantileBankshares Corporation and Peter W. Floeckher (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the year ended December 31, 2003,Exhibit 10.XX, Commission File No. 0-5127).

 

LL.                               ExecutiveSeverance Agreement dated as of March 10, 2004 by and among MercantileBankshares Corporation, Mercantile-Safe Deposit and Trust Company and DeborahA. Kakaris (Incorporated by reference to Registrant’s Annual Report on Form10-K for the year ended December 31, 2003, Exhibit 10.YY, Commission File No.0-5127).

 

MM.                     ExecutiveSeverance Agreement dated as of March 10, 2004 by and between MercantileBankshares Corporation and Priscilla S. Hoblitzell (Incorporated by referenceto Registrant’s Annual Report on Form 10-K for the year ended December 31,2003, Exhibit 10.ZZ, Commission File No. 0-5127).

 

NN.                           Amendedand Restated Executive Employment Agreement dated June 14, 2005 by and amongRegistrant, Mercantile-Safe Deposit and Trust Company and Jay M. Wilson(Incorporated by reference to Registrant’s Form 8-K, filed June 17, 2005,Exhibit 10.1, Commission File No. 0-5127).

 

OO.                           Amendedand Restated Executive Severance Agreement dated June 14, 2005 by and amongRegistrant, Mercantile-Safe Deposit and Trust Company and Jay M. Wilson(Incorporated by reference to Registrant’s Form 8-K, filed June 17, 2005,Exhibit 10-2, Commission File No. 0-5127).

 

PP.                               LeaseAgreement by and between MBC Realty, LLC and Mercantile-Safe Deposit and TrustCompany dated as of November 19, 2004 and effective as of December 13, 2005 (Incorporatedby reference to Registrant’s Annual Report on Form 10-K for the Year EndedDecember 31, 2004, Exhibit 10.PP, Commission File No. 0-5123).

 

QQ.                           MembershipInterests Purchase Agreement (MBC Realty, LLC) by and between Registrant andHarbor Group International L.L.C. dated as of October 20, 2004 (Incorporated byreference to Registrant’s Annual Report on Form 10-K for the Year EndedDecember 31, 2004, Exhibit 10.QQ, Commission File No. 0-5123).

 

RR.                             FirstAmendment to Membership Interests Purchase Agreement (MBC Realty, LLC) by andbetween Registrant and Harbor Group, International, L.L.C. dated as of November18, 2004 (Incorporated by reference to Registrant’s Annual Report on Form 10-Kfor the Year Ended December 31, 2004, Exhibit 10.RR, Commission File No.0-5123).

 

SS.                               Formof Option Agreement for grants made under the Mercantile Bankshares Corporation1999 Omnibus Stock Plan (Incorporated by reference to Registrant’s AnnualReport on Form 10-K for the Year Ended December 31, 2004, Exhibit 10.SS,Commission File No. 0-5123).

 

TT.                             Formof Restricted Stock Award Agreement for grants made under the MercantileBankshares Corporation 1999 Omnibus Stock Plan (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the Year Ended December 31, 2004,Exhibit 10.TT, Commission File No. 0-5123).

 

UU.                           MercantileBankshares Corporation 2004 Restricted Stock Program, as amended (Filedherewith).

 

VV.                             ExecutiveSeverance Agreement effective as of November 5, 2003 by and between Registrantand Alexander T. Mason (Incorporated by reference to Registrant’s Annual Reporton Form 10-K for the Year Ended December 31, 2004, Exhibit 10.VV, CommissionFile No. 0-5123).

 

WW.                   ExecutiveSeverance Agreement effective as of August 15, 2002 by and between Registrantand Kevin A. McCreadie (Incorporated by reference to Registrant’s Annual Reporton Form 10-K for the Year Ended December 31, 2004, Exhibit 10.WW, CommissionFile No. 0-5123).

 

XX.                           ExecutiveEmployment Agreement effective as of August 15, 2002 by and among Registrant,Mercantile Capital Advisors, Inc. and Kevin A. McCreadie (Incorporated byreference to Registrant’s Annual Report on Form 10-K for the Year EndedDecember 31, 2004, Exhibit 10.XX, Commission File No. 0-5123).

 

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YY.                             MercantileBankshares Corporation Deferred Compensation Plan (Incorporated by reference toRegistrant’s Current Report on Form 8-K, filed March 14, 2005, Exhibit 10.1,Commission File No. 0-5127).

 

(14)                            Code ofBusiness Conduct and Ethics (Incorporated by reference to Registrant’s CurrentReport on Form 8-K, filed December 16, 2005, Exhibit 99.1, Commission File No.0-5127).

 

(21)                            Subsidiariesof the Registrant (filed herewith).

 

(23)                            Consentof Independent Accountants (filed herewith).

 

(24)                            Powerof Attorney dated March 10, 2006 (filed herewith).

 

(31)                            Certificationspursuant to Section 302 of the Sarbanes Oxley Act of 2002

 

A.                                   Certification of the Chief ExecutiveOfficer of Mercantile Bankshares Corporation (filed herewith).

 

B.                                     Certification of the Chief FinancialOfficer of Mercantile Bankshares Corporation      (filed herewith).

 

(32)                            Certificationspursuant to Section 906 of the Sarbanes Oxley Act of 2002

 

A.                                   Certificateof the Chief Executive Officer of Mercantile Bankshares Corporation (furnishedherewith).

 

B.                                     Certificateof the Chief Financial Officer of Mercantile Bankshares Corporation (furnishedherewith).

 

**INDEX TO FINANCIAL STATEMENTS**

 

Management’s Report onInternal Control Over Financial Reporting is included in Item 8 of this AnnualReport on Form 10-K.

 

The Report of IndependentRegistered Public Accounting Firm on the Consolidated Financial Statements ofMercantile Bankshares Corporation and on Mercantile Bankshares Corporation’sinternal control over financial reporting is included in Item 8 of this AnnualReport on Form 10-K.

 

Consolidated FinancialStatements and related notes are included in Item 8 of this Annual Report onForm 10-K, as follows:

 

Consolidated BalanceSheets, December 31, 2005 and 2004

 

Statements ofConsolidated Income for the years ended December 31, 2005, 2004, and 2003

 

Statements ofConsolidated Cash Flows for the years ended December 31, 2005, 2004 and 2003

 

Statements of Changes inConsolidated Shareholders’ Equity for the years ended December 31, 2005, 2004and 2003

 

Notes to ConsolidatedFinancial Statements 

 

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**SIGNATURES**

 

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities and Exchange Actof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 

MERCANTILE BANKSHARESCORPORATION

 

 
| By:    | /s/ Edward J. Kelly,  III              |   | March 10, 2006 |
|--------|----------------------------------------|--------|----------------|
|   | Edward J. Kelly, III                   |   |
|   | President and Chief  Executive Officer |   |

 

 

Pursuantto the requirements of the Securities Act of 1934, this report has been signedbelow by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated:

 

Principal ExecutiveOfficer

 

 
| /s/ Edward J. Kelly,  III                        |   | March 10, 2006 |
|--------------------------------------------------|--------|----------------|
| Edward J. Kelly, III                             |   |
| Chairman, President and  Chief Executive Officer |   |
|                                             |   |

 
| Principal Financial  Officer                          |   |
|-------------------------------------------------------|--------|
|                                                  |   |
|                                                  |   |
| /s/ Terry L. Troupe                                   |   | March 10, 2006 |
| Terry L. Troupe                                       |   |
| Executive Vice  President and Chief Financial Officer |   |
|                                                  |   |
|                                                       |        |  |

 
| Principal Accounting  Officer |   |
|-------------------------------|--------|
|                          |   |
|                          |   |
| /s/ William T. Skinner,  Jr.  |   | March 10, 2006 |
| William T. Skinner, Jr.       |   |
| Controller                    |   |
|                               |        |  |

 

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A majority of the Board of Directors: 

 

Cynthia A. Archer, Richard O. Berndt, Howard B. Bowen, R. Carl Bowen,William R. Brody, Eddie C. Brown, George L. Bunting, Jr., Anthony W. Deering,Darrell D. Friedman, Freeman A. Hrabowski III, Robert A. Kinsley, Alexander T.Mason, Jenny G. Morgan, Morton P. Plant, Christian H. Poindexter, Clayton S.Rose, James L. Shea, Donald J. Shepard and Jay M. Wilson.   

 

 
| By:    | /s/ Edward J. Kelly, III            |   | March 10, 2006 |
|--------|-------------------------------------|--------|----------------|
|   | Edward J. Kelly, III                |   |
|   | For Himself and as Attorney-in-Fact |   |

 

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