**United StatesSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

### **FORM 10-K**

**(MARKONE)**

 
| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES**    |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|
| **EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       |                                                                     |
| **For  the fiscal year ended                               December  31, 2004**                                                                                                                                                                                                                                                                   |
| **OR**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |                                                                     |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES** |
| **EXCHANGE  ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       |                                                                     |
| **For the transition period from                                      to                                      ** |
| **Commission file number                                                0-5127**                                                                                                                                                                             |

 

**Mercantile Bankshares Corporation**

(Exact name ofregistrant as specified in its charter)

 
| **Maryland**                                                                   |   | **52-0898572**                        |
|--------------------------------------------------------------------------------|--------|---------------------------------------|
| State or other jurisdiction of  incorporation or organization                  |   | (I.R.S. Employer  Identification No.) |
|                                                                           |   |                                  |
| **Two Hopkins Plaza, P. O. Box 1477,  Baltimore, Maryland    21203** |
| (Address of principal executive offices)                                       |

 

Registrant’s telephone number, including area code:                           **(410) 237-5900**

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

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

 

Securities registered pursuant to Section 12(g) of the Act:

 

**Common Stock ($2 par value)**

(Title of class)

 

**Stock Purchase Rights**

(Title of class)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes  ý                      No  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 any amendment tothis Form 10-K. o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2)

Yes  ý                      No  o

 

 

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At June 30, 2004, the last business day of registrant’s most recentlycompleted second fiscal quarter, the aggregate market value of shares of commonstock held by non-affiliates of registrant (1) (including fiduciary accountsadministered by affiliates) was $3,560,710,629 based on the last sale price onthe Nasdaq National Market on June 30, 2004.

 

As of March 1, 2005, 79,237,620 shares of common stock wereoutstanding.

 

(1)  Excludes 3,037,926 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, 2004.  Exclusion of sharesheld 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 by Reference:  Part III - Definitive Proxy Statement ofRegistrant to be filed with the Securities and Exchange Commission underRegulation 14A within 120 days after the end of the Registrant’s fiscal yearcovered by this Annual Report on Form 10-K.

 

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**2004 ANNUAL REPORT ON FORM 10-K**

 

**TABLE OF CONTENTS**

 
| PART I     |
|------------|
|       |   |   |
| Item 1.    | Business |   |
| 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 Accountant Fees and Services |   |
|       |   |   |
| PART IV    |
|       |   |   |
| Item 15.   | Exhibits  and Financial Statement Schedules |   |
|       |   |   |
| Signatures |   |   |

 

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PART I

 

ITEM 1.  BUSINESS 

 

**General**

 

Mercantile Bankshares Corporation was incorporated under the laws ofMaryland on May 27, 1969.  It is a financialholding company and a bank holding company registered under the Bank HoldingCompany Act of 1956.  MercantileBankshares Corporation along with its consolidated subsidiaries is referred toin this report as “Bankshares,” “we” or “Registrant.” Bankshares, with $14.4billion in assets for the year ended December 31, 2004, is a regional multibankholding company with headquarters in Baltimore, Maryland.  It is comprised of 13 banks (the “Banks”) anda mortgage banking company.  Ten banksare headquartered in Maryland, two are in Virginia and one is in Delaware.  At December 31, 2004, Bankshares’ largestbank, Mercantile-Safe Deposit and Trust Company (“MSD&T”), representedapproximately 33% of total assets and operated 26 offices in Maryland and onecommercial office in Pennsylvania. Nearly all Bankshares’ substantial wealthmanagement operations and specialized corporate banking services are providedby MSD&T.

 

**Washington Expansion and AffiliateConsolidation**

 

To capitalize on the potential in affluent, fast growing metropolitanWashington, D.C., Bankshares consolidated most of its retail and smallbusiness, commercial lending and real estate operations in the Washingtonregion into its affiliate bank headquartered in Montgomery County, Maryland,and renamed the bank Mercantile Potomac Bank (“Mercantile Potomac”).

 

To further capitalize on the opportunities we see in the Washingtonregion, Bankshares announced on January 25, 2005 that it had entered into amerger agreement to acquire Community Bank of Northern Virginia (“CBNV”) fortotal consideration of approximately $212 million, 60% of which will be paid inthe form of Bankshares common stock and 40% of which will be paid in cash.Under the terms of the merger agreement, shareholders of CBNV may elect toreceive for each share of CBNV common stock they hold (excluding options),either .4005 shares of Bankshares common stock or cash in the amount of$20.375, subject to adjustment because the ratio of stock to cash considerationis fixed.  The merger is subject to CBNVshareholder approval and certain bank regulatory approvals, among otherconditions.  Bankshares filed a report onForm 8-K on January 25, 2005 disclosing the terms of this merger agreement.  Please see this report for more details.

 

Bankshares also announced on January 25, 2005 that it would mergeMercantile Potomac into MSD&T in order to provide a more substantialcapital base for funding the region’s growth opportunities.  Bankshares intends to operate the currentbranches of Mercantile Potomac as a division of MSD&T under the “MercantilePotomac Bank” trade name. CBNV will become part of the Mercantile Potomacdivision upon completion of the acquisition. At the same time Bankshares announced that it would combine MSD&Tand Mercantile Potomac, it also announced that it would merge its WesternMaryland affiliate, The Fidelity Bank (“Fidelity”), into its Frederick-basedaffiliate, Farmers & Mechanics Bank (“Farmers”).  Bankshares intends

 

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to operatethe current branches of Fidelity as a division of Farmers under the “FidelityBank” trade name.  The mergers ofMercantile Potomac into MSD&T and Fidelity into Farmers are both subject toregulatory approvals.

 

In 2004, Bankshares combined 11 of its banks into four banks in astrategic consolidation that positions its banking network to enhance customerservice, to operate more efficiently and to respond more effectively toregulatory and competitive challenges. The consolidation affected banks located primarily in Delaware, southernMaryland and on the eastern shores of Maryland and Virginia.  Each group of combined banks shared commongeographic boundaries and common market dynamics.  As with the Washington market consolidation,the four resulting banks were renamed in a manner that recognized their localidentities while highlighting their Mercantile affiliation.

 

Bankshares places particular emphasis on long-term customerrelationships by providing value-added services through its extensive affiliatebank network.  Each of the Banks has itsown identity, 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 with Bankshares,each Bank is able to provide its customers with the sophisticated bankingservices and financial resources of a major banking organization.

 

Bankshares directly owns all of the outstanding stock of the Banks anddirectly or indirectly owns all of the outstanding stock of certain otheraffiliates. The principal components of our banking and nonbanking network arelisted below.

 

*Lead Bank and Affiliates*

 

Mercantile-Safe Deposit andTrust Company

 

Mercantile Mortgage Corporation(“MMC”)

 

Mercantile Mortgage, LLC (49.9%owned by MMC)

 

Columbia National Real EstateFinance LLC (60% owned by MMC)

 

West River LLC

 

HarborPoint Capital, GP LLC

 

HarborPoint Capital LP (75%owned by MMC)

 

Mercantile Brokerage ServicesHoldings, LLC

 

Mercantile Brokerage Services,Inc.

 

Mercantile Capital Advisors,Inc.

 

Mercantile/Cleveland, LLC

 

Boyd Watterson Asset Management,LLC

 

MBC Agency, Inc.

 

Mercantile Life InsuranceCompany

 

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*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     |
|                                     |   |                     |
| The Fidelity Bank                        |   | Hagerstown, 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 Potomac Bank                  |   | Gaithersburg, Maryland   |
|                                     |   |                     |
| Mercantile Southern Maryland Bank        |   | Leonardtown, Maryland    |
|                                     |   |                     |
| The National Bank of Fredericksburg      |   | Fredericksburg, Virginia |
|                                     |   |                     |
| Westminster Union Bank                   |   | Westminster, Maryland    |

 

For purposes of segment reporting, two operating components have beenidentified: Banking and Investment & Wealth Management. For segmentreporting information, see Note No. 16 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 2004 to 2003” and “Reviewof Earnings and Balance Sheet for 2003 to 2002,” 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.

 

**Consumer Banking Services**

 

***Personal Banking***

 

The Banks offer numerous services to meet the checking, savings, invest­mentand credit needs of the individuals in their communities.  Personal banking services include IndividualRetirement Accounts, certificates of deposit and various checking and savingsplans, including an indexed money market account.  Investment services include mutual funds andannuities.  The Banks offer home equityloans and lines of credit, as well as installment loans, to meet a variety ofborrowing needs.

 

During 2004, Bankshares worked to create a consistent customerexperience throughout the affiliate bank network by standardizing a number ofbanking office procedures and by simplifying and standardizing

 

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its personal checking and savingsaccounts.  Customer accounts will beconverted to the new product line during 2005.

 

Through the affiliate bank network, customers have no-fee access totheir accounts at 237 Banking Twenty-FourSM ATMs, and they canperform many routine transactions at any of the 226 affiliate bankingoffices.  For added convenience,substantially all Bankshares affiliates provide customers with toll-freetelephone access to a centralized Customer Service Center and a voice-responseaccount information system.  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 offerssole proprietors similar and specifically tailored capabilities to meet smallbusiness needs.

 

***Home Mortgages***

 

Residential mortgages are provided through Mercantile Mortgage, LLC, ajoint venture between Mercantile Mortgage Corporation (“Mercantile Mortgage”),a sub­sidiary of MSD&T, and Wells Fargo Ventures, LLC.  A wide variety of competitively priced fixed-and variable-rate products are available, including jumbo loans.  Residential mortgage loans also are availablethrough the Banks.

 

Risks associated with residential mortgage lending include interestrate risk, which is mitigated through the sale of the majority of allconforming fixed-rate loans, and default risk by the borrower, which ismitigated through underwriting procedures and credit quality standards, amongother things.

 

**Commercial Banking Services**

 

***Lending***

 

*General Commercial Lending*

 

With their local knowledge and focus, our Banks are well-suited to meetthe traditional credit needs of businesses in their market areas.  Each Bank works closely with customers toextend credit for general business pur­poses, such as working capital, plantexpansion or equipment purchases, and for financing industrial and commercialreal estate.  Where appropriate, theBanks are adept at employing government guarantee programs, such as thoseavailable from the Small Business Administration.

 

In addition to supplying credit to the businesses in its own marketarea, MSD&T works in collaboration with other affiliates when theircustomers’ credit needs exceed the affiliate bank’s lending limit or when thereis a more specialized commercial banking need.

 

*Specialized Lending*

 

When local commercial customers do not qualify for traditionalfinancing, the Asset-Based Lending Group at MSD&T can help them convert thevalue of their accounts receivable, inventory and equipment into cash foroperations.  MSD&T lenders also workwith the affiliate banks to arrange more sophisticated financing in the areasof acquisitions and management buyouts.

 

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*Real Estate Lending*

 

We provide land acquisition and development, construction and interimfinancing to commercial real estate investors and developers.  Credits exceeding an affiliate bank’spredetermined threshold are made in collaboration with the Real Estate LendingGroup at MSD&T.

 

Mercantile Mortgage makes loans for land acquisition, development andconstruction of single-family and multifamily housing.

 

Permanent financing for multifamily projects and long-term, nonrecoursefinancing for commercial real estate are provided through Columbia NationalReal Estate Finance LLC (“CNREF”), a joint venture, the majority of which isowned by Mercantile Mortgage.  CNREF is aFreddie Mac Program Plus Seller Servicer and is a MAP (Multifamily AcceleratedProcessing) approved lender for HUD.  Ithas correspondent relationships with approximately 12 life insurance companiesand services a loan portfolio in excess of $5.8 billion.

 

Mercantile Mortgage also provides permanent financing for multifamilyprojects nationwide through HarborPoint Capital, LP, a joint venture, themajority of which is owned by Mercantile Mortgage.  HarborPoint Capital, LP, headquartered inDallas, Texas, is one of the nation’s few Fannie Mae DUS (DelegatedUnderwriting and Servicing) lenders.

 

***Cash Management***

 

Centralized at MSD&T, Cash Management Services helps businesscustomers of all Banks collect, transfer and invest their cash.  Through a variety of electronic payment andaccount management tools, Cash Management enables customers to monitor andmanage cash flows conveniently and efficiently. In addition to use by commercial customers, Cash Management services areused by nonprofit institutions such as unions, charities and philanthropicorganizations.

 

***Capital Markets***

 

In November 2003, Bankshares developed the Capital Markets Groupthrough MSD&T to provide additional financing capabilities for existingclient relationships and to address the financing needs of an expanded universeof prospects.  The Capital Markets Groupunderwrites and remarkets tax-exempt and taxable municipal variable-rate demandbonds for nonprofit organizations such as senior living and health care providers,private schools, health and social welfare organizations and culturalinstitutions. The Capital Markets Group also provides interest risk managementand financial advisory services to all types of commercial banking customers.The Capital Markets Group specialists work directly with borrowers, evaluatingand recommending financing and interest rate risk management strategies,including interest rate swaps, caps and collars.

 

The Capital Markets Group works closely with Bankshares’ commerciallenders in Maryland, Virginia, Delaware, Pennsylvania and Washington, D.C.,employing an approach that is consistent with Bankshares’ community bankingphilosophy.

 

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**Investment and Wealth Management Services**

 

Bankshares offers investment and wealth management services through theInvestment & Wealth Management division (“IWM”) of MSD&T.  IWM continues to build on a 140-yeartradition of providing premier investment and wealth management services toprivate individuals, family groups and institutions.

 

Today, Bankshares provides a range of wealth management services.  Over the past several years, IWM hasdeveloped sophisticated risk management and asset allocation analyses tocomplement the investment advice we offer. An open architecture platform enables Bankshares to offer an array ofproprietary investment products and carefully selected outside managers in arange of asset classes, including equity, fixed-income and alternativeinvestment products.  Bankshares’investment platform provides a range of investment vehicles, from separateaccount management to highly rated mutual funds.  Investment and wealth management services areavailable through professional advisors at MSD&T, through the affiliatebank network and through Baltimore-based Mercantile Brokerage Services, Inc. (“MBSI”),which offers full-service, discount and online brokerage capabilities andaccount services.  Sophisticated assetallocation and risk management capabilities, coupled with a range ofproprietary and nonproprietary investment alternatives and investment vehicles,enable Bankshares to provide high quality, advice-driven, risk-managedsolutions to meet clients’ investment objectives.  At December 31, 2004, Bankshares had $22billion of discretionary assets under management and $47.8 billion in assetsunder administration.

 

***Private Wealth Management***

 

When managing a client’s assets as part of an investment management ortrustee relationship, Bankshares focuses on consistent investment performanceand an asset allocation that is individually designed to meet each client’srisk/return parameters and investment objectives.  Professional advisors, working in partnershipwith our clients, provide access to proprietary and third-party separateaccount management, the family of Mercantile Funds, nonproprietary mutual fundsand a variety of alternative investments. Through MBSI, our clients have access to full-service, discount andonline brokerage capabilities.  Inaddition, IWM provides a wide range of sophisticated fiduciary and client administrativeservices, including trust administration, protection and continuity of truststructures, estate settlement, estate advice and planning, tax advice andplanning and charitable giving programs. IWM also acts in a custodial capacityfor its clients, providing safekeeping of assets, transaction execution, incomecollection, preparation of tax returns and record keeping.

 

***Family Office***

 

Designed to service the unique needs of families with substantialwealth, the Family Office team works with 100 families whose total assetsapproach $3.5 billion.  The Family Officeis comprised of leading professionals including Certified Financial Analysts,Certified Financial Planners and lawyers. The group integrates the full range of services required to seamlesslymanage its clients’ complex, multigenerational

 

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financialcircumstances.  The Family Office offersfamily governance, family education and philanthropic advisory programs inaddition to the normal services associated with Family Offices, such asinvestment management, trust structuring and administration, tax planning,estate planning, closely held business planning, credit, and charitable givingand administration.  The team ofspecialists within Family Office also provides expert guidance in sophisticatedinvestment strategies, incorporating nontraditional asset classes such asprivate equity, real estate and hedge fund investing.

 

***Private Banking***

 

The Private Banking Group provides one point of contact for its clients’deposit, investment and credit needs, ensuring that these services aredelivered within an overall asset management plan.  Private bankers can coordinate cash flows,arrange investment of short- and long-term funds and structure credit arrangementsto meet short- to long-term needs.

 

***Institutional Asset Management***

 

Bankshares, through IWM, the Banks and Boyd Watterson Asset Management,LLC, works to provide businesses and charitable organizations withsophisticated investment management and administrative services for theiremployee retirement plans, profit sharing plans and endowments.  Clients include state and local governmententities, unions, charitable organizations and military institutions.  For example, IWM is trustee for a group trustthat focuses on commercial real estate investments for Taft-Hartley pensionplans. IWM also can help nonprofit organizations, such as charitable andphilanthropic groups, with annual giving and capital campaigns, pooled incomefunds, gift annuities and charitable remainder trusts.  Bankshares offers corporations 401(k)programs tailored to their specific needs.

 

**Insurance Activities**

 

Keller Stonebraker Insurance, Inc., an independent, wholly ownedsubsidiary of Farmers & Mechanics Bank, arranges a full line of consumerand commercial business insurance products through offices in Hagerstown andCumberland, Maryland, and Keyser, West Virginia.  Consumer insurance products includeannuities, homeowners, automobile, life and personal umbrellas.  Commercial products include property andcasualty packages, workers’ compensation, bonds, professional liability,umbrella, and 401(k) and other benefit plans.

 

Potomac Basin Group Associates, Inc., operates as an independent,wholly owned subsidiary of Farmers & Mechanics Bank and is an independentinsurance agency specializing in corporate employee benefit plans through itsoffices in Beltsville and Ellicott City, Maryland.

 

MBC Agency, Inc., provides as agent, under group policies, credit lifeinsurance in connection with extensions of credit by the Banks.  Mercantile Life Insurance Company reinsuresthe insurance provided by MBC Agency, Inc.

 

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**Private Equity**

 

Bankshares, in partnership with MSD&T, began a focused privateequity investment initiative in 2000 with two objectives: providing analternative method of funding to develop additional long-term clientrelationships with emerging companies in Bankshares’ market area and providingan alternative use of capital to generate long-term returns.  The primary investments are private equitylimited partnerships located, or seeking investment opportunities, withinBankshares’ geographic trade area and, to a lesser extent, direct investmentsin privately held companies within the region. The private equity funds includesmall- and middle-market buyout funds, mezzanine funds and late-stage venturefunds where the target investments of the funds are or have the potential tobecome Bankshares customers.  For moreinformation on private equity investments, see Note Nos. 1, 6 and 10 of thefinancial statements.

 

**Other Nonbanking Affiliates**

 

On November 12, 2004, Mercantile consolidated its brokerage activitiesby merging Mercantile Securities, Inc., into Peremel & Company, Inc.  The resulting entity is named MercantileBrokerage Services, Inc., a general securities broker-dealer that offersfull-service, discount and online brokerage services.

 

Mercantile Capital Advisors, Inc. is a registered investment adviserthat provides investment advisory and administrative services to registeredinvestment companies, including Mercantile Funds, Inc., a family of equity,taxable and tax-exempt bond, and money market funds.

 

**Statistical Information**

 

The statistical information required in this Item 1 is set forth inItem 6, 7 and 8 of this Annual 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 Stockholder                                |   |   |
|                               |       | 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 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) |

 

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| (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 7 - Deposits                    |
| (VI)   |   | Return on Equity      |   |                                 |
|   |   | and Assets            |   | Return on Equity and Assets (Item 6) |
| (VII)  |   | Short-Term Borrowings |   | Notes to Financial Statements,       |
|   |   |                  |   | Note 8                               |

 

**Employees**

 

At December 31, 2004, Bankshares and its affiliateshad approximately 3,479 employees.

 

**Competition**

 

Thebanking business is highly competitive. Within their service areas, the Bankscompete with commercial banks (including local banks and branches or affiliatesof other larger banks), savings and loan associations and credit unions forloans and deposits, and with insurance companies and other financialinstitutions for various types of loans. There is also competition forcommercial and retail banking business from banks and financial institutionslocated outside our service areas. Interstate banking is an established part ofthe competitive environment. Bankshares is a financial holding company and isthe largest independent bank holding company headquartered in Maryland.  Measured in terms of assets under managementand administration, MSD&T believes it is one of the larger trustinstitutions in the mid-atlantic region of the United States. MSD&T and itssubsidiaries (i.e., Boyd Watterson & Mercantile Capital Advisors, Inc.)compete for various classes of fiduciary and investment advisory business withother banks and trust companies, insurance companies, investment counselingfirms, mutual funds and others. Mercantile Mortgage is one of many competitorsin its area of activity. MBC Agency, Inc. is limited to providing life, healthand accident insurance in connection with credit extended by the Banks.Mercantile Agency, Inc. commenced business in 1996 and is a small competitor inits area.

 

TheBanks ranged in asset size from approximately $150 million to $ 4.7 billion, atDecember 31, 2004. They face competition in their own local service areas aswell as from the larger competitors mentioned above.

 

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**Supervisionand 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.

 

*Capital Adequacy. *The Federal Reserve Board, the Office of the Comptroller ofthe Currency (the “OCC”), the federal regulator of national banks, and theFederal Deposit Insurance Corporation (the “FDIC”), federal regulator ofstate-chartered banks that are not members of the Federal Reserve System andinsurer of the deposits of all U.S. commercial banks, have issued substantiallysimilar risk-based and leverage capital guidelines applicable to United Statesbanking organizations.  In addition,these regulatory agencies may from time to time require that a bankingorganization maintain capital above the minimum levels, whether because of itsfinancial condition or actual 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 morerestrictive constraints on operations, management and capital distributions,depending on the category in which an institution is classified. Failure tomeet the capital guidelines could also subject a banking institution to capitalraising requirements.

 

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. Such regulations establish various degrees ofcorrective action to be taken when an institution is considered undercapitalized.Under the regulations, a “well capitalized” institution must have a Tier 1risk-based capital ratio of at least six percent, a total risk-based capitalratio of at least ten percent and a leverage ratio of at least five percent andnot be subject to a capital directive order. As of December 31, 2004, the most recent notification from theprimary regulators for each of Bankshares’ subsidiary banks categorized them aswell-capitalized under the prompt corrective action regulations.  Additional information regarding capitalrequirements for bank holding companies and tables reflecting Bankshares’regulatory capital position at December 31, 2004 can be found in Note No. 11 tothe financial statements in Item 8 of this Annual Report.

 

*The Gramm-Leach-Bliley Act*.  The Gramm-Leach-Bliley Act of 1999 (the “GLBAct”) was adopted on November 12, 1999 and amended several of the federalbanking laws, including the BHC Act

 

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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 haddetermined were so closely related to banking or managing or controlling banksas to be a proper incident thereto.  Inparticular, Glass-Steagall and the BHC Act imposed important restrictions on theability of bank holding companies or their subsidiaries to engage in thesecurities or insurance business.

 

TheGLB Act repealed the provisions of Glass-Steagall and restrictions in the BHCAct that limited affiliations among, and overlapping business activitiesbetween the 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 in banking,or managing or controlling banks; (b) perform certain servicing activities forsubsidiaries; and (c) engage in any activity, or acquire and retain the sharesof any company engaged in any activity that is either (i) financial in natureor incidental to such financial activity, as determined by the Federal ReserveBoard 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, with 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.

 

TheGLB Act also imposed a general scheme of functional regulation with respect tothe activities of bank holding companies and their bank and nonbanksubsidiaries to ensure that banking activities are regulated by bankregulators, securities activities are regulated by securities regulators, andinsurance activities are regulated by insurance regulators, although theFederal Reserve Board retains its role as the umbrella supervisor for bankholding companies.  Consequently, varioussecurities activities of bank subsidiaries of Bankshares are now subject toregulation by the Securities and Exchange Commission and

 

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theNational Association of Securities Dealers, Inc.  The functional regulation of the securitiesbrokerage activities of banks is not yet fully implemented.

 

Asa result 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 the purchase ofshares of mutual funds by bank customers and may engage in certain otheractivities in the future.

 

TheGLB Act also implements a number of requirements designed to protect theprivacy of customer information.  Afinancial institution must inform its customers at the outset of the customerrelationship, and at least annually thereafter, of the institution’s privacypolicies and procedures with respect to the customer’s nonpublic personalfinancial information.  With certainexceptions, an institution may not provide any nonpublic personal informationto unaffiliated third parties unless the customer has been informed that suchinformation may be so provided and the customer has been given the opportunityto opt out.  Furthermore, the GLB Actlimits a financial institution’s use of a customer’s account information formarketing purposes and imposes criminal penalties for the use of fraudulent ordeceptive means to obtain personal customer financial information.  The GLB Act permits states to adopt morerigorous laws with respect to privacy of customer information.

 

*The Fair Credit Reporting Act and the Fair andAccurate 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 other mattersunless the information consists solely of “transactions or experiences” (“Transactionor Experience Information”) between the customer and the bank or the banknotifies the customer that Transaction or Experience Information may be sharedand gives the customer the opportunity to opt out.  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, makespermanent the preemption of state law restrictions on affiliate informationsharing that is permitted by FCRA and amends FCRA in various respects,including to enhance the ability of consumers to combat identity theft,increase the accuracy of consumer credit reports, and allow consumers toexercise greater control over the type and amount of marketing solicitationsthat they receive.  The new marketingrestrictions, with some exceptions, would prevent banks from using Transactionor Experience Information received from an affiliate for marketing to aconsumer 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

 

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finalized.  More generally, the Federal Reserve Board andthe Federal Trade Commission have issued joint final rules establishingDecember 1, 2004 as the effective date for many of the provisions of the FACTAct that will require significant changes to affected companies’ businesspractices.

 

InDecember 2004, implementing section 216 of the FACT Act, the federal bankregulatory agencies announced interagency final rules to require financialinstitutions to adopt measures for properly disposing of “consumer information”derived from credit reports.  Federalbanking law requires financial institutions to protect customer information byimplementing information security programs. The rules adopted by the banking agencies require institutions to makecertain adjustments to their information security programs to include measuresfor the proper disposal of consumer information.  The rules define “consumer information” tomean “any record about an individual, whether in paper, electronic, or otherform, that is a consumer report or is derived from a consumer report and thatis maintained or otherwise possessed by or on behalf of the [institution] for abusiness purpose,” and include a compilation of such records, but exclude anyrecord that does not identify an individual. The rules take effect on July 1, 2005.

 

*The USA PATRIOT ACT*.  Congress adopted the USA PATRIOT ACT (the “PatriotAct”) on October 26, 2001 in response to the terrorist attacks that occurred onSeptember 11, 2001.  Under the PatriotAct, banks are required to maintain and prepare additional records and reportsthat are designed to assist the government’s efforts to combat terrorism.  The Patriot Act includes sweeping anti-moneylaundering and financial transparency laws and required additional regulations,including, among other things, standards for verifying client identificationwhen opening an account and rules to promote cooperation among financialinstitutions, regulators and law enforcement entities in identifying partiesthat may be involved in terrorism or money laundering.  Specifically, the customer identificationprogram (“CIP”) regulation issued under the Patriot Act requires each bank toimplement a written CIP appropriate for its size and type of business thatincludes certain minimum requirements. The CIP must be incorporated into thebank’s anti-money laundering compliance program, which is subject to approvalby the bank’s board of directors.  Theregulation applies to all federally regulated banks and savings associations,credit unions, and non-federally regulated private banks, trust companies, andcredit unions. All banks were required to comply with the CIP regulation forall accounts established on or after October 1, 2003.

 

*Interstate Banking*Pursuant tothe Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “InterstateBanking and Branching Act”), a bank holding company may acquire banks locatedin states other than its home state without regard to the permissibility ofsuch acquisitions under state law, but subject to any state requirement thatthe bank has been organized and operating for a minimum period of time, not toexceed five years, and the requirement that the bank holding company, after theproposed acquisition, controls no more than 10 percent of the total amount ofdeposits of insured depository institutions in the United States and no morethan 30 percent or such lesser or greater amount set by state law of suchdeposits in that state.

 

Subjectto certain restrictions, the Interstate Banking and Branching Act alsoauthorizes banks to merge across state lines to create interstate banks. TheInterstate Banking and Branching Act also permits a

 

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bankto open new branches in a state in which it does not already have bankingoperations if such state enacts a law permitting de novo branching.

 

*Other Regulatory Matters* In additionto the specific laws and regulations discussed above, there are numerousfederal and state laws and regulations which regulate the activities ofBankshares and the Banks, including requirements and limitations relating toreserves, permissible investments and lines of business, transactions withofficers, directors and affiliates, loan limits, consumer protection laws,privacy of financial information, predatory lending, fair lending, mergers andacquisitions, issuances of securities, dividend payments, inter-affiliateliabilities, extensions of credit and branch banking.  The BHC Act and the Federal Reserve Board’sregulations limit the ability of bank subsidiaries of bank holding companies toengage in certain tie-in arrangements with bank holding companies and theirnonbank subsidiaries in connection with any extension of credit or provision ofany property or services, subject to various exceptions.

 

Thelaws and regulations to which Bankshares is subject are constantly under reviewby Congress, regulatory agencies and state legislatures.  The likelihood and timing of any bankproposals or legislation and the impact they might have on Bankshares and itssubsidiaries cannot be determined at this time.

 

Banksharesis a separate and distinct legal entity from its subsidiaries.  It receives substantially all of its revenuefrom dividends from its subsidiaries and interest payments from the Banks onsubordinated debt. These dividends are the principal source of funds to paydividends on Bankshares’ common stock and interest on its debt. The payment ofdividends by a bank is subject to federal law restrictions as well as to thelaws of its state of incorporation in the case of a state-chartered bank. Also,a parent company’s right to participate in a distribution of assets upon asubsidiary’s liquidation or reorganization is subject to the prior claims ofthe subsidiary’s creditors.  It isFederal Reserve Board policy that a bank holding company should serve as asource of financial and managerial strength for, and commit resources tosupport each, of its subsidiary banks even in circumstances in which it mightnot do so (or may not legally be required or financially able to do so) absentsuch a policy.

 

Changesin control of Bankshares and the Banks are regulated under the BHC Act, theChange in Bank Control Act of 1978 and various state laws.

 

***The Banks***

 

In2004, several of the Banks were merged, as follows:

 

•                  The Forest HillState Bank was merged into County Banking and Trust Company, which survivedafter the merger under the name “Mercantile County Bank”

 

•                  The FirstNational Bank of St. Mary’s at Leonardtown and Bank of Southern Maryland wereboth merged into Calvert Bank and Trust Company, which survived the mergerunder the name “Mercantile Southern Maryland Bank”

 

•                  St. MichaelsBank and The Peoples Bank of Maryland were both merged into The ChestertownBank of Maryland, which survived the merger under the name “Mercantile EasternShore Bank”

 

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•                  PeninsulaBank and Farmers & Merchants Bank-Eastern Shore were both merged intoBaltimore Trust Company, which survived the merger under the name “MercantilePeninsula Bank”

 

Thesemergers were intended to enhance the delivery of services in the geographicareas served by the Banks involved.  Ineach case, merging several smaller Banks produced surviving institutions that,because of their larger size, are now able to allocate internal managementresponsibilities more effectively.  Insome cases, the surviving Banks also have higher legal lending limits, whichallows them to be more responsive to customers’ borrowing needs.

 

Allthe Banks, with the exception of The Citizens National Bank, The National Bankof Fredericksburg, 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 & MechanicsBank are members of the Federal Reserve System, and are thereby subject toregulation 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 andits affiliates are subject to the provisions of Section 23A and Section 23B ofthe Federal Reserve Act and the Federal Reserve Board’s Regulation W, whichimplements Sections 23A and 23B.  Section23A, among other provisions, limits the amount of loans or extensions of creditby the Banks to, and their investments in, Bankshares and the nonbank affiliatesof the 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 defaultof a bank subsidiary or related to FDIC assistance provided to a banksubsidiary in danger of default - the Banks may be assessed for the FDIC’s loss, subject to certainexceptions.

 

***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

 

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Commissionerof Financial Regulation of Maryland and the OCC, as the case may be.  In addition, MBC Agency, Inc., MercantileLife Insurance Company and Mercantile Agency, Inc. are subject to licensing andregulation by state insurance authorities. Mercantile Capital Advisors, Inc., Boyd Watterson and MercantileBrokerage Services, Inc. are subject to regulation by the Securities andExchange Commission and state securities law authorities, and Mercantile BrokerageServices, Inc. are also subject to regulation by the National Association ofSecurities Dealers, Inc.  Retail sales ofinsurance and securities products by Mercantile Agency, Inc. and MercantileBrokerage Services, Inc. are also subject to the requirements of theInteragency Statement on Retail Sales of Nondeposit Investment Productspromulgated in 1994 by the FDIC, the Federal Reserve Board, the Comptroller ofthe 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 national supply of bank credit in order toachieve economic results deemed appropriate by its Federal Reserve Board,including efforts to combat unemployment, recession or inflationarypressures.  Among the instruments ofmonetary policy used to implement these objectives are open market operationsin the purchase and sale of U.S. Government securities, changes in the discountrate charged on bank borrowings and changes in reserve requirements againstbank deposits.  These means are used invarying combinations to influence the general level of interest rates and thegeneral availability of credit.  Morespecifically, actions by the Federal Reserve Board influence the levels ofinterest rates paid on deposits and other bank funding sources and charged on bankloans as well as the level of availability of bank funds with which loans andinvestments can be made.

 

**Cautionary Statement**

 

This AnnualReport on Form 10-K contains forward-looking statements, within the meaning ofand pursuant to the safe harbor provisions of the Private Securities LitigationReform Act of 1995.  A forward-lookingstatement encompasses any estimate, prediction, opinion or statement of beliefcontained in 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 level of interest rates, business strategies and services, continuation or development of specified lending and other activities,credit quality, predictions or assessments related to determination andadequacy of loan loss allowances, monitored loans, internal controls, taxaccounting, importance and effects of capital levels, effects of assetsensitivity and interest rates, earnings simulation model projections, effortsto mitigate market 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

 

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conditions, and results may ultimately vary from the statements made inthis report.  The following factors,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 margins andadversely affect net interest income; (2) results may be adversely affected bycontinued diversification of assets and adverse changes to credit quality; (3)economic slowdown could adversely affect credit quality and loan originations;(4) loan growth may not improve to a degree that would help offset continuingpressure on net interest margin; (5) adverse governmental or regulatory policiesmay be enacted; (6) the expected growth opportunities or cost savings from ourmerger with Community Bank of Northern Virginia may not be fully realized ormay take longer to realize than expected; (7) Community Bank of Northern Virginia’s actual earnings may not be asstrong as projected; (8) declines in equity and bond markets may adverselyaffect IWM revenues; and  (9) theinability to manage adequately the spread between yields on earning assets andcost of funds could adversely affect results.

 

**Website Access To Information**

 

Bankshares’ annual reports on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K and all amendments to thosereports may be accessed through Bankshares’ website as soon as reasonablypracticable after such material is electronically filed with the Securities andExchange Commission.  Bankshares’ websiteis www.mercantile.com.

 

ITEM 2.                             PROPERTIES

 

The main offices of Bankshares and MSD&T are located in a 21-storybuilding at Two Hopkins Plaza in Baltimore, Maryland, which is owned by MBCRealty, LLC, a wholly-owned subsidiary of Harbor Group International,L.L.C.  Pursuant to a lease agreement byand between MBC 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 of back office and storage space at Two Hopkins Plaza, for aterm of ten years.  At December 31, 2004,MSD&T and Bankshares occupied approximately 206,000 square feet. The leaseagreement contains two five-year renewal options. The lease agreement requiresaggregate annual rent of approximately $3,900,000 in 2005. At December 31,2004, Bankshares also occupied approximately 132,000 square feet of leasedspace in a building located in Linthicum, Maryland, in which its operations andcertain other departments are located, and a 7,000 square foot call centerfacility in Federalsburg, Maryland. The Linthicum and Federalsburg propertiesare owned by Bankshares. Of the 226 banking offices, 111 are owned in fee, 32are owned subject to ground leases and 83 are leased, with aggregate annualrentals of approximately $ 8,797,000 as of December 31, 2004.

 

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ITEM 3.                             LEGAL PROCEEDINGS

 

OnJuly 12, 2004 former employee John Pileggi filed suit against Bankshares,MSD&T and Edward J. Kelly. The complaint alleges that the public statementsmade by the defendants regarding the circumstances of Mr. Pileggi’s terminationgives rise to claims of libel, invasion of privacy and false light. Mr. Pileggialso alleges breach of contract. The complaint seeks actual and punitivedamages amounting to $240 million. MSD&T terminated Mr. Pileggi’semployment on March 18, 2004 for the reasons set out in a press release ofthat same date. Bankshares believes the suit is without merit.

 

OnSeptember 27, 2004, Bankshares and MSD&T filed a countersuit againstMr. Pileggi.  The countersuit alleges that Mr. Pileggi, during his employmentwith MSD&T, engaged in activities that constituted fraud, breach ofcontract, and breach of his fiduciary duty to MSD&T, including, but notlimited to, the activity described in MSD&T’s press release datedMarch 18, 2004.  The countersuit seeks compensatory and punitivedamages amounting to $8,200,000, along with other appropriate relief.

 

ITEM 4.                             SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

No matter was submitted during the fourth quarter of thefiscal year covered by this Report to a vote of security holders which isrequired to be disclosed pursuant to the instructions contained in the form forthis Report.

 

SPECIAL ITEM:  EXECUTIVEOFFICERS OF THE REGISTRANT

 

The members of Bankshares’ holding company managementcommittee are:

 
| **Name**                | ** ** | **Position**                                                | ** ** | **Age** |
|-------------------------|------------|-------------------------------------------------------------|------------|---------|
|                    |       |                                                        |       |    |
| Edward J. Kelly, III    |       | Chairman, President and Chief Executive  Officer            |       | 51      |
| Alexander T. Mason      |       | Vice Chairman and Chief Operating Officer,                  |       | 53      |
|                    |       | Bankshares                                                  |       |    |
| J. Marshall Reid        |       | President and Chief Operating Officer,  MSD&T           |       | 59      |
| Kenneth A. Bourne, Jr.  |       | Executive Vice President, Banking Division,  MSD&T      |       | 62      |
| Peter W. Floeckher, Jr. |       | Executive Vice President, Affiliate  Management, Bankshares |       | 55      |
| Jay M. Wilson           |       | Vice Chairman, Bankshares; Chief Executive  Officer,        |       |    |
|                    |       | Investment and Wealth Management                            |       | 58      |

 

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| Kevin A. McCreadie      |   | Chief Investment Officer, Investment and                  |   | 44     |
|-------------------------|--------|-----------------------------------------------------------|--------|--------|
|                    |   | Wealth Management                                         |   |   |
| Terry L. Troupe         |   | Executive Vice President and Chief  Financial Officer,    |   |   |
|                    |   | Bankshares                                                |   | 57     |
| John L. Unger           |   | Executive Vice President and General  Counsel, Bankshares |   | 51     |
| Michael M. Paese        |   | Executive Vice President, Chief  Administrative Officer,  |   |   |
|                    |   | Chief Risk Officer and Deputy  General Counsel,           |   |   |
|                    |   | Bankshares                                                |   | 37     |
| Deborah A. Kakaris      |   | Executive Vice President, Operations and                  |   |   |
|                    |   | Technology Services,  Bankshares                          |   | 41     |
| Frank K. Turner, Jr.    |   | Executive Vice President, Corporate and  Correspondent    |   |   |
|                    |   | Banking Services, Bankshares                              |   | 49     |
| Priscilla S. Hoblitzell |   | Senior Vice President, Investment Banking/                |   |   |
|                    |   | Strategic Planning, Bankshares                            |   | 44     |
| Kaye A. Simmons         |   | Senior Vice President and Treasurer,  Bankshares          |   | 49     |
| Ellen D. Harvey         |   | Senior Vice President, Fixed Income  Portfolio            |   |   |
|                    |   | Manager, Bankshares                                       |   | 51     |

 

No familyrelationships, as defined by the rules and regulations of the Securities andExchange Commission, exist among any of the Executive Officers.  Allofficers are elected annually by the Board of Directors and hold office at thepleasure of the Board.

 

Effective March 1, 2001, Mr. Kelly became President and Chief Executiveof Bankshares and Chairman of the Board and Chief Executive Officer ofMSD&T.  In addition, effective March1, 2003 Mr. Kelly became Chairman of Bankshares. Mr. Kelly served as ManagingDirector, Head of Global Financial Institutions, and as Co-Head of InvestmentBanking Client Management of J. P. Morgan, Chase & Co. during January,2001.  Prior thereto, he was a ManagingDirector of J. P. Morgan & Co. Incorporated and held the followingadditional positions with that Company: Head, Global Financial Institutionsfrom February, 2000 through December, 2000; Co-Head, Global FinancialInstitutions and Head, Latin America Investment Banking from December, 1997through February, 2000; Member, Global Investment Banking Committee fromDecember, 1997 through December, 2000; and Co-Head, Financial Institutions(Americas) from February, 1996 through December, 1997.

 

Mr. Mason joined Bankshares in November, 2003, and is Vice Chairman ofBankshares.  Effective January 2, 2005,he was named Bankshares’ Chief Operating Officer. Prior to joining Bankshares,he was Vice Chairman of Deutsche Bank in the Americas and Managing Director ofDeutsche Bank Securities.  He also servedas chief operating officer of the firm’s Global Corporate Finance Departmentand headed up the

 

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firms Global Industry Group practice.  He was elected a director of MSD&T inJanuary, 2005, and a director of Bankshares in January, 2005.

 

Mr. Reid was elected President and Chief Operating Officer of MSD&Tin September, 1997. He joined MSD&T as a Senior Vice President in 1993 andserved as an Executive Vice President from 1994 until September, 1997.

 

Mr. Bourne has been an Executive Vice President of MSD&T since1989.  He joined the bank as a trainee in1970.

 

Mr. Floeckher was appointed Executive Vice President and Head of theAffiliates for Bankshares in November, 2003. He served as President and Chief Executive Officer of Citizens NationalBank from 1995 until November, 2003.  Mr.Floeckher is responsible for oversight of the Banks, which includes riskmanagement, compliance and enhanced performance through coordinated sharing ofbest practices.

 

Mr. Wilson has been a Vice Chairman of Bankshares, and Chief ExecutiveOfficer of the Investment and Wealth Management Division of MSD&T sinceJanuary 2005.  From September 1998 untilDecember 2004, he was General Partner of Spring Capital Partners, L.P., aprivate equity fund providing expansion and acquisition capital to emerginggrowth companies.  He was elected adirector of MSD&T in January 2005, and a director of Bankshares in January2005.

 

Mr. McCreadie joined the Investment and Wealth Management Division ofMSD&T in 2002, and is the Chief Investment Officer of that Division.Previously, he was a Partner at Brown Investment Advisory & Trust Company,from 1999-2002, where he was a Senior Portfolio Manager and Co-head ofPortfolio Management, and a member of the firm’s Investment and OperatingCommittees.  Prior to that,Mr. McCreadie was a Vice President and Portfolio Manager for J.P. MorganInvestment Management, where he was employed from 1981-1999.

 

Mr. Troupe has been Chief Financial Officer of Bankshares and MSD&Tsince September, 1996.

 

Mr. Unger became General Counsel on March 23, 2002 and was electedSecretary of Bankshares and MSD&T on July 1, 2002.  Prior to joining Bankshares, Mr. Unger wasGeneral Counsel to IMI Resort Holdings, Inc., a privately held real estatecompany in Greenville, South Carolina.

 

Mr. Paese was named Chief Administrative Officer of Bankshares inNovember, 2003, is Deputy General Counsel, and became Chief Risk Officer onJanuary 2, 2005.  He joined MSD&T asa Senior Vice President in January, 2003. Before joining Mercantile, Mr. Paese was Senior Counsel to the FinancialServices Committee of the U.S. House of Representatives (minority).  Mr. Paese advised the Committee on legal andpolicy issues relating to U.S. capital markets and corporate governance.  Prior thereto, Mr. Paese was Vice Presidentin equity capital markets, at J .P. Morgan & Co. Incorporated.  Prior thereto, Mr. Paese was an associate atDavis, Polk & Wardwell.

 

Mrs. Kakaris has been an Executive Vice President of Bankshares andMSD&T since 2002.  She is responsiblefor Operations and Technology Services.  Mrs. Kakaris joined the bank in 1988 andserved as a Senior Vice President from 1997 until March, 2002.

 

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Mr. Turner is an Executive Vice President of Bankshares andMSD&T.  Mr. Turner began his bankingcareer with Mercantile in 1978.  He iscurrently responsible for the syndicated lending, correspondent banking andprivate equity groups.

 

Ms. Hoblitzell joined Bankshares as a Senior Vice President in April,2003.  Prior to joining Bankshares, shewas self-employed.  Prior thereto, Ms.Hoblitzell was a Vice President at Goldman, Sachs & Co.

 

Ms. Simmons joined Bankshares in 2003, after the merger with F&MBancorp.  She had been Treasurer ofF&M Bancorp since 2000 and Executive Vice President and Chief FinancialOfficer of Farmers & Mechanics Bank since 2000. Prior to that time,Ms. Simmons served as Senior Vice President of Finance and Treasurer ofCitizens Bancorp from 1989 to 1997.

 

Ms. Harvey joined Bankshares in 2003 as a Senior Vice President andFixed Income Portfolio Manager.  FromApril, 2000 until December, 2002, she was a partner and manager of Fixed Incomewith Brown Advisory in Baltimore. Previously, she was a principal of Morgan Stanley from January, 1996until December, 1999, where she served as Fixed Income Portfolio Manager.

 

#### PARTII

 

ITEM 5.          MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDERMATTERS 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.

 

**ISSUER PURCHASES OF EQUITY SECURITIES**

 
| **Period**                                | ** ** | **Total Number of  Shares Purchased** | ** ** | **Average Price  Paid Per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number (or  Approximate Dollar Value)  of Shares that May Yet Be  Purchased Under the Plan  or Programs** | ** **  |
|-------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|-------------|
| October 1, 2004 – October 31, 2004   | ** ** | **0**                                 | ** ** | **—**                        | ** ** | **0**                                                                                    | ** ** | **476,327**                                                                                                         | ** **  |
|                                      |       |                                  |       |                              |       |                                                                                     |       |                                                                                                                |        |
| November 1, 2004 – November 30, 2004 | ** ** | **6,886**                             | **(1)**    | **$**                             | **50.93**  | ** **                                                                               | **0**      | ** **                                                                                                          | **476,327** | ** ** |
|                                      |       |                                  |       |                              |       |                                                                                     |       |                                                                                                                |        |
| December 1, 2004 – December 31, 2004 | ** ** | **0**                                 | ** ** | **—**                        | ** ** | **0**                                                                                    | ** ** | **476,327**                                                                                                         | ** **  |
|                                           |            |                                       |            |                                   |            |                                                                                          |            |                                                                                                                     |             |  |

 

----

(1)  Representsoutstanding shares surrendered in connection with exercise of options.

 

21

----

 

ITEM 6.                             SELECTED FINANCIAL DATA

 

Five-YearSelected Financial Data

 
| **Years  Ended December 31,**                      | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars  in thousands, except per share data)** | ** ** | **2004**       | ** **     | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
| NET INTEREST INCOME                                | ** ** | **$**          | **545,781**    |       | $          | 472,349    |       | $          | 441,035    |       | $          | 417,327 |   | $ | 408,434 |   |
| NET INCOME                                         | ** ** | **$**          | **229,407**    |       | $          | 196,814    |       | $          | 190,238    |       | $          | 181,295 |   | $ | 175,230 |   |
| NET INCOME PER SHARE OF COMMON  STOCK              |       |           |           |       |       |       |       |       |       |       |       |
| Basic                                              | ** ** | **$**          | **2.90**       |       | $          | 2.70       |       | $          | 2.74       |       | $          | 2.57 |   | $ | 2.53 |   |
| Diluted                                            | ** ** | **$**          | **2.87**       |       | $          | 2.68       |       | $          | 2.72       |       | $          | 2.55 |   | $ | 2.51 |   |
| TOTAL ASSETS                                       | ** ** | **$**          | **14,425,690** |       | $          | 13,695,472 |       | $          | 10,790,376 |       | $          | 9,928,786 |   | $ | 8,938,030 |   |
| LONG-TERM DEBT                                     | ** ** | **$**          | **690,955**    |       | $          | 647,722    |       | $          | 287,214    |       | $          | 269,437 |   | $ | 92,547 |   |
| PROVISION FOR LOAN LOSSES                          | ** ** | **$**          | **7,221**      |       | $          | 12,105     |       | $          | 16,378     |       | $          | 13,434 |   | $ | 17,231 |   |
| PER SHARE CASH DIVIDENDS                           |       |           |           |       |       |       |       |       |       |       |       |
| Common                                             | ** ** | **$**          | **1.38**       |       | $          | 1.29       |       | $          | 1.18       |       | $          | 1.10 |   | $ | 1.02 |   |
| CASH DIVIDENDS DECLARED AND  PAID                  |       |           |           |       |       |       |       |       |       |       |       |
| On common stock                                    | ** ** | **$**          | **109,295**    |       | $          | 95,842     |       | $          | 81,909     |       | $          | 77,597 |   | $ | 70,641 |   |
| YEAR-END LOAN DATA                                 |       |           |           |       |       |       |       |       |       |       |       |
| Commercial                                         | ** ** | **$**          | **2,820,752**  |       | $          | 2,577,021  |       | $          | 2,300,956  |       | $          | 2,228,750 |   | $ | 2,215,039 |   |
| Commercial real estate                             | ** ** | **3,115,274**  |           | 2,738,832  |       | 2,016,307  |       | 1,819,268  |       | 1,409,987  |       |
| Construction                                       | ** ** | **1,268,350**  |           | 1,064,021  |       | 810,985    |       | 652,486    |       | 824,752    |       |
| Residential real estate                            | ** ** | **1,486,106**  |           | 1,335,375  |       | 1,066,694  |       | 1,060,519  |       | 1,086,674  |       |
| Consumer                                           | ** ** | **989,121**    |           | 1,067,360  |       | 775,673    |       | 801,474    |       | 832,206    |       |
| Home equity lines                                  | ** ** | **495,462**    |           | 415,500    |       | 239,232    |       | 189,867    |       | 168,944    |       |
| Lease financing                                    | ** ** | **53,368**     |           | 74,051     |       | 102,180    |       | 153,882    |       | 155,692    |       |
| Total loans                                        | ** ** | **10,228,433** |           | 9,272,160  |       | 7,312,027  |       | 6,906,246  |       | 6,693,294  |       |
| Less:                                              |       |           |           |       |       |       |       |       |       |       |       |
| Allowance for loan losses                          | ** ** | **(149,002**   | )              | (155,337   | )          | (138,601   | )          | (141,463   | )          | (138,612   | )          |
| Loans, net                                         | ** ** | **$**          | **10,079,431** |       | $          | 9,116,823  |       | $          | 7,173,426  |       | $          | 6,764,783 |   | $ | 6,554,682 |   |

 

22

----

 

Five-YearSummary of Consolidated Income

 
| **Years  Ended December 31,**                        | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars  in thousands)**                          | ** ** | **2004**    | ** **  | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
| INTEREST INCOME                                      |       |        |        |       |       |       |       |       |       |       |       |
| Interest and fees on loans                           | ** ** | **$**       | **546,531** |       | $          | 472,943    |       | $          | 468,678    |       | $          | 543,242 |   | $ | 548,360 |   |
| Interest and dividends on  securities                | ** ** | **111,003** |        | 113,254    |       | 112,091    |       | 99,624     |       | 95,736     |       |
| Other interest income                                | ** ** | **1,503**   |        | 3,397      |       | 4,848      |       | 5,986      |       | 1,448      |       |
| Total interest income                                | ** ** | **659,037** |        | 589,594    |       | 585,617    |       | 648,852    |       | 645,544    |       |
| INTEREST EXPENSE                                     |       |        |        |       |       |       |       |       |       |       |       |
| Interest on deposits                                 | ** ** | **83,403**  |        | 93,190     |       | 122,569    |       | 199,703    |       | 182,448    |       |
| Interest on short-term  borrowings                   | ** ** | **7,844**   |        | 5,604      |       | 11,259     |       | 25,120     |       | 48,711     |       |
| Interest on long-term debt                           | ** ** | **22,009**  |        | 18,451     |       | 10,754     |       | 6,702      |       | 5,951      |       |
| Total interest expense                               | ** ** | **113,256** |        | 117,245    |       | 144,582    |       | 231,525    |       | 237,110    |       |
| NET INTEREST INCOME                                  | ** ** | **545,781** |        | 472,349    |       | 441,035    |       | 417,327    |       | 408,434    |       |
| Provision for loan losses                            | ** ** | **7,221**   |        | 12,105     |       | 16,378     |       | 13,434     |       | 17,231     |       |
| NET INTEREST INCOME AFTER PROVISION  FOR LOAN LOSSES |       | **538,560** |        | 460,244    |       | 424,657    |       | 403,893    |       | 391,203    |       |
| NONINTEREST INCOME                                   |       |        |        |       |       |       |       |       |       |       |       |
| Investment and wealth  management                    | ** ** | **90,050**  |        | 78,933     |       | 68,435     |       | 69,331     |       | 69,850     |       |
| Service charges on deposit  accounts                 | ** ** | **44,263**  |        | 39,194     |       | 33,539     |       | 30,101     |       | 26,194     |       |
| Other income                                         | ** ** | **79,616**  |        | 65,445     |       | 42,545     |       | 46,972     |       | 30,448     |       |
| Total noninterest income                             | ** ** | **213,929** |        | 183,572    |       | 144,519    |       | 146,404    |       | 126,492    |       |
| NONINTEREST EXPENSES                                 |       |        |        |       |       |       |       |       |       |       |       |
| Salaries and employee benefits                       | ** ** | **232,297** |        | 198,043    |       | 165,371    |       | 152,887    |       | 140,391    |       |
| Net occupancy and equipment  expenses                | ** ** | **55,746**  |        | 52,366     |       | 40,368     |       | 38,448     |       | 34,607     |       |
| Amortization of goodwill                             | ** ** | **—**  |        | —     |       | —     |       | 9,072      |       | 5,213      |       |
| Other expenses                                       | ** ** | **103,915** |        | 87,038     |       | 66,869     |       | 63,552     |       | 63,294     |       |
| Total noninterest expenses                           | ** ** | **391,958** |        | 337,447    |       | 272,608    |       | 263,959    |       | 243,505    |       |
| Income before income taxes                           | ** ** | **360,531** |        | 306,369    |       | 296,568    |       | 286,338    |       | 274,190    |       |
| Applicable income taxes                              | ** ** | **131,124** |        | 109,555    |       | 106,330    |       | 105,043    |       | 98,960     |       |
| NET INCOME                                           | ** ** | **$**       | **229,407** |       | $          | 196,814    |       | $          | 190,238    |       | $          | 181,295 |   | $ | 175,230 |   |

 

23

----

 

Five-YearStatistical Summary

 
| **Years  Ended December 31,**      | ** ** | ** **    | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------|------------|---------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars  in thousands)**        | ** ** | **2004**      | ** **     | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
| AVERAGE BALANCE SHEET  STATISTICS  |       |          |           |       |       |       |       |       |       |       |       |
| Loans:                             |       |          |           |       |       |       |       |       |       |       |       |
| Commercial                         | ** ** | **$**         | **2,733,580**  |       | $          | 2,485,622  |       | $          | 2,371,395  |       | $          | 2,412,371 |   | $ | 2,240,283 |   |
| Commercial real estate             | ** ** | **2,919,840** |           | 2,309,712  |       | 1,911,927  |       | 1,565,964  |       | 1,294,615  |       |
| Construction                       | ** ** | **1,144,044** |           | 929,939    |       | 733,237    |       | 795,931    |       | 738,393    |       |
| Residential real estate            | ** ** | **1,444,148** |           | 1,171,194  |       | 1,072,297  |       | 1,059,798  |       | 950,531    |       |
| Consumer                           | ** ** | **1,477,797** |           | 1,192,515  |       | 999,988    |       | 998,792    |       | 945,810    |       |
| Total loans                        | ** ** | **9,719,409** |           | 8,088,982  |       | 7,088,844  |       | 6,832,856  |       | 6,169,632  |       |
| Federal funds sold, et al          | ** ** | **59,848**    |           | 250,462    |       | 178,624    |       | 141,245    |       | 29,434     |       |
| Securities:                        |       |          |           |       |       |       |       |       |       |       |       |
| U.S. Government obligations        | ** ** | **1,551,141** |           | 1,731,032  |       | 2,089,004  |       | 1,705,543  |       | 1,628,477  |       |
| States and political  subdivisions | ** ** | **94,308**    |           | 69,888     |       | 38,799     |       | 40,359     |       | 25,170     |       |
| Mortgage-backed securities         | ** ** | **1,250,947** |           | 927,235    |       | 216,391    |       | 48,203     |       | 21,252     |       |
| Other investments (1)              | ** ** | **57,351**    |           | 29,889     |       | 9,489      |       | 9,188      |       | 7,031      |       |
| Total securities                   | ** ** | **2,953,747** |           | 2,758,044  |       | 2,353,683  |       | 1,803,293  |       | 1,681,930  |       |
| Total earning assets               | ** ** | **$**         | **12,733,004** |       | $          | 11,097,488 |       | $          | 9,621,151  |       | $          | 8,777,394 |   | $ | 7,880,996 |   |
| Deposits:                          |       |          |           |       |       |       |       |       |       |       |       |
| Noninterest-bearing deposits       | ** ** | **$**         | **2,879,290**  |       | $          | 2,269,720  |       | $          | 1,856,706  |       | $          | 1,618,838 |   | $ | 1,438,578 |   |
| Savings deposits (2)               | ** ** | **4,286,180** |           | 3,597,185  |       | 2,936,197  |       | 2,471,674  |       | 2,345,808  |       |
| Time deposits                      | ** ** | **3,248,222** |           | 3,124,949  |       | 2,839,507  |       | 2,958,158  |       | 2,412,468  |       |
| Total deposits                     | ** ** | **$**         | **10,413,692** |       | $          | 8,991,854  |       | $          | 7,632,410  |       | $          | 7,048,670 |   | $ | 6,196,854 |   |
| Borrowed funds:                    |       |          |           |       |       |       |       |       |       |       |       |
| Short-term borrowings              | ** ** | **$**         | **932,493**    |       | $          | 851,348    |       | $          | 845,938    |       | $          | 744,907 |   | $ | 860,241 |   |
| Long-term debt                     | ** ** | **645,375**   |           | 517,386    |       | 279,471    |       | 117,823    |       | 87,679     |       |
| Total borrowed funds               | ** ** | **$**         | **1,577,868**  |       | $          | 1,368,734  |       | $          | 1,125,409  |       | $          | 862,730 |   | $ | 947,920 |   |
| AVERAGE RATES (3)                  |       |          |           |       |       |       |       |       |       |       |       |
| Loans:                             |       |          |           |       |       |       |       |       |       |       |       |
| Commercial                         | ** ** | **5.31**      | **%**          | 5.44       | %          | 6.26       | %          | 7.88       | %          | 9.33       | %          |
| Commercial real estate             | ** ** | **5.95**      |           | 6.16       |       | 6.85       |       | 8.16       |       | 8.84       |       |
| Construction                       | ** ** | **5.46**      |           | 5.41       |       | 6.09       |       | 7.96       |       | 9.66       |       |
| Residential real estate            | ** ** | **5.90**      |           | 6.46       |       | 7.30       |       | 7.94       |       | 7.98       |       |
| Consumer                           | ** ** | **5.72**      |           | 6.25       |       | 7.12       |       | 8.28       |       | 8.70       |       |
| Total loans                        | ** ** | **5.67**      |           | 5.91       |       | 6.68       |       | 8.02       |       | 8.96       |       |
| Federal funds sold, et al          | ** ** | **2.51**      |           | 1.33       |       | 2.71       |       | 4.23       |       | 4.89       |       |
| Securities:                        |       |          |           |       |       |       |       |       |       |       |       |
| U.S. Government obligations        | ** ** | **3.69**      |           | 4.25       |       | 4.67       |       | 5.48       |       | 5.67       |       |
| States and political  subdivisions | ** ** | **5.73**      |           | 6.50       |       | 8.08       |       | 8.17       |       | 8.26       |       |
| Mortgage-backed securities         | ** ** | **3.85**      |           | 3.90       |       | 5.59       |       | 7.47       |       | 7.48       |       |
| Other investments (1)              | ** ** | **4.17**      |           | 2.90       |       | 6.78       |       | 8.21       |       | 10.07      |       |
| Total securities                   | ** ** | **3.83**      |           | 4.19       |       | 4.82       |       | 5.61       |       | 5.75       |       |
| Composite rate earned              | ** ** | **5.23**      | **%**          | 5.37       | %          | 6.15       | %          | 7.47       | %          | 8.26       | %          |
| Deposits:                          |       |          | ** **     |       |       |       |       |       |       |       |       |
| Savings deposits (2)               | ** ** | **0.37**      | **%**          | 0.46       | %          | 0.87       | %          | 1.62       | %          | 2.06       | %          |
| Time deposits                      | ** ** | **2.08**      |           | 2.45       |       | 3.42       |       | 5.40       |       | 5.56       |       |
| Total interest-bearing deposits    | ** ** | **1.11**      |           | 1.39       |       | 2.12       |       | 3.68       |       | 3.83       |       |
| Borrowed funds:                    |       |          |           |       |       |       |       |       |       |       |       |
| Short-term borrowings              | ** ** | **0.84**      |           | 0.66       |       | 1.33       |       | 3.37       |       | 5.66       |       |
| Long-term debt                     | ** ** | **3.41**      |           | 3.57       |       | 3.85       |       | 5.69       |       | 6.79       |       |
| Total borrowed funds               | ** ** | **1.89**      |           | 1.76       |       | 1.96       |       | 3.69       |       | 5.77       |       |
| Composite rate paid                | ** ** | **1.24**      | **%**          | 1.45       | %          | 2.10       | %          | 3.68       | %          | 4.16       | %          |

 

----

(1)  Includes interest-bearing deposits in otherbanks.

(2)  Includes savings, checking plus interest andmoney market deposit accounts.

(3)  Presented on a tax-equivalent basis.

 

24

----

 

 
| **Years  Ended December 31,**                                           | ** ** | ** **  | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------|------------|-------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars  in thousands)**                                             | ** ** | **2004**    | ** **     | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
| RETURN ON EQUITY AND ASSETS                                             |       |        |           |       |       |       |       |       |       |       |       |
| Average total assets                                                    | ** ** | **$**       | **13,992,971** |       | $          | 11,971,581 |       | $          | 10,123,457 |       | $          | 9,227,202 |   | $ | 8,299,316 |   |
| Average shareholders’ equity                                       | ** ** | **$**       | **1,871,670**  |       | $          | 1,497,145  |       | $          | 1,257,967  |       | $          | 1,197,058 |   | $ | 1,054,071 |   |
| Return on average total assets                                          | ** ** | **1.64**    | **%**          | 1.64       | %          | 1.88       | %          | 1.96       | %          | 2.11       | %          |
| Return on average shareholders’  equity                            | ** ** | **12.26**   | **%**          | 13.15      | %          | 15.12      | %          | 15.15      | %          | 16.62      | %          |
| Average shareholders’ equity as  a percent of average total assets | ** ** | **13.38**   | **%**          | 12.51      | %          | 12.43      | %          | 12.97      | %          | 12.70      | %          |
| Dividends paid per share as a  percent of basic net income per share    | ** ** | **47.6**    | **%**          | 47.8       | %          | 43.1       | %          | 42.8       | %          | 40.3       | %          |
|                                                                    |       |        |           |       |       |       |       |       |       |       |       |
| SOURCES OF INCOME                                                       |       |        |           |       |       |       |       |       |       |       |       |
| Commercial loans                                                        | ** ** | **16.3**    | **%**          | 17.1       | %          | 19.9       | %          | 23.4       | %          | 26.5       | %          |
| Commercial real estate loans                                            | ** ** | **19.8**    |           | 18.2       |       | 17.9       |       | 16.0       |       | 14.8       |       |
| Construction loans                                                      | ** ** | **7.1**     |           | 6.3        |       | 5.9        |       | 7.9        |       | 9.2        |       |
| Residential real estate loans                                           | ** ** | **9.7**     |           | 9.8        |       | 10.7       |       | 10.6       |       | 9.8        |       |
| Consumer loans                                                          | ** ** | **9.7**     |           | 9.6        |       | 9.8        |       | 10.4       |       | 10.7       |       |
| Federal funds sold, et al                                               | ** ** | **0.2**     |           | 0.4        |       | 0.6        |       | 0.8        |       | 0.2        |       |
| Securities                                                              | ** ** | **12.7**    |           | 14.9       |       | 15.4       |       | 12.5       |       | 12.4       |       |
| Total interest income                                                   | ** ** | **75.5**    |           | 76.3       |       | 80.2       |       | 81.6       |       | 83.6       |       |
| Investment and wealth  management                                       | ** ** | **10.3**    |           | 10.2       |       | 9.4        |       | 8.7        |       | 9.1        |       |
| Other income                                                            | ** ** | **14.2**    |           | 13.5       |       | 10.4       |       | 9.7        |       | 7.3        |       |
| Total income                                                            | ** ** | **100.0**   | **%**          | 100.0      | %          | 100.0      | %          | 100.0      | %          | 100.0      | %          |
|                                                                    |       |        |           |       |       |       |       |       |       |       |       |
| NET INTEREST INCOME  (Tax Equivalent)                                   |       |        |           |       |       |       |       |       |       |       |       |
| Interest earned:                                                        |       |        |           |       |       |       |       |       |       |       |       |
| Loans                                                                   | ** ** | **$**       | **551,062**    |       | $          | 477,840    |       | $          | 473,500    |       | $          | 548,192 |   | $ | 552,966 |   |
| Federal funds sold, et al                                               | ** ** | **1,501**   |           | 3,337      |       | 4,833      |       | 5,968      |       | 1,439      |       |
| Taxable securities                                                      | ** ** | **107,814** |           | 110,634    |       | 110,342    |       | 97,818     |       | 94,674     |       |
| Tax-exempt securities                                                   | ** ** | **5,404**   |           | 4,543      |       | 3,135      |       | 3,298      |       | 2,080      |       |
| Total interest income                                                   | ** ** | **665,781** |           | 596,354    |       | 591,810    |       | 655,276    |       | 651,159    |       |
| Interest paid:                                                          |       |        |           |       |       |       |       |       |       |       |       |
| Savings deposits                                                        | ** ** | **15,680**  |           | 16,520     |       | 25,536     |       | 39,993     |       | 48,362     |       |
| Time deposits                                                           | ** ** | **67,723**  |           | 76,670     |       | 97,033     |       | 159,710    |       | 134,086    |       |
| Total interest-bearing deposits                                         | ** ** | **83,403**  |           | 93,190     |       | 122,569    |       | 199,703    |       | 182,448    |       |
| Short-term borrowings                                                   | ** ** | **7,844**   |           | 5,604      |       | 11,259     |       | 25,120     |       | 48,711     |       |
| Long-term debt                                                          | ** ** | **22,009**  |           | 18,451     |       | 10,754     |       | 6,702      |       | 5,951      |       |
| Total interest expense                                                  | ** ** | **113,256** |           | 117,245    |       | 144,582    |       | 231,525    |       | 237,110    |       |
| Net interest income                                                     | ** ** | **$**       | **552,525**    |       | $          | 479,109    |       | $          | 447,228    |       | $          | 423,751 |   | $ | 414,049 |   |
|                                                                         |            |             |                |            |            |            |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

25

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ITEM 7.      MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 

 

I. EXECUTIVEOVERVIEW

 

 Mercantile Bankshares Corporation (“Bankshares”)is a regional multibank holding company headquartered in Baltimore, Maryland.At December 31, 2004, Bankshares had $14.4 billion in assets, $10.2 billion inloans and $10.8 billion in deposits. The two principal lines of business areBanking and Investment & Wealth Management (“IWM”), delivered through thelead bank Mercantile-Safe Deposit and Trust Company (“MSD&T”) and 12affiliated banks. See “Segment Reporting” below for more information.

 

 Bankshares recorded its 29thconsecutive year of increased net income in 2004. Net income for Bankshares was$229.4 million for the year ended December 31, 2004, compared with $196.8million for the year 2003.  Diluted netincome per common share for 2004 increased by 7.1% to $2.87 compared with $2.68for 2003. The most noteworthy factors affecting 2004 earnings were the successfulintegration of F&M Bancorp (“Farmers”), the consolidation of 11 bankaffiliates into four (“the Affiliate Bank Rationalization”), improvement in thenet interest margin, growth in loans, improving credit quality and improvedprofit contribution from the IWM division.

 

 On August 12, 2003, Bankshares completed itsacquisition of Farmers, a bank holding company headquartered in Frederick,Maryland.  On the date of purchase,Farmers had total loans of $1.4 billion, total investment securities of $638.0million, total earning assets of $2.0 billion and total deposits of $1.7billion.  There were 10.4 million sharesissued in connection with the acquisition, which was accounted for as apurchase and resulted in total consideration paid of $558.1 million (includingthe cash component).  Farmers is thesecond largest affiliate bank in the organization behind only MSD&T intotal assets.  The results of operationsand balances for Farmers are included in the consolidated financial statementsfrom the merger date forward. Bankshares recorded $385.9 million of goodwill,$36.0 million of core deposit intangible, $5.8 million of client relationshipintangibles and $1.1 million in other identified intangible assets.

 

 In the third quarter of 2004, Banksharesconsolidated 11 affiliate banks into four banks. The consolidated banks sharedcommon markets. The consolidation of these banks allows the surviving banks toserve their local customers with greater size, scale and expertise. Thisinitiative was not undertaken to reduce operating costs, although some savingswill arise out of the consolidation. It was to enable these banks to streamlineoperating processes, controls and compliance efforts; recruit seasonedprofessionals to these markets; and provide a greater breadth of services atthe local level. Bankshares is highly committed to the affiliate bank model,whereby local boards of directors provide strong oversight, and bank presidentsmaintain strong relationships within the community. As with any strategicinitiative there are costs involved. In 2004, Banking incurred approximately$3.6 million in restructuring charges related to the consolidations. A majorityof these costs were in severance charges and other personnel costs ofapproximately $2.3 million and $1.1 million in legal and consulting fees. Managementexpects to achieve cost savings of not less than $3 million in 2005.

 

 In response to the improving economy, theBoard of Governors of the Federal Reserve System (“Federal Reserve Board”)began increasing short-term interest rates. After reducing short-term rates by50 basis points in 2002 and 25 basis points in 2003, the Federal Reserve Boardincreased short-term rates 125 basis points in 2004. By year-end 2004, thebenchmark targeted overnight federal funds rate had risen from 1.00% to 2.25%. Althoughthe net interest margin improved only 3 basis points to 4.35% for 2004 from4.32% for 2003, this compares very favorably with the 33 basis point declineexperienced during 2003. The net interest margin for 2002 was 4.65%. Mosteconomists are forecasting that the Federal Reserve Board will continue toraise short-term rates during 2005. If these forecasts are correct, Banksharesshould benefit from such action. See “Analysis of Interest Rate and InterestDifferentials” below and the discussions of “Net Interest Income” and “Interest Rate Risk” below.

 

 At December 31, 2004, loans outstanding were$10.2 billion, an increase of 10.3% over the $9.3 billion outstanding atDecember 31, 2003. Excluding initial balances acquired in acquisitions, thiswas the best year-end loan growth Bankshares has reported since year-endDecember 31, 2000. Much of the lending growth has been driven by the strongreal estate markets in both commercial and residential properties. An improvingeconomy also produced positive growth in the commercial and industrialportfolio.

 

 Credit quality measures improved on both anabsolute and relative basis. Nonperforming loans declined from $50.4 million ayear ago to $30.9 million at December 31, 2004. This is the lowest levelreported at year-end since December 31, 2000. Nonperforming loans as a percentof year-end loans were .30% at December 31, 2004. This is the lowest level atyear-end in more than 20 years. Reflecting these improvements, the provisionfor loan losses declined by $4.9 million to $7.2 million for the year endedDecember 31, 2004.

 

 The IWM Division includes the results fromBoyd Watterson Asset Management, LLC (“Boyd Watterson”), an investmentmanagement firm, and Peremel & Company, Inc. (“Peremel”), a directed anddiscount brokerage company, acquired on March 1, 2003 and April 1, 2003,respectively. In the aggregate, these companies were purchased forapproximately $29 million in cash.  TheBoyd Watterson acquisition has a potential additional contingent payment of upto $8.6 million based upon performance, among other factors. The contingentpayment will be recorded as goodwill, assuming specific metrics are met, andbecomes payable three years

 

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from theacquisition date.  Bankshares recordedapproximately $10.1 million of identified intangibles, mostly clientrelationships, as a result of these acquisitions.  These intangibles are amortized on astraight-line basis over a range of three to eight years.  Goodwill recorded on these transactionstotaled approximately $18.0 million at December 31, 2004. A combination of netnew business and improving equity markets produced a 15% increase in IWMnoninterest income. See “Segment Reporting” below for additional information. Atthe same time, growth in direct noninterest expense was held to 3%.Accordingly, the contribution to net income more than doubled to $11.6 millionin 2004, from $5.1 million in 2003.

 

 The year 2004 proved to be another year ofrelatively solid performance, as indicated by the standard industry measures ofreturn on average assets (“ROA”) and return on average shareholders’ equity (“ROE”).The 2004 ROA was 1.64%, unchanged from 2003. Primarily due to the equity issuedin the Farmers acquisition, Bankshares’ 2004 ROE decreased to 12.26% from13.15% in 2003. Average assets increased by 16.9%, or $2.0 billion; averagedeposits increased by 15.8%, or $1.4 billion; and average loans increased by20.2%, or $1.6 billion, for the year ended December 31, 2004 compared with theprior year. The respective increases in the 2004 average balances are largelyattributable to the inclusion of Farmers for a full year. Bankshares also reports cash operating earnings,defined as “GAAP” (Generally Accepted Accounting Principles) earnings excludingthe amortization of intangible assets associated with purchase accounting forbusiness combinations; securities gains and losses; and other significantgains, losses or expenses (such as those associated with integrating acquiredentities’ operations into Bankshares) unrelated to Bankshares’ core operations. Cash operating earnings totaled $235.5 million for 2004, an increase of17.7% over $200.2 million for 2003. Diluted cash operating earnings per share for 2004 were $2.95 comparedwith $2.73 for 2003.  A reconciliation ofGAAP basis net income to cash operating earnings can be found below under  “Non-GAAP Reconciliation.”

 

 Average shareholders’ equity to average assetswas at 13.38% for 2004, an increase from 12.51% for 2003. In the second quarterof 2004, 1 million shares at a cost of $44.1 million were repurchased underBankshares’ buyback plan. The buyback was accomplished by entering into aprivately negotiated agreement for the accelerated repurchase of these shares.In 2003, 5,500 shares were repurchased in the open market. At December 31,2004, Bankshares had remaining authorization to repurchase up to 476,327shares.

 

 Management believes that reporting several keymeasures based on tangible assets (total assets less intangible assets) andtangible equity (total equity less intangible assets) is important, as thismore closely approximates the basis for measuring the adequacy of capital forregulatory purposes. For the year 2004, return on average tangible assets was1.75% compared with 1.71% for 2003. The ratio of average tangible equity toaverage tangible assets for 2004 was 9.70% compared with 10.34% for 2003. Thedecline in average tangible equity to average tangible assets was largelyattributable to the use of $124.1 million of cash (or 25% of the considerationpaid) to acquire Farmers. A reconciliation of GAAP to non-GAAP measures isbelow. See “Non-GAAP Reconciliation.”

 

 The remaining sections of Management’sDiscussion and Analysis of Financial Condition and Results of Operations willprovide a more detailed explanation of the important trends and materialchanges in components of our financial statements. The discussion suggests thatsustaining future earnings growth comparable to our experience in past yearswill require, among other things, efficient generation of loan growth in acompetitive market, while maintaining an adequate spread between yields onearning assets and the cost of funds. Our degree of success in meeting thesegoals depends on unpredictable factors such as possible changes in prevailinginterest rates, the mix of deposits, credit quality and general economicconditions. This discussion and analysis should be read in conjunction with theconsolidated financial statements and other financial information presented inthis report.

 

NETINCOME

(Dollars in millions)

Five-YearCompound Growth Rate: 7.8%

 

 

DILUTEDEARNINGS PER SHARE

(In dollars)

Five-YearCompound Growth Rate: 5.0%

 

 

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TOTALASSETS

(Dollars in millions)December 31,

Five-YearCompound Growth Rate: 12.8%

 

 

INTERESTYIELDS AND RATES

(Tax-equivalent basis)

 

 

**CriticalAccounting Policies and Related Estimates**

 

 Set forth below is a discussion of theaccounting policies and related estimates that management believes are the mostcritical to understanding Bankshares’ consolidated financial statements,financial condition and results of operations, and which require complexmanagement judgments, uncertainties and/or estimates. Information regardingBankshares’ other accounting policies is included in Note No. 1 of thefinancial statements.

 

*InvestmentSecurities*

 

 Investment securities classified as “held-to-maturity”are acquired with the intent and ability to hold until maturity and are carriedat cost. Investment securities classified as “available-for-sale” are acquiredto be held for indefinite periods of time and may be sold in response tochanges in interest rates and/or prepayment risk or for liquidity managementpurposes. These securities are carried at fair value. Securities may becomeimpaired on an other-than-temporary basis, which involves a degree of judgment.Therefore, an assessment is made at the end of each quarter to determinewhether there have been any events or economic circumstances to indicate that asecurity is impaired on an other-than-temporary basis.  An other-than-temporary impairment maydevelop if, based on all available evidence, the carrying amount of theinvestment is not recoverable within a reasonable period of time.  Factors considered in making this assessmentinclude among others, the intent and ability to hold the investment for aperiod of time sufficient for a recovery in value, external credit ratings andrecent downgrades, market price fluctuations due to factors other than interestrates, and the probability of collection of contractual cash flows.  Securities on which there is an unrealizedloss that is deemed to be other-than-temporary are written down to fair value,and the adjustment is recorded as a realized loss.

 

*Allowancefor Loan Losses*

 

 Arriving at an appropriate level of allowancefor loan losses involves a high degree of judgment. Bankshares’ allowance forloan losses provides for probable losses based on evaluations of known andinherent risks in the loan portfolio. Management uses historical quantitativeinformation to assess the adequacy of the allowance for loan losses as well asqualitative information about the prevailing economic and business environmentamong other things. The allowance for loan losses is comprised of specificallocations to impaired loans, general allocations to pools of loans not deemedimpaired and an unallocated amount.

 

 The specific allowance allocation is based onan analysis of the loan portfolio. 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 possess certain qualities or characteristics thatmay lead to collection and loss issues. The identified loans are evaluated forpotential loss in accordance with Statement of Financial Accounting Standards("SFAS") No. 114 and SFAS No. 118 by analyzing current collateralvalues or present value of cash flows, as well as the capacity of theguarantor, as applicable.

 

 The general allowance calculation begins withsegmentation of the remaining (unimpaired) portfolio according to loan types.Historical loss factors are maintained for each loan type, providing thestarting point of the analysis. Historical loss factors are applied to allnon-Watchlist loans. Management is currently utilizing the past five-year losshistory specific to each major segment to perform the allocation. Historicalloss factors are adjusted to reflect the point in time that managementinitially identified a potential impairment loss in such risk-rated loans asopposed to when such loss is actually taken as a charge-off against theallowance. This adjustment is necessary, as Bankshares’ practice has generallybeen to work with its borrowers through their economic difficulties and recorda charge-off when all recovery efforts have been exhausted. Accordingly,historical losses may tend to lag the national and regional economic cycles.Bankshares also has developed data on probability of default and loss givendefault, which have been incorporated for the higher risk rated credits, whichinclude Watchlist loans that are not currently impaired. Those loss factors arethen applied to all loans within the same risk rating. Qualitative factors thatmay cause credit losses to deviate from average historical experience are thendeveloped. These include but are not limited to: changes in the volume andseverity of past due loans; changes in the volume of Watchlist loans andnonaccruals; concentrations in a specific industry or geographic location;administrative risk concerns that include changes in the loan review and loangrading system; changes in lending policies and procedures (which include

 

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underwriting,collection, charge-off and recovery practices); changes in management or thestaff of any previously mentioned areas; and current economic conditions andindicators. Both internal and external peer data are utilized as applicable toestablish these factors. Management’s judgment and experience are key to thisprocess. These factors are revised to address current conditions and trends inthe portfolio.

 

 The allowance amount not allocated representsthe differential between the combined specific and general allocations and theactual allowance. The unallocated allowance recognizes the imprecision inherentin estimating and measuring loss when allocating the allowance to individual orpools of loans. It also takes into consideration the allowance level deemedappropriate by each affiliate based on its local knowledge and feedback fromBank regulators and their view from the standpoint of safety and soundness,among other factors.

 

 For a full discussion of Bankshares’methodology for assessing the adequacy of the allowance for loan losses, see “Allowancefor Loan Losses” below and Note No. 1 of the financial statements.

 

*Loans onNonaccrual Status or Deemed to Be Impaired*

 

 A loan asset will be classifiedand placed into nonaccrual status when the principal or interest payments onany loan (e.g., commercial, mortgage and construction loans) are past due 90days or more at the end of a calendar quarter and/or the payment in full ofprincipal or interest is not expected. Any accrued but uncollected interest isreversed at that time. Consumer installment loans are charged off when theybecome 90 days past due. Additionally, a loan may be put on nonaccrual statussooner than 90 days, if in management’s judgment, the loan or portions thereofare deemed uncollectible.  Banksharesceases to accrue interest income on such loans. Subsequent receipts onnonaccrual loans are recorded as a reduction of principal, and interest incomeis recorded only once principal recovery is reasonably assured.  Generally a loan may be restored to accruingstatus when all past due principal, interest and late charges have been paidand the bank expects repayment of the remaining contractual principal andinterest.

 

 A loan is considered impaired,based on current information and events, if it is probable that Bankshares willnot collect all principal and interest payments according to the contractualterms 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). Theimpairment of a loan is measured based on the present value of expected futurecash flows discounted at the loan’s effective interest rate, or the fair valueof the collateral if the repayment is expected to be provided predominantly bythe underlying collateral. A majority of Bankshares’ impaired loans are measured by reference to thefair value of the collateral.

 

*IncomeTaxes*

 

 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 to management’sjudgment, based on available evidence, that future realization is more likelythan not.  If management determines thatBankshares may be unable to realize all or part of net deferred tax assets inthe future, then Bankshares would be required to record a valuation allowanceagainst such deferred tax asset.  In suchan event, a direct charge to income tax expense may be required to reduce therecorded value of the net deferred tax asset to the expected realizable amount.  Although management has determined that avaluation allowance is not currently required, no assurance can be given thatone will not be required in the future. For more informationregarding Bankshares’ accounting for income taxes, see Note No. 12 of thefinancial statements.

 

*Valuationof Goodwill/Intangible Assets and Analysis for Impairment*

 

 Bankshares has increased its market share, inpart, through the acquisition of entire financial institutions accounted forunder the purchase method of accounting, as well as from the purchase of otherfinancial institutions’ branches (not the entire institution). Bankshares isrequired to record assets acquired and liabilities assumed at their fair value,which involves an estimate determined by the use of internal or other valuationtechniques. See Note No. 19 of the financial statements for further informationon the accounting for goodwill and other intangible assets.

 

II. ANALYSISOF OPERATING RESULTS FOR 2004 TO 2003

 

**SegmentReporting**

 

 Bankshares has historically identified threedistinct business segments for which financial information is segregated foruse in assessing performance and allocating resources when reporting to theBoard of Directors. This segmentation is consistent with the reportingstructure established at the time Bankshares was formed. At that time theorganization consisted of: a lead bank, MSD&T, with two business segments –Banking and Investment & Wealth Management (“IWM”); and a Community Banksegment, which has been built through acquisitions and continued operation ofindependent charters. With the Farmers acquisition in 2003 and theconsolidation of 11 affiliate banks into four banks in 2004, the distinctionbetween banking segments has become less apparent. Increased lending authorityat the Banks has resulted in additional loan growth within their market areasand reduced referral and overline business to MSD&T. As a result of theconvergence of the two banking segments, Bankshares currently reports thesesegments collectively as Banking. The Banking segment consists of the group of13 affiliate banks.  Mortgage bankingactivities are

 

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not viewed asa separate business line due to the insignificant impact on the core businessof Bankshares and, accordingly, are included in the Banking segment.  A schedule disclosing the details of theseoperating segments can be found in Note No. 16 of the financialstatements.  Segment financialinformation is subjective and, unlike financial accounting, is not necessarilybased on GAAP.  As a result, financialinformation of the reporting segments is not necessarily comparable withsimilar information reported by others and may not be comparable withBankshares’ consolidated results. Certain expense amounts, such as operations overhead, have beenreclassified from internal financial reporting in order to provide for properallocation of costs in the reported data.

 

*Banking*

 

 The Banking segment includes the Retail, SmallBusiness, Commercial and Mortgage Banking lines of business. Banking productsinclude:

 

•                  RetailBanking:  Checking, savings and moneymarket accounts, time deposits and IRAs, insurance, equity lines and loans,lines of credit, and equipment and transportation (auto, recreational vehicleand marine) loans.

 

•                  Small BusinessBanking:  Deposit and credit products andservices to businesses with annual revenues up to $3 million or credit needs upto $750 thousand, including receivables and inventory financing, equipmentleases, and real estate financing.

 

•                  CommercialBanking:  Commercial deposit, lending andcommercial real estate solutions to businesses typically with annual revenuesbetween $4 million and $50 million, and including commercial loans and lines ofcredit, letters of credit, asset-based lending, commercial real estate,construction loans and capital market products.

 

•                  MortgageBanking: residential mortgage loan origination, construction and servicing.

 

 In the third quarter of 2004, Banksharesconsolidated 11 affiliate banks into four banks. The consolidated banks sharedcommon markets. The consolidation of these banks allows the surviving banks toserve their local customers with greater size, scale and expertise. Thisinitiative was not undertaken to reduce operating costs, although some savingswill arise out of the consolidation. It was to enable these banks to streamlineoperating processes, controls and compliance efforts; recruit seasonedprofessionals to these markets; and provide a greater breadth of services atthe local level. Bankshares is highly committed to the affiliate bank model,whereby local boards of directors provide strong oversight, and bank presidentsmaintain strong relationships within the community. As with any strategicinitiative there are costs involved. In 2004, Banking incurred approximately$3.6 million in restructuring charges related to the consolidations. A majorityof these costs were in severance charges and other personnel costs ofapproximately $2.3 million and $1.1 million in legal and consulting fees.Management expects to achieve cost savings of not less than $3 million in 2005.

 
| **2004  (Dollars in thousands)**   | ** ** | **Banking**    | ** **    | **IWM**     | ** ** | **Other**   | ** ** | **Total**      | ** ** |
|------------------------------------|------------|----------------|---------------|-------------|------------|-------------|------------|----------------|------------|
| Net interest income                | ** ** | **$**          | **544,640**   | ** **  | **$**      | **—**  | ** ** | **$**          | **1,141**  | ** ** | **$** | **545,781** | ** ** |
| Provision for loan losses          | ** ** | **(7,221**     | **)**         | **—**  | ** ** | **—**  | ** ** | **(7,221**     | **)**      |
| Noninterest income                 | ** ** | **114,477**    | ** **    | **90,516**  | ** ** | **8,936**   | ** ** | **213,929**    | ** ** |
| Noninterest expenses               | ** ** | **(319,540**   | **)**         | **(68,741** | **)**      | **(3,677**  | **)**      | **(391,958**   | **)**      |
| Adjustments                        | ** ** | **18,098**     | ** **    | **(3,603**  | **)**      | **(14,495** | **)**      | **—**     | ** ** |
| Income (loss) before income  taxes | ** ** | **350,454**    | ** **    | **18,172**  | ** ** | **(8,095**  | **)**      | **360,531**    | ** ** |
| Income tax (expense) benefit       | ** ** | **(127,462**   | **)**         | **(6,609**  | **)**      | **2,947**   | ** ** | **(131,124**   | **)**      |
| Net income (loss)                  | ** ** | **$**          | **222,992**   | ** **  | **$**      | **11,563**  | ** ** | **$**          | **(5,148** | **)** | **$** | **229,407** | ** ** |
| Average loans                      | ** ** | **$**          | **9,719,249** | ** **  | ** ** | ** **  | **$**      | **160**        | ** ** | **$** | **9,719,409** | ** ** |
| Average earning assets             | ** ** | **12,704,204** | ** **    | ** **  | ** ** | **28,800**  | ** ** | **12,733,004** | ** ** |
| Average assets                     | ** ** | **13,541,941** | ** **    | ** **  | ** ** | **451,030** | ** ** | **13,992,971** | ** ** |
| Average deposits                   | ** ** | **10,498,445** | ** **    | ** **  | ** ** | **(84,753** | **)**      | **10,413,692** | ** ** |
| Average equity                     | ** ** | **1,480,574**  | ** **    | ** **  | ** ** | **391,096** | ** ** | **1,871,670**  | ** ** |

 
| **2003  (Dollars in thousands)**   | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|------------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest income                |       | $           | 477,507    |    | $          | —    |       | $          | (5,158     | ) | $ | 472,349 |   |
| Provision for loan losses          |       | (12,105     | )          | —  |       | —    |       | (12,105    | )          |
| Noninterest income                 |       | 98,426      |       | 78,608  |       | 6,538     |       | 183,572    |       |
| Noninterest expenses               |       | (265,893    | )          | (66,633 | )          | (4,921    | )          | (337,447   | )          |
| Adjustments                        |       | 9,941       |       | (3,483  | )          | (6,458    | )          | —     |       |
| Income (loss) before income  taxes |       | 307,876     |       | 8,492   |       | (9,999    | )          | 306,369    |       |
| Income tax (expense) benefit       |       | (107,743    | )          | (3,397  | )          | 1,585     |       | (109,555   | )          |
| Net income (loss)                  |       | $           | 200,133    |    | $          | 5,095     |       | $          | (8,414     | ) | $ | 196,814 |   |
| Average loans                      |       | $           | 8,088,749  |    |       |      | $          | 233        |       | $ | 8,088,982 |   |
| Average earning assets             |       | 11,086,263  |       |    |       | 11,225    |       | 11,097,488 |       |
| Average assets                     |       | 11,701,443  |       |    |       | 270,138   |       | 11,971,581 |       |
| Average deposits                   |       | 9,142,644   |       |    |       | (150,790  | )          | 8,991,854  |       |
| Average equity                     |       | 1,309,477   |       |    |       | 187,668   |       | 1,497,145  |       |

 

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 The addition of Farmers during 2003 had asignificant impact on nearly every line of the consolidated balance sheet andstatement of consolidated income as well as the performance of the Bankingsegment, as set forth below. Net income for Banking for 2004 increased 11.4% to$223.0 million, from $200.1 million for 2003. Net interest income for Banking increased 14.1% to $544.6 million for2004 from $477.5 million for 2003. The growth in net interest income in 2004reflected a 14.6% increase in average earning assets, which more than offset a4 basis point decline in the net interest margin from 4.38% in 2003 to 4.34% in2004. Contributing to the net interest margin decline was the capitalrestructuring of the Banks during the third quarter of last year. Subordinateddebt totaling $300 million, issued by Bankshares in April 2003, and used inpart to fund the cash portion of the Farmers acquisition, was invested in alike amount of subordinated debt issued by the Banks. Excess equity capital waspaid to Bankshares in the form of a special cash dividend.

 

 As a reflection of the overall improvement inthe Banking credit quality trends, Banking recorded a decrease of $4.9 millionin the provision for loan losses for 2004. Banking recorded a provision forloan losses of $7.2 million in 2004 compared with $12.1 million in 2003. Theallowance as a percent of loans was 1.46% at year-end 2004 compared with 1.68%at year-end 2003.

 

 Average assets for Banking increased 15.7% to$13.5 billion in 2004. Average investments and loans increased 7.0% and 20.2%,respectively, while other assets accounted for the balance of the increase inaverage assets. Average deposits for Banking increased 14.8% to $10.5 billionin 2004. The growth in the Banking average balances was due primarily to theFarmers acquisition.

 

 In 2004, commercial loans, includingcommercial mortgages, accounted for 58.2% of Banking’s average total loans,slightly lower than the 59.3% for 2003. These loans increased 17.9% from the2003 average.  Construction and consumerloans accounted for approximately the same portion of loans in 2004 as in 2003,at 27.0% and 26.2%, respectively. Construction loans increased 23.0%, while consumer loans increased23.9%, from 2003 levels. Residential real estate loans, which were 14.8% and14.5% of average total loans for 2004 and 2003, respectively, increased 23.3%.

 

 At December 31, 2004, noninterest-bearingdeposits accounted for 27.5% of Banking’s average total deposits, slightlyhigher than the 25.0% in 2003. These deposits increased 26.6% from the 2003 average.Savings, interest checking and money market accounts accounted for 40.8% ofBanking’s average total deposits, compared with 39.4% in 2003. Savings depositsincreased 22.0%, interest-bearing checking deposits increased 20.3% and moneymarket deposits increased 15.8% from 2003. Certificates of deposit represented31.7% of total deposits, down slightly from 35.6% in 2003.

 

 The year-over-year increases in noninterestincome and noninterest expenses from 2003 are attributable primarily to theFarmers acquisition and branch expansion programs. Noninterest income increasedby $16.1 million, with deposit service charges increasing by $5.1 million,insurance fees increasing by $8.7 million and electronic banking feesincreasing by $4.8 million, accounting for the largest gains. These gains werepartially offset by a decrease of $6.8 million in net gains on investmentsecurities sold. Noninterest expenses increased by $53.6 million from 2003.More than 72% of this increase is related to salaries and benefits, which grewby $32.7 million. Severance costs related to the affiliate bank consolidationswere approximately $2.3 million. Occupancy expense increased by $3.1 million,and amortization of intangible assets increased by $2.6 million, whilefurniture and equipment expenses decreased by $1.3 million.

 

*Investment& Wealth Management*

 

 Investment and Wealth Management (“IWM”)includes Asset Management, Private Banking, Trust Services, Retail BrokerageServices and Custody Services. IWM provides a full line of investment productsand retirement, tax and estate planning services. IWM products include:

 

•                  Retail BrokerageServices: Stocks, bonds, proprietary and nonproprietary mutual funds, fixed andvariable annuities.

 

•                  Asset ManagementServices: Proprietary and nonproprietary mutual funds, proprietary andnonproprietary separate account management, customized wealth advisoryservices, defined benefit and defined contribution retirement services, familyoffice services, individual and institutional trust services and custodyservices.

 

•                  Private BankingServices: Deposits, loans and mortgages.

 

 On November 12, 2004, Bankshares consolidatedits brokerage activities by merging Mercantile Securities, Inc., into Peremel.The resulting entity is called Mercantile Brokerage Services, Inc., a generalsecurities broker-dealer that offers full-service, discount and onlinebrokerage services.

 

 Continued progress was made in growing the IWMbusiness and enhancing client services. Resources related to distribution wereadded within IWM as well as the affiliate Banks, including the addition of asmall team of financial advisors. Improvements were made in client reporting.Effective January 1, 2005, IWM converted its trust accounting platform toSunGard Wealth Management Systems.

 

 Net income in IWM increased to $11.6 millionin 2004, from $5.1 million in 2003. Pretax profit margins, prior to corporateoverhead allocations, were 24.1% and 15.2% for 2004 and 2003,respectively.  For more information oncorporate overhead see “Other” in

 

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“SegmentReporting” below.

 

 At December 31, 2004, assets underadministration by IWM were $47.8 billion, an increase of $1.8 billion from theprior year. Bankshares had investment management responsibility for $22.0billion, up $0.8 billion from the prior year.

 

 Revenues increased $11.9 million, or 15.1%, to$90.5 million in 2004 from $78.6 million in 2003. Revenue increases wereachieved in the three principal client segments: private wealth, institutionaland brokerage. Growth in IWM revenues was due principally to stronger marketsduring 2004 than 2003, new business development efforts and the inclusion of afull year’s results from Boyd Watterson and Peremel, which were acquired onMarch 1, 2003 and April 1, 2003, respectively. Together, these acquisitionsaccounted for $2.4 million of the increase in revenues.

 

 The improved performance in equity marketsthat began in the second quarter of 2003 had a positive impact on IWM revenuesthroughout 2004.  Slightly more than 40%of IWM’s managed assets is invested in equities, including real estate.Approximately one-third is invested in fixed income securities and just above20% is invested in short-term money market investments. Between December 31, 2003and December 31, 2004, all major equity indices rose.  The S&P 500 index was up 9%, the DowJones Industrial Average was up 4% and the Nasdaq was up 30%.

 

 Gross new assets from new business developmentefforts exceeded $925 million, up approximately 8% from 2003. All clientsegments contributed to this growth, with institutional real estate andbrokerage showing the highest growth rates. Revenues related to gross newassets were partially offset by higher levels of terminating accounts in thePrivate Wealth Management segment. Also contributing to revenue growth during2004 were increases in and the performance of the three hedge funds of funds (“hedgefunds”).

 

 Additional revenue growth will depend oncontinued new sales and increased distribution, equity and bond marketconditions and further acquisitions, if any.

 

 Expenses increased 3.2% to $68.7 million in2004. Increases in legal and professional service expenses were offset largelyby decreases in personnel-related and technology expenses. Also contributing tothe increase was the inclusion of a full year’s results for Boyd Watterson andPeremel.  Excluding the impact of theacquisitions, expenses fell 1.4%, or $0.8 million.  Expenses for 2003 included $3.6 million ofseverance and $0.5 million paid to terminate a technology equipment lease.

 

 During the first quarter of 2004, Banksharesentered into a seven-year service contract with SunGard Wealth ManagementServices to provide a new core accounting system and back-office operationsbeginning in January 2005. Year-to-date, IWM has incurred approximately $0.9million in restructuring charges related to the conversion to SunGard’sAddVantage trust accounting system. A majority of these costs were severancecharges of approximately $0.6 million. Conversion costs of approximately $1.8million that were incurred in 2004 are being amortized over the life of thecontract.

 

*Other*

 

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

 

Net interest income increased $6.3 million due to a full year ofintercompany income related to the subordinated debt referred to in the Bankingsection. Noninterest income increased $2.4 million related to income fromprivate equity investments.

 

 The “adjustments” line, whichrepresents corporate allocations from the lead Bank (MSD&T), increased $8.0million in 2004 over 2003. This increase is due mostly to allocations relatedto Sarbanes-Oxley compliance and increased staffing in corporate supportfunctions.

 

32

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ANALYSIS OFINTEREST RATES AND INTEREST DIFFERENTIALS

 

The followingtable presents the distribution of the average consolidated balance sheets,interest income/expense and annualized yields earned and rates paid.

 
| ** **                                        | ** ** | **2004**                | ** **     | **2003**                 | ** **  | ** **           | **2002**   | ** **              |
|---------------------------------------------------|------------|-------------------------|----------------|--------------------------|-------------|----------------------|------------|-------------------------|
| **(Dollars in thousands)**                        | ** ** | **Average  Balance(2)** | ** **     | **Income(1)  / Expense** | ** **  | **Yield(1)  / Rate** | ** ** | **Average  Balance(2)** | ** ** | **Income(1)  / Expense** | ** ** | **Yield(1)  / Rate** | ** ** | **Average  Balance(2)** | ** ** | **Income(1)  / Expense** | ** ** | **Yield(1)  / Rate** | ** ** |
| Earning assets                                    |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                            |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                        | ** ** | **$**                   | **2,733,580**  | ** **               | **$**       | **145,170**          | ** ** | **5.31**                | **%** | $ | 2,485,622 |   | $ | 135,186 |   | 5.44 | % | $ | 2,371,395 |   | $ | 148,380 |   | 6.26 | % |
| Commercial real estate                            | ** ** | **2,919,840**           | ** **     | **173,626**              | ** **  | **5.95**             | ** ** | 2,309,712               |   | 142,166 |   | 6.16 |   | 1,911,927 |   | 130,995 |   | 6.85 |   |
| Construction                                      | ** ** | **1,144,044**           | ** **     | **62,508**               | ** **  | **5.46**             | ** ** | 929,939                 |   | 50,324 |   | 5.41 |   | 733,237 |   | 44,667 |   | 6.09 |   |
| Residential real estate                           | ** ** | **1,444,148**           | ** **     | **85,187**               | ** **  | **5.90**             | ** ** | 1,171,194               |   | 75,651 |   | 6.46 |   | 1,072,297 |   | 78,233 |   | 7.30 |   |
| Consumer                                          | ** ** | **1,477,797**           | ** **     | **84,571**               | ** **  | **5.72**             | ** ** | 1,192,515               |   | 74,513 |   | 6.25 |   | 999,988 |   | 71,225 |   | 7.12 |   |
| Total loans                                       | ** ** | **9,719,409**           | ** **     | **551,062**              | ** **  | **5.67**             | ** ** | 8,088,982               |   | 477,840 |   | 5.91 |   | 7,088,844 |   | 473,500 |   | 6.68 |   |
| Federal funds sold, et al                         | ** ** | **59,848**              | ** **     | **1,501**                | ** **  | **2.51**             | ** ** | 250,462                 |   | 3,337 |   | 1.33 |   | 178,624 |   | 4,833 |   | 2.71 |   |
| Securities:                                       |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| Taxable securities                                |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury securities                          | ** ** | **741,127**             | ** **     | **28,710**               | ** **  | **3.87**             | ** ** | 1,021,513               |   | 41,233 |   | 4.04 |   | 1,478,387 |   | 67,531 |   | 4.57 |   |
| U.S. Agency securities                            | ** ** | **810,014**             | ** **     | **28,554**               | ** **  | **3.53**             | ** ** | 709,519                 |   | 32,399 |   | 4.57 |   | 610,617 |   | 30,072 |   | 4.92 |   |
| Mortgage-backed securities                        | ** ** | **1,250,947**           | ** **     | **48,159**               | ** **  | **3.85**             | ** ** | 927,235                 |   | 36,135 |   | 3.90 |   | 216,391 |   | 12,096 |   | 5.59 |   |
| Other investments (3)                             | ** ** | **57,193**              | ** **     | **2,389**                | ** **  | **4.18**             | ** ** | 20,804                  |   | 807 |   | 3.88 |   | 9,131 |   | 628 |   | 6.88 |   |
| Tax-exempt securities                             |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions                 | ** ** | **94,308**              | ** **     | **5,404**                | ** **  | **5.73**             | ** ** | 69,888                  |   | 4,543 |   | 6.50 |   | 38,799 |   | 3,135 |   | 8.08 |   |
| Total securities                                  | ** ** | **2,953,589**           | ** **     | **113,216**              | ** **  | **3.83**             | ** ** | 2,748,959               |   | 115,117 |   | 4.19 |   | 2,353,325 |   | 113,462 |   | 4.82 |   |
| Interest-bearing deposits in other banks          | ** ** | **158**                 | ** **     | **2**                    | ** **  | **1.17**             | ** ** | 9,085                   |   | 60 |   | 0.66 |   | 358 |   | 15 |   | 4.12 |   |
| Total earning assets                              | ** ** | **12,733,004**          | ** **     | **665,781**              | ** **  | **5.23**             | ** ** | 11,097,488              |   | 596,354 |   | 5.37 |   | 9,621,151 |   | 591,810 |   | 6.15 |   |
| Cash and due from banks                           | ** ** | **291,540**             | ** **     |                     | ** **  |                 | ** ** | 266,173                 |   |   |   |   |   | 227,034 |   |   |   |   |   |
| Bank premises and equipment, net                  | ** ** | **141,368**             | ** **     |                     | ** **  |                 | ** ** | 118,071                 |   |   |   |   |   | 101,660 |   |   |   |   |   |
| Other assets                                      | ** ** | **985,222**             | ** **     |                     | ** **  |                 | ** ** | 637,461                 |   |   |   |   |   | 314,511 |   |   |   |   |   |
| Less: allowance for loan losses                   | ** ** | **(158,163**            | **)**          |                     | ** **  |                 | ** ** | (147,612                | ) |   |   |   |   | (140,899 | ) |   |   |   |   |
| Total assets                                      | ** ** | **$**                   | **13,992,971** | ** **               |        | ** **           |       | ** **              | $ | 11,971,581 |   |   |   |   |   | $ | 10,123,457 |   |   |   |   |   |
| Interest-bearing liabilities                      |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                         |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                           | ** ** | **$**                   | **1,425,423**  | ** **               | **4,197**   | ** **           | **0.29**   | ** **              | $ | 1,168,074 |   | 4,702 |   | 0.40 |   | $ | 966,283 |   | 8,405 |   | 0.87 |   |
| Checking plus interest accounts                   | ** ** | **1,289,295**           | ** **     | **1,899**                | ** **  | **0.15**             | ** ** | 1,071,877               |   | 2,061 |   | 0.19 |   | 873,497 |   | 2,908 |   | 0.33 |   |
| Money market                                      | ** ** | **1,571,462**           | ** **     | **9,584**                | ** **  | **0.61**             | ** ** | 1,357,234               |   | 9,757 |   | 0.72 |   | 1,096,417 |   | 14,223 |   | 1.30 |   |
| Time deposits $100,000 and over                   | ** ** | **1,314,423**           | ** **     | **26,101**               | ** **  | **1.99**             | ** ** | 1,272,327               |   | 29,464 |   | 2.32 |   | 1,080,347 |   | 34,671 |   | 3.21 |   |
| Other time deposits                               | ** ** | **1,933,799**           | ** **     | **41,622**               | ** **  | **2.15**             | ** ** | 1,852,622               |   | 47,206 |   | 2.55 |   | 1,759,160 |   | 62,362 |   | 3.54 |   |
| Total interest-bearing deposits                   | ** ** | **7,534,402**           | ** **     | **83,403**               | ** **  | **1.11**             | ** ** | 6,722,134               |   | 93,190 |   | 1.39 |   | 5,775,704 |   | 122,569 |   | 2.12 |   |
| Short-term borrowings                             | ** ** | **932,493**             | ** **     | **7,844**                | ** **  | **0.84**             | ** ** | 851,348                 |   | 5,604 |   | 0.66 |   | 845,938 |   | 11,259 |   | 1.33 |   |
| Long-term debt                                    | ** ** | **645,375**             | ** **     | **22,009**               | ** **  | **3.41**             | ** ** | 517,386                 |   | 18,451 |   | 3.57 |   | 279,471 |   | 10,754 |   | 3.85 |   |
| Total interest-bearing funds                      | ** ** | **9,112,270**           | ** **     | **113,256**              | ** **  | **1.24**             | ** ** | 8,090,868               |   | 117,245 |   | 1.45 |   | 6,901,113 |   | 144,582 |   | 2.10 |   |
| Noninterest-bearing deposits                      | ** ** | **2,879,290**           | ** **     |                     | ** **  |                 | ** ** | 2,269,720               |   |   |   |   |   | 1,856,706 |   |   |   |   |   |
| Other liabilities and accrued expenses            | ** ** | **129,741**             | ** **     |                     | ** **  |                 | ** ** | 113,848                 |   |   |   |   |   | 107,671 |   |   |   |   |   |
| Total liabilities                                 | ** ** | **12,121,301**          | ** **     |                     | ** **  |                 | ** ** | 10,474,436              |   |   |   |   |   | 8,865,490 |   |   |   |   |   |
| Shareholders’ equity                         | ** ** | **1,871,670**           | ** **     |                     | ** **  |                 | ** ** | 1,497,145               |   |   |   |   |   | 1,257,967 |   |   |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**                   | **13,992,971** | ** **               |        | ** **           |       | ** **              | $ | 11,971,581 |   |   |   |   |   | $ | 10,123,457 |   |   |   |   |   |
| Net interest rate spread                          | ** ** | ** **              | ** **     | **$**                    | **552,525** | ** **           | **3.99**   | **%**                   |   |   | $ | 479,109 |   | 3.92 | % |   |   | $ | 447,228 |   | 4.05 | % |
| Effect of noninterest-bearing funds               | ** ** | ** **              | ** **     |                     | ** **  | **0.36**             | ** ** |                    |   |   |   | 0.40 |   |   |   |   |   | 0.60 |   |
| Net interest margin on earning assets             | ** ** | ** **              | ** **     |                     | ** **  | **4.35**             | **%**      |                    |   |   |   | 4.32 | % |   |   |   |   | 4.65 | % |
| Tax-equivalent adjustment included in:            |       |                    | ** **     |                     | ** **  |                 | ** ** |                    |   |   |   |   |   |   |   |   |   |   |   |
| Loan income                                       | ** ** | ** **              | ** **     | **$**                    | **4,531**   | ** **           |       | ** **              |   |   | $ | 4,897 |   |   |   |   |   | $ | 4,822 |   |   |   |
| Investment securities income                      | ** ** | ** **              | ** **     | **2,213**                | ** **  |                 | ** ** |                    |   | 1,863 |   |   |   |   |   | 1,371 |   |   |   |
| Total                                             | ** ** | ** **              | ** **     | **$**                    | **6,744**   | ** **           |       | ** **              |   |   | $ | 6,760 |   |   |   |   |   | $ | 6,193 |   |   |   |
|                                                   |            |                         |                |                          |             |                      |            |                         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Presentedon a tax-equivalent basis using the statutory federal corporate income tax rateof 35%. See “Non-GAAP Reconciliation.”

(2) Averageinvestment securities are reported at amortized cost and exclude unrealizedgains (losses) on securities available-for-sale. Nonaccrual loans are includedin average loans.

(3)Investments in hedge funds and other nonmarketable investments werereclassified from securities available-for-sale into other assets for the threeyears presented. The average balances of $104.4 million, $94.1 million and$14.1 million with associated income of $6.6 million, $7.0 million and $0.8million were reclassified for the years 2004, 2003 and 2002, respectively.

 

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**NetInterest Income**

 

 Net interest income represents the largestsource of Bankshares’ revenue. Changes in both the level of interest rates andthe amount and composition of interest-earning assets and interest-bearingliabilities affect it. Interest rate risk represents one of the moresignificant risks facing financial institutions like Bankshares.  See additional discussion under the caption “InterestRate Risk” below.  It is measured interms of the effect changes in market interest rates have on net interestincome. Bankshares is asset sensitive, with assets repricing more quickly thanliabilities in response to changes in interest rates. In a falling rateenvironment, Bankshares’ net interest margin (net interest income expressed asa percent of average earning assets) compresses, causing the growth in netinterest income to slow. Net interest income, on a fully tax-equivalent basis,was $552.5 million for 2004. This represents an increase of 15.3%, or $73.4million, over the prior year’s $479.1 million. In 2003, fully tax-equivalentnet interest income increased by $31.9 million, or 7.1%, over 2002. Investmentsin hedge funds and other nonmarketable investments were reclassified fromsecurities available-for-sale into nonmarketable investment securities, whichare included as Other Assets. The impact on the net interest margin of thisreclassification was a reduction in the net interest margin of 1 and 2 basispoints, in 2004 and 2003, respectively. This reclassification did not have animpact on the 2002 net interest margin. As previously noted, net interestincome is affected by changes in the volume of earning assets and the netinterest margin earned thereon. The “Rate/Volume Analysis” table below presentsfurther details supporting this discussion.

 

 Average earning assets increased by $1.6billion, or 14.7%, in 2004, due primarily to a full year’s results from theFarmers acquisition. Average total loans grew $1.6 billion, or 20.2%, during2004. As with earning assets, this growth is due primarily to a full yearrelated to the Farmers acquisition. Organic loan growth was fairly consistentthroughout the year. Average securities, the other major component of earningassets, increased by $204.6 million, or 7.4%, in 2004 compared with an increaseof $395.6 million, or 16.8%, in the prior year. The increase in 2003 waslargely attributable to the Farmers acquisition. The slowing growth of theinvestment portfolio in 2004 is attributable to liquidity needed to fund improvedloan growth.  See “III. Analysis ofFinancial Condition” below for a more in-depth discussion of balance sheettrends.  The overall growth in averageearning assets added $69.4 million to net interest income in 2004.

 

 Also contributing to the increase in netinterest income was a 3 basis point increase in the net interest margin from4.32% in 2003 to 4.35% in 2004. This represented the first increase in the netinterest margin in three years. The net interest spread also increased by 7basis points to 3.99% in 2004 from 3.92% in 2003. The net interest spread isthe difference between the yield earned on total earning assets and the ratepaid on total interest-bearing liabilities. The improvement in the net interestspread is reflected in the volume variance in the Rate/Volume Analysis, as itresulted primarily from a change in the mix of earning assets from loweryielding securities to higher yielding loans. The individual loan and securityrates earned in 2004 were consistently lower than 2003 and are reflected as therate variance in the Rate/Volume Analysis. The benefit from the improved netinterest spread was partially offset by a decline in the benefit Banksharesderives from its noninterest-bearing sources of funding. Such benefit declinedby 4 basis points in 2004 and 20 basis points in 2003, due to historically lowinterest rates in those periods. Approximately 24% of the funding of averageearning assets is derived from noninterest-bearing sources.

 

 In response to the improving economy, the FederalReserve Board began increasing short-term interest rates in 2004. Afterreducing short-term rates by 50 basis points in 2002 and 25 basis points in2003, the Federal Reserve Board increased short-term rates by 125 basis pointsin 2004.

 

 Looking forward to 2005, Managementanticipates a moderate increase in short-term interest rates. As tointermediate and long-term interest rates, a clear direction can not bediscerned based on recent trends. These rates remain at or near recent lows andcreate a downward movement in the net interest margin as fixed-rate loans andinvestments mature and are replaced by loans and investments at lower currentyields.  However, with some signs of animproving economy beginning to emerge, Management anticipates the net interestmargin will remain stable, as improving loan growth should result in earningassets more heavily weighted toward higher yielding loans compared withinvestment securities and as rising rates increase the benefit of noninterestbearing funds.  For additionalinformation regarding interest rate sensitivity, see the discussion in the “InterestRate Risk” section below.

 

34

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SOURCESOF INCOME

(Dollars in millions)

 

 

USESOF INCOME

(Dollars in millions)

 

 

 A rate/volume analysis, which demonstrateschanges in tax-equivalent interest income and expense for significant assetsand liabilities, appears below. The calculation of rate and volume variances isbased on a procedure established for banks by the Securities and ExchangeCommission.

 
| ** **                                 | ** ** | **Year ended December 31,**            | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                                 | ** ** | **2004 vs. 2003  Due to variances in** | ** ** | **2003 vs. 2002  Due to variances in** | ** ** |
| **(Dollars  in thousands)**                | ** ** | **Total**                              | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** |
| Interest earned on:                        |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Loans:                                     |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Commercial (1)                             | ** ** | **$**                                  | **9,984**  | ** ** | **$** | **(3,502** | **)** | **$** | **13,486** |   | $ | (13,194 | ) | $ | (20,341 | ) | $ | 7,147 |   |
| Commercial real estate (2)                 | ** ** | **31,460**                             | ** ** | **(6,094** | **)** | **37,554** |   | 11,171 |   | (16,083 | ) | 27,254 |   |
| Construction (3)                           | ** ** | **12,184**                             | ** ** | **598** | ** ** | **11,586** |   | 5,657 |   | (6,326 | ) | 11,983 |   |
| Residential real estate                    | ** ** | **9,536**                              | ** ** | **(8,095** | **)** | **17,631** |   | (2,582 | ) | (9,797 | ) | 7,215 |   |
| Consumer                                   | ** ** | **10,058**                             | ** ** | **(7,768** | **)** | **17,826** |   | 3,288 |   | (10,425 | ) | 13,713 |   |
| Taxable securities (4)                     | ** ** | **(2,762**                             | **)**      | **(10,200** | **)** | **7,438** |   | 247 |   | (17,130 | ) | 17,377 |   |
| Tax-exempt securities (4)                  | ** ** | **861**                                | ** ** | **(726** | **)** | **1,587** |   | 1,408 |   | (1,104 | ) | 2,512 |   |
| Federal funds sold, et al                  | ** ** | **(1,836**                             | **)**      | **704** | ** ** | **(2,540** | ) | (1,496 | ) | (3,440 | ) | 1,944 |   |
| Interest-bearing deposits in  other banks  | ** ** | **(58**                                | **)**      | **1** | ** ** | **(59** | ) | 45 |   | (321 | ) | 366 |   |
| Total interest income                      | ** ** | **69,427**                             | ** ** | **(35,082** | **)** | **104,509** |   | 4,544 |   | (84,967 | ) | 89,511 |   |
| Interest paid on:                          |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Savings deposits                           | ** ** | **(505**                               | **)**      | **(1,541** | **)** | **1,036** |   | (3,703 | ) | (5,458 | ) | 1,755 |   |
| Checking plus interest deposits            | ** ** | **(162**                               | **)**      | **(580** | **)** | **418** |   | (847 | ) | (1,507 | ) | 660 |   |
| Money market accounts                      | ** ** | **(173**                               | **)**      | **(1,713** | **)** | **1,540** |   | (4,466 | ) | (7,849 | ) | 3,383 |   |
| Certificates of deposit  $100,000 and over | ** ** | **(3,363**                             | **)**      | **(4,338** | **)** | **975** |   | (5,207 | ) | (11,368 | ) | 6,161 |   |
| Other time deposits                        | ** ** | **(5,584**                             | **)**      | **(7,652** | **)** | **2,068** |   | (15,156 | ) | (18,469 | ) | 3,313 |   |
| Short-term borrowings                      | ** ** | **2,240**                              | ** ** | **1,706** | ** ** | **534** |   | (5,655 | ) | (5,727 | ) | 72 |   |
| Long-term debt                             | ** ** | **3,558**                              | ** ** | **(1,006** | **)** | **4,564** |   | 7,697 |   | (1,458 | ) | 9,155 |   |
| Total interest expense                     | ** ** | **(3,989**                             | **)**      | **(15,124** | **)** | **11,135** |   | (27,337 | ) | (51,836 | ) | 24,499 |   |
| Net interest earned                        | ** ** | **$**                                  | **73,416** | ** ** | **$** | **(19,958** | **)** | **$** | **93,374** |   | $ | 31,881 |   | $ | (33,131 | ) | $ | 65,012 |   |

 

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(1) Tax-equivalentadjustments of $3.1 million for 2004, $3.1 million for 2003 and $3.3 millionfor 2002 are included in the calculation of commercial loan rate variances.

(2)Tax-equivalent adjustments of $0.5 million for 2004, $0.5 million for 2003 and$0.3 million for 2002 are included in the calculation of commercial real estateloan rate variances.

(3)Tax-equivalent adjustments of $0.9 million for 2004, $1.3 million for 2003 and$1.2 million for 2002 are included in the calculation of construction loan ratevariances.

(4)Tax-equivalent adjustments of $2.2 million for 2004, $1.9 million for 2003 and$1.4 million for 2002 are included in the calculation of investment securitiesrate variances.

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

 

35

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**InterestIncome**

 

 Fully tax-equivalent interest income amountedto $665.8 million in 2004, an increase of $69.4 million, or 11.6%, from $596.4million in 2003. This compares favorably with the $4.5 million, or .8%,increase in 2003 from 2002. The increase in 2004 was due to growth in averageloans and securities that contributed $104.5 million in additional interestincome. This increase was offset by a decline in market interest rates,resulting in a $35.1 million reduction in interest income from the lower yieldon earning assets.  During 2003, the$85.0 million reduction in interest income from lower earning asset yields wasoffset by $89.5 million in additional interest income generated by the growthin earning assets primarily due to the acquisition of Farmers.

 

 At year-end 2004, the prime rate was 5.25%,compared with 4.00% and 4.25% at year-end 2003 and 2002, respectively. Theaverage prime rate was 4.35% for 2004, compared with 4.12% for 2003, anincrease of 23 basis points. The yield on average total loans in 2004 was5.67%, a 24 basis point decrease from 5.91% in 2003. The commercial andconstruction loan portfolios are the most sensitive to changes in short-terminterest rates. However, the construction portfolio was the only category toreport increased average yield compared with last year. The residential realestate and consumer loan portfolios are affected mostly by intermediate andlong-term rates and do not move with prime rate. The yields on the consumerloan portfolio and the residential real estate portfolios decreased by 53 and56 basis points, respectively.

 

 The yield on investment securities, 3.83% in2004, declined 36 basis points from 4.19% in 2003. The yield on the portfoliodecreased 63 basis points in 2003 from 4.82% in 2002. Bankshares has beenchanging the mix of the portfolio to offset the negative impact on interestincome from reinvesting at lower yields. During 2004 Bankshares followed astrategy begun in 2002 to shift from U.S. Treasury to higher yielding U.S.agency securities and mortgage-backed securities. This has resulted in a mix of20%, 29% and 45% of treasury, agency and mortgage-backed securities,respectively, in 2004. The other 6% of the investment securities was comprisedof 3% municipals and 3% other investments at year-end.

 

**InterestExpense**

 

 Total interest expense in 2004 was $113.3million, a decrease of $4.0 million from $117.2 million in 2003. The decreasein interest expense for 2004 was attributable to a decrease in the rate paid ontotal interest-bearing funds of 21 basis points, which was partially offset bya 12.6% growth in average balances. Total interest expense in 2003 was $27.3million less than the $144.6 million reported in 2002. With the combination ofinterest rates at record-low levels and the Federal Reserve Board’s increase inshort-term rates in the econd half of 2004, management anticipates that ratespaid on managed-rate deposits (savings, checking plus interest and money marketaccounts) will increase. See management’s discussion under “Interest Rate Risk”below for further information regarding Bankshares’ exposure to changes ininterest rates.

 

 The rate paid on average totalinterest-bearing deposits was 1.11% in 2004, a decline of 28 basis points from1.39% for the prior year. The rate paid on savings, checking plus interest andmoney market accounts declined 11 basis points, 4 basis points and 11 basispoints, respectively. Certificates of deposit of $100,000 and over declined 33basis points, while the rate paid on other time deposits declined 40 basispoints in 2004.

 

 The most interest rate sensitive source offunds is short-term borrowings. This category is comprised of federal fundspurchased, securities sold under agreements to repurchase and commercial paper.The duration of these funds is very short, with most repricing daily.Reflecting the rate environment, the rate paid on short-term borrowingsincreased 18 basis points to 0.84% in 2004, after having decreased by 67 basispoints in 2003 to 0.66%. The rate paid on long-term debt declined 16 basispoints in 2004, following a decline of 28 basis points in the prior year. Thedecline is related primarily to the $200 million of 10-year debt issued byMSD&T in the fourth quarter of 2001. These notes, which were issued at afixed rate of 5.70%, were converted to a floating rate through an interest rateswap. The notes reprice quarterly and carried an effective cost of 2.38% during2004. Additionally, Bankshares issued $300 million of subordinated debt inApril 2003.  The notes were issued at afixed rate of 4.65%.  Subsequently, $150million of this debt was converted to a floating rate through interest rateswaps.  The effect of the swap loweredthe cost on the $300 million debt to 3.46% during 2004.

 

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NONINTERESTINCOME

 

A schedule ofnoninterest income over the past three years is presented below:

 
| ** **                            | ** ** | **Year ended December 31,** | ** **  | **% Change** | ** ** |
|---------------------------------------|------------|-----------------------------|-------------|--------------|------------|
| **(Dollars  in thousands)**           | ** ** | **2004**                    | ** **  | **2003**     | ** ** | **2002** | ** ** | **2004/2003** | ** ** | **2003/2002** | ** ** |
| Investment and wealth  management     | ** ** | **$**                       | **90,050**  |         | $          | 78,933 |   | $ | 68,435 |   | 14.1 | % | 15.3 | % |
| Service charges on deposit  accounts  | ** ** | **44,263**                  |        | 39,194       |       | 33,539 |   | 12.9 |   | 16.9 |   |
| Mortgage banking related fees:        |       |                        |        |         |       |   |   |   |   |   |   |
| Commercial                            | ** ** | **8,478**                   |        | 6,645        |       | 5,609 |   | 27.6 |   | 18.5 |   |
| Residential                           | ** ** | **3,017**                   |        | 4,466        |       | 4,336 |   | (32.4 | ) | 3.0 |   |
| Total mortgage banking related  fees  | ** ** | **11,495**                  |        | 11,111       |       | 9,945 |   | 3.5 |   | 11.7 |   |
| Net investment securities gains       | ** ** | **1,239**                   |        | 7,137        |       | 846 |   | (82.6 | ) | 743.6 |   |
| Nonmarketable investments             |       |                        |        |         |       |   |   |   |   |   |   |
| Private equity and other  investments | ** ** | **2,569**                   |        | 823          |       | (1,254 | ) | 212.2 |   | 165.6 |   |
| Hedge funds                           | ** ** | **5,529**                   |        | 6,385        |       | — |   | (13.4 | ) | 100.0 |   |
| Bank-owned life insurance             | ** ** | **3,324**                   |        | 2,981        |       | 1,575 |   | 11.5 |   | 89.3 |   |
| Total nonmarketable investments       | ** ** | **11,422**                  |        | 10,189       |       | 321 |   | 12.1 |   | 3,074.1 |   |
| Other income:                         |       |                        |        |         |       |   |   |   |   |   |   |
| Electronic banking fees               | ** ** | **21,766**                  |        | 16,930       |       | 15,076 |   | 28.6 |   | 12.3 |   |
| Charges and fees on loans             | ** ** | **10,833**                  |        | 9,549        |       | 8,440 |   | 13.4 |   | 13.1 |   |
| Insurance                             | ** ** | **13,358**                  |        | 4,656        |       | 1,141 |   | 186.9 |   | 308.1 |   |
| All other income                      | ** ** | **9,503**                   |        | 5,873        |       | 6,776 |   | 61.8 |   | (13.3 | ) |
| Total other income                    | ** ** | **55,460**                  |        | 37,008       |       | 31,433 |   | 49.9 |   | 17.7 |   |
| Total                                 | ** ** | **$**                       | **213,929** |         | $          | 183,572 |   | $ | 144,519 |   | 16.5 | % | 27.0 | % |

 

**NoninterestIncome**

 

 Noninterest income for 2004 increased by $30.4million, or 16.5%, to $213.9 million compared with $183.6 million for2003.  The table above shows the majorcomponents of noninterest income. The increases over 2003 were significantlyimpacted in nearly every category by the inclusion of Farmers for a full year.  IWM revenue represented the largest source ofnoninterest income at 42%. Revenues increased 14.1% to $90.1 million in 2004.Growth in IWM was due principally to stronger equity markets on average during2004 compared with 2003, new business development efforts and the inclusion ofBoyd Watterson and Peremel, which were acquired on March 1, 2003 and April 1,2003, respectively. Additional growth will depend on continued new sales andincreased distribution, equity and bond market conditions and further acquisitions,if any.  See the discussion under “SegmentReporting” above for additional information relating to IWM.

 

 Service charges on deposit accounts increasedin line with the growth in core consumer and commercial deposit balances.  This growth is due not only to a full year offees related to the Farmers acquisition, but also to significant growth indeposits throughout Bankshares’ affiliates. Service charges on deposit accountsincreased $5.1 million, or 12.9%, in 2004. Additionally, a reduction in waivers of nonsufficient funds andoverdraft charges increased these fees $3.2 million, or 18.5%. Commercialaccount analysis fees increased $0.7 million, or 12.2%, primarily due toreduced earnings credits on these accounts as a result of lower interest ratesduring 2004.

 

 Mortgage banking fees increased3.5% to $11.5 million in 2004. Bankshares’ mortgage banking revenue is comprised of loan originationfees, which is the largest category at 56% of total mortgage banking fees;servicing fees; and net gain on sales of mortgage loans.  Mercantile Mortgage Corporation’s commercialloan origination and servicing fees increased by a combined $1.8 million due tothe activities of its subsidiary, Columbia National Real Estate Financing, LLC(“CNREF”).  Commercial mortgages are brokered, withservicing retained by CNREF provided for the investor.  Management expects these fees to increase in2005 due to the formation of HarborPoint Capital, LP, in July of 2004. Themortgage banking subsidiary owns a 75% interest in HarborPoint Capital, LP, aFannie Mae Delegated Underwriting and Servicing licensed lender. HarborPoint Capital, LP, was a start-up in 2004 with nononinterest income in 2004.  Residentialmortgage banking fees decreased by $1.4 million due to a slowdown inrefinancing activities.

 

 Investment securities gains in2004 mostly represent sales of equity securities, with the balance related tothe continued restructuring of the investment securities bond portfolios heldin the available-for-sale portfolios. The gains in 2003 represent sales of equity securities, with the balancerelated to the continued restructuring of the investment securities bondportfolio.

 

 Investment in hedge funds and othernonmarketable investments were reclassified from securities into other assets,for the periods presented, with their income or loss reported as other income.Income from private equity and other investments increased $1.7

 

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million, or212.2%, in 2004 and increased $2.1 million, or 165.6%, in 2003. Hedge fundsincome declined $0.9 million, or 13.4%, in 2004. Hedge funds were introduced in2003 and, therefore, had no comparable income in the prior year. Bank-owned life insurance (“BOLI”) revenuesare derived from Bankshares’ investment of $50.0 million during the third quarter of 2002 and investmentsin insurance contracts on the lives of some directors and key executives.  The Company invested in BOLI to providefunding for future employee benefit costs. Executive and middle-managementemployees are insured under the plan. Income, which reflects changes in thecash surrender value, was $0.3 million higher than in 2003 due to a full year’searnings related to BOLI investment acquired in the Farmers acquisition. BOLI investmentincome is exempt from federal and state income tax, and related costs of theinsurance are not tax deductible. The BOLI is invested primarily in high gradecorporate and government bonds and mortgage-backed securities.

 

 Other income includes severalcategories. Electronic banking fees consist of merchant card processing fees,foreign ATM fees and check card fees. These fees increased by $4.8 million, up28.6% from 2003. Charges and fees on loans consist of letters of credit fees,late fees and other assessed loan fees. Letters of credit fees increased  $1.8 million, late fees increased $0.3million, while other loan fees decreased $0.8 million. Insurance revenues arederived from fee income related to the sale and servicing of insuranceproducts.  The $8.7 million increase isdue primarily to Farmers, which operates two wholly owned subsidiaries, KellerStonebraker Insurance, Inc., and Potomac Basin Group Associates, Inc. Theseinsurance agencies provide a full line of consumer and commercial products.  Consumer products include annuities,homeowners, automobile, life and personal umbrella insurance products.  Commercial products include property andcasualty packages, workers’ compensation, bonds, professional liability and401(k) and other benefit plans. All otherincome consists of revenues from various sources, such as safe deposit boxrent, travelers’ checks and money order fees and miscellaneous income. Allother income increased $3.6 million from 2003 due largely to a $1.7 milliongain on the sale of bank premises and a full year of revenue related toFarmers.

 

NONINTERESTEXPENSES

 

A schedule ofnoninterest expenses over the past three years is presented below:

 
| ** **                              | ** ** | **Year ended December 31,** | ** **  | **% Change** | ** ** |
|-----------------------------------------|------------|-----------------------------|-------------|--------------|------------|
| **(Dollars  in thousands)**             | ** ** | **2004**                    | ** **  | **2003**     | ** ** | **2002** | ** ** | **2004/2003** | ** ** | **2003/2002** | ** ** |
| Salaries                                | ** ** | **$**                       | **187,621** |         | $          | 160,326 |   | $ | 133,200 |   | 17.0 | % | 20.4 | % |
| Employee benefits                       | ** ** | **44,676**                  |        | 37,717       |       | 32,171 |   | 18.5 |   | 17.2 |   |
| Net occupancy expense of bank  premises | ** ** | **24,307**                  |        | 20,756       |       | 15,904 |   | 17.1 |   | 30.5 |   |
| Furniture and equipment expenses        | ** ** | **31,439**                  |        | 31,610       |       | 24,464 |   | (0.5 | ) | 29.2 |   |
| Communications and supplies             | ** ** | **16,904**                  |        | 15,188       |       | 13,375 |   | 11.3 |   | 13.6 |   |
| Other expenses:                         |       |                        |        |         |       |   |   |   |   |   |   |
| Professional services                   | ** ** | **25,302**                  |        | 19,500       |       | 11,221 |   | 29.8 |   | 73.8 |   |
| Advertising and promotional  expenses   | ** ** | **8,418**                   |        | 9,155        |       | 6,872 |   | (8.1 | ) | 33.2 |   |
| Electronic banking expenses             | ** ** | **11,509**                  |        | 8,621        |       | 8,135 |   | 33.5 |   | 6.0 |   |
| Amortization of intangible  assets      | ** ** | **8,142**                   |        | 4,943        |       | 1,972 |   | 64.7 |   | 150.7 |   |
| Outsourcing expenses                    | ** ** | **5,342**                   |        | 4,145        |       | 4,152 |   | 28.9 |   | (0.2 | ) |
| All other expenses                      | ** ** | **28,298**                  |        | 25,486       |       | 21,141 |   | 11.0 |   | 20.6 |   |
| Total other expenses                    | ** ** | **87,011**                  |        | 71,850       |       | 53,494 |   | 21.1 |   | 34.3 |   |
| Total                                   | ** ** | **$**                       | **391,958** |         | $          | 337,447 |   | $ | 272,608 |   | 16.2 | % | 23.8 | % |

 

**NoninterestExpenses**

 

 Noninterest expenses increased $54.5 million,or 16.2%, from 2003.  The table aboveshows the major components of noninterest expenses.  The principal reasons for the year-over-yearincrease were the full-year inclusion of Farmers, Boyd Watterson and Peremel;costs related to the consolidation of 11 bank affiliates into four; costsrelated to conversion and outsourcing the IWM back office to SunGard; andincreased professional services related to compliance costs.

 

 Controlling costs and maintaining operationalefficiencies remains a primary objective for Bankshares.  A closely monitored key measure is Bankshares’overall efficiency ratio.  It is computedby dividing noninterest expenses by the sum of net interest income on atax-equivalent basis and noninterest income. Bankshares’ efficiency ratio was51.14% for the year ended December 31, 2004 compared with 50.92% for the yearended December 31, 2003. 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.  Bankshares’ cash operating efficiency ratiowas 49.63% compared with 49.52% for the years ended December 31, 2004 and 2003,respectively. See “Non-GAAP Reconciliation” below.

 

 Salary related expenses, which includesalaries, commissions and incentive compensation are the largest component ofnoninterest expense at 48%. Salaries increased $27.3 million, or 17.0%. Nearlyone-third of this increase ($9.2 million) was due to Farmers, Boyd

 

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Watterson andPeremel, included in 2004 for a full year. Also contributing to the increasewere higher commissions and incentive compensation tied directly to Bankshares’revenue and overall performance of nearly $6.3 million, higher costs related tonew branch openings of $1.2 million, increases in staffing forcompliance-related matters of approximately $1.3 million, with the majority ofthe remaining increase due to normal merit and staffing increases.

 

 Employee benefit expenses increased nearly$7.0 million, or 18.5%. Again, approximately one-third ($2.3 million) was dueto the acquisitions in 2003, included in 2004 for a full year. The majority ofthe remaining increase was due to higher employee and retiree health insurancecosts.

 

 Net occupancy expense, which includes premisesdepreciation, rents, maintenance and utilities, increased due to the inclusionfor a full year of the net additional 39 branch locations as well as the threecorporate offices related to acquisitions. Additionally, generally higher rental payments and an increase inexpenses associated with improvements are reflected in the increase to netoccupancy expense. The prior year included $1.2 million relating to thetermination of certain Banking lease agreements, primarily related to theFarmers integration.

 

 Furniture and equipment expensesinclude depreciation, rental and maintenance expense associated with the upkeepand improvement of hardware and computer software.  These expenses decreased primarily due toexpenses related to the cancellation of equipment maintenance contracts withrespect to the Farmers acquisition and the cancellation of an IWM technologyequipment contract in 2003.

 

 Communications and supplies expenses increaseddue to supplies needed for additional branch office locations, includingbrochures and operational supplies, as well as increased customer informationmailings and disclosures related to the Affiliate Bank Rationalization.

 

 Other expenses consist ofprofessional services, marketing, electronic banking, amortization and allother expenses such as travel and membership, licensing and insurance, andother operational expenses. Other expenses increased $15.2 million, or 21.1%,in 2004.  The increase in each categorywas largely due to acquisitions. Professional fees increased $5.8 million in2004. Part of this increase relates to a change to the Directors’ DeferredCompensation Plan approved at the 2004 Annual Shareholders’ meeting.  Beginning April 1, 2004, all deferreddirectors’ fees are covered by the plan. At April 1, 2004, directors had the option to leave their deferredbalance in the old phantom stock plan or convert their balance into vestedshares under the new plan. The phantom stock plan is a cash plan, with changesto the plan balance tied to the changes in the value of shares of MercantileBankshares’ common stock at the end of each quarter. Substantially allaffiliate bank directors converted their balances to the new plan. Thisresulted in the addition of approximately 149,000 stock equivalents and $6.4million to capital surplus. These vested shares will be issued after a directorretires. Professional services increased with costs incurred in connection withthe investigation of potential acquisitions of $1.0 million, legal costsrelated to investigatory and litigation matters that, in management’s view, arenot normal recurring expenses of $2.5 million, and Sarbanes-Oxley compliancecosts of $2.5 million related to Section 404. The increase in electronicbanking expense of $2.9 million in 2004 was more than offset by the revenuesgenerated from these services (referred to in noninterest income section).Amortization of other identifiable intangibles increased to $8.1 million in2004 from $4.9 million in 2003 as a result of a full year of expense related toacquisitions.  All other expenseincreases are comprised mostly of travel and membership, up 3%, and licensingand insurance, up $1.7 million, or 33.0%. Increases in these two categories are attributable mostly to theincreased activities relating to the acquisition of Farmers. Additionally,other operational expenses include armored courier service, check clearing andprocessing charges and other miscellaneous charges. Excluding any chargesrelated to the pending acquisition of Community Bank of Northern Virginia (“CBNV”),management expects 2005 increases to moderate. The elimination of certain externalprofessional fees, however, will be partially offset by ongoing investments inBankshares’ regulatory and compliance infrastructure.

 

III. ANALYSISOF FINANCIAL CONDITION

 

**InvestmentSecurities**

 

 Bankshares’ investment securities portfolio isstructured to manage liquidity, interest rate risk and regulatory capital andto take advantage of market conditions that create more economically attractivereturns on investments. At December 31, 2004, the total investment securitiesportfolio was $2.9 billion, a decrease of $141.8 million, or 4.6%, from $3.1billion at December 31, 2003. The portfolio consists of short-term andintermediate-term U.S. Treasury and U.S. Government Agency obligations,adjustable-rate mortgage-backed securities (ARMs) and intermediate average-lifeagency collateralized mortgage obligations (CMOs).  More than 98% of the total investmentportfolio is classified as available-for-sale.

 

 As part of a new investment portfolio strategydesigned to maintain a core amount of liquidity and to increase portfolioyields in a low interest rate environment, Bankshares’ began to increase itsholdings of mortgage-backed securities in 2002. Mortgage-backed securities werepurchased for the investment portfolio because they have short or intermediate-termdurations and represent a stable source of cash flows.  As a result of this new program and theFarmers acquisition, mortgage-backed securities rose $33.7 million to $1.3billion during 2004.  Similarly, theproportion of mortgage-backed securities to total available-for-sale securitiesincreased from

 

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42% in 2003 to45% over the same period in 2004.  In2004, U.S. Treasury obligations decreased $236.7 million, or 28.0%, while U.S.Agency obligations increased by $59.4 million, or 7.5%.

 

 At year-end 2004, the weighted-averagematurity of the debt securities available-for-sale portfolio was 2.4 years, areduction of 0.6 years from year-end 2003. Since 45% of this portfolio ismortgage-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 securitiesavailable-for-sale portfolio as of December 31, 2004 was 99.8% ofamortized cost, compared with 101.2% at December 31, 2003.  At December 31, 2004, these investmentshad unrealized gains of $13.6 million and unrealized losses of $19.0 million.The market value and unrealized loss on securities as of December 31,2004, segregated by those securities that have been in an unrealized lossposition for a year or more, was $277.8 million and $8.4 million, respectively.Because the declines in fair value were due to changes in interest rates, notin estimated cash flows, no charge from an other-than-temporary impairment wasrecorded at December 31, 2004. The reference point for determining thosesecurities in an unrealized loss is quarter-end. As such, it is possible that asecurity had a market value that exceeded its amortized cost on other daysduring the past 12-month period. More information on the investment portfoliois provided in the table above and in Note No. 3 of the financial statements.

 

BONDINVESTMENT PORTFOLIO

 

The followingsummary shows the maturity distribution and average tax-equivalent yields forthe bond investment portfolio at December 31, 2004.

 
| **(Dollars in thousands)**                       | ** ** | **Within 1  Year** | ** ** | **1-5  Years** | ** ** | **5-10  Years** | ** ** | **After 10  Years** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|----------------|------------|-----------------|------------|---------------------|------------|-----------|------------|
| Securities available-for-sale*(1)*               |       |               |       |           |       |            |       |                |       |      |       |
| U.S. Treasury and other U.S. Government agencies |       |               |       |           |       |            |       |                |       |      |       |
| Fair Value                                       |       | $                  | 474,295    |           | $          | 987,687         |       | $                   | 41         |      | $          | 9 |   | $ | 1,462,032 |   |
| Yield                                            |       | 3.86               | %          | 3.22           | %          | 7.54            | %          | 7.55                | %          | 3.43      | %          |
| States and political subdivisions                |       |               |       |           |       |            |       |                |       |      |       |
| Fair Value                                       |       | $                  | 4,168      |           | $          | 15,809          |       | $                   | 39,502     |      | $          | 3,391 |   | $ | 62,870 |   |
| Yield                                            |       | 1.98               | %          | 3.55           | %          | 5.33            | %          | 6.21                | %          | 4.71      | %          |
| Mortgage-backed securities *(2)*                 |       |               |       |           |       |            |       |                |       |      |       |
| Fair Value                                       |       | $                  | 78,358     |           | $          | 977,523         |       | $                   | 239,208    |      | $          | 22,212 |   | $ | 1,317,301 |   |
| Yield                                            |       | 4.53               | %          | 3.91           | %          | 4.36            | %          | 4.01                | %          | 4.03      | %          |
| Other bonds, notes and debentures                |       |               |       |           |       |            |       |                |       |      |       |
| Fair Value                                       |       | $                  | 4,026      |           | $          | 2,900           |       | $                   | —     |      | $          | — |   | $ | 6,926 |   |
| Yield                                            |       | 3.92               | %          | 4.28           | %          | —          | %          | —              | %          | 4.07      | %          |
| Asset-backed securities*(2)*                     |       |               |       |           |       |            |       |                |       |      |       |
| Fair Value                                       |       | $                  | 13,528     |           | $          | 9,835           |       | $                   | —     |      | $          | — |   | $ | 23,363 |   |
| Yield                                            |       | 3.37               | %          | 2.72           | %          | —          | %          | —              | %          | 3.10      | %          |
| Total securities available-for-sale              |       |               |       |           |       |            |       |                |       |      |       |
| Fair Value                                       |       | $                  | 574,375    |           | $          | 1,993,754       |       | $                   | 278,751    |      | $          | 25,612 |   | $ | 2,872,492 |   |
| Yield                                            |       | 3.93               | %          | 3.56           | %          | 4.50            | %          | 4.30                | %          | 3.73      | %          |
| Securities held-to-maturity                      |       |               |       |           |       |            |       |                |       |      |       |
| States and political subdivisions                |       |               |       |           |       |            |       |                |       |      |       |
| Amortized cost                                   |       | $                  | 2,812      |           | $          | 9,273           |       | $                   | 7,694      |      | $          | 397 |   | $ | 20,176 |   |
| Yield                                            |       | 6.20               | %          | 6.44           | %          | 7.71            | %          | 8.01                | %          | 6.92      | %          |

 

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(1)  Investment securities available-for-sale arepresented at estimated fair value. Yields on such securities are based on amortizedcost.

(2)  Maturities are reflected based on projectedmaturities at time of purchase. Actual maturities will vary as a result of thelevel of loan prepayments in the underlying mortgage pools.

 

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LOANCOMPOSITION AND GROWTH

Average Loans(Dollars in millions)

Five-YearCompound Growth Rate: 12.6%

 

 

**LoanPortfolio**

 

 A comparative chart of average loan balancesis included above; year-end balances are in Note No.4 (Loans and Allowance forLoan Losses) of the Financial Statements.

 

 Loans totaled $10.2 billion for the year endedDecember 31, 2004, an increase of 10.3% over the $9.3 billion for the yearended December 31, 2003.  Loansaveraged $9.7 billion in 2004 compared with $8.1 billion in 2003, an increaseof 20.2%. On average in 2004, commercial loans grew 10.0%; commercial realestate grew 26.4%; construction grew 23.0%; residential real estate loans grew23.3%; and consumer loans increased 23.9% over 2003. Most of the increases inthe various loan categories resulted primarily from the Farmers acquisition. Onan average basis, the percentage of commercial real estate loans to total loansincreased to 30% in 2004 from 28% in 2003. Additionally, construction loansincreased slightly in 2004 from 2003, while commercial loans declined to 28% in2004 from 30% in 2003. Strong demand continued throughout 2004 for realestate-based loans including commercial, residential and home equity loans andlines. At December 31, 2004, commercial and commercial real estateconstituted the largest portion, at 58%, of the total loan portfolio.

 

COMPOSITION OFEARNING ASSETS

 
| ** **                 | ** ** | **Average Balances** | ** **     |
|----------------------------|------------|----------------------|----------------|
| **(Dollars in thousands)** | ** ** | **2004**             | ** **     | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Loans                      | ** ** | **$**                | **9,719,409**  | ** ** | **76.3** | **%** | $ | 8,088,982 |   | 72.9 | % | $ | 7,088,844 |   | 73.7 | % | $ | 6,832,856 |   | 77.8 | % | $ | 6,169,632 |   | 78.3 | % |
| Investment securities(1)   | ** ** | **2,953,747**        | ** **     | **23.2** | ** ** | 2,758,044 |   | 24.9 |   | 2,353,683 |   | 24.5 |   | 1,803,293 |   | 20.6 |   | 1,681,930 |   | 21.3 |   |
| Federal funds sold, et al  | ** ** | **59,848**           | ** **     | **0.5** | ** ** | 250,462 |   | 2.2 |   | 178,624 |   | 1.8 |   | 141,245 |   | 1.6 |   | 29,434 |   | 0.4 |   |
| Total                      | ** ** | **$**                | **12,733,004** | ** ** | **100.0** | **%** | $ | 11,097,488 |   | 100.0 | % | $ | 9,621,151 |   | 100.0 | % | $ | 8,777,394 |   | 100.0 | % | $ | 7,880,996 |   | 100.0 | % |

 

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(1) Includesinterest-bearing deposits in other banks.

 

DEPOSIT MIX

 
| ** **                                   | ** ** | **Average Balances** | ** **     |
|----------------------------------------------|------------|----------------------|----------------|
| **(Dollars in thousands)**                   | ** ** | **2004**             | ** **     | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Noninterest-bearing deposits                 | ** ** | **$**                | **2,879,290**  | ** ** | **27.6** | **%** | $ | 2,269,720 |   | 25.2 | % | $ | 1,856,706 |   | 24.3 | % | $ | 1,618,838 |   | 23.0 | % | $ | 1,438,578 |   | 23.2 | % |
| Interest-bearing deposits:                   |       |                 |           |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                      | ** ** | **1,425,423**        | ** **     | **13.7** | ** ** | 1,168,074 |   | 13.0 |   | 966,283 |   | 12.7 |   | 853,911 |   | 12.2 |   | 854,035 |   | 13.8 |   |
| Checking plus interest                       | ** ** | **1,289,295**        | ** **     | **12.4** | ** ** | 1,071,877 |   | 11.9 |   | 873,497 |   | 11.4 |   | 771,186 |   | 10.9 |   | 718,669 |   | 11.6 |   |
| Money market                                 | ** ** | **1,571,462**        | ** **     | **15.1** | ** ** | 1,357,234 |   | 15.1 |   | 1,096,417 |   | 14.4 |   | 846,577 |   | 12.0 |   | 773,104 |   | 12.5 |   |
| Certificates of deposit -  $100,000 and over | ** ** | **1,314,423**        | ** **     | **12.6** | ** ** | 1,272,327 |   | 14.2 |   | 1,080,347 |   | 14.2 |   | 1,145,569 |   | 16.2 |   | 852,495 |   | 13.7 |   |
| Other time deposits                          | ** ** | **1,933,799**        | ** **     | **18.6** | ** ** | 1,852,622 |   | 20.6 |   | 1,759,160 |   | 23.0 |   | 1,812,589 |   | 25.7 |   | 1,559,973 |   | 25.2 |   |
| Total                                        | ** ** | **$**                | **10,413,692** | ** ** | **100.0** | **%** | $ | 8,991,854 |   | 100.0 | % | $ | 7,632,410 |   | 100.0 | % | $ | 7,048,670 |   | 100.0 | % | $ | 6,196,854 |   | 100.0 | % |

 

41

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**Deposits**

 

 Bankshares’ primary source of funding for itsinvesting and lending activities is deposits gathered by the 226 branches ofits banking affiliates. Average total deposits in 2004 were $10.4 billion,representing an increase of $1.4 billion, or 15.8%, over the prior year averageof $9.0 billion. The Farmers acquisition accounted for a substantial portion ofthis growth. For the year ended December 31, 2004, 81.8% of the fundingfor average earning assets was derived from deposits, compared with 81.0% forthe year ended December 31, 2003. The affiliate banking model positionsBankshares to compete not only with the large national and regional bankingcompanies in the gathering of these funds, but also with local community banks.Management believes Bankshares is positioned to retain these deposits in arising interest rate environment. 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, areversal of recent trends, the investment portfolio should provide adequateliquidity.

 

 In 2004, interest-bearing deposits represented72.4% of average total deposits and were $7.5 billion, reflecting growth of12.1% from 2003. The combination of savings, checking plus interest and moneymarket accounts increased 19.2% on average. The move to these deposit productsreflected customers’ preference for shorter-term investments, given the currentinterest rate environment. Certificates of deposit $100,000 and over and othertime deposits increased 3.9% on average in 2004 over 2003.

 

 Total average noninterest-bearing depositsrose from $2.3 billion in 2003 to $2.9 billion in 2004, or 26.9%. Demand forthis product has been strong among both commercial and retail customers throughout2004. The low earnings credit rate (resulting from the overall low marketinterest rates) paid on the corporate cash management product required greaterdeposit balances to be maintained to pay for services. Management expects thatas rates rise, the growth in deposit balances related to cash managementproducts may slow, as could fee income growth from these products.

 

RISKMANAGEMENT

 

 Bankshares has established an integrated riskmanagement structure in which senior management regularly identifies, measuresand manages risks. The Chief Risk Officer coordinates and directs the work ofseveral standing management committees charged with managing the risksBankshares faces (see below) and provides regular reports to the AuditCommittee.  These committees are:

 

• The Asset and Liability Committee(“ALCO”) which, as described in more detail below, manages interest rate risk,market risk and liquidity risk.

 

• The Credit Quality Committee,which oversees the establishment of consistent credit quality polices, monitorsthe functioning of the loan review function and determines the allowance forloan and lease loss reserves and related issues.

 

• The Compliance Committeeestablishes compliance guidelines and ensures strict compliance with allrelevant regulatory and statutory requirements for Bankshares and itsaffiliates.

 

• The Disclosure Committee,comprised of senior representatives of all of Bankshares’ business lines,reviews Bankshares’ periodic filings and disclosures and ensures compliancewith the requirements of U.S. securities laws. In conjunction with the ChiefExecutive Officer and the Chief Financial Officer, the Disclosure Committee ischarged with the design and oversight of internal controls over financialreporting.

 

• The Technology and OperationsCommittee evaluates on an ongoing basis risk in bank operations andtechnology risk to Bankshares.

 

**CreditRisk Analysis**

 

 Bankshares’ loans and commitments aresubstantially to borrowers located in its immediate region. Bankshares hasrestricted its participation in multibank credits where Bankshares is not themanaging or agent bank. Central to the operation of a sound and successfulfinancial institution is the balanced management of asset growth and creditquality. Responsibility for loan underwriting and monitoring is clearly fixedon key management personnel in each of our affiliates and, ultimately, on theboards of directors of each affiliate. These responsibilities are supported atthe holding company level by appropriate underwriting guidelines and effectiveongoing loan review. In addition, Bankshares has set an internal limit for eachaffiliate bank that is well below the regulatory limit on the maximum amount ofcredit that may be extended to a single borrower. The lead bank, MSD&T, hasa house limit of $25 million and the house limit at the next largest affiliateis $10 million. Bankshares’ house limit is $30 million, with exceptionsapproved by the MSD&T Banking Executive Committee of the Board andBankshares management.

 

 The Bankshares loan review function examineseach affiliate bank at least once every five quarters. These examinationsprovide Bankshares management with an independent perspective as to overallloan portfolio quality, risk profile, risk trends and credit administration processesat each affiliate. The Bankshares Audit Committee receives quarterly reports onthe findings.

 

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

 

 

ALLOWANCE FORLOAN LOSSES

 
| ** **                                               | ** ** | **Year  ended December 31,** | ** **     |
|----------------------------------------------------------|------------|-----------------------------------|----------------|
| **(Dollars in thousands)**                               | ** ** | **2004**                          | ** **     | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Allowance balance - beginning                            | ** ** | **$**                             | **155,337**    |   | $ | 138,601 |   | $ | 141,463 |   | $ | 138,612 |   | $ | 117,997 |   |
| Allowance of acquired banks                              | ** ** | **—**                        |           | 13,205 |   | — |   | — |   | 5,868 |   |
| Charge-offs:                                             |       |                              |           |   |   |   |   |   |   |   |   |
| Commercial                                               | ** ** | **(13,428**                       | )              | (5,140 | ) | (13,393 | ) | (3,757 | ) | (2,640 | ) |
| Commercial real estate                                   | ** ** | **(67**                           | )              | (625 | ) | (471 | ) | (42 | ) | (235 | ) |
| Construction                                             | ** ** | **—**                        |           | (170 | ) | — |   | (90 | ) | (11 | ) |
| Residential real estate                                  | ** ** | **(427**                          | )              | (246 | ) | (251 | ) | (104 | ) | (322 | ) |
| Consumer                                                 | ** ** | **(4,453**                        | )              | (4,367 | ) | (3,306 | ) | (3,507 | ) | (2,998 | ) |
| Lease financing                                          | ** ** | **(5**                            | )              | (1,776 | ) | (4,800 | ) | (5,828 | ) | — |   |
| Total                                                    | ** ** | **(18,380**                       | )              | (12,324 | ) | (22,221 | ) | (13,328 | ) | (6,206 | ) |
| Recoveries:                                              |       |                              |           |   |   |   |   |   |   |   |   |
| Commercial                                               | ** ** | **1,662**                         |           | 1,029 |   | 686 |   | 635 |   | 1,765 |   |
| Commercial real estate                                   | ** ** | **118**                           |           | 174 |   | 161 |   | 160 |   | 198 |   |
| Construction                                             | ** ** | **5**                             |           | 136 |   | 226 |   | 78 |   | 177 |   |
| Residential real estate                                  | ** ** | **378**                           |           | 125 |   | 128 |   | 147 |   | 144 |   |
| Consumer                                                 | ** ** | **2,555**                         |           | 1,970 |   | 1,570 |   | 1,725 |   | 1,438 |   |
| Lease financing                                          | ** ** | **106**                           |           | 316 |   | 210 |   | — |   | — |   |
| Total                                                    | ** ** | **4,824**                         |           | 3,750 |   | 2,981 |   | 2,745 |   | 3,722 |   |
| Net charge-offs                                          | ** ** | **(13,556**                       | )              | (8,574 | ) | (19,240 | ) | (10,583 | ) | (2,484 | ) |
| Provision for loan losses                                | ** ** | **7,221**                         |           | 12,105 |   | 16,378 |   | 13,434 |   | 17,231 |   |
| Allowance balance - ending                               | ** ** | **$**                             | **149,002**    |   | $ | 155,337 |   | $ | 138,601 |   | $ | 141,463 |   | $ | 138,612 |   |
| Average loans                                            | ** ** | **$**                             | **9,719,409**  |   | $ | 8,088,982 |   | $ | 7,088,844 |   | $ | 6,832,856 |   | $ | 6,169,632 |   |
| Percent of net charge-offs to average loans              | ** ** | **0.14**                          | **%**          | 0.11 | % | 0.27 | % | 0.15 | % | 0.04 | % |
| Period-end loans                                         | ** ** | **$**                             | **10,228,433** |   | $ | 9,272,160 |   | $ | 7,312,027 |   | $ | 6,906,246 |   | $ | 6,693,294 |   |
| Percent of allowance for loan losses to period-end loans | ** ** | **1.46**                          | **%**          | 1.68 | % | 1.90 | % | 2.05 | % | 2.07 | % |

 

 Bankshares maintains an allowance for loanlosses at a level considered by management to be adequate to absorb potentiallosses inherent in the loan portfolio. The allowance for loan losses iscomprised of specific allocations to impaired loans, general allocations topools of loans not deemed impaired and an unallocated amount. The portfolioreview and the calculation of the allowance for loan losses are performed on aquarterly basis by Bankshares management. The calculation is reviewed by theBankshares Credit Quality Committee and each affiliate bank as to its specificallowance. The aggregate calculation establishes a targeted minimum level forthe allowance at each affiliate, subject to review and feedback from eachaffiliate. Final approval rests with the Credit Quality Committee. The finalevaluation is reviewed with the Bankshares Audit Committee. All loan lossreserves are subject to annual bank regulatory examinations and determinationsas to their methodology and adequacy. Overall, the determinations of theallowance for loan losses incorporate SFAS No. 114, “Accounting by Creditorsfor Impairment of a Loan,” and SFAS No. 118, “Accounting by Creditors forImpairment of a Loan-Income Recognition and Disclosure.” 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.

 

43

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ALLOCATION OFALLOWANCE FOR LOAN LOSSES

 

The tablebelow presents the amount of allowance for loan losses and the percentagedistribution of loan amounts in each category, at the date shown:

 
| ** **                      | ** ** | **Allowance amount allocated as  of December 31,** | ** **  |
|---------------------------------|------------|---------------------------------------------------------|-------------|
| ** **                      | ** ** | **2004**                                                | ** **  | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **(Dollars in thousands)**      | ** ** | **Amount**                                              | ** **  | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** |
| Allowance amount allocated to:  |       |                                                    |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                      | ** ** | **$**                                                   | **56,337**  | ** ** | **27.6** | **%** | $ | 92,079 |   | 27.8 | % | $ | 88,111 |   | 31.5 | % | $ | 65,938 |   | 32.3 | % | $ | 55,400 |   | 33.1 | % |
| Commercial real estate (1) | ** ** | **32,770**                                              | ** **  | **30.5** | ** ** | 28,237 |   | 29.5 |   | 21,275 |   | 27.6 |   | 13,315 |   | 26.3 |   | — |   | 21.0 |   |
| Construction                    | ** ** | **11,080**                                              | ** **  | **12.4** | ** ** | 10,806 |   | 11.5 |   | 9,644 |   | 11.1 |   | 7,124 |   | 9.4 |   | 18,000 |   | 12.3 |   |
| Residential real estate         | ** ** | **10,303**                                              | ** **  | **14.5** | ** ** | 7,263 |   | 14.4 |   | 3,645 |   | 14.6 |   | 2,866 |   | 15.4 |   | 9,700 |   | 16.2 |   |
| Consumer                        | ** ** | **14,247**                                              | ** **  | **14.5** | ** ** | 14,447 |   | 16.0 |   | 6,565 |   | 13.9 |   | 6,149 |   | 14.4 |   | 5,500 |   | 15.0 |   |
| Lease financing                 | ** ** | **2,578**                                               | ** **  | **0.5** | ** ** | 2,505 |   | 0.8 |   | 9,361 |   | 1.3 |   | 26,594 |   | 2.2 |   | — |   | 2.4 |   |
| Allowance amount not allocated  | ** ** | **21,687**                                              |        |   | ** ** | — |   |   |   | — |   |   |   | 19,477 |   |   |   | 50,012 |   |   |   |
| Total                           | ** ** | **$**                                                   | **149,002** | ** ** | **100.0** | **%** | $ | 155,337 |   | 100.0 | % | $ | 138,601 |   | 100.0 | % | $ | 141,463 |   | 100.0 | % | $ | 138,612 |   | 100.0 | % |

 

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(1) Commercialreal estate allowance amount is included in commercial for December 31,2000.

 

**Allowancefor Loan Losses**

 

 The allowance for loan losses is comprised ofspecific allocations to impaired loans, general allocations to pools of loansnot deemed impaired and an unallocated amount. Current trends and economicconditions that affect the collectibility of the loan portfolio areincorporated into the general allocation. These can include, but are notlimited to, exposure to an industry experiencing problems, changes in thenature or volume of the portfolio, delinquency and nonaccrual trends.

 

 The specific allowance allocation is based onan analysis of the loan portfolio by each affiliate bank and Loan Review. Eachloan with an outstanding balance in excess of a specified threshold that iseither on nonaccrual status or on the Watchlist is evaluated. The Watchlistrepresents loans identified and closely followed by management. They possesscertain qualities or characteristics that may lead to collection and lossissues. Monitored loans, which are included in the Watchlist, displayadditional risk characteristics suggesting they may be classified asnonperforming loans in the near feature. The identified loans are evaluated forpotential loss in accordance with SFAS No. 114 and SFAS No. 118 by analyzingcurrent collateral values or present value of cash flows, as well as thecapacity of the guarantor, as applicable. The specific allocation resultingfrom this review decreased 28.9% to $10.6 million from $14.9 million at December 31,2004 and 2003, respectively related to specific loan balances of $18.4 millionand $26.7 million. The decrease is largely attributable to a charge-off relatedto one credit in the amount of $3.8 million, where Bankshares accepted apayment terminating its interest in that credit. Two remaining credit exposuresat MSD&T accounted for $9.5 million, based on the fair value of thecollateral, of the specific allocation at December 31, 2004. These creditswere also specifically reserved at December 31, 2003. See “NonperformingAssets” below for more detail.

 

 The general allowance calculation, which iscompleted on a quarterly basis, begins with segmentation of the remaining(unimpaired) portfolio according to loan types. Historical loss factors aremaintained for each loan type, providing the starting point of the analysis.Historical loss factors are applied to all non-Watchlist loans. Management iscurrently utilizing the past five-year loss history specific to each majorsegment to perform the allocation. Historical loss factors are adjusted toreflect the point in time that management initially identified a potentialimpairment loss in such risk-rated loans, as opposed to when such loss isactually taken as a charge-off against the allowance. This adjustment isnecessary, as Bankshares’ practice generally has 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 tolag the national and regional economic cycles. Bankshares also has developeddata on probability of default and loss given default, which have beenincorporated for the higher risk rated credits, which include Watchlist loansthat are not currently impaired. Those loss factors are then applied to allloans within the same risk rating. Qualitative factors that may cause creditlosses to deviate from average historical experience are then developed. Theseinclude but are not limited to: changes in the volume and severity of past dueloans; changes in the volume of Watchlist loans and nonaccruals; concentrationsin a specific industry or geographic location; administrative risk concernsthat include changes in the loan review and loan grading system; changes inlending policies and procedures (which include underwriting, collection,charge-off and recovery practices); changes in management or the staff of anypreviously mentioned areas; and current economic conditions and indicators.Both internal and external peer data are utilized as applicable to establishthese factors. Management’s judgment and experience are key to this process.These factors are revised to address current conditions and trends in theportfolio. The general allowance was $138.4 million and $140.4 million at December 31,2004 and 2003, respectively. Changes in the general allocation can beattributed to the ongoing refinement of the methodology in 

 

44

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quantifyingrisk segments and estimation techniques used in the calculation. Historicalloss factors increased for the commercial and industrial portfolio and theleasing portfolio and reflect the increase in recent charge-off activities.Historical loss experience declined in the other portfolios. Improvement in theeconomy and delinquencies contributed to a lower allocation to each portfolio.In addition, the general allocation for the commercial and industrial portfoliodeclined due to the significant decrease in monitored loans from $28.4 millionat December 31, 2003 to $6.4 million at December 31, 2004. Thiscategory has the highest risk rating and corresponding loss allocation forperforming loans. During 2004, management enhanced its risk rating categoriesto provide more granularity in assessing the overall risk profile of theportfolio. The increased allocation to residential real estate loans wasattributable to this enhancement.

 

 The allowance amount not allocated representsthe differential between the combined specific and general allocations and theactual allowance. The unallocated allowance recognizes the imprecision inherentin estimating and measuring loss when allocating the allowance to individual orpools of loans. It takes into consideration the allowance level deemed appropriateby each affiliate based on its local knowledge and feedback from Bankregulators and their view from the standpoint of safety and soundness, amongother factors.

 

 The allowance for loan losses as a percent ofloans declined to 1.46% at December 31, 2004 compared with 1.68% at December 31,2003. This reflects overall improving credit quality trends and thedisposition, as previously mentioned, of problem credits. Bankshares accepted a$6.0 million payment, which terminated its interest in one of the two monitoredloans secured by commercial aircraft and resulted in a loss of $8.1million.  During 2004 the provision forloan loss expense was $7.2 million compared with $12.1 million in 2003. Netcharge-offs increased to $13.6 million during 2004 compared with $8.6 millionduring 2003. The commercial portfolio represented the largest net charge-offamount for 2004 at $11.8 million, or 86.8% of total net charge-offs. Netcharge-offs as a percent of average loans were .14%, .11% and .27% for theyears ended December 31, 2004, 2003 and 2002, respectively. Intensivecollection efforts continue after a loan is charged off in order to maximizethe recovery of amounts previously charged off. Recoveries as a percent ofloans charged-off were 26.3% in 2004, 30.4% in 2003 and 13.4% in 2002.Recoveries in a given year may not relate to loans charged off in that year.Further details related to the allowance for loan losses are shown in thetables above and in Note No. 4 of the financial statements.

 

 NONPERFORMING ASSETS

 

A five-yearcomparison of nonperforming assets is presented below:

 
| ** **                                                                         | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**                                                         | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Nonaccrual loans *(1)*                                                             |       |                  |       |   |   |   |   |   |   |   |   |
| Commercial                                                                         | ** ** | **$**                 | **25,030** |   | $ | 36,569 |   | $ | 15,938 |   | $ | 17,720 |   | $ | 15,888 |   |
| Commercial real estate                                                             | ** ** | **1,959**             |       | 7,363 |   | 9,322 |   | 5,564 |   | 6,848 |   |
| Construction                                                                       | ** ** | **9**                 |       | 651 |   | 1,365 |   | 2,201 |   | 3,394 |   |
| Residential real estate                                                            | ** ** | **2,748**             |       | 3,721 |   | 2,479 |   | 2,251 |   | 3,123 |   |
| Consumer                                                                           | ** ** | **672**               |       | 1,224 |   | 261 |   | 408 |   | 249 |   |
| Lease financing                                                                    | ** ** | **480**               |       | 824 |   | 4,006 |   | 4,775 |   | 863 |   |
| Total                                                                              | ** ** | **30,898**            |       | 50,352 |   | 33,371 |   | 32,919 |   | 30,365 |   |
| Renegotiated loans*(1)*                                                            | ** ** | **—**            |       | — |   | — |   | — |   | — |   |
| Loans contractually past due 90 days or more and still accruing  interest          | ** ** | **—**            |       | — |   | — |   | — |   | — |   |
| Total nonperforming loans                                                          | ** ** | **30,898**            |       | 50,352 |   | 33,371 |   | 32,919 |   | 30,365 |   |
| Other real estate owned                                                            | ** ** | **212**               |       | 191 |   | 132 |   | 181 |   | 1,005 |   |
| Total nonperforming assets                                                         | ** ** | **$**                 | **31,110** |   | $ | 50,543 |   | $ | 33,503 |   | $ | 33,100 |   | $ | 31,370 |   |
| Nonperforming loans as a percent of period-end loans                               | ** ** | **.30**               | **%**      | .54 | % | .46 | % | .48 | % | .45 | % |
| Nonperforming assets as a percent of period-end loans and other real  estate owned | ** ** | **.30**               | **%**      | .55 | % | .46 | % | .48 | % | .47 | % |

 

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(1)  Aggregate gross interest income of $2.5million and $4.1 million in 2004 and 2003, respectively, on nonaccrual andrenegotiated loans would have been recorded if these loans had been accruing ontheir original terms throughout the period or since origination if held forpart of the period. The amount of interest income on the nonaccrual andrenegotiated loans that was recorded totaled $0.8 million and $2.1 million in2004 and 2003, respectively.

 

 Note: Management was monitoring loansestimated to aggregate $6.4 million at December 31, 2004 and $28.4 millionat December 31, 2003 that were not classified as nonaccrual orrenegotiated loans. These loans had characteristics which indicated they mightbecome nonaccrual in the future.

 

45

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**NonperformingAssets**

 

 Nonperforming assets consist of nonaccrualloans, renegotiated loans and other real estate owned (i.e., real estateacquired in foreclosure or in lieu of foreclosure). With respect to nonaccrualloans, our policy is that, regardless of the value of the underlying collateraland/or guarantees, no interest is accrued on the entire balance once eitherprincipal or interest payments on any loan is 90 days past due at the end of acalendar quarter. All accrued and uncollected interest on such loans isreversed out of interest income and is recognized only as it is collected. If aloan is impaired and has a specific loss allocation based on an analysis underSFAS No. 114, all payments are applied against the loan’s principal. A loan maybe put on nonaccrual status sooner than this standard if, in management’sjudgment, such action is warranted.

 

 Nonperforming assets as a percent ofperiod-end loans and other real estate owned was .30% at December 31, 2004compared with .55% in the preceding year. At year-end 2004, nonperforming assets were $31.1 million compared with$50.5 million at year-end 2003.  Nonperformingloans totaled $30.9 million at December 31, 2004 compared with $50.4million at December 31, 2003. Nonperforming loans decreased in all categories of the loan portfolio.The largest dollar decrease in nonperforming loans was $11.5 million in thecommercial and industrial category, which accounted for 81% of nonperformingloans at December 31, 2004.  Thedecline primarily relates to the previously mentioned acceptance of payment andcharge-off of a nonperforming loan in the fourth quarter of 2004. Therestoration of one customer to full accrual status accounted for $2.5 millionof the $5.4 million decrease in commercial real estate nonaccrual loans.

 

The level ofmonitored loans, or loans with characteristics suggesting that they may beclassified as nonperforming in the near future, decreased during the year. At December 31,2004, monitored loans were $6.4 million compared with $28.4 million a yearbefore. Bankshares had two loans in the “monitored” category that were made in1998 and 1999 and were secured by commercial aircraft.  On November 6, 2004, Bankshares accepteda $6.0 million payment, which terminated its interest in one of the loans. Thisloan had an outstanding principal balance of $14.1 million at that date.  The $8.1 million difference was chargedagainst the allowance for loan losses in the fourth quarter of 2004.  Although both loans continued to beperforming in accordance with their terms, management’s decision to accept thispayment was attributable to a number of factors including the noncore nature ofthe loan, the residual risk and the risk of declining collateral value, andcontinuing concerns about the commercial airline industry.  The other loan to the same borrowerrepresents a $2.6 million exposure and remains in the monitored category.  This loan matures in February 2009 andcarries a significant guarantee.

 

 Other real estate owned was $212 thousand at December 31,2004 compared with $191 thousand at December 31, 2003. These propertiesgenerally are sold within a short period. Therefore, regardless of the amount,the properties generally will have changed from year to year. Other real estateowned is carried at the lower of cost or fair market value. Refer to the datain the “Nonperforming Assets” chart above, which shows the changes in theamounts of various categories of nonperforming assets over the last five yearsand sets forth the relationship between nonperforming loans and total loans.

 

LOAN MATURITYSCHEDULE

 

The followingtable illustrates loan diversity by maturity distribution for commercial(including commercial real estate and lease financing) and construction loansas of December 31, 2004.

 
|                       | ** ** | **Maturing**        | ** ** |
|----------------------------|------------|---------------------|------------|
| **(Dollars in thousands)** | ** ** | **1 year  or less** | ** ** | **Over 1  through  5 years** | ** ** | **Over 5  years** | ** ** | **Total** | ** ** |
| Commercial                 |       | $                   | 1,871,052  |   | $ | 2,783,265 |   | $ | 1,335,077 |   | $ | 5,989,394 |   |
| Construction               |       | 485,441             |       | 575,252 |   | 207,657 |   | 1,268,350 |   |
| Total                      |       | $                   | 2,356,493  |   | $ | 3,358,517 |   | $ | 1,542,734 |   | $ | 7,257,744 |   |

 

 Of the $4.9 billion in loans maturing afterone year, $2.1 billion, or 42.0%, have fixed interest rates and $2.8 billion,or 58.0%, have variable interest rates.

 

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**Asset/Liabilityand Market Risk Management**

 

Asset/liabilitymanagement involves the evaluation, monitoring and management of interest raterisk, market risk, liquidity and funding. The Asset/Liability ManagementCommittee oversees policy guidelines and reports periodically to the AuditCommittee of the Board of Directors. This Committee consists of seniorfinancial and business executives. Treasury division management and otherfinance personnel monitor the day-to-day exposure to interest rates in responseto loan and deposit flows.

 

**InterestRate Risk**

 

 Interest rate risk, which potentially can havea significant earnings impact, is an integral part of being a financialintermediary. Bankshares is subject to interest rate risk due to a variety offactors including:

•                  Assets andliabilities may mature or reprice at different times (for example, currentlyour assets reprice faster than our liabilities and if interest rates fall,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-sensitivewhen its assets (loans and securities) reprice faster or to a greater extentthan liabilities (deposits and borrowings). An asset-sensitive balance sheetwill produce more net interest income when rates rise and less net interestincome when rates fall. A balance sheet is described as liability-sensitivewhen its liabilities (deposits or borrowings) reprice more frequently or to agreater degree than its assets (loans and securities). A liability-sensitivebalance sheet will produce a lower level of net interest income when interestrates rise and more net interest income when rates fall. Bankshares’ large andrelatively rate- insensitive deposit base funds a portfolio with a largepercentage of floating-rate commercial and consumer loans, which creates a biastowards asset sensitivity.

 

 To manage this asset sensitivity in ourbalance sheet, we maintain a large portfolio of fixed-rate, althoughshort-duration, investments. Periodically, we elect to use derivatives to protectassets and liabilities from changes in interest rates. When deciding whether touse derivatives instead of cash market instruments to achieve the same goal, weconsider a number of factors, such as cost, efficiency, the effect on ourliquidity and capital, and our overall strategy. The derivatives we use forinterest rate risk management purposes are primarily interest rate swaps. Wefully incorporate the market risk associated with interest rate risk managementderivatives into our earnings simulation model in the same manner as otheron-balance-sheet financial instruments.

 

 We analyze and manage interest rate risk byforecasting a wide range of interest rate scenarios for time periods as long as24 months. However, in analyzing interest rate sensitivity for policymeasurement, we compare our forecasted net interest income in both  “high rate” and “low rate” scenarios to ourmost likely earnings estimate utilizing a “flat rate” scenario. The policymeasurement periods are 12 and 24 months in length, beginning with the firstmonth of the forecast. Our objective is to manage prudently theinterest-bearing assets and liabilities on our balance sheet in ways thatminimize our exposure to changes in interest rates. Our policy is to limit therisk we take through balance sheet management actions to 5% and 8% of our netinterest income in the 12-month and 24-month measurement periods, respectively.

 

 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 approachevaluates expected net interest income in a 200 basis point range both aboveand below the “flat rate” scenario. However, due to the currently low absolutelevels of interest rates, we have modified the “low rate” scenario to measure adecline of 50 basis points.

 

 To capture the impact of yield curve-relatedrisk, we simultaneously measure the impact of nonparallel shifts in rates. Aparallel shift would move all points on the yield curve by the same increments.A nonparallel shift would consist of a 100 basis point increase in short-termrates, while long-term rates would increase by a different amount. A rate shiftin which short-term rates rise to a greater extent than long-term rates isreferred to as a “flattening” of the yield curve. Conversely, long-term ratesrising to a greater extent than short-term rates would lead to a “steepening”of the yield curve.

 

 Improving economic growth in the first half of2004 resulted in the Federal Reserve Board adjusting its position on the levelof interest rates. Whereas the Federal Reserve Board continued to pursue anaccommodative monetary policy in 2003, it began tightening monetary policy on June 30,2004. By December 31, 2004, the Federal Reserve Board had raised interestrates by 125 basis points. As a result, the historically steep yield curveenvironment that persisted in 2003 began to shift to a flatter yield curveenvironment. Accordingly, throughout 2004 we evaluated rate shifts thatincluded a flattening of the yield curve. Interest rate risk managementdecisions are made based on a composite view of both parallel and nonparallelshifts.

 

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 Bankshares’ Consolidated Balance Sheet hadbeen positioned for a rate rise, and the increase in 2004 net interest incomereflects some of the benefit of the Federal Reserve Board rate increases.Additionally, in 2004 we continued our investment strategy of shifting theportfolio mix into a higher percentage of mortgage-backed securities. We usemortgage-backed securities as a hedge against both rising and falling interestrates, depending on their purchase price, which has a significant impact ontheir yield in different rate environments. We selectively include currentcoupon mortgage securities in our portfolio as a hedge against a continued lowrate environment. Mortgage securities purchased at a discount are used to hedgeagainst declining rates.

 

EARNINGSSENSITIVITY

 

 The following table summarizes the effect apositive 100 and 200 basis point change and a negative 50 basis point change ininterest rates would have on Bankshares’ net interest income over the next 12months.

 
| ** **                   | ** ** | **Calculated increase / (decrease)  in  projected net interest income** | ** ** |
|------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Change in interest rates** | ** ** | **As of December 31,**                                                  | ** ** |
| **(basis points)**           | ** ** | **2004**                                                                | ** ** | **2003** | ** ** |
| +200                         |       | 5.5                                                                     | %          | 4.6 | % |
| +100                         |       | 2.8                                                                     | %          | 2.4 | % |
| -50                          |       | (1.8                                                                    | )%         | (2.1 | )% |

 

 As seen in the “Earnings Sensitivity” tableabove, within a one-year horizon, the earnings sensitivity model forecaststhat, compared with the net interest income projection under stable rates, netinterest income would increase by 2.8% and 5.5% if interest rates increased by100 and 200 basis points, respectively, and that net interest income woulddecrease by 1.8% if interest rates decreased by 50 basis points. These resultsare not necessarily indicative of future actual results, nor do they take intoaccount certain actions that management may undertake in response to future changesin interest rates.

 

**MarketRisk**

 

 Market risk is defined as the constraintimposed by lower market values of assets and liabilities as interest rates andequity markets fluctuate. Changes in market values also impact the fee incomeearned by IWM, where a significant portion of the fee schedule is tied tocurrent asset values under management or administration. Bankshares hasdesignated substantially all of its investment portfolio as available-for-sale,and in accordance with financial reporting standards, this portfolio isreported at fair value. Changes in fair value, net of tax, are reflected as acomponent of shareholders’ equity.

 

*TradingActivities*

 

 In 2004, we began marketing capital marketsproducts to our customers. From a market risk perspective, Bankshares’ netincome is exposed to changes in interest rates, credit spreads and equity andtheir implied volatilities. The primary purpose of the Capital Markets Groupbusiness is to accommodate customers in the management of their market price risks.Derivative transactions executed with customers are simultaneously hedged inthe capital markets. All derivatives transacted with customers or used to hedgecapital market transactions with customers are carried at fair value. TheAsset/Liability Management Committee establishes and monitors counterparty risklimits. The notional amount, exposure amount and estimated net fair value ofall customer accommodation derivatives at December 31, 2004 are included inNote No. 18 of the financial statements.

 

*EquityMarkets*

 

 We are directly and indirectlyaffected by changes in the equity markets. We make and manage direct equityinvestments in start-up businesses, emerging growth companies and othercorporate capitalizations. We also invest in hedge funds managers that makesimilar investments. These private equity investments are made within capitalallocations approved by Bankshares management. Management reviews theseinvestments at least quarterly and assesses them for possibleother-than-temporary impairment. For nonmarketable investments, the analysis isbased on 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 equityinvestments totaled $24.7 million at December 31, 2004 and $17.6 million atDecember 31, 2003. Hedge funds investment totaled $77.5 million at December 31,2004 and $81.1 million at December 31, 2003.

 

 Changes in equity market pricesmay also indirectly affect Bankshares’ net income (1) by affecting the value ofthird-party assets under management or administration and, hence, fee income;(2) by affecting particular borrowers, whose ability to repay principal and/orinterest may be affected by the stock market; or (3) by affecting brokerageactivity, related commission income and other business activities; and (4) byaffecting the income derived from the value of hedge funds investments.

 

 Bankshares’ maintenance ofcapital ratios well above regulatory requirements (see “Capital Resources andAdequacy” below) provides management with the flexibility to utilize theavailable-for-sale portfolio for liquidity and interest rate risk managementneeds, even during a period when valuations are depressed. Maintaining a fairlyshort duration in the portfolio also mitigates market risk.

 

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**LiquidityRisk**

 

 Liquidity risk is the possibility thatBankshares will not be able to fund 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, theAsset/Liability Management Committee 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 the available-for-sale portfolio provideasset liquidity, in addition to the immediately liquid resources of cash anddue from banks and federal funds sold and securities purchased under resaleagreements. By limiting the maturity of securities and maintaining aconservative investment posture, management can rely on the investmentportfolio to help meet any short-term funding needs. U.S. Treasury and U.S.Agency securities, which provide the greatest liquidity, averaged $1.6 billionin 2004, a 10.4% decrease from the average of $1.7 billion in 2003.

 

 Core customer deposits historically haveprovided a sizable source of relatively stable and low cost funds. At December31, 2004, core deposits (total deposits less certificates of deposit of$100,000 and over), averaged $9.1 billion compared with $7.7 billion atDecember 31, 2003. However, should there be an outflow of deposits, a reversalof recent trends, the investment portfolio should provide adequate liquidity.Although not viewed as core deposits, a substantial portion of short-termborrowings comprised of securities sold under agreements to repurchase andcommercial paper originate from core deposit relationships tied to theovernight cash management program offered to customers. Short-term borrowingsaveraged $932.5 million during 2004, a 9.5% increase from the 2003 level.Short-term borrowings were $887.9 million at December 31, 2004 and $809.0million at December 31, 2003.

 

 In addition to these sources, Bankshares hasaccess to national markets for certificates of deposit, commercial paper anddebt financing. Should Bankshares need to supplement its liquidity, it also has$1.8 billion in lines with the Federal Home Loan Bank Atlanta (“FHLB”) andback-up commercial paper lines of $40 million with commercial banks. Banksharesis required to obtain approval from holders of Bankshares’ 6.72% and 6.80%unsecured senior notes if Bankshares incrementally borrows in excess of $150million under the FHLB lines.

 

 Long-term debt increased to $691.0 million atDecember 31, 2004 from $647.7 million at December 31, 2003, primarily due tothe sale of the Hopkins Plaza Building which, based on the terms of the salesagreement, under the applicable accounting rules was required to be treated asa financing of the $51.2 million sale price. During 2004, $8.0 million wasrepaid on previously existing long-term debt. Bankshares can access the capitalmarkets for long-term funding by issuing registered debt and privateplacements. In December 2004, Moody’s Investors Service affirmed MercantileBankshares Corporation’s commercial paper rating of  “P-1” and the Corporation’s subordinated debtrating of  “A2.” Also in December 2004,Standard & Poor’s Ratings Service affirmed Bankshares’ rating of  “A+/Stable/A-1” and counterparty ratingof  “A+/Stable/A-1.” Rating agencies basetheir ratings on many quantitative and qualitative factors including capitaladequacy, liquidity, asset quality, quality of the management team, businessmix and the level and quality of earnings.

 

TIER I CAPITAL RATIO*

 
| Regulatory  Tier I Minimum: 4% |
|--------------------------------|
|                                |

 

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* Tier Iequity as percentages of risk-adjusted total assets at December 31,

 

DIVIDENDS PER SHARE

 
| Five-Year  Compound Growth Rate: 8.0% |
|---------------------------------------|
|                                       |

 

**CapitalResources and Adequacy**

 

 Bankshares has consistently maintained acapital to asset ratio higher than its peers, as reported in data furnished byits regulators. Shareholders’ equity averaged $1.9 billion during 2004, whichrepresented an increase of $374.5 million, or 25.0%, over the prior year’saverage.

 

  Maintenance of capital strength has long beena guiding principle of Bankshares. Ample capital is necessary to sustaingrowth, to provide a measure of protection against unanticipated declines inasset values and to safeguard the funds of depositors. Capital also provides asource of funds to meet loan demand and enables Bankshares to manage its assetsand liabilities effectively.

 

 Shareholders’ equity increased 4.1% to $1.9billion at year-end 2004 from $1.8 billion at year-end 2003. The increase canbe attributed primarily to earnings growth offset by increased cash dividendpayments and share repurchases. Book value per share was $24.18 at December 31,2004 compared with $23.08 at December 31, 2003. The ratio of average equity toaverage assets was 13.38%

 

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in 2004 and12.51% in 2003, ranking Bankshares among the most strongly capitalized banks inthe industry. Excluding intangible assets, average tangible equity to averagetangible assets was 9.70% in 2004 and 10.34% in 2003.

 

 While maintaining exceptional capital strengthand financing growth of the corporation, Bankshares also has pursued a sharerepurchase program. In 2001, the Board of Directors authorized the repurchaseof shares of common stock under these programs. At December 31, 2004, thereremained 476,327 shares of common stock authorized for repurchase. The sharerepurchase program has supported management’s strategy to enhance shareholdervalue. Management has repurchased shares in open market and privatelynegotiated transactions during periods when capital accumulates at a rate inexcess of that required to support the growth of earning assets. See Note No.11 of the financial statements and the “Statements of Changes in ConsolidatedShareholders’ Equity” below for details related to the share repurchaseprogram.

 

 Various bank regulatory agencies haveimplemented capital guidelines, which are directly related to a bank’srisk-based capital ratios. By regulatory definition, a well-capitalizedinstitution, such as Bankshares, faces fewer regulatory constraints on itsoperations than institutions classified as undercapitalized. For example, onlywell-capitalized banks can accept brokered deposits without advance regulatory approval.In addition, FDIC deposit insurance premium rates are significantly lower forbanks with higher capital levels. The “Tier I Capital Ratios” graph above showsthat Bankshares has maintained capital levels well in excess of the regulatoryminimum over each of the last five years. For a further discussion of theregulatory capital requirements that apply to Bankshares, see Note No. 11 ofthe 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 dividend restrictions have not limited dividendpayments at Bankshares, and it is not anticipated that they will have aconstraining effect in the future. In addition to dividend restrictions,capital requirements also are affected by off-balance sheet risks. Theseinclude such items as letters of credit and commitments to extend credit. Referto Note No. 10 of the financial statements for information regarding Bankshares’commitments.

 

DIVIDENDS

 
| ** **       | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------|------------|----------|------------|----------|------------|
| **Quarter**      | ** ** | **4th**  | ** ** | **3rd**  | ** ** | **2nd** | ** ** | **1st** | ** ** | **4th** | ** ** | **3rd** | ** ** | **2nd** | ** ** | **1st** | ** ** |
| Common dividends | ** ** | **.35**  | ** ** | **.35**  | ** ** | **.35** | ** ** | **.33** |   | .33 |   | .33 |   | .33 |   | .30 |   |

 

 Bankshares has paid quarterly cash dividendson its common stock since September 1970 when such stock was first issued.Bankshares intends to consider quarterly payment of dividends on its commonstock, but such payment is necessarily dependent on many factors, including thefuture earnings and financial requirements of Bankshares and its affiliates.

 

 For the 28th consecutive year, the annualdividend paid on common stock exceeded the prior year’s level. Effective withthe June 2004 dividend, the quarterly cash dividend was increased 6% to $.35from $.33 per share. Over the last five years, dividends have increased at acompound growth rate of 8.0%. Management periodically will evaluate thedividend rate in light of Bankshares’ capital strength, profitability andconditions prevailing in the economy in general and the banking industry inparticular. The annual dividends paid per common share were $1.38 in 2004 and$1.29 in 2003. Total cash dividends paid were $109.3 million in 2004 and $95.8million in 2003. The “Dividends” table above presents quarterly dividends paidover the last two years.

 

RECENT COMMONSTOCK PRICES

Market Prices(1)

 
| ** **  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-------------|------------|-----------|------------|-----------|------------|
| **Quarter** | ** ** | **4th**   | ** ** | **3rd**   | ** ** | **2nd** | ** ** | **1st** | ** ** | **4th** | ** ** | **3rd** | ** ** | **2nd** | ** ** | **1st** | ** ** |
| High        | ** ** | **53.09** | ** ** | **49.34** | ** ** | **47.93** | ** ** | **46.01** |   | 45.95 |   | 42.49 |   | 41.30 |   | 40.47 |   |
| Low         | ** ** | **47.07** | ** ** | **44.18** | ** ** | **40.31** | ** ** | **41.50** |   | 39.76 |   | 38.91 |   | 33.90 |   | 30.16 |   |

 

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(1) The stockof Mercantile Bankshares Corporation is traded on the Nasdaq National Marketunder the symbol MRBK. The quotations represent actual transactions.

 

As of February28, 2005, there were 10,152 shareholders of record.

 

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**Off-BalanceSheet Arrangements and Contractual Obligations**

 

*Off-BalanceSheet Arrangements*

 

 Bankshares consolidates majority-ownedsubsidiaries that it controls. Other affiliates, including certain jointventures in which there is less than 20% ownership, are generally carried atlower of cost or fair market value. Bankshares does not dispose of troubledloans or problem assets by means of unconsolidated special purpose entities.

 

 Bankshares’ mortgage banking subsidiary, as aFannie Mae Delegated Underwriting and Servicing lender, has a loss sharingarrangement for loans originated on behalf of and sold to Fannie Mae. In theordinary course of business, Bankshares routinely originates and sells mortgageloans on the secondary market. Typically these loans are sold under forwardcommitments on a servicing released basis. Refer to Note No. 10 of thefinancial statements for additional information regarding commitments relatingto mortgage banking.

 

*ContractualObligations and Other Commitments*

 

 Through the normal course of business,Bankshares enters into certain contractual obligations and other commitments.Such obligations generally relate to funding operations through debtarrangements as well as leases of premises and equipment. These commitments for2005 include budgeted requests for approximately $26.1 million of capitalexpenditures for new and existing banking offices and replacement of furniture,equipment and technology. While these items have been included in the budgetfor 2005, they are subject to a review and approval process prior to funding.For further information on commitments, see Notes No. 5, 9 and 10 of thefinancial statements.

 

 Guarantees are contracts that contingentlyrequire us to make payments to a guaranteed party based on an event or changesin an underlying asset, liability, rate or index.

 

 As a financial services provider, Banksharesroutinely enters into commitments to extend credit, including loan commitments,standby letters of credit and financial guarantees. While contractualobligations represent future cash requirements of Bankshares, a significantportion of commitments to extend credit are likely to expire without beingdrawn upon. Such commitments are subject to the same credit policies andapproval processes accorded to loans made by Bankshares. Additionally,Bankshares has committed to invest funds in third-party private equityinvestments.

 

The tablebelow summarizes significant contractual obligations and other commitments:

 
| **(Dollars  in thousands)**                         | *** *** | **1 Year  or less** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **After 5  years** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|--------------|---------------------|------------|----------------|------------|----------------|------------|--------------------|------------|-----------|------------|
| Contractual obligations                             |         |                |       |           |       |           |       |               |       |      |       |
| Long-term debt (1)                                  |         | $                   | 7,918      |           | $          | 75,722         |       | $                  | 42,132     |      | $          | 565,183 |   | $ | 690,955 |   |
| Operating leases                                    |         | 13,371              |       | 22,792         |       | 13,707         |       | 21,955             |       | 71,825    |       |
| Purchase obligations                                |         | 5,000               |       | 10,000         |       | 10,000         |       | 10,000             |       | 35,000    |       |
| Total contractual obligations  by period            |         | $                   | 26,289     |           | $          | 108,514        |       | $                  | 65,839     |      | $          | 597,138 |   | $ | 797,780 |   |
| Other commitments                                   |         |                |       |           |       |           |       |               |       |      |       |
| Commitments to extend credit                        |         |                |       |           |       |           |       |               |       | $         | 4,229,011  |   |
| Standby letters of credit and  financial guarantees |         |                |       |           |       |           |       |               |       | 379,807   |       |
| Unfunded third-party private  equity investments    |         |                |       |           |       |           |       |               |       | 28,922    |       |
| Total other commitments                             |         |                |       |           |       |           |       |               |       | $         | 4,637,740  |   |

 

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(1) Includes $51.2million in financing resulting from the sale of the Hopkins Plaza Building.Includes principal payments only.

 

REVIEW OFEARNINGS AND BALANCE SHEET FOR 2003 TO 2002

 

**Performance& Operating Analysis**

 

 On August 12, 2003, Bankshares completed itsacquisition of Farmers, a bank holding company headquartered in Frederick,Maryland.  On the date of purchase,Farmers had total loans of $1.4 billion, total investment securities of $638.0million, total earning assets of $2.0 billion, and total deposits of $1.7billion. The results of operations and balances for Farmers are included in theconsolidated financial statements from the merger date forward. Thisacquisition had a significant impact on 2003 performance compared with 2002.

 

 Net income in 2003 was $196.8 million comparedwith $190.2 million in 2002, a 3% increase. Diluted net income per common share was $2.68 in 2003 compared with$2.72 in 2002, a decrease of 1%. Return on average assets was 1.64%, and returnon average equity was 13.15% in 2003 compared with 1.88% and 15.12%,respectively, in 2002. Average assets increased 18% to $12.0 billion; average 

 

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depositsincreased 18% to $9.0 billion; and average loans increased 14% to $8.1 billionfor the year ended December 31, 2003 compared with the prior year.

 

 Net interest income, on a fully tax-equivalentbasis, was $479.1 million in 2003 compared with $447.2 million in 2002.  Both changes in the level of interest ratesand changes in the amount and composition of interest-earning assets andinterest-bearing liabilities affected net interest income.  In 2003 the Federal Reserve Board reducedshort-term rates by 25 basis points. Bankshares is asset sensitive, and in a falling rate environment, thenet interest margin (net interest income expressed as a percent of averageearning assets) tends to compress, and growth in net interest income tends toslow. The 13 basis point decline in the spread was attributable to thedifficulty of further reducing the rate paid on managed-rate deposits.Bankshares’ net interest margin declined to 4.32% in 2003 from 4.65% in 2002,primarily due to the reduced benefit derived from noninterest-bearingfunds.  This benefit fell from 60 basispoints for 2002 to 40 basis points for 2003.

 

 Noninterest income increased by 27% to $183.6million in 2003 from $144.5 million in 2002, largely due to the Farmersacquisition.  Additionally, an increasein IWM revenue of $10.5 million was due principally to the inclusion of BoydWatterson and Peremel, which were acquired in March and April of 2003,respectively. Together these acquisitions added $8.2 million in IWM revenues.The $6.3 million increase in investment securities gains mostly representssales of equity securities, with the balance related to the continuedrestructuring of the investment securities bond portfolio.  Nonmarketable investments increased by $9.9million to $10.2 million in 2003 from $0.3 million in 2002, as a result ofincome derived from Bankshares’ investment of $75 million in hedge funds and$50 million in bank-owned life insurance in 2003. Other noninterest income,including service charges on deposit accounts, mortgage banking fees and othernoninterest income remained strong, increasing by $12.4 million in 2003compared with 2002 as a result of the Farmers acquisition.

 

 Noninterest expense increased by 24% to $337.4million in 2003 from $272.6 million in 2002, principally as a result of theacquisitions. More than 50% of the increase was attributable to the increase insalaries and benefits. Contributing to this overall increase were $4.3 millionin commissions and incentive compensation and approximately $3.6 million inseverance expense, of which $0.8 million related to the accelerated vesting ofrestricted stock awards for employees in IWM whose employment was terminated.

 

 Net occupancy expense increased by $4.9million, or 31%, during 2003 due mainly to the net additional 39 branchlocations and three corporate offices relating to the acquisitions. Additionally,$1.2 million that related to terminating certain Banking lease agreements wasreflected in the increase.

 

 Professional services, communications andsupplies and marketing expenses increased $12.4 million, or 39%. Pretaxmerger-related expense contributed $4.8 million to this increase. Amortizationof other identifiable intangibles increased $3.0 million in connection with theacquisitions.

 

**SegmentReporting**

 

*Banking*

 

 Net income in 2003 was $200.1 million comparedwith $183.7 million in 2002, an 8.9% increase. For the year ended December 31,2003, average assets increased 16.3% to $11.7 billion; average depositsincreased 18.9% to $9.1 billion; and average loans increased 14.1% to $8.1billion.

 

 Net interest income, on a fully tax-equivalentbasis, was $477.5 million in 2003 compared with $443.4 million in 2002.  The increase in net interest income wasattributable to a 15.3% increase in average earning assets, which offset a 25basis point decline in the net interest margin. Increases of 16.1% and 14.1%were recorded in the investment and loan portfolios, respectively. The Farmersacquisition contributed approximately 50% of these increases. The net interestmargin declined to 4.38% in 2003 from 4.63% in 2002.

 

 Noninterest income increased to $98.4 millionin 2003 from $77.0 million in 2002 largely due to the Farmers acquisition.Service charges on deposits and loan-related fees reflected the largestincreases.  Additionally, other income consisting of revenues fromelectronic banking and merchant card processing, safe deposit box rent,travelers’ checks, money orders and bill collection increased by $16.7 million,or 29.0%, from 2002.

 

 Noninterest expense totaled $265.9 million in2003 compared with $227.4 million in 2002, an increase of $38.5 million, or16.9%. The increase in noninterest expense was principally due to theacquisitions. The increase was primarily related to increases in salaries andemployee benefit expense of $20.9 million. The acquisitions, normal meritincreases and incentive compensation contributed to this increase. In addition,occupancy and equipment expenses increased $4.6 million due to theacquisitions, higher rent and facility and technology maintenance cost.

 

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*IWM*

 

 Net income in 2003 was $5.1 million comparedwith $12.1 million in 2002, a 58% decrease. Pretax profit margins, prior to corporate overhead allocations, were15.2% and 32.9% for 2003 and 2002, respectively.  These declines reflected decreasing equitymarket values and ongoing reorganization costs for the division.  Assets under administration by IWM increased$10.0 billion, or 38%, to $46.0 billion for the year ended December 31, 2003compared with the prior year. The acquisition of Boyd Watterson and Peremel contributedapproximately $3.6 billion and $0.6 billion, respectively, to the increase inassets under administration.

 

 IWM fee income increased to $78.6 million, or15.7%, in 2003 from $68.0 million in 2002. Revenues from IWM represented thelargest source of Bankshares’ noninterest income at 45%.

 

 Noninterest expense totaled $66.6 million in2003 compared with $45.6 million in 2002, an increase of $21.0 million, or 46%.Expense growth associated with a full year of investments in people and newproduct capabilities exceeded the increase in revenues.  Additionally, expenses for 2003 included $3.6million of severance and $0.5 million paid to terminate a technology equipmentlease, both of which were related to the ongoing repositioning of IWM’scapabilities and its infrastructure.  In2002, severance expense for IWM totaled $1.7 million.

 

**CreditQuality Measures**

 

 Provision for loan losses was $12.1 million in2003 compared with $16.4 million in 2002. Net charge-offs in 2003 were $8.6 million, or .11% of average totalloans, compared with $19.2 million, or .27%, in 2002.  The allowance for loan losses was $155.3million, or 1.68% of total loans, at December 31, 2003 compared with $138.6million, or 1.90%, at December 31, 2002.

 

 At December 31, 2003, total nonperformingassets were $50.5 million, or .54% of total loans, compared with $33.5 million,or .46%, at December 31, 2002.  The 2003increase was primarily in the commercial portfolio.

 

**CapitalRatios**

 

 The ratio of average shareholders’ equity toaverage total assets was 12.51% at December 31, 2003 and 12.43% at December 31,2002.  Bankshares’ total risk-basedcapital ratio at December 31, 2003 was 16.63%, and its Tier I capital ratio was12.46%, exceeding the minimum regulatory guidelines of 8% and 4%,respectively.  Bankshares’ leverageratios were 9.60% and 11.20% at December 31, 2003 and 2002, respectively,exceeding the minimum regulatory guideline of 4%. As of December 31, 2003, allof Bankshares’ bank affiliates exceeded all capital adequacy requirementsnecessary to be considered “well-capitalized.” For additional information on Bankshares’ risk-based capital ratio, seeNote No. 11 of the financial statements.

 

QUARTERLYRESULTS OF OPERATIONS

 

The followingis a summary of the quarterly results of operations:

 
| ** **                                              | ** ** | **Three months ended** | ** **  |
|---------------------------------------------------------|------------|------------------------|-------------|
| **2004  (Dollars in thousands, except per share data)** | ** ** | **Dec. 31**            | ** **  | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| Net interest income (1)                                 | ** ** | **$**                  | **143,710** | ** ** | **$** | **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                                                   | ** ** | **.77**                | ** **  | **.72** | ** ** | **.71** | ** ** | **.70** | ** ** |
| Diluted                                                 | ** ** | **.76**                | ** **  | **.71** | ** ** | **.71** | ** ** | **.69** | ** ** |
|                                                         |            |                        |             |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                              | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|
| **2003  (Dollars in thousands, except per share data)** | ** ** | **Dec. 31**            | ** ** | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| Net interest income (1)                                 |       | $                      | 130,886    |   | $ | 120,678 |   | $ | 110,339 |   | $ | 110,446 |   |
| Provision for loan losses                               |       | 3,033                  |       | 3,005 |   | 3,051 |   | 3,016 |   |
| Net income                                              |       | 50,645                 |       | 47,173 |   | 50,010 |   | 48,986 |   |
| Per share of common stock:                              |       |                   |       |   |   |   |   |   |   |
| Basic                                                   |       | .64                    |       | .64 |   | .73 |   | .71 |   |
| Diluted                                                 |       | .63                    |       | .63 |   | .72 |   | .71 |   |
|                                                         |            |                        |            |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          Incomefrom certain nonmarketable investments, primarily hedge funds, werereclassified into noninterest income from interest and dividends on investmentsecurities.

 

53

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NON-GAAPRECONCILIATION

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** **                           | **For the twelve months ended** | ** **  | **For the quarter ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------|---------------------------------|-------------|---------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** **                           | **December 31,**                | ** **  | **December 31,**          | ** ** |
| **(Dollars in thousands, except  per share data)**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** **                           | **2004**                        | ** **  | **2003**                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            |        |                      |       |   |   |   |   |
| (1) The net interest margin and efficiency ratios are presented on a  fully tax-equivalent (FTE) and annualized basis.  The FTE basis adjusts for the tax-favored  status of income from certain loans and investments.  Management believes this measure to be the  preferred industry measurement of net interest income and provides a relevant  comparison between taxable and non-taxable investments.                                                                                                                                               |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| Net interest income (GAAP  basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** **                           | **$**                           | **545,781** |                      | $          | 472,349 | ** ** | **$** | **143,710** |   | $ | 130,886 |   |
| Tax-equivalent adjustment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** **                           | **6,744**                       |        | 6,760                     | ** ** | **1,660** |   | 1,881 |   |
| Net interest income -  tax-equivalent                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** **                           | **$**                           | **552,525** |                      | $          | 479,109 | ** ** | **$** | **145,370** |   | $ | 132,767 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                           | ** **                      |        |                      | ** ** | ** ** |   |   |   |
| (2) Management excludes the balance of intangible assets and their  related amortization expense from its calculation of return on average  tangible assets, return on average tangible equity and average tangible  equity to average tangible assets.   This adjustment allows management to review the core operating results  and core capital position of Bankshares.   This is consistent with the treatment by bank regulatory agencies, which  exclude goodwill and other intangible assets from their calculation of  risk-based capital ratios. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                           | ** **                      |        |                      | ** ** | ** ** |   |   |   |
| Return on average assets (GAAP  basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                           | **1.64**                        | **%**       | 1.64                      | %          | **1.68** | **%** | 1.47 | % |
| Impact of excluding average  intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** **                           | **0.11**                        | ** **  | 0.07                      |       | **0.11** | ** ** | 0.10 |   |
| Return on average tangible  assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** **                           | **1.75**                        | **%**       | 1.71                      | %          | **1.79** | **%** | 1.57 | % |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            | ** **  |                      |       |   | ** ** |   |   |
| Return on average equity (GAAP  basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                           | **12.26**                       | **%**       | 13.15                     | %          | **12.62** | **%** | 11.09 | % |
| Impact of excluding average  intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** **                           | **5.74**                        | ** **  | 3.40                      |       | **5.54** | ** ** | 5.40 |   |
| Return on average tangible  equity                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** **                           | **18.00**                       | **%**       | 16.55                     | %          | **18.16** | **%** | 16.49 | % |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            | ** **  |                      |       |   | ** ** |   |   |
| Average equity to average  assets (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** **                           | **13.38**                       | **%**       | 12.51                     | %          | **13.35** | **%** | 13.26 | % |
| Impact of excluding average  intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** **                           | **(3.68**                       | **)**       | (2.17                     | )          | **(3.51** | **)** | (3.75 | ) |
| Average tangible equity to  average tangible assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** **                           | **9.70**                        | **%**       | 10.34                     | %          | **9.84** | **%** | 9.51 | % |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            |        |                      |       |   |   |   |   |
| When computing the cash operating efficiency ratio and cash operating  earnings, management excludes the amortization of intangible assets,  restructuring charges, merger-related expenses, gains on sales of premises  and gains and losses from sales of investment securities in order to assess  the core operating results of Bankshares and because of the uncertainty as to  timing and amount of gain or loss to be recognized.                                                                                                                            |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            |        |                      |       |   |   |   |   |
| (3) The efficiency ratio is measured by dividing noninterest expenses  by the sum of net interest income on an FTE basis and noninterest income.                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            |        |                      |       |   |   |   |   |
| Efficiency ratio (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                 | **51.14**                       | **%**       | 50.92                     | %          | **52.70** | **%** | 54.47 | % |
| Impact of excluding:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | Securities gains and (losses)        |                            | **0.08**    | ** **                | 0.56       |   | **0.18** | ** ** | 0.04 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | Gains on sales of premises           |                            | **0.11**    | ** **                | 0.02       |   | **0.01** | ** ** | — |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | Amortization of deposit  intangibles |                            | **(0.71**   | **)**                     | (0.45      | ) | **(0.68** | **)** | (0.60 | ) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | Amortization of other  intangibles   |                            | **(0.35**   | **)**                     | (0.29      | ) | **(0.31** | **)** | (0.40 | ) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | Restructuring charges                |                            | **(0.59**   | **)**                     | —     |   | **(0.70** | **)** | — |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | Merger-related expenses              |                            | **(0.05**   | **)**                     | (1.24      | ) | **—** | ** ** | (2.59 | ) |
| Cash operating efficiency ratio                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                 | **49.63**                       | **%**       | 49.52                     | %          | **51.20** | **%** | 50.92 | % |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (4) Management presents cash operating earnings and diluted cash  operating earnings per share in order to assess the core operating results of  Bankshares.                                                                                                                                                                                                                                                                                                                                                                                                        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                           | ** **                      |        |                      | ** ** | ** ** |   |   |   |
| Net income (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** **                           | **$**                           | **229,407** | ** **                | $          | 196,814 |   | **$** | **60,612** | ** ** | $ | 50,645 |   |
| Less: Securities (gains) and  losses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** **                           | **(749**                        | **)**       | (4,314                    | )          | **(426** | **)** | (74 | ) |
| Gains on sales of premises, net  of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** **                           | **(1,005**                      | **)**       | (138                      | )          | **(26** | **)** | — |   |
| Plus: Amortization of deposit  intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                           | **3,305**                       | ** **  | 1,821                     |       | **826** | ** ** | 670 |   |
| Amortization of other  intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** **                           | **1,616**                       | ** **  | 1,167                     |       | **388** | ** ** | 446 |   |
| Restructuring charges, net of  tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** **                           | **2,711**                       | ** **  | —                    |       | **850** | ** ** | — |   |
| Merger-related expenses, net of  tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                           | **248**                         | ** **  | 4,844                     |       | **—** | ** ** | 2,847 |   |
| Cash operating earnings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** **                           | **$**                           | **235,533** | ** **                | $          | 200,194 |   | **$** | **62,224** | ** ** | $ | 54,534 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                                 |                            | ** **  |                      |       |   | ** ** |   |   |
| Diluted net income per share  (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** **                           | **$**                           | **2.87**    | ** **                | $          | 2.68 |   | **$** | **0.76** | ** ** | $ | 0.63 |   |
| Less: Securities (gains) and  losses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** **                           | **(0.01**                       | **)**       | (0.06                     | )          | **(0.01** | **)** | — |   |
| Gains on sales of premises, net  of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** **                           | **(0.01**                       | **)**       | —                    |       | **—** | ** ** | — |   |
| Plus: Amortization of deposit  intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                           | **0.04**                        | ** **  | 0.02                      |       | **0.01** | ** ** | 0.01 |   |
| Amortization of other  intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** **                           | **0.02**                        | ** **  | 0.02                      |       | **0.01** | ** ** | 0.01 |   |
| Restructuring charges, net of  tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** **                           | **0.04**                        | ** **  | —                    |       | **0.01** | ** ** | — |   |
| Merger-related expenses, net of  tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                           | **—**                      | ** **  | 0.07                      |       | **—** | ** ** | 0.04 |   |
| Diluted cash operating earnings  per share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** **                           | **$**                           | **2.95**    | ** **                | $          | 2.73 |   | **$** | **0.78** | ** ** | $ | 0.69 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                      |                                 |             |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

54

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RECENT FASBPRONOUNCEMENTS

 

 In December 2003, the American Institute ofCertified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accountingfor Certain Loans or Debt Securities Acquired in a Transfer,” which addressesthe accounting for differences between contractual cash flows and expected cashflows for loans acquired in a transfer when those differences are attributableat least in part to credit quality.  Itincludes such loans acquired in purchase business combinations where there isevidence of deterioration in credit quality since origination. This SOPrequires the difference between expected cash flows and the purchase price tobe accreted as an adjustment to yield over the life of the acquired loans; thedifference between contractual cash flows and expected cash flows is notsubject to accretion. This SOP would represent a change from current practicewhere the allowance for loan losses is carried over in purchase accounting. TheSOP is effective for loans acquired after December 15, 2004. Bankshares willevaluate the impact it will have on operations and financial statements withrespect to new acquisitions.

 

 In November 2003, the Emerging Issues TaskForce (“EITF”) Issue 03-1, “The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments.” The Task Force discussed the meaningof other-than-temporary impairment and its application to certain investmentscarried at cost. The Task Force requested that the FASB staff consider otherimpairment models within U.S. GAAP when developing its views. The Task Forcealso requested that the scope of the impairment issue be expanded to includeequity investments and investments subject to FASB Statement No. 115, “Accountingfor Certain Investments in Debt and Equity Securities,” and that that issue beaddressed by the Task Force as a separate EITF issue. At the EITF meeting, theTask Force reached a consensus on one issue that certain quantitative andqualitative disclosures should be required for securities accounted for underStatement 115 that are impaired at the balance sheet date but for which another-than-temporary impairment has not been recognized. The Board ratified theconsensus on that one issue at its November 25, 2003 meeting. In September2004, the Financial Accounting Standards Board (“FASB”) directed the FASB staffto issue two proposed FASB Staff Positions (“FSP”): Proposed FSP EITF Issue03-1-a, which provides guidance for the application of paragraph 16 of EITFIssue 03-1 to debt securities that are impaired because of interest rate and/orsector spread increases, and Proposed FSP EITF Issue 03-1-b, which delays theeffective date of Issue 03-1 for debt securities that are impaired because ofinterest rate and/or sector spread increases. The outcome of the proposedguidance under certain interpretations could have an adverse impact onBankshares’ capital and earnings as it relates to securities deemed impairedwithin the available-for-sale investment portfolio. Bankshares cannot determinethe potential impact until the FASB finalizes the proposed statement.

 

In December2003, the FASB issued Statement No. 132 (revised 2003) SFAS No. 132R  “Employers’ Disclosures about Pensions andOther Postretirement Benefits,” which revises employers’ disclosures aboutpension plans and other postretirement benefit plans. It does not change themeasurement or recognition of those plans required by FASB Statements No. 87, “Employers’Accounting for Pensions”, No. 88, “Employers’ Accounting for Settlements andCurtailments of Defined Benefit Pension Plans and for Termination Benefits”,and No. 106, “Employers’ Accounting for Postretirement Benefits Other ThanPensions.” This Statement retains the disclosure requirements contained in FASBStatement No. 132, “Employers’ Disclosures about Pensions and OtherPostretirement Benefits,” which it replaces. It requires additional disclosuresto those in the original Statement 132 about the assets, obligations, cashflows, and net periodic benefit cost of defined benefit pension plans and otherdefined benefit postretirement plans. Statement SFAS 132R is effective forfinancial statements with fiscal years ending after December 15, 2003.Bankshares has complied with the standards and disclosure requirements of thisstatement as noted in Note No. 14.

 

 In May 2004, the FASB issued FSP FAS 106-2, “Accountingand Disclosure Requirements Related to the Medicare Prescription Drug,Improvement and Modernization Act of 2003,” which requires (a) the effects of thefederal subsidy to be considered an actuarial gain and treated like similargains and losses and (b) certain disclosures for employers that sponsorpostretirement heath care plans that provide prescription drug benefits. TheFASB’s related existing guidance, FSP FAS 106-1, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003,” is superseded upon the effective date of FSP FAS106-2. The effective date of the new FSP is the first interim or annual periodbeginning after June 15, 2004. Bankshares is currently reviewing the potentialeffect of the benefit that is at least actuarially equivalent to Medicare partD on its postretirement benefit plans.

 

  In December 2004, the FASB issued StatementNo. 123 (Revised 2004) SFAS No. 123R, “Share-Based Payment,” which requiresthat the compensation cost relating to share-based payment transactions berecognized in financial statements. Share-based compensation arrangementsinclude share options, restricted share plans, performance-based awards, shareappreciation rights and employee share purchase plans. That cost will bemeasured based on the fair value of the equity or liability instruments issued.SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation,”and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees.” SFAS No. 123 permitted entities the option ofcontinuing to apply the guidance in Opinion 25, as long as the Notes to thefinancial statements disclosed what net income would have been had thepreferable fair-value-based method been used. Bankshares will be required toapply FASB 123R as of the first interim or annual reporting period that beginsafter June 15, 2005. Bankshares’ adopted the cost recognition provision of SFASNo. 123, “Accounting for Stock-Based Compensation,” in 1995 and has beenexpensing compensation cost related to these options. Bankshares does notanticipate this revision will have a material effect on the financialstatements.

 

55

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ITEM 7A.                   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The information requiredby this Item 7A is set forth under the captions “Risk Management,”  “Interest Rate Risk,” “Interest RateSensitivity Analysis (Static Gap)” and “Earnings Simulation Model Projections”in Item 7.

 

56

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ITEM8.          FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

**Management’s Report on Internal Control overFinancial Reporting**

 

Management ofMercantile Bankshares Corporation, (together with its consolidatedsubsidiaries, we, us or Bankshares), is responsible for establishing andmaintaining adequate internal control over financial reporting as defined inRules 13a-15(f) and 15d-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)            pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of the assets of Bankshares;

 

(ii)           provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of Bankshares are being made only in accordancewith authorization of management and directors of Bankshares; and

 

(iii)          provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof our assets that could have a material effect on the financial statements.

 

 Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

 Management assessed the effectiveness of ourinternal control over financial reporting as of December 31, 2004. In makingthis 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 assessment and those criteria,management has concluded that, as of December 31, 2004, Bankshares’ internalcontrol over financial reporting was effective.

 

 Our independent auditors have audited management’sassessment of the effectiveness of Bankshares’ internal control over financialreporting as of December 31, 2004 as stated in their report that appears on thefollowing page.

 
| /s/ Edward  J. Kelly III                              |   |
|-------------------------------------------------------|--------|
| Chairman,  President and Chief Executive Officer      |
|                                                  |
| /s/ Terry L.  Troupe                                  |   |
| Executive  Vice President and Chief Financial Officer |
|                                                  |
| Mercantile  Bankshares Corporation                    |
| March 14,  2005                                       |
|                                                       |        |  |

 

57

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### **Report of Independent Registered PublicAccounting Firm**

### ** **

To****the Board of Directors andShareholders of Mercantile Bankshares Corporation:

 

We have completed an integrated audit of Mercantile BanksharesCorporation’s 2004 consolidated financial statements and of its internalcontrol over financial reporting as of December 31, 2004 and audits of its 2003and 2002 consolidated financial statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States).  Our opinions, based on our audits, are presentedbelow.

 

Consolidated financial statements

 

In our opinion, the accompanying consolidated balance sheets and therelated consolidated statements of income, shareholders’ equity and cash flowspresent fairly, in all material respects, the financial position of MercantileBankshares Corporation and its subsidiaries****at December31, 2004 and 2003 and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2004 in conformitywith accounting principles generally accepted in the United States ofAmerica.  These financial statements arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.  Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit of financial statements includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, in our opinion, management’s assessment, included in theaccompanying “Management’s Report on Internal Control over Financial Reporting”,that the Company maintained effective internal control over financial reportingas of December 31, 2004 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 31,2004 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 toexpress opinions on management’s assessment and on the effectiveness of theCompany’s internal 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 internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles.  A company’s internal control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company;(ii) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures ofthe company are being made only in accordance with authorizations of managementand directors of the company; and (iii) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, ordisposition of the company’s assets that could have a material effect on thefinancial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 
| /s/ PricewaterhouseCoopers LLP |   |
|--------------------------------|--------|
|                           |
| Baltimore, Maryland            |
| March 14, 2005                 |

 

58

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**Item 8.Financial Statements and Supplementary Data**

 

ConsolidatedBalance Sheets

 
| **DECEMBER  31,**                                                                                                                                                           | ** ** | ** **     | ** **     | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|
| **(Dollars  in thousands, except per share data)**                                                                                                                          | ** ** | **2004**       | ** **     | **2003**   | ** ** |
| **ASSETS**                                                                                                                                                                  | ** ** | ** **     | ** **     | ** ** | ** ** |
| Cash and due from banks                                                                                                                                                     | ** ** | **$**          | **244,875**    | ** ** | $          | 321,882 |   |
| Interest-bearing deposits in  other banks                                                                                                                                   | ** ** | **158**        | ** **     | 14,583     |       |
| Federal funds sold                                                                                                                                                          | ** ** | **101**        | ** **     | 26,236     |       |
| Total cash and cash equivalents                                                                                                                                             | ** ** | **245,134**    | ** **     | 362,701    |       |
|                                                                                                                                                                        |       |           | ** **     |       |       |
| Investment securities  available-for-sale *(1), (3)*                                                                                                                        | ** ** | **2,908,694**  | ** **     | 3,042,432  |       |
| Investment securities held-to-maturity*(1), (3)*fair value of $21,094 (2004) and $30,115 (2003)                                                                             | ** ** | **20,176**     | ** **     | 28,213     |       |
|                                                                                                                                                                        |       |           | ** **     |       |       |
| Loans held-for-sale*(1)*                                                                                                                                                    | ** ** | **11,000**     | ** **     | 14,925     |       |
|                                                                                                                                                                        |       |           | ** **     |       |       |
| Loans*(4)*                                                                                                                                                                  | ** ** | **10,228,433** | ** **     | 9,272,160  |       |
| Less: allowance for loan losses*(1), (4)*                                                                                                                                   | ** ** | **(149,002**   | **)**          | (155,337   | )          |
| Loans, net                                                                                                                                                                  | ** ** | **10,079,431** | ** **     | 9,116,823  |       |
|                                                                                                                                                                        |       |           | ** **     |       |       |
| Bank premises and equipment,  net *(1), (5)*                                                                                                                                | ** ** | **139,946**    | ** **     | 140,922    |       |
| Other real estate owned, net*(1)*                                                                                                                                           | ** ** | **212**        | ** **     | 191        |       |
| Goodwill, net *(1), (19)*                                                                                                                                                   | ** ** | **507,791**    | ** **     | 522,173    |       |
| Other intangible assets, net *(1), (19)*                                                                                                                                    | ** ** | **48,226**     | ** **     | 56,223     |       |
| Other assets*(6)*                                                                                                                                                           | ** ** | **465,080**    | ** **     | 410,869    |       |
| Total assets                                                                                                                                                                | ** ** | **$**          | **14,425,690** | ** ** | $          | 13,695,472 |   |
|                                                                                                                                                                        |       |           | ** **     |       |       |
| **LIABILITIES**                                                                                                                                                             |       |           | ** **     |       |       |
| Deposits:                                                                                                                                                                   |       |           | ** **     |       |       |
| Noninterest-bearing deposits                                                                                                                                                | ** ** | **$**          | **3,049,031**  | ** ** | $          | 2,750,721 |   |
| Interest-bearing deposits                                                                                                                                                   | ** ** | **7,750,168**  | ** **     | 7,511,832  |       |
| Total deposits                                                                                                                                                              | ** ** | **10,799,199** | ** **     | 10,262,553 |       |
| Short-term borrowings *(8)*                                                                                                                                                 | ** ** | **887,857**    | ** **     | 809,021    |       |
| Accrued expenses and other  liabilities *(6)*                                                                                                                               | ** ** | **129,996**    | ** **     | 134,735    |       |
| Long-term debt *(9)*                                                                                                                                                        | ** ** | **690,955**    | ** **     | 647,722    |       |
| Total liabilities                                                                                                                                                           | ** ** | **12,508,007** | ** **     | 11,854,031 |       |
|                                                                                                                                                                        |       |           | ** **     |       |       |
| **COMMITMENTS AND CONTINGENCIES***(5),(9),  (10)*                                                                                                                           |       |           | ** **     |       |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                               |       |           | ** **     |       |       |
| Preferred stock, no par value;  authorized 2,000,000 shares; issued and outstanding - None                                                                                  | ** ** | ** **     | ** **     |       |       |
| Common stock, $2 par value;  authorized 130,000,000 shares; issued shares - 79,300,506 (2004) and  79,772,705 (2003); restricted shares - 143,528 (2004) and 121,369 (2003) | ** ** | **158,601**    | ** **     | 159,545    |       |
| Capital surplus                                                                                                                                                             | ** ** | **530,705**    | ** **     | 548,664    |       |
| Retained earnings                                                                                                                                                           | ** ** | **1,231,102**  | ** **     | 1,110,748  |       |
| Accumulated other comprehensive  income (loss)                                                                                                                              | ** ** | **(2,725**     | **)**          | 22,484     |       |
| Total shareholders’ equity                                                                                                                                             | ** ** | **1,917,683**  | ** **     | 1,841,441  |       |
| Total liabilities and  shareholders’ equity                                                                                                                            | ** ** | **$**          | **14,425,690** | ** ** | $          | 13,695,472 |   |

 

See notes toconsolidated financial statements.

 

59

----

 

Statements ofConsolidated Income

 
| **FOR THE YEARS ENDED DECEMBER  31,**                    | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
|----------------------------------------------------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|
| **(Dollars  in thousands, except per share data)**       | ** **   | **2004**     | ** **   | **2003**     | ** **   | **2002**     | ** **   |
| **INTEREST INCOME**                                      |         |         |         |         |         |         |         |
| Interest and fees on loans *(1)*                         | ** **   | **$**        | **546,531**  |         | $            | 472,943      |         | $ | 468,678 |   |
| Interest and dividends on  investment securities:        |         |         |         |         |         |         |         |
| Taxable interest income                                  | ** **   | **105,423**  |         | 109,767      |         | 109,699      |         |
| Tax-exempt interest income                               | ** **   | **3,266**    |         | 2,746        |         | 1,895        |         |
| Other investment income                                  | ** **   | **2,314**    |         | 741          |         | 497          |         |
| Total interest and dividends on  investment securities   | ** **   | **111,003**  |         | 113,254      |         | 112,091      |         |
| Other interest income                                    | ** **   | **1,503**    |         | 3,397        |         | 4,848        |         |
| Total interest income                                    | ** **   | **659,037**  |         | 589,594      |         | 585,617      |         |
| **INTEREST EXPENSE**                                     |         |         |         |         |         |         |         |
| Interest on deposits*(7)*                                | ** **   | **83,403**   |         | 93,190       |         | 122,569      |         |
| Interest on short-term  borrowings                       | ** **   | **7,844**    |         | 5,604        |         | 11,259       |         |
| Interest on long-term debt                               | ** **   | **22,009**   |         | 18,451       |         | 10,754       |         |
| Total interest expense                                   | ** **   | **113,256**  |         | 117,245      |         | 144,582      |         |
| **NET INTEREST INCOME**                                  | ** **   | **545,781**  |         | 472,349      |         | 441,035      |         |
| Provision for loan losses *(1),(4)*                      | ** **   | **7,221**    |         | 12,105       |         | 16,378       |         |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES** | ** **   | **538,560**  |         | 460,244      |         | 424,657      |         |
| **NONINTEREST INCOME**                                   |         |         |         |         |         |         |         |
| Investment and wealth  management *(1)*                  | ** **   | **90,050**   |         | 78,933       |         | 68,435       |         |
| Service charges on deposit  accounts                     | ** **   | **44,263**   |         | 39,194       |         | 33,539       |         |
| Mortgage banking related fees                            | ** **   | **11,495**   |         | 11,111       |         | 9,945        |         |
| Investment securities gains*(3)*                         | ** **   | **1,239**    |         | 7,137        |         | 846          |         |
| Nonmarketable investments                                | ** **   | **11,422**   |         | 10,189       |         | 321          |         |
| Other income                                             | ** **   | **55,460**   |         | 37,008       |         | 31,433       |         |
| Total noninterest income                                 | ** **   | **213,929**  |         | 183,572      |         | 144,519      |         |
| **NONINTEREST EXPENSES**                                 |         |         |         |         |         |         |         |
| Salaries                                                 | ** **   | **187,621**  |         | 160,326      |         | 133,200      |         |
| Employee benefits*(14)*                                  | ** **   | **44,676**   |         | 37,717       |         | 32,171       |         |
| Net occupancy expense of bank  premises *(1),(5)*        | ** **   | **24,307**   |         | 20,756       |         | 15,904       |         |
| Furniture and equipment  expenses*(1),(5)*               | ** **   | **31,439**   |         | 31,610       |         | 24,464       |         |
| Communications and supplies                              | ** **   | **16,904**   |         | 15,188       |         | 13,375       |         |
| Other expenses                                           | ** **   | **87,011**   |         | 71,850       |         | 53,494       |         |
| Total noninterest expenses                               | ** **   | **391,958**  |         | 337,447      |         | 272,608      |         |
| Income before income taxes                               | ** **   | **360,531**  |         | 306,369      |         | 296,568      |         |
| Applicable income taxes*(1),(12)*                        | ** **   | **131,124**  |         | 109,555      |         | 106,330      |         |
| **NET INCOME**                                           | ** **   | **$**        | **229,407**  |         | $            | 196,814      |         | $ | 190,238 |   |
| **NET INCOME PER SHARE OF  COMMON STOCK***(11):*         |         |         |         |         |         |         |         |
| Basic                                                    | ** **   | **$**        | **2.90**     |         | $            | 2.70         |         | $ | 2.74 |   |
| Diluted                                                  | ** **   | **$**        | **2.87**     |         | $            | 2.68         |         | $ | 2.72 |   |
| **DIVIDENDS PAID PER COMMON  SHARE**                     | ** **   | **$**        | **1.38**     |         | $            | 1.29         |         | $ | 1.18 |   |
|                                                          |              |              |              |              |              |              |              |  |  |  |  |  |  |

 

See notes toconsolidated financial statements.

 

60

----

 

Statements ofChanges in Consolidated Shareholders’ Equity

 

**FOR THEYEARS ENDED DECEMBER 31, 2004, 2003 AND 2002**

 
| **(Dollars in thousands, except  per share data)**                                                    | ** ** | **Total** | ** **    | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **  | **Accumulated Other  Comprehensive  Income (Loss)** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-------------------|------------|----------------------|------------|------------------------|-------------|-----------------------------------------------------|------------|
| BALANCE, DECEMBER 31, 2001                                                                            |       | $         | 1,230,206     |              | $          | 139,551              |       | $                      | 159,947     |                                                | $          | 904,479 |   | $ | 26,229 |   |
| Net income                                                                                            |       | 190,238   |          |              |       |                 |       | 190,238                |        |                                                |       |
| Unrealized gains on securities available-for-sale, net of  reclassification adjustment, net of taxes  |       | 29,632    |          |              |       |                 |       |                   |        | 29,632                                              |       |
| Comprehensive income                                                                                  |       | 219,870   |          |              |       |                 |       |                   |        |                                                |       |
| Cash dividends paid:                                                                                  |       |      |          |              |       |                 |       |                   |        |                                                |       |
| Common stock ($1.18 per share)                                                                        |       | (81,909   | )        |              |       |                 |       | (81,909                | )      |                                                |       |
| Issuance of 107,680 shares for dividend reinvestment and stock purchase  plan                         |       | 3,872     |          | 215               |       | 3,657                |       |                   |        |                                                |       |
| Issuance of 23,231 shares for employee stock purchase dividend  reinvestment plan                     |       | 921       |          | 46                |       | 875                  |       |                   |        |                                                |       |
| Issuance of 237,421 shares for employee stock option plan                                             |       | 3,994     |          | 475               |       | 3,519                |       |                   |        |                                                |       |
| Restricted stock awards:                                                                              |       |      |          |              |       |                 |       |                   |        |                                                |       |
| Issuance of 76,250 shares                                                                             |       | 3,430     |          | 153               |       | 3,277                |       |                   |        |                                                |       |
| Deferred compensation                                                                                 |       | (3,430    | )             |              |       |                 |       | (3,430                 | )      |                                                |       |
| Amortization                                                                                          |       | 870       |          |              |       |                 |       | 870                    |        |                                                |       |
| Purchase of 1,384,200 shares under stock repurchase plan                                              |       | (53,953   | )             | (2,768            | )          | (51,185              | )          |                   |        |                                                |       |
| Vested stock options                                                                                  |       | 487       |          | —            |       | 487                  |       | —                 |        | —                                              |       |
| 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:                                                                                  |       |      |          |              |       |                 |       |                   |        |                                                |       |
| 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*(11)*                                                                            |       | 204,198   |          |              |       |                 |       |                   |        |                                                |       |
| Cash dividends paid:                                                                                  |       |      |          |              |       |                 |       |                   |        |                                                |       |
| 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*(15)*                                                                            |       | 1,892     |          | —            |       | 1,892                |       | —                 |        | —                                              |       |
| **BALANCE, DECEMBER 31, 2004* ****(11)*                                                          | ** ** | **$**     | **1,917,683** | ** **        | **$**      | **158,601**          | ** ** | **$**                  | **530,705** | ** **                                          | **$**      | **1,231,102** | ** ** | **$** | **(2,725** | **)** |

 

See notes toconsolidated financial statements.

 

61

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Statements ofConsolidated Cash Flows

Increase (decrease) in cash and cash equivalents

 
| **FOR THE  YEARS ENDED DECEMBER 31,  (Dollars in thousands)**                      | ** ** | **2004**     | ** **  | **2003**   | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------|-------------|------------|------------|----------|------------|
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         |       |         | ** **  |       |       |     |       |
| Net income                                                                         | ** ** | **$**        | **229,407** | ** ** | $          | 196,814  |       | $ | 190,238 |   |
| Adjustments to reconcile net  income to net cash provided by operating activities: |       |         | ** **  |       |       |     |       |
| Provision for loan losses                                                          | ** ** | **7,221**    | ** **  | 12,105     |       | 16,378   |       |
| Depreciation                                                                       | ** ** | **15,645**   | ** **  | 14,251     |       | 13,071   |       |
| Amortization of other  intangible assets                                           | ** ** | **8,142**    | ** **  | 4,943      |       | 1,972    |       |
| Provision for deferred taxes  (benefits) expenses                                  | ** ** | **(23,749**  | **)**       | (8,993     | )          | 10,437   |       |
| Investment securities gains                                                        | ** ** | **(1,239**   | **)**       | (7,137     | )          | (846     | )          |
| Write-downs (income) of  investments in private equity funds                       | ** ** | **(1,561**   | **)**       | (243       | )          | 2,167    |       |
| Write-downs of other real  estate owned                                            | ** ** | **14**       | ** **  | 7          |       | 54       |       |
| Gains on sales of other real  estate owned                                         | ** ** | **(204**     | **)**       | (366       | )          | (51      | )          |
| Gains on sales of premises                                                         | ** ** | **(1,664**   | **)**       | (228       | )          | (456     | )          |
| Net (increase) decrease in  assets:                                                |       |         | ** **  |       |       |     |       |
| Interest receivable                                                                | ** ** | **2,486**    | ** **  | 4,741      |       | 1,792    |       |
| Other receivables                                                                  | ** ** | **5,423**    | ** **  | (12,928    | )          | (678     | )          |
| Bank-owned life insurance                                                          | ** ** | **(3,683**   | **)**       | (2,003     | )          | (869     | )          |
| Other assets                                                                       | ** ** | **2,873**    | ** **  | (19,034    | )          | (16,437  | )          |
| Loans held-for-sale                                                                | ** ** | **3,925**    | ** **  | 31,096     |       | 137,950  |       |
| Net increase (decrease) in  liabilities:                                           |       |         | ** **  |       |       |     |       |
| Interest payable                                                                   | ** ** | **(1,113**   | **)**       | 24,132     |       | (8,637   | )          |
| Accrued expenses                                                                   | ** ** | **(5,116**   | **)**       | (49,669    | )          | (5,221   | )          |
| Taxes payable                                                                      | ** ** | **12,423**   | ** **  | 9,955      |       | (5,240   | )          |
| Net cash provided by operating  activities                                         | ** ** | **249,230**  | ** **  | 197,443    |       | 335,624  |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         |       |         | ** **  |       |       |     |       |
| Proceeds from maturities of  investment securities held-to-maturity                | ** ** | **8,037**    | ** **  | 15,149     |       | 3,553    |       |
| Proceeds from maturities of  investment securities available-for-sale              | ** ** | **917,216**  | ** **  | 961,583    |       | 568,491  |       |
| Proceeds from sales of  investment securities available-for-sale                   | ** ** | **49,314**   | ** **  | 572,615    |       | 79,293   |       |
| Purchases of investment securities  held-to-maturity                               | ** ** | **—**   | ** **  | (2,590     | )          | (4,425   | )          |
| Purchases of investment  securities available-for-sale                             | ** ** | **(871,948** | **)**       | (1,488,190 | )          | (822,769 | )          |
| Net increase in customer loans                                                     | ** ** | **(973,155** | **)**       | (663,922   | )          | (425,202 | )          |
| Proceeds from sales of other  real estate owned                                    | ** ** | **533**      | ** **  | 959        |       | 227      |       |
| Capital expenditures                                                               | ** ** | **(10,474**  | **)**       | (17,355    | )          | (14,723  | )          |
| Proceeds from sales of premises                                                    | ** ** | **3,872**    | ** **  | 602        |       | 975      |       |
| Purchase of bank-owned life  insurance                                             | ** ** | **—**   | ** **  | —     |       | (50,000  | )          |
| Business acquisitions (net of  cash received)                                      | ** ** | **—**   | ** **  | (83,689    | )          | —   |       |
| Other investing activity                                                           | ** ** | **(9,799**   | **)**       | (4,507     | )          | (87,906  | )          |
| Net cash used in investing  activities                                             | ** ** | **(886,404** | **)**       | (709,345   | )          | (752,486 | )          |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         |       |         | ** **  |       |       |     |       |
| Net increase in  noninterest-bearing deposits                                      | ** ** | **298,310**  | ** **  | 367,640    |       | 202,867  |       |
| Net increase in checking plus  interest and savings accounts                       | ** ** | **254,537**  | ** **  | 146,789    |       | 608,722  |       |
| Net increase (decrease) in  certificates of deposit                                | ** ** | **(16,200**  | **)**       | (204,910   | )          | 1,978    |       |
| Net increase (decrease) in  short-term borrowings                                  | ** ** | **78,836**   | ** **  | (187,374   | )          | (29,893  | )          |
| Proceeds from issuance of  long-term debt                                          | ** ** | **51,250**   | ** **  | 300,000    |       | —   |       |
| Repayment of long-term debt                                                        | ** ** | **(8,044**   | **)**       | (8,638     | )          | (8,300   | )          |
| Proceeds from issuance of  shares                                                  | ** ** | **14,322**   | ** **  | 11,369     |       | 8,784    |       |
| Repurchase of common shares                                                        | ** ** | **(44,110**  | **)**       | (212       | )          | (53,953  | )          |
| Dividends paid                                                                     | ** ** | **(109,295** | **)**       | (95,842    | )          | (81,909  | )          |
| Net cash provided by financing  activities                                         | ** ** | **519,607**  | ** **  | 328,822    |       | 648,296  |       |
| Net increase (decrease) in cash  and cash equivalents                              | ** ** | **(117,567** | **)**       | (183,080   | )          | 231,434  |       |
| Cash and cash equivalents at  beginning of period                                  | ** ** | **362,701**  | ** **  | 545,781    |       | 314,347  |       |
| Cash and cash equivalents at  end of period                                        | ** ** | **$**        | **245,134** | ** ** | $          | 362,701  |       | $ | 545,781 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |         | ** **  |       |       |     |       |
| Cash payments for interest                                                         | ** ** | **$**        | **114,370** | ** ** | $          | 115,921  |       | $ | 153,219 |   |
| Cash payments for income taxes                                                     | ** ** | **138,832**  | ** **  | 115,448    |       | 100,919  |       |
|                                                                                    |            |              |             |            |            |          |            |  |  |  |  |  |  |

 

See notes toconsolidated financial statements.

 

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 Notes to Consolidated Financial Statements

 

1. SIGNIFICANTACCOUNTING POLICIES

 

A. Basis ofPresentation

 

 The consolidated financial statements, whichinclude the accounts of Mercantile Bankshares Corporation (“Bankshares”) andall of its affiliates, are prepared in conformity with accounting principlesgenerally accepted in the United States of America and follow general practicewithin the banking industry. All significant intercompany transactions havebeen eliminated. For purposes of comparability, certain prior period amountshave been reclassified to conform with current period presentation.

 

 The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and contingent assets andliabilities at the date of the financial statements, and the disclosure ofrevenues and expenses during the reporting period. These estimates andassumptions, such as the accounting for loan losses, depreciation and pensionobligations, are based on information available as of the date of the financialstatements and could differ from actual results.

 

 Assets (other than cash deposits) held forothers under fiduciary and agency relationships are not included in theaccompanying balance sheets since they are not assets of Bankshares or itsaffiliates. Acquisitions accounted for as purchases are included in thefinancial statements from the respective dates of affiliation.

 

B. InvestmentSecurities

 

 Investments are classified as either “held-to-maturity”or “available-for-sale.” Investment securities classified as “held-to-maturity”are acquired with the intent and ability to hold until maturity and are carriedat cost, adjusted for amortization of premiums and accretion of discounts.Amortization and accretion are computed by the level yield methods adjusted forthe effects of prepayments on the underlying investments. Investment securitiesclassified as “available-for-sale” are acquired to be held for indefiniteperiods of time and may be sold in response to changes in interest rates and/orprepayment risk or for liquidity management purposes. These securities arecarried at fair value, and any unrealized appreciation or depreciation in themarket value of available-for-sale securities is reported as accumulated othercomprehensive income, a separate component of shareholders’ equity, net ofapplicable taxes. Realized gains and losses are recognized on a specificidentification trade date basis. Amortized cost is used to compute gains orlosses on the sales of securities, which are reported in the Statement ofConsolidated Income.

 

 An assessment is made at the end of eachquarter to determine whether there have been any events or economiccircumstances 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.

 

C. Loans

 

 Interest income on loans isaccrued at the contractual rate on the principal amount outstanding. Loanorigination and commitment fees, direct loan acquisition and origination costs,when significant, are deferred and accreted to interest income over the life ofthe loan or over the commitment period. Loans held-for-sale in conjunction withthe mortgage banking business are carried at the lower of aggregate cost orfair value. Fees related to loans held-for-sale are recognized as a componentof mortgage banking income upon the sale of the loan. When scheduled principalor interest payments are past due 90 days or more at quarter-end on any loan,the accrual of interest income is discontinued. Subsequent receipts on theseloans are recorded as a reduction of principal, and interest income is recordedonly once principal recovery is reasonably assured. Previously accrued butuncollected interest on these loans is charged against interest income.Generally a loan may be restored to accruing status when all past dueprincipal, interest and late charges have been paid and Bankshares expectsrepayment of the remaining contractual principal and interest.

 

 Under Statements of FinancialAccounting Standards (SFAS) Nos. 114 and 118, “Accounting by Creditors forImpairment of a Loan-an amendment of FASB Statements No. 5 and 15,” a loan isconsidered impaired, based on current information and events, if it is probablethat Bankshares will not collect all principal and interest payments accordingto the contractual terms of the loan agreement. Impaired loans do not include large groups of smaller balance homogeneousloans that are evaluated collectively for impairment (e.g., residentialmortgages and consumer installment loans). The allowance for loan lossesrelated to these loans is included in the allowance for loan losses applicableto other than impaired loans. The impairment of a loan is measured based on thepresent value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value ofthe collateral if the repayment is expected to be provided predominantly by theunderlying collateral. A majority of Bankshares’ impaired loans are measured by reference to the fair value of thecollateral.

 

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D. Allowancefor Loan Losses

 

 The allowance for loan losses is maintained ata level considered by management to be adequate to absorb inherent losses inthe loan portfolio. Management’s assessment includes the systematic evaluationof several factors: current economic conditions and their impact on specificborrowers and industry groups; the level of classified and nonperforming loans;the historical loss experience by loan type; the results of regulatoryexaminations; and, in specific cases, the estimated value of underlyingcollateral. The assessments of economic conditions, results of regulatoryexaminations and other risk elements are determined primarily by management ateach affiliate and reviewed by Bankshares.

 

 The allowance is increased by the loan lossprovision charged to operating expenses and reduced by loan charge-offs, net ofrecoveries. The provision for loan losses is based on a continuing review ofthe loan portfolios, past loss experience and current economic conditions thatmay affect borrowers’ ability to pay.

 

E. LoansHeld-for-Sale

 

 Bankshares enters into commitments to sellloans which it has originated. Generally, these loans are held for a shortterm. Amounts reported are at the lower of cost or fair value. Fair value wasdeemed equal to the carrying amounts because loans are originated for sale onlyafter obtaining investor commitment to offset changes in market rates in thenear term. The determination of any write-down to market value includesconsideration of all open positions and outstanding commitments from investors.Declines in the market value of loans held-for-sale are recorded as a charge inmortgage banking related fees. Sales of loans are recorded when the proceedsare received, and any difference between the proceeds and the carrying amountis recorded as a gain or loss in mortgage banking related fees.

 

F. BankPremises and Equipment

 

 Bank premises and equipment are stated at costless accumulated depreciation and amortization. Depreciation and amortizationare computed using both the straight-line and accelerated methods over theestimated useful lives of the properties. Expenditures for repairs andmaintenance are charged to operating expenses as incurred. Expenditures forimprovements that extend the life of an asset are capitalized and depreciatedover the asset’s remaining useful life. Gains or losses realized on thedisposition of properties are reflected in consolidated income.

 

G. Other RealEstate Owned

 

 Other real estate owned consists primarily ofreal estate obtained through foreclosure or acceptance of deeds in lieu offoreclosure. Other real estate owned is held for sale and is stated at thelower of cost or fair value.

 

H. Goodwilland Intangible Assets

 

 Goodwill is the excess of the cost ofBankshares’ investment over its equity in the net assets of purchasedbusinesses. Amortization of goodwill was discontinued after December 2001, inaccordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” whichrequires that goodwill be reviewed at least annually for impairment. Prior to2002, goodwill was being amortized on a straight-line basis over a 15-yearperiod from the respective acquisition dates.

 

 Intangible assets consist mainly of depositintangibles and customer list intangibles which are being amortized on astraight-line basis over an original life of between three and 15 years.Bankshares reviews its intangible assets periodically for other-than-temporaryimpairment.  If such impairment isindicated, impairment is recognized by accelerating the amortization of theasset to the extent the carrying value exceeds the estimated fair value.Accumulated amortization for total intangible assets was $20.3 million and$13.0 million at year-end 2004 and 2003, respectively.

 

 Bankshares recognizes as assets the right toservice mortgage loans for others. Market quotes were used to determine thefair value of the mortgage servicing rights at the date of the sale.  The capitalized mortgage servicing rights areamortized in proportionate amounts over the estimated period of net servicingincome. Bankshares analyzes the capitalized mortgage servicing rights forimpairment 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. StockOptions and Restricted Stock Awards

 

 Bankshares’ stock-based compensation plans areaccounted for in accordance with the provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation.” Under this standard, compensation cost foroptions is determined based on the fair value of each option and the number ofoptions that are granted and expected to vest. Compensation expense forrestricted stock awards is based on the closing market value of Banksharesstock on the date an award is granted.

 

J. IncomeTaxes

 

 Income taxes are recorded inaccordance with SFAS No. 109, “Accounting for Income Taxes.”  The asset and liability approach underlyingSFAS No. 109 requires the recognition of deferred tax liabilities and assetsfor the expected future tax consequences of temporary differences between thecarrying amounts and tax bases of Bankshares’ assets and liabilities. Deferred taxes aredetermined using enacted tax rates in effect for the year in which thetemporary difference is expected to reverse. To the extent tax rates or laws 

 

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change, deferred tax assets and liabilities are adjusted in the periodthat the tax change is enacted.  Incometax expense includes: deferred tax expense, which represents the net change inthe deferred tax asset or liability balance during the year plus any change ina valuation allowance; and current tax expense, which represents the aggregateamount of tax currently payable to or receivable from tax authorities.

 

K. EarningsPer Share

 

 Basic and diluted earnings per share (“EPS”)amounts are computed in accordance with the provisions of SFAS No. 128, “EarningsPer Share.” Basic EPS is computed by dividing income available to commonshareholders by weighted average common shares outstanding during the period.Diluted EPS is computed using the same components as in basic EPS with thedenominator adjusted for the dilutive effect of stock options and restrictedstock awards.

 

L. Cash Flows

 

 For purposes of reporting cash flows, cash andcash equivalents include cash and due from banks, interest-bearing deposits inother banks, federal funds sold and securities purchased under resaleagreements. Generally, federal funds are purchased and sold for one-dayperiods; securities purchased/sold under resale agreements are purchased/soldfor periods of one to 60 days.

 

M. Derivativesand Hedging Activities

 

 Derivatives are accounted for in accordancewith SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as subsequently amended by SFAS No. 137, SFAS No. 138 and SFAS No.149, which establishes accounting and reporting standards for derivatives andhedging activities. Under SFAS No. 133, Bankshares may designate a derivativeas either a hedge of the fair value of a recognized fixed-rate asset orliability or an unrecognized firm commitment (“fair value” hedge), a hedge of aforecasted transaction or of the variability of future cash flows of afloating-rate asset or liability (“cash flow” hedge), or a foreign currencyfair value or cash flow hedge (“foreign currency” hedge). All derivatives arerecorded as other assets or other liabilities on the balance sheet at theirrespective fair values with unrealized gains and losses recorded either inother comprehensive income or in the results of operations, depending on thepurpose for which the derivative is held. Derivatives that do not meet thecriteria for designation as a hedge under SFAS No. 133 at inception, or fail tomeet the criteria thereafter, are included in trading account assets or liabilities.

 

 Changes in the fair value of a derivative thatis designated and qualifies as a fair value hedge, along with the gain or losson the hedged asset or liability that is attributable to the hedged risk, arerecorded as other noninterest income in the results of operations. To theextent of the effectiveness of a hedge, changes in the fair value of aderivative that is designated and qualifies as a cash flow hedge are recordedin other comprehensive income. For all hedge relationships, ineffectiveness resultingfrom differences between the changes in fair values or cash flows of the hedgeditem and changes in fair value of the derivative are recognized as othernoninterest income in the results of operations. The net interest settlement onderivatives designated as fair value or cash flow hedges is treated as anadjustment of the interest income or interest expense of the hedged assets orliabilities.

 

 At inception of a hedge transaction,Bankshares formally documents the hedge, as well as the risk managementobjective and strategy for undertaking the hedge transactions. This processincludes identification of the hedging instrument, hedged item, risk beinghedged and the methodology for measuring ineffectiveness. Both at inception andon an ongoing basis, an assessment is made as to whether the derivatives usedin hedging transactions have been highly effective in offsetting changes in thefair value of hedged items and whether those derivatives may be expected toremain highly effective in future periods.

 

 Bankshares discontinues hedge accountingprospectively when either it is determined that the derivative is no longerhighly effective in offsetting changes in the fair value or cash flows of ahedged item; the derivative expires or is sold, terminated or exercised; thederivative is de-designated because it is unlikely that a forecastedtransaction will occur; or management determines that designation of thederivative as a hedging instrument is no longer appropriate.

 

 When hedge accounting is discontinued, thederivative is reclassified as a trading account asset or liability. When a fairvalue hedge is discontinued, the hedged asset or liability is no longeradjusted for changes in fair value, and the existing basis adjustment isamortized or accreted as an adjustment to yield over the remaining life of theasset or liability. When a cash flow hedge is discontinued but the hedged cashflows or forecasted transaction are still expected to occur, unrealized gainsand losses that were accumulated in other comprehensive income are included inthe results of operations in the same period when the results of operations arealso affected by the hedged cash flow. They are recognized in the results ofoperations immediately if the cash flow hedge was discontinued because aforecasted transaction is not expected to occur.

 

 Under SFAS No. 133, as amended, commitments topurchase loans and certain commitments to sell loans are derivatives. Thesecommitments can be designated as a hedge; otherwise, they are recorded as afreestanding derivative and classified as a trading account asset or liability.

 

 Bankshares occasionally may enter into acontract (“host contract”) that contains a derivative that is embedded in thefinancial instrument. If applicable, an embedded derivative is separated fromthe host contract and can be designated as a hedge; otherwise, the derivativeis recorded as a freestanding derivative and classified as a trading accountasset or liability.

 

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N.Nonmarketable Investments

 

 Nonmarketable investments include privateequity investments that are not publicly traded, securities acquired to meetvarious regulatory requirements (for example, Federal Reserve Bank Stock),bank-owned life insurance and hedge funds investments. Bankshares’ reviewstypically include an analysis of the facts and circumstances of eachinvestment, the expectations for the investments’ cash flows and capital needs,the viability of its business model and our exit strategy. Since these privateequity investments have no readily ascertainable fair value, they are reportedat amounts that we have estimated to be fair value. In estimating the fairvalue of each investment, we must apply judgment using certain assumptions.Bankshares believes that an investments’ cost is the best indication of itsfair value initially, provided that there have been no significant positive ornegative developments subsequent to its acquisition that indicate the necessityof an adjustment to a fair value estimate. Private equity investments arereviewed at least quarterly for possible other-than-temporary impairment. Ifand when such an event takes place, Bankshares adjusts the investments’ fairvalue by an amount that Bankshares believes reflects the nature of the event.Bankshares recognizes any adjustment to fair value as other noninterest income.Bank-owned life insurance is carried at cash surrender value, whichapproximates fair value. Investments in hedge funds are recorded at fair value.Changes in fair values are reported as noninterest income.

 

2.               BUSINESS COMBINATIONS

 

 The following provides information concerningacquisitions completed during the three years ended December 31, 2004.These acquisitions were accounted for as purchases. The results of operationsof these acquisitions subsequent to the acquisition dates are included inBankshares’ Statements of Consolidated Income. Individually, the results ofoperations of these acquisitions prior to the acquisition dates were notmaterial to Bankshares’ results of operations.

 

 In March and April 2003, Banksharesacquired in separate transactions, Boyd Watterson Asset Management, LLC (“BoydWatterson”), an investment management firm, and Peremel & Company, Inc.(“Peremel”), a directed and discount brokerage company.  In the aggregate, the companies werepurchased for approximately $29 million in cash.  The Boyd Watterson acquisition has apotential additional contingent payment of up to $8.6 million which, if paid,will be recorded as goodwill.  Thecontingent payment will be recorded assuming certain metrics are met and becomepayable three years from the acquisition date. Bankshares finalized and recorded approximately $10.1 million ofidentified intangibles, mostly client relationships, as a result of theseacquisitions.  These intangibles arebeing 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, 2004.

 

 On August 12, 2003, Bankshares completedits acquisition of F&M Bancorp (“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 10.4 million shares ofBankshares common stock.  Farmerstransactions 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. Asof December 31, 2004, Bankshares recorded $385.9 million of goodwill,$36.0 million of core deposit intangible, $5.8 million of mostly clientrelationship intangibles (relating to the two insurance subsidiaries) and $1.1million in a trademark intangible. Intangible assets subjected to amortizationare being amortized on a straight-line basis. The weighted average amortizationperiod for the acquired core deposit intangible is nine years, and the client relationshipidentified intangible ranges from three to 15 years. On October 24, 2003,certain assets and liabilities of Farmers were transferred to other Banksharesaffiliates in order to align customers’ accounts with the Bankshares affiliateserving the geographic area where those customers reside.

 

 Goodwill was adjusted $14.4 million, net ofthe related deferred taxes, from $400.3 million in 2003 to $385.9 million in2004. Bankshares finalized its valuations of various financial assets reducinggoodwill by $5.3 million. The initial estimate of goodwill was further reducedby $7.1 million, and $2.0 million as deferred taxes and exit costs weresettled, respectively.

 

 Farmers, acquired in a business combination,falls under the guidance of the Emerging Issues Task Force (“EITF”) in EITFIssue No. 95-3, “Recognition of Liability in Connection with a PurchaseBusiness Combination.” EITF Issue No. 95-3 requires an entity to recognize aliability for an exit cost on the date that the entity commits itself to anexit plan. “Exit costs”, are defined to include those costs recorded by Farmersprior to the merger date and, therefore, are not included in Bankshares resultsof operations.  Prior to August 12,2003, Farmers recorded exit costs of $33.6 million relating to severance,systems conversion, branch consolidation and costs associated with terminatingcontracts (including leases). Management has determined that $3.2 million ofthe estimated $33.6 million in exit costs will not be disbursed. This $3.2million was reversed out of the accrued exit costs, with correspondingdecreases to deferred taxes ($1.2 million) and goodwill ($2.0 million). As of December 31,2004, $28.6 million of these exit costs were paid.

 

 Bankshares’ exit costs, referredto herein as “merger-related” costs, are defined to include those costs for itsbranch closings and related severance, combining operations such as systemsconversions, integration planning consultant’s fees, and marketing consultant’sfees incurred by Bankshares prior to and after the merger date and are includedin Bankshares’ results of operations.  

 

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Bankshares expensed merger-related costs totaling $8.0 million for theyear-ended December 31, 2003. The costs associated with these activitieswere included in noninterest expenses.

 

3. INVESTMENTSECURITIES

 

The amortizedcost and fair value of investment securities at December 31, 2004 and 2003were as follows:

 
| ** **                         | ** ** | **2004**            | ** **    | **2003**                     | ** ** |
|------------------------------------|------------|---------------------|---------------|------------------------------|------------|
| **(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 | ** ** | **$**               | **20,176**    | ** **                   | **$**      | **921** | ** ** | **$** | **3** | ** ** | **$** | **21,094** |   | $ | 28,213 |   | $ | 1,905 |   | $ | 3 |   | $ | 30,115 |   |
| Securities available-for-sale      |       |                |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                      | ** ** | **$**               | **605,505**   | ** **                   | **$**      | **4,534** | ** ** | **$** | **980** | ** ** | **609,059** |   | $ | 823,356 |   | $ | 22,437 |   | $ | 39 |   | $ | 845,754 |   |
| U.S. Government agencies           | ** ** | **853,930**         | ** **    | **3,742**                    | ** ** | **4,699** | ** ** | **852,973** |   | 778,916 |   | 15,096 |   | 401 |   | 793,611 |   |
| States and political  subdivisions | ** ** | **61,984**          | ** **    | **917**                      | ** ** | **31** | ** ** | **62,870** |   | 77,897 |   | 2,073 |   | 100 |   | 79,870 |   |
| Mortgage-backed securities         | ** ** | **1,326,056**       | ** **    | **4,372**                    | ** ** | **13,127** | ** ** | **1,317,301** |   | 1,288,109 |   | 7,352 |   | 11,831 |   | 1,283,630 |   |
| Other bonds, notes and  debentures | ** ** | **30,387**          | ** **    | **28**                       | ** ** | **126** | ** ** | **30,289** |   | 34,440 |   | 319 |   | — |   | 34,759 |   |
| Total bonds                        | ** ** | **2,877,862**       | ** **    | **13,593**                   | ** ** | **18,963** | ** ** | **2,872,492** |   | 3,002,718 |   | 47,277 |   | 12,371 |   | 3,037,624 |   |
| Other investments                  | ** ** | **34,936**          | ** **    | **1,266**                    | ** ** | **—** | ** ** | **36,202** |   | 3,426 |   | 1,382 |   | — |   | 4,808 |   |
| Total                              | ** ** | **$**               | **2,912,798** | ** **                   | **$**      | **14,859** | ** ** | **$** | **18,963** | ** ** | **$** | **2,908,694** |   | $ | 3,006,144 |   | $ | 48,659 |   | $ | 12,371 |   | $ | 3,042,432 |   |

 

The amortizedcost and fair value of the bond investment portfolio by contractual maturity atDecember 31, 2004 and 2003 are shown below:

 
| ** **                    | ** ** | **2004**            | ** **    | **2003**        | ** ** |
|-------------------------------|------------|---------------------|---------------|-----------------|------------|
| **(Dollars in thousands)**    | ** ** | **Amortized  Cost** | ** **    | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities held-to-maturity   |       |                |          |            |       |   |   |   |   |
| Within 1 year                 | ** ** | **$**               | **2,812**     | ** **      | **$**      | **2,831** |   | $ | 4,179 |   | $ | 4,245 |   |
| 1-5 years                     | ** ** | **9,273**           | ** **    | **9,550**       |       | 13,390 |   | 14,114 |   |
| 5-10 years                    | ** ** | **7,694**           | ** **    | **8,281**       |       | 8,057 |   | 8,861 |   |
| After 10 years                | ** ** | **397**             | ** **    | **432**         |       | 2,587 |   | 2,895 |   |
| Total                         | ** ** | **$**               | **20,176**    | ** **      | **$**      | **21,094** |   | $ | 28,213 |   | $ | 30,115 |   |
| Securities available-for-sale |       |                |          |            |       |   |   |   |   |
| Within 1 year                 | ** ** | **$**               | **571,279**   | ** **      | **$**      | **574,375** |   | $ | 620,663 |   | $ | 628,712 |   |
| 1-5 years                     | ** ** | **2,002,424**       | ** **    | **1,993,754**   |       | 1,940,913 |   | 1,964,171 |   |
| 5-10 years                    | ** ** | **278,645**         | ** **    | **278,751**     |       | 372,736 |   | 375,078 |   |
| After 10 years                | ** ** | **25,514**          | ** **    | **25,612**      |       | 68,406 |   | 69,663 |   |
| Total                         | ** ** | **$**               | **2,877,862** | ** **      | **$**      | **2,872,492** |   | $ | 3,002,718 |   | $ | 3,037,624 |   |

 

 At December 31, 2004 and 2003, no singleissue of investment securities exceeded 10% of shareholders’ equity. At December 31,2004 and 2003, securities with an amortized cost of $1.1 billion and $1.2billion, respectively, were pledged as collateral for certain deposits asrequired.

 

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 The following table shows the unrealized grosslosses and fair value of securities in the securities available-for-saleportfolio at December 31, 2004, by length of time that individualsecurities in each category have been in a continuous loss position.

 

 We had a limited number of securities in acontinuous loss position for 12 months or more at December 31, 2004, whichconsisted primarily of mortgage-backed securities. Because the declines in fairvalue were due to changes in market interest rates, not in estimated cashflows, no other-than-temporary impairment was recorded at December 31,2004.

 
| ** **                        | ** ** | **Less than  12 months**      | ** ** | **12 months  or more** | ** ** | **Total**                     | ** ** |
|-----------------------------------|------------|-------------------------------|------------|------------------------|------------|-------------------------------|------------|
| **(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 followingtable shows the gross realized gains and losses on the sale of securities inthe available-for-sale portfolio including, marketable equity securities:

 
| ** **                    | ** ** | **2004**                   | ** ** | **2003**                    | ** ** | **2002**                   | ** ** |
|-------------------------------|------------|----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(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                          | ** ** | **$**                      | **—** | ** **                  | **$**      | **202**                    |       | $ | — |   | $ | 985 |   | $ | 1 |   | $ | 679 |   |
| Other investments             | ** ** | **1,441**                  | ** ** | **—**                  |       | 8,122                      |       | — |   | 1,524 |   | — |   |
| Total                         | ** ** | **$**                      | **1,441**  | ** **                  | **$**      | **202**                    |       | $ | 8,122 |   | $ | 985 |   | $ | 1,525 |   | $ | 679 |   |

 

4. LOANS ANDALLOWANCE FOR LOAN LOSSES

 

Loans at December 31,2004 and 2003 were as follows:

 
| **(Dollars in thousands)** | ** ** | **2004**      | ** **     | **2003**  | ** ** |
|----------------------------|------------|---------------|----------------|-----------|------------|
| Commercial                 | ** ** | **$**         | **2,820,752**  |      | $          | 2,577,021 |   |
| Commercial real estate     | ** ** | **3,115,274** |           | 2,738,832 |       |
| Construction               | ** ** | **1,268,350** |           | 1,064,021 |       |
| Residential real estate    | ** ** | **1,486,106** |           | 1,335,375 |       |
| Consumer                   | ** ** | **1,484,583** |           | 1,482,860 |       |
| Lease financing            | ** ** | **53,368**    |           | 74,051    |       |
| Total                      | ** ** | **$**         | **10,228,433** |      | $          | 9,272,160 |   |

 

 At December 31, 2004 and 2003, $30.9million and $50.4 million, respectively, were considered nonaccrual loans(loans in which interest income is recognized only as collected). Interestincome on nonaccrual loans that would have been recorded if accruing was $2.5million and $4.1 million in 2004 and 2003, respectively. Interest income onnonaccrual loans that was recorded totaled $0.8 million and $2.1 million in2004 and 2003, respectively. See Note No. 1C for an explanation of thenonaccrual loan policy.

 

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The changes inthe allowance for loan losses follow:

 
| **(Dollars in thousands)**             | ** ** | **2004**    | ** **  | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------|------------|-------------|-------------|----------|------------|----------|------------|
| Allowance balance at beginning of year | ** ** | **$**       | **155,337** |     | $          | 138,601  |       | $ | 141,463 |   |
| Allowance of acquired bank             | ** ** | **—**  |        | 13,205   |       | —   |       |
| Charge-offs                            | ** ** | **(18,380** | )           | (12,324  | )          | (22,221  | )          |
| Recoveries                             | ** ** | **4,824**   |        | 3,750    |       | 2,981    |       |
| Provision for loan losses              | ** ** | **7,221**   |        | 12,105   |       | 16,378   |       |
| Allowance balance at end of year       | ** ** | **$**       | **149,002** |     | $          | 155,337  |       | $ | 138,601 |   |

 

Informationwith respect to impaired loans and the related valuation allowance (if themeasure of the impaired loan is less than the recorded investment) as of December 31,2004 and 2003 is shown below. Refer to Note No. 1C for an expanded discussionon impaired loans.

 
| **(Dollars in thousands)**                                                    | ** ** | **2004**    | ** **  | **2003** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------|-------------|----------|------------|
| Impaired loans with a specific valuation allowance                            | ** ** | **$**       | **18,365**  |     | $          | 26,715 |   |
| All other impaired loans                                                      | ** ** | **9,113**   |        | 18,692   |       |
| Total impaired loans                                                          | ** ** | **$**       | **27,478**  |     | $          | 45,407 |   |
| Specific allowance for loan losses applicable to impaired loans               | ** ** | **$**       | **10,611**  |     | $          | 14,925 |   |
| General allowance for loan losses applicable to other than impaired  loans    | ** ** | **138,391** |        | 140,412  |       |
| Total allowance for loan losses                                               | ** ** | **$**       | **149,002** |     | $          | 155,337 |   |
| Year-to-date interest income on impaired loans recorded on a cash  basis      | ** ** | **$**       | **379**     |     | $          | 443 |   |
| Year-to-date average recorded investment in impaired loans during the  period | ** ** | **$**       | **39,025**  |     | $          | 31,241 |   |

 

5. BANKPREMISES AND EQUIPMENT

 

Bank premisesand equipment at December 31, 2004 and 2003 consisted of the following:

 
| **(Dollars in thousands)**                | ** ** | **2004**     | ** **  | **2003** | ** ** |
|-------------------------------------------|------------|--------------|-------------|----------|------------|
| Land                                      | ** ** | **$**        | **27,590**  |     | $          | 29,370 |   |
| Building and leasehold improvements       | ** ** | **148,119**  |        | 158,928  |       |
| Equipment                                 | ** ** | **106,621**  |        | 105,395  |       |
| Total bank premises and equipment         | ** ** | **282,330**  |        | 293,693  |       |
| Accumulated depreciation and amortization | ** ** | **(142,384** | )           | (152,771 | )          |
| Bank premises and equipment, net          | ** ** | **$**        | **139,946** |     | $          | 140,922 |   |

 

 Bankshares’ bank affiliates conduct a part oftheir branch banking operations from leased facilities. Generally, the initialterms of the leases range from a period of one to 15 years. Most of the leasescontain options for renewal at the fair rental value for periods of one to 20years. In addition to minimum rentals, certain leases have escalation clausesbased on various price indices and include provisions for additional paymentsto cover taxes, insurance and maintenance.

 

Total rentalexpense for 2004, 2003 and 2002 was:

 
| **(Dollars in thousands)**   | ** ** | **2004**  | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Bank premises (1)            | ** ** | **$**     | **9,501**  |     | $          | 8,807    |       | $ | 6,092 |   |
| Equipment / software expense | ** ** | **5,670** |       | 5,984    |       | 4,456    |       |
| Total rental expense         | ** ** | **$**     | **15,171** |     | $          | 14,791   |       | $ | 10,548 |   |

 

----

(1) Amounts donot reflect offset for rental income.

 

 The main offices of Bankshares and MSD&Tare located in a 21-story building at Two Hopkins Plaza in Baltimore, Maryland,which is owned by MBC Realty, LLC, a wholly owned subsidiary of Harbor GroupInternational, L.L.C. Pursuant to a lease agreement by and between MBC Realty,LLC (which was previously owned byBankshares) 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 of back office and storagespace at Two Hopkins Plaza, for a term of ten years. At December 31, 2004,MSD&T and Bankshares occupied approximately 206,000 square feet. The leaseagreement contains two five-year renewal options. The lease agreement isaccounted for 

 

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as alease-financing obligation. See Note No. 9 “Long-term Debt” below

 

At December 31,2004, the aggregate minimum rental commitments under noncancelable operatingleases were as follows 2005-$13.4 million, 2006-$11.9 million,2007-$10.9million, 2008-$8.2 million, 2009-$5.4 million, thereafter - $22.0million.

 

6. OTHERASSETS & LIABILITIES

 

The followingtable provides selected information on Bankshares’ other assets at December 31,2004 and 2003:

 
| **(Dollars in thousands)**           | ** ** | **2004**    | ** **  | **2003** | ** ** |
|--------------------------------------|------------|-------------|-------------|----------|------------|
| Nonmarketable investments            |       |        |        |     |       |
| Private equity and other investments | ** ** | **$**       | **56,476**  |     | $          | 38,833 |   |
| Hedge funds                          | ** ** | **74,190**  |        | 81,082   |       |
| Bank-owned life insurance            | ** ** | **83,836**  |        | 80,086   |       |
| Total nonmarketable investments      | ** ** | **214,502** |        | 200,001  |       |
| Interest receivable                  | ** ** | **62,061**  |        | 66,557   |       |
| Deferred taxes, net                  | ** ** | **47,299**  |        | 4,066    |       |
| Prepaid assets                       | ** ** | **84,130**  |        | 92,401   |       |
| All other assets                     | ** ** | **57,088**  |        | 47,844   |       |
| Total other assets                   | ** ** | **$**       | **465,080** |     | $          | 410,869 |   |

 

 Net gains (losses) from sales or impairment ofprivate equity and other nonmarketable investments were $2.6 million, $0.8million and $(1.3) million in 2004, 2003 and 2002, respectively. Noninterestincome from hedge funds was $5.5 million, $6.4 million and zero in 2004, 2003,and 2002, respectively. Other noninterest income from bank-owned life insurancewas $3.3 million, $3.0 million and $1.6 million in 2004, 2003 and 2002,respectively.

 

The followingtable provides selected information on Bankshares’ other liabilities at December 31,2004 and 2003:

 
| **(Dollars in thousands)** | ** ** | **2004**   | ** **  | **2003** | ** ** |
|----------------------------|------------|------------|-------------|----------|------------|
| Accrued expenses           | ** ** | **$**      | **61,599**  |     | $          | 63,328 |   |
| Interest payable           | ** ** | **16,551** |        | 17,664   |       |
| All other liabilities      | ** ** | **51,846** |        | 53,743   |       |
| Total other liabilities    | ** ** | **$**      | **129,996** |     | $          | 134,735 |   |

 

7. DEPOSITS

 

 Included in time deposits are certificates ofdeposit issued in denominations of $100,000 and over, which totaled $1.4billion and $1.3 billion at December 31, 2004 and 2003, respectively. At December 31,2004, the amount outstanding and maturity distribution of certificates ofdeposit issued in amounts of $100,000 and over are presented in the followingtable:

 
| ** **                                 | ** ** | ** ** | ** ** | **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** | ** ** |
| Certificates of deposits $100,000 and over |       | $          | 1,393,907  |                | $          | 950,504 |   | $ | 190,123 |   | $ | 99,410 |   | $ | 41,608 |   | $ | 108,612 |   | $ | 3,650 |   |
|                                            |            |            |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest ondeposits for the years ended December 31, 2004, 2003 and 2002 consisted ofthe following:

 
| **(Dollars in thousands)** | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------|------------|------------|------------|----------|------------|----------|------------|
| Savings                    | ** ** | **$**      | **4,197**  |     | $          | 4,702    |       | $ | 8,405 |   |
| Checking plus interest     | ** ** | **1,899**  |       | 2,061    |       | 2,908    |       |
| Money market               | ** ** | **9,584**  |       | 9,757    |       | 14,223   |       |
| Time - $100,000 and over   | ** ** | **26,101** |       | 29,464   |       | 34,671   |       |
| Other time                 | ** ** | **41,622** |       | 47,206   |       | 62,362   |       |
| Total interest on deposits | ** ** | **$**      | **83,403** |     | $          | 93,190   |       | $ | 122,569 |   |

 

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8. SHORT-TERMBORROWINGS

 

 The following table provides selectedinformation on Bankshares’ short-term borrowings and applicable weightedaverage interest rates at December 31, 2004 and 2003:

 
| ** **                                                               | ** ** | **Year-end** | ** **  | **During  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** | ** ** | **$** | **726,041** | ** ** | **.96** | **%** |
| Commercial paper                                                         | ** ** | **216,630**  | ** **  | **.80**          | ** ** | **286,844** | ** ** | **206,308** | ** ** | **.44** | ** ** |
| Other short-term borrowings                                              | ** ** | **—**   | ** **  | **—**       | ** ** | **—** | ** ** | **144** | ** ** | **2.19** | ** ** |
| Total                                                                    | ** ** | **$**        | **887,857** | ** **       | **1.29**   | **%** | ** ** | ** ** | **$** | **932,493** | ** ** | **.84** | **%** |
| ** **                                                               | ** ** | ** **   | ** **  | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **Year-end** | ** **  | **During  Year** | ** ** |
| **2003 (Dollars in thousands)**                                          | ** ** | **Amount**   | ** **  | **Rate**         | ** ** | **Highest** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| Federal funds purchased and securities sold under repurchase  agreements |       | $            | 618,141     |             | .57        | % | $ | 777,450 |   | $ | 627,839 |   | .71 | % |
| Commercial paper                                                         |       | 190,880      |        | .30              |       | 261,032 |   | 222,714 |   | .49 |   |
| Other short-term borrowings                                              |       | —       |        | —           |       | 1,720 |   | 795 |   | 2.22 |   |
| Total                                                                    |       | $            | 809,021     |             | .51        | % |   |   | $ | 851,348 |   | .66 | % |

 

 Other short-term borrowings consist of borrowingsfrom the Federal Home Loan Bank Atlanta (“FHLBA”). During 2004 and 2003,commercial paper borrowings were partially supported by back-up lines of creditof $40.0 million. Unused committed lines of credit at December 31, 2004and 2003 were $40.0 million. These lines of credit are paid for quarterly,semiannually or annually on a fee basis of .09% to .10%. Should Bankshares needto supplement its liquidity, it also has $1.8 billion in lines with the FHLB.

 

9. LONG-TERMDEBT

 

Long-term debtat December 31, 2004 and 2003 consisted of the following:

 
| **(Dollars in thousands)**                      | ** ** | **2004**    | ** **  | **2003** | ** ** |
|-------------------------------------------------|------------|-------------|-------------|----------|------------|
| Senior notes of Bankshares, unsecured           |       |        |        |     |       |
| Ranging from 6.72% to 6.80%, due 2006 to 2009   | ** ** | **$**       | **50,000**  |     | $          | 50,000 |   |
| Senior notes of MSD&T, unsecured (1)        |       |        |        |     |       |
| 5.70%, due 2011                                 |       |        |        |     |       |
| Book value                                      | ** ** | **199,704** |        | 199,672  |       |
| Fair value basis adjustment                     | ** ** | **6,147**   |        | 6,594    |       |
| Adjusted balance                                | ** ** | **205,851** |        | 206,266  |       |
| Subordinated notes of Bankshares, unsecured (2) |       |        |        |     |       |
| 4.625%, due 2013                                |       |        |        |     |       |
| Book value                                      | ** ** | **299,346** |        | 299,284  |       |
| Fair value basis adjustment                     | ** ** | **(6,289**  | **)**       | (7,960   | )          |
| Adjusted balance                                | ** ** | **293,057** |        | 291,324  |       |
| Lease finance obligation, Hopkins building (3)  |       |        |        |     |       |
| 4.00%, due 2011                                 | ** ** | **51,186**  |        | —   |       |
| Advances from Federal Home Loan Bank (4)        |       |        |        |     |       |
| Ranging from 2.00% to 6.95%, due 2005 to 2016   | ** ** | **90,861**  |        | 100,132  |       |
| Total                                           | ** ** | **$**       | **690,955** |     | $          | 647,722 |   |

 

----

Note: All debtis subject to interest payments at various intervals. Several of the FHLBadvances and the lease financing obligation are subject to monthly principalpayments.

 

(1) The debthas a face value of $200 million, with an unamortized discount of $296 thousandbased on an effective rate of 2.38%. These fixed-rate notes were converted tofloating rates through an interest rate swap. This swap was designed as a hedgeof the fair value of the debt; therefore, the debt has been adjusted to reflectthe change in the fair value of the swap.

 

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(2) The debthas a face value of $300 million, with an unamortized discount of $654 thousandbased on an effective rate of 3.46%. $150 million of these fixed-rate noteswere converted to floating rates through interest rate swaps. These swaps weredesigned as a hedge of the fair value of the debt; therefore, the debt has beenadjusted to reflect the change in the fair value of the swap.

 

(3) Representsthe unamortized amount due on the lease of the Hopkins Plaza Building.

 

(4) Of the$90.9 million that the Federal Home Loan Bank of Atlanta (“FHLBA”) advanced toBankshares as of December 31, 2004, $47.1 million is convertible tothree-month LIBOR at the option of the FHLBA. These advances are convertible ona quarterly basis upon written notice from the FHLBA. With the exception of a$10.7 million advance, each of these convertible advances is within its conversionperiod and may be converted on any quarterly payment date should the FHLBA givenotice. The $10.7 million advance has an initial conversion date of July 14,2006.

 

 The annual maturities on all long-term debtare 2005 - $7.9 million, 2006 - $68.2 million, 2007 - $7.5 million, 2008 -$24.4 million, 2009 - $17.8 million, thereafter-$565.2 million.

 

10.COMMITMENTS AND CONTINGENCIES

 

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

 

 Commitments to extend credit are agreements tolend to a customer as long so there is no violation of any conditionestablished in the contract. Commitments generally have fixed expiration datesor other termination clauses and may require payment of a fee. Since many ofthe commitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. Totalcommitments to extend credit were $4.2 billion at December 31, 2004 and$3.6 billion at December 31, 2003.

 

 Letters of credit are commitments issued toguarantee the performance of a customer to a third party. Outstanding lettersof credit were $379.8 million at December 31, 2004 and $281.4 million at December 31,2003.  In accordance with FASBInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others,” the feesreceived for issuing letters of credit are deferred and amortized over the lifeof the commitment.  The unamortized feeson letters of credit at December 31, 2004 and December 31, 2003 had acarrying value of $1.3 million and $1.0 million, respectively.

 

 Bankshares’ mortgage banking subsidiary is aFannie Mae Delegated Underwriting and Servicing lender and has a loss-sharingarrangement for loans originated on behalf of and sold to Fannie Mae.  The unamortized principal balance of theunderlying loans totaled $190.7 million at December 31, 2004 and $149.4million at December 31, 2003.  Noloss reserve has been established for potential losses on loans originated andsold in the secondary market since there have been no losses recognized duringthe history of this arrangement and no losses were incurred at December 31,2004.  The mortgage subsidiary also hasoriginated and sold loans with recourse in the event of foreclosure on theunderlying real estate.  The unamortizedamount of principal balance of loans sold with recourse totaled $1.7 millionand $2.3 million at December 31, 2004 and 2003, respectively.  These mortgages are generally in goodstanding and are well-collateralized, with no loss ensued and no future lossexpected.

 

 Bankshares has committed to invest funds inthird-party private equity investments. At December 31, 2004 and 2003,$28.9 million and $16.1 million, respectively, remained unfunded.

 

 Bankshares entered into a seven-year servicecontract with SunGard Wealth Management Services to provide a new coreaccounting system and back-office operations beginning in January 2005.The annual purchase obligation commitments on this contract are 2005 - $5.0million, 2006 - $5.0 million, 2007 - $5.0 million, 2008 - $5.0 million, 2009 -$5.0 million, thereafter - $10.0 million. For additional information on othercommitments see Notes No. 5, 9, and 18.

 

In theordinary course of business, Bankshares and its subsidiaries are involved in anumber of pending and threatened legal actions and proceedings. In certain ofthese actions and proceedings, including an action brought by a formerexecutive of the Investment and Wealth Management division, claims forsubstantial monetary damages are asserted against Bankshares and itssubsidiaries. In view of the inherent difficulty of predicting the outcome ofsuch matters, Bankshares cannot state what the eventual outcome of pendingmatters will be. However, based on current knowledge, management does notbelieve that liabilities, if any, arising from pending litigation matters, willhave a material adverse effect on the consolidated financial position orliquidity of Bankshares. If payment associated with a claim becomes probableand the cost can be reasonably estimated, a contingent liability would beestablished based on information currently available, advice of counsel andavailable insurance coverage.

 

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11. SHAREHOLDERS’ EQUITY

 

 The Board ofDirectors has the authority to classify and reclassify any unissued shares ofpreferred stock by fixing the preferences, rights, voting powers (which mayinclude separate class voting on certain matters), restrictions andqualifications, dividends, times and prices of redemption and conversionrights.

 

 Bankshares hasa Dividend Reinvestment and Stock Purchase Plan. The Plan allows shareholdersto invest their cash dividends automatically in Bankshares stock at a pricethat is 5% less than the market price on the dividend payment date. Planparticipants also may make additional cash payments to purchase stock throughthe Plan at the market price. The number of shares of common stock that remainavailable for issuance under the Plan is 350,577 shares. Bankshares reservesthe right to amend, modify, suspend or terminate the Plan at any time at itsdiscretion.

 

 Bankshares hasan Employee Stock Purchase Plan. The Plan allows employees (other thanexecutive officers of Bankshares) to purchase stock through payroll deductionand dividend reinvestment at the then current market price for employeepurchases and at 95% of market for dividend reinvestment. The number of sharesof common stock which remain available for issuance under the Plan is 740,244shares. Bankshares reserves the right to amend, modify, suspend or terminatethe Plan at any time at its discretion.

 

 The Board ofDirectors has authorized Bankshares to purchase shares of its common stock.Purchases may be made from time to time, subject to regulatory requirements, inthe open market or in privately negotiated transactions. Purchased shares areretired. The number of shares remaining available for purchase under the planswas 476,327 shares at December 31, 2004. During 2004 and 2003, 1,000,000 and5,500 shares, respectively, were repurchased by Bankshares.  In April 2004, Bankshares entered into aprivately negotiated agreement for the accelerated repurchase of the one millionshares.  Shares repurchased in 2003 wereacquired in open market transactions.

 

 Pursuant to aShareholders Protection Rights Agreement adopted in June 1999, each share ofoutstanding common stock carries a right, initially for the purchase of 1/1,000of a share of preferred stock at an exercise price of $150 (subject toadjustment). The rights, which do not carry voting or dividend rights, may beredeemed by Bankshares at $.01 per right. The rights expire on September 29,2009 unless sooner exercised, exchanged or redeemed. The rights will not becomeexercisable and will not trade separately from the common stock until the tenthbusiness day (or such other date as the Board of Directors selects) aftercommencement of a tender or exchange offer for, or announcement of theacquisition by a person or group of 10% or more of the outstanding commonstock. Upon exercisability of the rights after acquisition by a person or group(acquiring person) of 10% or more of the outstanding common stock or uponcertain business combinations or other defined transactions involvingBankshares, each right (except rights of the acquiring person, which becomevoid) will entitle its holder to acquire common stock (or at Bankshares’discretion, preferred stock) of Bankshares, or common stock of the acquiringentity in a business combination or other defined transaction, with a value oftwice the then current exercise price of the right. In certain such cases,Bankshares may exchange one share of common stock (or at Bankshares’discretion, 1/1,000 of a share of preferred stock) for each right that has notbecome void. The Board of Directors has classified 1,600,000 shares ofpreferred stock as Class A Preferred Stock for potential issuance on exerciseof rights.

 

 Cash dividends paid to Bankshares by itsconsolidated subsidiaries for the years ended 2004, 2003 and 2002 were $145.8million, $310.8 million and $135.7 million, respectively.  In aggregate, our affiliate banks have $409.3million of capital beyond the level necessary to maintain “well-capitalized”status at December 31, 2004.  The amountof dividends that Bankshares’ bankand nonbank affiliates could have paid to the holding company without approvalfrom bank regulators at December 31, 2004 was $309.2 million.

 

A change to the Directors’ Deferred Compensation Planwas approved at the 2004 Annual Shareholders’ meeting. Beginning April 1, 2004,all deferred directors’ fees are covered by the plan. At April 1, 2004,directors had the option to leave their deferred balance in the old phantomstock plan or convert their balance into vested shares under the new plan. Allbut 13 directors converted their balances to the new plan. This resulted inadding approximately 149,000 stock equivalents and $6.4 million to capitalsurplus. These vested shares will be issued after a director retires.

 

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*Earnings Per Share*

 

 Basic earningsper share (“EPS”) is computed by dividing income available to commonshareholders by weighted average common shares outstanding, which were 79,220,085for 2004, 72,892,409 for 2003 and 69,545,591 for 2002. Diluted EPS is computedusing the same components as in basic EPS with the denominator adjusted for thedilutive effect of stock options, restricted stock awards and vested directors’deferred compensation plan shares. The adjusted weighted average shares were79,854,337 for 2004, 73,421,487 for 2003 and 70,067,292 for 2002. The followingtables provide a reconciliation between the computation of basic EPS anddiluted EPS for the years ended December 31, 2004, 2003 and 2002:

 
| **2004 (In thousands, except per share data)**           | ** ** | **Net  Income** | ** **  | **Weighted Average  Common Shares** | ** ** | **EPS**    | ** ** |
|----------------------------------------------------------|------------|-----------------|-------------|-------------------------------------|------------|------------|------------|
| Basic EPS                                                | ** ** | **$**           | **229,407** | ** **                          | **79,220** | ** ** | **$**      | **2.90** | ** ** |
| Dilutive effect of:                                      | ** ** | ** **      | ** **  | ** **                          | ** ** | ** ** | ** ** |
| Stock options and restricted stock awards                | ** ** | ** **      | ** **  | **518**                             | ** ** | ** ** | ** ** |
| Vested directors’ deferred compensation plan shares | ** ** | ** **      | ** **  | **116**                             | ** ** | ** ** | ** ** |
| Diluted EPS                                              | ** ** | **$**           | **229,407** | ** **                          | **79,854** | ** ** | **$**      | **2.87** | ** ** |

 

 
| **2003 (In thousands, except per share data)** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
|------------------------------------------------|------------|-----------------|------------|-------------------------------------|------------|---------|------------|
| Basic EPS                                      |       | $               | 196,814    |                                | 72,892     |    | $          | 2.70 |   |
| Dilutive effect of:                            |       |            |       |                                |       |    |       |
| Stock options and restricted stock awards      |       |            |       | 529                                 |       |    |       |
| Diluted EPS                                    |       | $               | 196,814    |                                | 73,421     |    | $          | 2.68 |   |

 

 
| **2002 (In thousands, except per share data)** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
|------------------------------------------------|------------|-----------------|------------|-------------------------------------|------------|---------|------------|
| Basic EPS                                      |       | $               | 190,238    |                                | 69,546     |    | $          | 2.74 |   |
| Dilutive effect of:                            |       |            |       |                                |       |    |       |
| Stock options and restricted stock awards      |       |            |       | 521                                 |       |    |       |
| Diluted EPS                                    |       | $               | 190,238    |                                | 70,067     |    | $          | 2.72 |   |

 

*Comprehensive Income*

 

 The two majorcomponents of comprehensive income are net income and other comprehensiveincome. Other comprehensive income includes such items as net unrealized gainsand losses on securities available-for-sale. The following table summarizes themarket value change net of the tax effect of unrealized gains (losses) onsecurities available-for-sale for each of the three years in the period endedDecember 31, 2004. The total amount is included in the “Statements of Changesin Consolidated Shareholders’ Equity.”

 
| **(Dollars in thousands)**                                    | ** ** | **2004**    | ** **  | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------|------------|-------------|-------------|----------|------------|----------|------------|
| Net income                                                    | ** ** | **$**       | **229,407** |     | $          | 196,814  |       | $ | 190,238 |   |
| Other comprehensive income, net of taxes:                     |       |        |        |     |       |     |       |
| Unrealized holding (losses) gains arising during the  period  | ** ** | **(24,460** | **)**       | (29,063  | )          | 30,143   |       |
| Reclassification adjustment for gains included in net  income | ** ** | **(749**    | **)**       | (4,314   | )          | (511     | )          |
| Total                                                         | ** ** | **$**       | **204,198** |     | $          | 163,437  |       | $ | 219,870 |   |

 

*Capital Adequacy*

 

 Bankshares andits bank affiliates are subject to various regulatory capital requirementsadministered by the federal and state banking agencies. Failure to meet minimumcapital requirements can initiate certain mandatory—and possibly additionaldiscretionary—actions by regulators that, if undertaken, could have a directmaterial effect on Bankshares’ financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, Banksharesand its bank affiliates must meet specific capital guidelines that involvequantitative measures of Bankshares’ assets, liabilities and certainoff-balance sheet items as calculated under regulatory accounting practices.Bankshares’ capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings and otherfactors.

 

 Quantitativemeasures established by regulation to ensure capital adequacy requireBankshares and its bank affiliates to maintain at least the minimum amounts andratios (set forth in the table below) of Tier I capital (as defined in theregulations) to risk-weighted assets (as defined). Management believes that, asof December 31, 2004, Bankshares and its bank affiliates exceeded all capital 

 

74

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adequacy requirements to which they are subject.

 

 As of December31, 2004, the most recent notification from the primary regulators for each ofBankshares’ affiliate banking institutions categorized them as well-capitalizedunder the prompt corrective action regulations. To be categorized aswell-capitalized, a bank must maintain certain capital ratios above minimumlevels, as set forth in the table below. These capital ratios include Tier Icapital and total risk-based capital as percents of net risk-weighted assetsand Tier I capital as a percent of adjusted average total assets (leverageratio). There are no conditions or events since the last notifications thatmanagement believes have changed the affiliate banks’ category.

 

 Actual capitalamounts and ratios are also presented in the table below for Bankshares andMercantile-Safe Deposit and Trust Company (“MSD&T”), the lead bank. Nodeduction from capital is required for interest rate risk.

 
| ** **                    | ** ** | ** **     | ** **    | ** **    | ** ** | **Minimum Ratio  for Capital  Adequacy Purposes** |       | **Minimum Ratio to be  Well-Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-------------------------------|------------|----------------|---------------|---------------|------------|---------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**    | ** ** | **Bankshares** | ** **    | **MSD&T** | ** ** | **Bankshares**                                    | ** ** | **MSD&T**                                                                         |       | **Bankshares** | ** ** | **MSD&T** | ** ** |
| **As of December 31, 2004**   |       |           |          |          |       |                                              |       |                                                                                  |       |   |   |   |   |
| Tier I capital                | ** ** | **$**          | **1,370,112** |          | $          | 411,587                                           |       |                                                                                  |       |   |   |   |   |   |   |
| Total risk-based capital      | ** ** | **1,802,520**  |          | 459,812       |       |                                              |       |                                                                                  |       |   |   |   |   |
| Net risk-weighted assets      | ** ** | **11,109,137** |          | 3,847,161     |       |                                              |       |                                                                                  |       |   |   |   |   |
| Adjusted average total assets | ** ** | **13,674,386** |          | 4,504,451     |       |                                              |       |                                                                                  |       |   |   |   |   |
|                          |       |           |          |          |       |                                              |       |                                                                                  |       |   |   |   |   |
| Tier I capital ratio          | ** ** | **12.33**      | **%**         | 10.70         | %          | **4.00**                                          | **%**      | 4.00                                                                                  | %          | ** ** | **(1)** | 6.00 | % |
| Total capital ratio           | ** ** | **16.23**      | **%**         | 11.95         | %          | **8.00**                                          | **%**      | 8.00                                                                                  | %          | ** ** | **(1)** | 10.00 | % |
| Leverage ratio                | ** ** | **10.02**      | **%**         | 9.14          | %          | **4.00**                                          | **%**      | 4.00                                                                                  | %          | ** ** | **(1)** | 5.00 | % |
|                          |       |           |          |          |       |                                              |       |                                                                                  |       |   |   |   |   |
| As of December 31, 2003       |       |           |          |          |       |                                              |       |                                                                                  |       |   |   |   |   |
| Tier I capital                |       | $              | 1,248,492     |          | $          | 396,186                                           |       |                                                                                  |       |   |   |   |   |   |   |
| Total risk-based capital      |       | 1,666,064      |          | 440,479       |       |                                              |       |                                                                                  |       |   |   |   |   |
| Net risk-weighted assets      |       | 10,020,487     |          | 3,529,223     |       |                                              |       |                                                                                  |       |   |   |   |   |
| Adjusted average total assets |       | 13,011,399     |          | 4,353,713     |       |                                              |       |                                                                                  |       |   |   |   |   |
|                          |       |           |          |          |       |                                              |       |                                                                                  |       |   |   |   |   |
| Tier I capital ratio          |       | 12.46          | %             | 11.23         | %          | 4.00                                              | %          | 4.00                                                                                  | %          |   | (1) | 6.00 | % |
| Total capital ratio           |       | 16.63          | %             | 12.48         | %          | 8.00                                              | %          | 8.00                                                                                  | %          |   | (1) | 10.00 | % |
| Leverage ratio                |       | 9.60           | %             | 9.10          | %          | 4.00                                              | %          | 4.00                                                                                  | %          |   | (1) | 5.00 | % |

 

----

(1) Bankshares is not subject to this requirement.

 

12. INCOME TAXES

 

Applicable income taxes on net income for 2004, 2003and 2002 consisted of the following:

 
| ** **                     | ** ** | **2004**    | ** **  | **2003**   | ** ** | **2002**    | ** ** |
|--------------------------------|------------|-------------|-------------|------------|------------|-------------|------------|
| **(Dollars in thousands)**     | ** ** | **Federal** | ** **  | **State**  | ** ** | **Total**   | ** ** | **Federal** | ** ** | **State** | ** ** | **Total** | ** ** | **Federal** | ** ** | **State** | ** ** | **Total** | ** ** |
| Current tax expense            | ** ** | **$**       | **140,618** | ** ** | **$**      | **14,255**  | ** ** | **$** | **154,873** |   | $ | 107,870 |   | $ | 10,678 |   | $ | 118,548 |   | $ | 90,964 |   | $ | 4,929 |   | $ | 95,893 |   |
| Deferred tax expense (benefit) | ** ** | **(21,937** | **)**       | **(1,812** | **)**      | **(23,749** | **)**      | (7,457 | ) | (1,536 | ) | (8,993 | ) | 8,503 |   | 1,934 |   | 10,437 |   |
| Total                          | ** ** | **$**       | **118,681** | ** ** | **$**      | **12,443**  | ** ** | **$** | **131,124** |   | $ | 100,413 |   | $ | 9,142 |   | $ | 109,555 |   | $ | 99,467 |   | $ | 6,863 |   | $ | 106,330 |   |

 

75

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Significant components of Bankshares’ deferred taxassets and liabilities as of December 31, 2004 and 2003 were as follows:

 
| **(Dollars in thousands)**                             | ** ** | **2004**   | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|------------|------------|----------|------------|
| Deferred tax assets:                                   |       |       |       |     |       |
| Allowance for loan losses                              | ** ** | **$**      | **58,322** |     | $          | 59,183 |   |
| Write-down of other real estate owned                  | ** ** | **134**    |       | 114      |       |
| Deferred income                                        | ** ** | **22,328** |       | 45,446   |       |
| Net unrealized losses on securities available-for-sale | ** ** | **1,382**  |       | —   |       |
| Other                                                  | ** ** | **7,913**  |       | 6,495    |       |
| Total deferred tax assets                              | ** ** | **90,079** |       | 111,238  |       |
| Deferred tax liabilities:                              |       |       |       |     |       |
| Purchase accounting adjustments                        | ** ** | **8,570**  |       | 12,868   |       |
| Net unrealized gains on securities available-for-sale  | ** ** | **—** |       | 13,804   |       |
| Depreciation                                           | ** ** | **24,546** |       | 69,643   |       |
| Accrued employee benefits                              | ** ** | **9,512**  |       | 10,705   |       |
| Prepaid items                                          | ** ** | **152**    |       | 152      |       |
| Total deferred tax liabilities                         | ** ** | **42,780** |       | 107,172  |       |
| Net deferred tax assets / (liabilities)                | ** ** | **$**      | **47,299** |     | $          | 4,066 |   |

 

 A valuationallowance has not been established against Bankshares’ deferred tax assetsbecause management has determined that it is more likely than not that all suchtax assets will be realized in the future.

 

 Areconciliation between actual tax expense and taxes computed at the statutoryfederal rate of 35% for each of the three years in the period ended December31, 2004 follows:

 
| ** **                                            | ** ** | **2004**   | ** **  | **2003**                 | ** ** | **2002**   | ** ** |
|-------------------------------------------------------|------------|------------|-------------|--------------------------|------------|------------|------------|
| **(Dollars in thousands)**                            | ** ** | **Amount** | ** **  | **% of  Pretax  Income** | ** ** | **Amount** | ** ** | **% of  Pretax  Income** | ** ** | **Amount** | ** ** | **% of  Pretax  Income** | ** ** |
| Tax computed at statutory rate                        | ** ** | **$**      | **126,186** | ** **               | **35.0**   | **%**      | $          | 107,229 |   | 35.0 | % | $ | 103,799 |   | 35.0 | % |
| Increases (decreases) in tax resulting from:          |       |       |        |                     |       |       |       |   |   |   |   |   |   |
| Tax-exempt interest income                            | ** ** | **(3,567** | **)**       | **(0.9**                 | )          | (3,581     | )          | (1.2 | ) | (3,243 | ) | (1.1 | ) |
| State income taxes, net of federal income tax benefit | ** ** | **8,088**  | ** **  | **2.2**                  |       | 5,942      |       | 1.9 |   | 4,461 |   | 1.5 |   |
| Other, net                                            | ** ** | **417**    | ** **  | **0.1**                  |       | (35        | )          | — |   | 1,313 |   | 0.5 |   |
| Actual tax expense                                    | ** ** | **$**      | **131,124** | ** **               | **36.4**   | **%**      | $          | 109,555 |   | 35.7 | % | $ | 106,330 |   | 35.9 | % |

 

13. RELATED PARTY TRANSACTIONS

 

 In the normalcourse of business, loans are made to officers and directors of Bankshares andits affiliates, as well as to their related interests. In the opinion ofmanagement, these loans are consistent with sound banking practices, are withinregulatory lending limitations and do not involve more than the normal risk ofcollectibility. At December 31, 2004 and 2003, loans to executive officers anddirectors of Bankshares and its principal affiliates, including loans to theirrelated interests, totaled $129.1 million and $98.4 million, respectively.During 2004, loan additions and loan deletions were $170.6 million and $139.9million, respectively.

 

76

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14. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS

 

 Banksharessponsors qualified and nonqualified pension plans and other postretirementbenefit plans for its employees. With regard to the pension plans, there is noadditional minimum pension liability required to be recognized. Included in theother postretirement benefit plans are health care and life insurance. AllBankshares affiliates have adopted the same health care and life insuranceplans, except for one affiliate, which has separate benefit plans. Employeeswere eligible for company-paid health care benefits if their age plus length ofservice was equal to at least 65 as of December 31, 1990. Employees may becomeeligible 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 unfundedobligations, with an accrued liability of $18.5 million at December 31,2004.

 

 The followingtable provides a reconciliation of the changes in the plans’ benefitobligations and fair value of assets for each of the two years in the periodended December 31, 2004:

 
| ** **                                     | ** ** | **Pension Benefits** | ** **  | ** **          | ** ** | ** **         | ** ** |
|------------------------------------------------|------------|----------------------|-------------|---------------------|------------|--------------------|------------|
| ** **                                     | ** ** | **2004**             | ** **  | **2003**            | ** ** | **Other Benefits** | ** ** |
| **(Dollars  in thousands)**                    | ** ** | **Qualified**        | ** **  | **Non-  qualified** | ** ** | **Total**          | ** ** | **Qualified** | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Change in Benefit Obligations**              |       |                 |        |                |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Benefit obligation at beginning of year        | ** ** | **$**                | **168,104** | ** **          | **$**      | **6,560**          | ** ** | **$** | **174,664** | ** ** | $ | 155,160 |   | $ | 5,986 |   | $ | 161,146 |   | **$** | **15,050** | ** ** | $ | 13,044 |   |
| Service cost                                   | ** ** | **5,603**            | ** **  | **618**             | ** ** | **6,221**          | ** ** | 4,563 |   | 404 |   | 4,967 |   | **352** | ** ** | 205 |   |
| Interest cost                                  | ** ** | **10,528**           | ** **  | **386**             | ** ** | **10,914**         | ** ** | 9,993 |   | 314 |   | 10,307 |   | **1,028** | ** ** | 854 |   |
| Amendments                                     | ** ** | **4,865**            | ** **  | **83**              | ** ** | **4,948**          | ** ** | — |   | — |   | — |   | **—** | ** ** | — |   |
| Actuarial (gain) loss                          | ** ** | **18,276**           | ** **  | **(4,517**          | **)**      | **13,759**         | ** ** | 8,244 |   | 39 |   | 8,283 |   | **1,589** | ** ** | 2,010 |   |
| Acquisition                                    | ** ** | **—**           | ** **  | **—**          | ** ** | **—**         | ** ** | — |   | — |   | — |   | **—** | ** ** | — |   |
| Benefits paid                                  | ** ** | **(8,954**           | **)**       | **(220**            | **)**      | **(9,174**         | **)**      | (9,856 | ) | (183 | ) | (10,039 | ) | **(1,109** | **)** | (1,063 | ) |
| Benefit obligation at end of year              | ** ** | **198,422**          | ** **  | **2,910**           | ** ** | **201,332**        | ** ** | 168,104 |   | 6,560 |   | 174,664 |   | **16,910** | ** ** | 15,050 |   |
|                                           |       |                 |        |                |       |               | ** ** |   |   |   |   |   |   |   | ** ** |   |   |
| **Change in Plan Assets**                      |       |                 |        |                |       |               | ** ** |   |   |   |   |   |   |   | ** ** |   |   |
| Fair value of plan assets at beginning of year | ** ** | **197,260**          | ** **  | **—**          | ** ** | **197,260**        | ** ** | 153,935 |   | — |   | 153,935 |   | **—** | ** ** | — |   |
| Actual return on plan assets                   | ** ** | **23,332**           | ** **  | **—**          | ** ** | **23,332**         | ** ** | 33,431 |   | — |   | 33,431 |   | **—** | ** ** | — |   |
| Acquisition                                    | ** ** | **—**           | ** **  | **—**          | ** ** | **—**         | ** ** | — |   | — |   | — |   | **—** | ** ** | — |   |
| Employer contribution                          | ** ** | **—**           | ** **  | **220**             | ** ** | **220**            | ** ** | 19,750 |   | 183 |   | 19,933 |   | **1,109** | ** ** | 1,063 |   |
| Plan participants’ contributions          | ** ** | **—**           | ** **  | **—**          | ** ** | **—**         | ** ** | — |   | — |   | — |   | **1,687** | ** ** | 1,476 |   |
| Benefits paid                                  | ** ** | **(8,954**           | **)**       | **(220**            | **)**      | **(9,174**         | **)**      | (9,856 | ) | (183 | ) | (10,039 | ) | **(2,796** | **)** | (2,539 | ) |
| Fair value of plan assets at end of year       | ** ** | **211,638**          | ** **  | **—**          | ** ** | **211,638**        | ** ** | 197,260 |   | — |   | 197,260 |   | **—** | ** ** | — |   |
| Funded status                                  | ** ** | **13,216**           | ** **  | **(2,910**          | **)**      | **10,306**         | ** ** | 29,156 |   | (6,560 | ) | 22,596 |   | **(16,910** | **)** | (15,050 | ) |
| Unrecognized net actuarial (gain) loss         | ** ** | **36,362**           | ** **  | **(2,593**          | **)**      | **33,769**         | ** ** | 27,083 |   | 2,016 |   | 29,099 |   | **6,190** | ** ** | 4,963 |   |
| Unrecognized prior service cost                | ** ** | **9,738**            | ** **  | **249**             | ** ** | **9,987**          | ** ** | 5,655 |   | 189 |   | 5,844 |   | **—** | ** ** | — |   |
| Unrecognized transition (assets)/obligation    | ** ** | **—**           | ** **  | **—**          | ** ** | **—**         | ** ** | — |   | 94 |   | 94 |   | **—** | ** ** | — |   |
| Prepaid (accrued) benefit cost                 | ** ** | **$**                | **59,316**  | ** **          | **$**      | **(5,254**         | **)**      | **$** | **54,062** | ** ** | $ | 61,894 |   | $ | (4,261 | ) | $ | 57,633 |   | **$** | **(10,720** | **)** | $ | (10,087 | ) |

 

Amounts recognized in the consolidated balance sheetsconsist of:

 
| ** **                             | ** ** | **Pension Benefits** | ** ** | ** **          | ** ** | ** **         | ** ** |
|----------------------------------------|------------|----------------------|------------|---------------------|------------|--------------------|------------|
| ** **                             | ** ** | **2004**             | ** ** | **2003**            | ** ** | **Other Benefits** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Qualified**        | ** ** | **Non-  qualified** | ** ** | **Total**          | ** ** | **Qualified** | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Prepaid benefit cost                   | ** ** | **$**                | **59,316** | ** **          | **$**      | **—**         | ** ** | **$** | **59,316** |   | $ | 61,894 |   | $ | — |   | $ | 61,894 | ** ** | **$** | **—** |   | $ | — |   |
| Accrued benefit cost                   | ** ** | **—**           | ** ** | **(5,254**          | **)**      | **(5,254**         | **)**      | — |   | (4,261 | ) | (4,261 | ) | **(10,720** | **)** | (10,087 | ) |
| Intangible assets                      | ** ** | **—**           | ** ** | **—**          | ** ** | **—**         |       | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Accumulated other comprehensive income | ** ** | **—**           | ** ** | **—**          | ** ** | **—**         |       | — |   | — |   | — | ** ** | **—** | ** ** | — |   |
| Net amount recognized                  | ** ** | **$**                | **59,316** | ** **          | **$**      | **(5,254**         | **)**      | **$** | **54,062** |   | $ | 61,894 |   | $ | (4,261 | ) | $ | 57,633 | ** ** | **$** | **(10,720** | **)** | $ | (10,087 | ) |

 

The following is a comparison of the projected andaccumulated benefit obligation to the fair value of assets for the pensionplans:

 
| ** **                     | ** ** | **Pension Benefits at December  31,** | ** **  |
|--------------------------------|------------|---------------------------------------|-------------|
| ** **                     | ** ** | **2004**                              | ** **  | **2003** | ** ** |
| **(Dollars in thousands)**     | ** ** | **Qualified**                         | ** **  | **Non-  qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** |
| Projected benefit obligation   | ** ** | **$**                                 | **198,422** | ** ** | **$** | **2,910** | ** ** | **$** | **201,332** |   | $ | 168,104 |   | $ | 6,560 |   | $ | 174,664 |   |
| Accumulated benefit obligation | ** ** | **189,535**                           | ** **  | **2,910** | ** ** | **192,445** |   | 160,926 |   | 5,968 |   | 166,894 |   |
| Fair value of assets           | ** ** | **211,638**                           | ** **  | **—** | ** ** | **211,638** |   | 197,260 |   | — |   | 197,260 |   |
|                                |            |                                       |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

77

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The components of net periodic benefit cost for thepension plans for 2004, 2003 and 2002 follow:

 
| ** **                           | ** ** | **Pension Benefits** | ** ** |
|--------------------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **2004**             | ** ** | **2003** | ** ** | **2002** | ** ** |
| **(Dollars in thousands)**           | ** ** | **Qualified**        | ** ** | **Non-****qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Non-****qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Non-****qualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                | **5,603**  | ** ** | **$** | **618** | ** ** | **$** | **6,221** |   | $ | 4,563 |   | $ | 404 |   | $ | 4,967 |   | $ | 4,058 |   | $ | 390 |   | $ | 4,448 |   |
| Interest cost                        | ** ** | **10,528**           | ** ** | **386** | ** ** | **10,914** |   | 9,993 |   | 314 |   | 10,307 |   | 9,731 |   | 332 |   | 10,063 |   |
| Expected return on plan assets       | ** ** | **(15,387**          | **)**      | **—** | ** ** | **(15,387** | **)** | (12,395 | ) | — |   | (12,395 | ) | (12,158 | ) | — |   | (12,158 | ) |
| Amortization of prior service cost   | ** ** | **782**              | ** ** | **23** | ** ** | **805** |   | 779 |   | 23 |   | 802 |   | 996 |   | 23 |   | 1,019 |   |
| Recognized net actuarial (gain) loss | ** ** | **1,052**            | ** ** | **92** | ** ** | **1,144** |   | 2,421 |   | 32 |   | 2,453 |   | — |   | 94 |   | 94 |   |
| Amortization of transition asset     | ** ** | **—**           | ** ** | **94** | ** ** | **94** |   | — |   | 99 |   | 99 |   | — |   | 99 |   | 99 |   |
| Net periodic benefit cost            | ** ** | **$**                | **2,578**  | ** ** | **$** | **1,213** | ** ** | **$** | **3,791** |   | $ | 5,361 |   | $ | 872 |   | $ | 6,233 |   | $ | 2,627 |   | $ | 938 |   | $ | 3,565 |   |

 

The components of net periodic benefit cost for theother postretirement benefit plans for 2004, 2003 and 2002 follow:

 
| ** **                           | ** ** | **Other Benefits** | ** ** |
|--------------------------------------|------------|--------------------|------------|
| **(Dollars in thousands)**           | ** ** | **2004**           | ** ** | **2003** | ** ** | **2002** | ** ** |
| Service cost                         | ** ** | **$**              | **352**    |   | $ | 205 |   | $ | 182 |   |
| Interest cost                        | ** ** | **1,028**          |       | 854 |   | 939 |   |
| Expected return on plan assets       | ** ** | **—**         |       | — |   | — |   |
| Amortization of prior service cost   | ** ** | **—**         |       | — |   | — |   |
| Recognized net actuarial (gain) loss | ** ** | **362**            |       | 153 |   | 324 |   |
| Amortization of transition asset     | ** ** | **—**         |       | — |   | — |   |
| Net periodic benefit cost            | ** ** | **$**              | **1,742**  |   | $ | 1,212 |   | $ | 1,445 |   |

 

There was no increase in the minimum liability includedin other comprehensive income relating to pension benefits and otherpostretirement benefits for 2004 and 2003.

 

 The weightedaverage assumptions used to determine the benefit obligation are shown in thefollowing table:

 
| ** **                    | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-------------------------------|------------|----------------------|------------|--------------------|------------|
| **As of December 31,**        | ** ** | **2004**             | ** ** | **2003**           |       | **2004** | ** ** | **2003** | ** ** |
| Discount rate                 | ** ** | **5.75**             | **%**      | 6.25               | %          | **5.75** | **%** | 6.25 | % |
| Rate of compensation increase | ** ** | **4.00**             | **%**      | 4.00               | %          | **4.00** | **%** | 4.00 | % |

 

 The weightedaverage assumptions used to determine the net periodic benefit cost are shownin the following table:

 
| ** **                               | ** ** | **Pension Benefits** |       | **Other Benefits** | ** ** |
|------------------------------------------|------------|----------------------|------------|--------------------|------------|
| **As of December 31,**                   | ** ** | **2004**             | ** ** | **2003**           |       | **2004** | ** ** | **2003** | ** ** |
| Discount rate                            | ** ** | **6.25**             | **%**      | 6.50               | %          | **6.25** | **%** | 6.50 | % |
| 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 determiningpension expense for the qualified pension plan, a long-term return on assets of8% was assumed.  This return consists ofan average return of 10% on equity securities and 5% on debt securities.

 

Assumed health care cost trend rates are shown in thefollowing table:

 
| **Assumed health care cost trend rates as of December 31,**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| 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                                 | ** ** | **2010** |       | 2009     |       |

 

78

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 For measurementpurposes, a 10% annual rate of increase in the per capita cost of coveredhealth care benefits was assumed for 2005 and assumed to decrease by 1% perannum until the annual rate reaches 5% and to remain level thereafter. Thisrate represents Bankshares’ portion of the annual rate of increase. Assumedhealth care cost trend rates have a significant effect on the amounts reportedfor the health care plans. A 1% change in assumed health care cost trend rateswould have the following effects:

 
| ** **                                               | ** ** | **1% Increase** | ** ** | **1% Decrease** | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| Effect on total of service and interest cost  components |       | $               | 106        |            | $          | (92 | ) |
| Effect on postretirement benefit obligation              |       | 1,100           |       | (979            | )          |
|                                                          |            |                 |            |                 |            |  |  |

 

Pension Plan Assets

 

Bankshares’ qualified pension plan weighted averageasset allocations by category are as follows:

 
| ** **         | ** ** | **Plan Assets  at December 31** | ** ** |
|--------------------|------------|---------------------------------|------------|
| **Asset category** | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| Equity securities  | ** ** | **66**                          | **%**      | 68 | % |
| Debt securities    | ** ** | **31**                          | ** ** | 30 |   |
| Cash               | ** ** | **3**                           | ** ** | 2 |   |
| Total              | ** ** | **100**                         | **%**      | 100 | % |

 

 The returnobjectives for the qualified pension plan are (1) provide a growing andpredictable income stream from year to year; (2) achieve an annual return atleast equal to the 8% actuarial assumption rate; (3) preserve the capital valueof the pension plan; and (4) achieve growth of capital with comparable pensionfunds.

 

 Assetallocation targets are between 30% to 50% in debt securities and 50% to 70% inequity securities. At December 31, 2004, assets of the qualified pension planconsisted of 66% equity securities, 31% debt securities, and 3% cash.

 

 One finalobjective of the qualified pension plan is to maintain the fair value of planassets greater than the plan benefit obligations. At December 31, 2004, thefair value of plan assets was 107% of benefit obligations.

 

 The qualifiedpension plan had no investments in Bankshares common stock as of December 31,2004 and 2003.

 

Cash Flows

 

 Generally,Bankshares makes cash contributions to the pension plan in amounts up to thatpermitted by guidelines established under employee benefit and tax laws aftertaking into consideration the funded status. If it is determined that therewill be cash contributions, they are normally made after valuations have beenfinalized for the plan year and prior to the tax return filing date.  No contribution was made in 2004 for the planyear, and Bankshares does not anticipate making a contribution in 2005.

 

The following benefit payments, which reflect expectedfuture service, as appropriate, are to be paid:

 
| ** **                 | ** ** | **Pension Benefits** | ** ** | ** **          | ** ** |
|----------------------------|------------|----------------------|------------|---------------------|------------|
| **(Dollars in thousands)** | ** ** | **Qualified**        | ** ** | **Non-  qualified** | ** ** | **Total** | ** ** | **Other  Benefits** | ** ** |
| 2005                       |       | $                    | 9,520      |                | $          | 238 |   | $ | 9,758 |   | $ | 1,615 |   |
| 2006                       |       | 9,944                |       | 256                 |       | 10,200 |   | 1,503 |   |
| 2007                       |       | 10,460               |       | 287                 |       | 10,747 |   | 1,492 |   |
| 2008                       |       | 11,131               |       | 329                 |       | 11,460 |   | 1,500 |   |
| 2009                       |       | 11,793               |       | 345                 |       | 12,138 |   | 1,543 |   |
| Years 2010-2014            |       | 70,150               |       | 2,726               |       | 72,876 |   | 6,948 |   |
|                            |            |                      |            |                     |            |  |  |  |  |  |  |  |  |

 

79

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15.  STOCK PLANS

 

Omnibus Stock Plan (1989)

 

 The OmnibusStock Plan adopted in 1989 permitted the grant of stock options and other stockincentives to key employees of Bankshares and its affiliates. The 1989 Planprovided for the issuance of up to 2,902,500 shares of Bankshares authorizedbut unissued common stock. Options outstanding were granted at the stock marketvalue on the grant date and include both stock options which become exercisablecumulatively at the rate of 25% a year and those which are exercisableimmediately on grant. If certain levels of earnings per share of Bankshares andnet income of affiliates are not achieved, all or a portion of those optionswhich become exercisable at the rate of 25% a year are forfeited and becomeavailable for future grants. All options will terminate 10 years from date ofgrant if not exercised. No further grants will be made under the 1989 Plan.

 

1999 Omnibus Stock Plan

 

 The 1999Omnibus Stock Plan permits the grant of stock options and other stockincentives, including restricted stock awards, to key employees of Banksharesand its affiliates. The 1999 Plan provides for the issuance of up to 3,000,000shares of Bankshares authorized but unissued common stock. Options outstandingwere granted at market value and include both performance-based andnonperformance-based options. Options become exercisable ratably over three orfour years. If certain levels of earnings per share of Bankshares and netincome of affiliates are not achieved, all or a portion of theperformance-based options are forfeited and become available for future grants.All options will terminate 10 years from date of grant if not exercised.Restricted stock awards outstanding were granted at market value and vestratably over three years or in total at the end of a specified three-yearperiod.  The number of shares of commonstock which remain available for future grants under the Plan at December 31,2004 is 1,171,430 shares.

 

The table below summarizes activity under the OmnibusStock Plan and the 1999 Omnibus Stock Plan during the three years endedDecember 31, 2004:

 
| ** **                                                       | ** ** | ** **                          | ** ** | ** **                           | ** ** | **As of December 31,**   | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                                                       | ** ** | **Options issued  and outstanding** | ** ** | **Weighted average  exercise price** | ** ** | **Options  exercisable** | ** ** | **Weighted average  exercise price** | ** ** |
| Balance, December 31, 2001                                       |       | 1,603,215                           |       | $                                    | 21.87      |                     |       |   |   |   |
| Granted                                                          |       | 160,250                             |       | 45.00                                |       |                     |       |   |   |
| Terminated / forfeited                                           |       | (221,407                            | )          | 25.36                                |       |                     |       |   |   |
| Exercised                                                        |       | (238,969                            | )          | 17.59                                |       |                     |       |   |   |
| Balance, December 31, 2002                                       |       | 1,303,089                           |       | 24.90                                |       | 729,522                  |       | $ | 18.77 |   |
| Granted                                                          |       | 421,350                             |       | 35.65                                |       |                     |       |   |   |
| Options (at fair value) related to option plan of  acquired bank |       | 322,528                             |       | 20.93                                |       |                     |       |   |   |
| Terminated / forfeited                                           |       | (202,811                            | )          | 28.27                                |       |                     |       |   |   |
| Exercised                                                        |       | (332,725                            | )          | 19.39                                |       |                     |       |   |   |
| Balance, December 31, 2003                                       |       | 1,511,431                           |       | 27.81                                |       | 899,039                  |       | 21.98 |   |
| Granted                                                          |       | 460,572                             |       | 45.61                                |       |                     |       |   |   |
| Terminated / forfeited                                           |       | (46,155                             | )          | 37.32                                |       |                     |       |   |   |
| Exercised                                                        |       | (358,837                            | )          | 19.08                                |       |                     |       |   |   |
| Balance, December 31, 2004                                       | ** ** | **1,567,011**                       | ** ** | **34.77**                            | ** ** | **769,225**              | ** ** | **27.17** | ** ** |
|                                                                  |            |                                     |            |                                      |            |                          |            |  |  |  |  |

 

The following table provides selected information onstock options outstanding and exercisable at December 31, 2004:

 
| ** **          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                    | ** ** |
|---------------------|------------|-------------------------|------------|------------------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Number  outstanding** | ** ** | **Weighted average  remaining  contractual  life (years)** | ** ** | **Weighted  average  exercise price** | ** ** | **Number  exercisable** | ** ** | **Weighted  average  exercise price** | ** ** |
| $10.50 - $18.63     |       | 152,017                 |       | 1.25                                                       |       | $ | 15.30 |   | 152,017 |   | $ | 15.30 |   |
| $19.55 - $25.74     |       | 396,318                 |       | 5.37                                                       |       | 24.56 |   | 396,318 |   | 24.56 |   |
| $34.61 - $39.25     |       | 370,541                 |       | 8.10                                                       |       | 35.23 |   | 108,655 |   | 35.15 |   |
| $42.65 - $51.23     |       | 648,135                 |       | 8.71                                                       |       | 45.32 |   | 112,235 |   | 44.73 |   |
|                     |            |                         |            |                                                            |            |  |  |  |  |  |  |  |  |

 

80

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 The weightedaverage fair value of options granted during 2004, 2003 and 2002 was $6.21,$6.82 and $11.10, respectively. Compensation expense associated with theoptions granted and expected to vest for 2004, 2003 and 2002 was $2.7 million,$2.0 million and $1.2 million, respectively.

 

 The weightedaverage fair value of options granted is estimated as of the grant date usingthe Black-Scholes option pricing model. The following weighted averageassumptions were used as inputs to the Black-Scholes model for grants in 2004,2003 and 2002, respectively:

 

•                  Dividend yieldof 2.92%, 3.37% and 2.49%

•                  Volatility of22.32%, 26.20% and 26.41%

•                  Risk-freeinterest rate of 2.66%, 3.28% and 4.55%

•                  Expected term of3.0, 5.4 and 5.4 years

 

  The number ofrestricted stock awards granted in 2004, 2003 and 2002 was 35,982, 101,932 and76,250, respectively. Total compensation expense associated with the restrictedstock awards for 2004, 2003 and 2002 was $2.2 million, $3.0 million and $0.9million, respectively. Compensation expense is recognized on a straight-linebasis over a three-year vesting period. Due to the separation of personnel fromIWM, restricted stock expense of $0.8 million was accelerated into the year2003 that otherwise would have been recognized over future periods.

 

  Compensationcosts for stock options and restricted stock awards are included in salaryexpense.  Another form of stock-basedcompensation is phantom stock, which is used 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 planrequires all deferred fees to be settled in Bankshares’ stock.  This reduces the expense fluctuations thatoccurred with phantom stock, which resulted in variances corresponding to thechanges in Bankshares’ stock price. The compensation cost for the phantom stockis included in other expenses.

 

Stock-based compensation amounts for 2004, 2003 and2002 are summarized in the following table:

 
| **(Dollars in thousands)**             | ** ** | **2004**  | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Stock options expense                  | ** ** | **$**     | **2,676**  |     | $          | 2,045    |       | $ | 1,189 |   |
| Restricted stock awards expense        | ** ** | **2,191** |       | 2,986    |       | 872      |       |
| Subtotal included in salaries expense  | ** ** | **4,867** |       | 5,031    |       | 2,061    |       |
| Phantom stock expense                  | ** ** | **74**    |       | 1,581    |       | (371     | )          |
| Total stock-based compensation expense | ** ** | **$**     | **4,941**  |     | $          | 6,612    |       | $ | 1,690 |   |

 

16. SEGMENT REPORTING

 

 Operatingsegments are defined as components of an enterprise about which separatefinancial information is available that management relies on for decisionmaking and performance assessment. Bankshares has two reportable segments — Bankingand IWM. The Banking segment is comprised of 13 affiliate banks. The accountingpolicies of the segments are the same as those described in Note No. 1 of thefinancial statements. However, the segment data reflect intersegmenttransactions and balances.

 

 Bankshares hashistorically identified three distinct business segments for which financialinformation is segregated for use in assessing performance and allocatingresources when reporting to the Board of Directors. This segmentation isconsistent with the reporting structure established at the time Bankshares wasformed. At that time the organization consisted of: a lead bank, MSD&T,with two business segments – Banking and Investment & Wealth Management (“IWM”);and a Community Bank segment, which has been built through acquisitions andcontinued operation of independent charters. With the Farmers acquisition in2003 and the consolidation of 11 affiliate banks into four banks in 2004, thedistinction between banking segments has become less apparent. Increasedlending authority at the Community Banks has resulted in additional loan growthwithin their market areas and reduced referral and overline business toMSD&T. As a result of the convergence of the two banking segments,Bankshares currently reports these segments collectively as Banking.

 

 The followingtables present selected segment information for the years ended December 31,2004, 2003 and 2002. The components in the “Other” column consist of amountsfor the nonbank affiliates, unallocated corporate expenses and intercompanyeliminations. Certain expense amounts such as operations overhead have beenreclassified from internal financial reporting in order to provide for full costabsorption. These reclassifications are shown in the “Adjustments” line.Farmers is included in the “Banking” column, 

 

81

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whereas Boyd Wattersonand Peremel are included in the “IWM” column.

 
| **2004 (Dollars in thousands)**   | ** ** | **Banking**    | ** **    | **IWM**     | ** ** | **Other**   | ** ** | **Total**      | ** ** |
|-----------------------------------|------------|----------------|---------------|-------------|------------|-------------|------------|----------------|------------|
| Net interest income               | ** ** | **$**          | **544,640**   | ** **  | **$**      | **—**  | ** ** | **$**          | **1,141**  | ** ** | **$** | **545,781** | ** ** |
| Provision for loan losses         | ** ** | **(7,221**     | **)**         | **—**  | ** ** | **—**  | ** ** | **(7,221**     | **)**      |
| Noninterest income                | ** ** | **114,477**    | ** **    | **90,516**  | ** ** | **8,936**   | ** ** | **213,929**    | ** ** |
| Noninterest expenses              | ** ** | **(319,540**   | **)**         | **(68,741** | **)**      | **(3,677**  | **)**      | **(391,958**   | **)**      |
| Adjustments                       | ** ** | **18,098**     | ** **    | **(3,603**  | **)**      | **(14,495** | **)**      | **—**     | ** ** |
| Income (loss) before income taxes | ** ** | **350,454**    | ** **    | **18,172**  | ** ** | **(8,095**  | **)**      | **360,531**    | ** ** |
| Income tax (expense) benefit      | ** ** | **(127,462**   | **)**         | **(6,609**  | **)**      | **2,947**   | ** ** | **(131,124**   | **)**      |
| Net income (loss)                 | ** ** | **$**          | **222,992**   | ** **  | **$**      | **11,563**  | ** ** | **$**          | **(5,148** | **)** | **$** | **229,407** | ** ** |
| Average loans                     | ** ** | **$**          | **9,719,249** | ** **  | ** ** | ** **  | **$**      | **160**        | ** ** | **$** | **9,719,409** | ** ** |
| Average earning assets            | ** ** | **12,704,204** | ** **    | ** **  | ** ** | **28,800**  | ** ** | **12,733,004** | ** ** |
| Average assets                    | ** ** | **13,541,941** | ** **    | ** **  | ** ** | **451,030** | ** ** | **13,992,971** | ** ** |
| Average deposits                  | ** ** | **10,498,445** | ** **    | ** **  | ** ** | **(84,753** | **)**      | **10,413,692** | ** ** |
| Average equity                    | ** ** | **1,480,574**  | ** **    | ** **  | ** ** | **391,096** | ** ** | **1,871,670**  | ** ** |

 

 
| **2003 (Dollars in thousands)**   | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|-----------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest income               |       | $           | 477,507    |    | $          | —    |       | $          | (5,158     | ) | $ | 472,349 |   |
| Provision for loan losses         |       | (12,105     | )          | —  |       | —    |       | (12,105    | )          |
| Noninterest income                |       | 98,426      |       | 78,608  |       | 6,538     |       | 183,572    |       |
| Noninterest expenses              |       | (265,893    | )          | (66,633 | )          | (4,921    | )          | (337,447   | )          |
| Adjustments                       |       | 9,941       |       | (3,483  | )          | (6,458    | )          | —     |       |
| Income (loss) before income taxes |       | 307,876     |       | 8,492   |       | (9,999    | )          | 306,369    |       |
| Income tax (expense) benefit      |       | (107,743    | )          | (3,397  | )          | 1,585     |       | (109,555   | )          |
| Net income (loss)                 |       | $           | 200,133    |    | $          | 5,095     |       | $          | (8,414     | ) | $ | 196,814 |   |
| Average loans                     |       | $           | 8,088,749  |    |       |      | $          | 233        |       | $ | 8,088,982 |   |
| Average earning assets            |       | 11,086,263  |       |    |       | 11,225    |       | 11,097,488 |       |
| Average assets                    |       | 11,701,443  |       |    |       | 270,138   |       | 11,971,581 |       |
| Average deposits                  |       | 9,142,644   |       |    |       | (150,790  | )          | 8,991,854  |       |
| Average equity                    |       | 1,309,477   |       |    |       | 187,668   |       | 1,497,145  |       |

 

 
| **2002 (Dollars in thousands)**   | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|-----------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest income               |       | $           | 443,362    |    | $          | —    |       | $          | (2,327     | ) | $ | 441,035 |   |
| Provision for loan losses         |       | (16,378     | )          | —  |       | —    |       | (16,378    | )          |
| Noninterest income                |       | 77,039      |       | 67,965  |       | (485      | )          | 144,519    |       |
| Noninterest expenses              |       | (227,419    | )          | (45,617 | )          | 428       |       | (272,608   | )          |
| Adjustments                       |       | 7,072       |       | (2,219  | )          | (4,853    | )          | —     |       |
| Income (loss) before income taxes |       | 283,676     |       | 20,129  |       | (7,237    | )          | 296,568    |       |
| Income tax (expense) benefit      |       | (99,942     | )          | (8,052  | )          | 1,664     |       | (106,330   | )          |
| Net income (loss)                 |       | $           | 183,734    |    | $          | 12,077    |       | $          | (5,573     | ) | $ | 190,238 |   |
| Average loans                     |       | $           | 7,088,425  |    |       |      | $          | 419        |       | $ | 7,088,844 |   |
| Average earning assets            |       | 9,611,781   |       |    |       | 9,370     |       | 9,621,151  |       |
| Average assets                    |       | 10,058,519  |       |    |       | 64,938    |       | 10,123,457 |       |
| Average deposits                  |       | 7,688,472   |       |    |       | (56,062   | )          | 7,632,410  |       |
| Average equity                    |       | 1,221,782   |       |    |       | 36,185    |       | 1,257,967  |       |

 

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17. FAIR VALUE OF FINANCIAL INSTRUMENTS

 

 SFAS No. 107, “Disclosuresabout the Fair Value of Financial Instruments,” requires that we discloseestimated fair values for our financial instruments. This disclosure should beread in conjunction with the financial statements and Notes to FinancialStatements in this Annual Report.

 

 We base fairvalues on estimates or calculations using present value techniques when quotedmarket prices are not available. Because broadly traded markets do not existfor many of our financial instruments, we try to incorporate the current marketconditions in the fair value calculation. These valuations are our estimatesand are often based on current pricing policy, the characteristics of thefinancial instrument and other such factors. These calculations are subjective,involve uncertainties and rely on management judgment. There may be inherentweaknesses in any calculation technique, and changes in underlying assumptionsused, including discount rates and estimates of future cash flow that couldsignificantly affect the results.

 

 We have notincluded certain material items in our disclosure, such as the value of thelong-term relationships with our deposit and wealth management customers, sincethese intangibles are not financial instruments. For all of these reasons, thetotal of the fair value calculations do not represent the underlying value ofBankshares.

 

The estimated fair values of Bankshares’ financialinstruments at December 31, 2004 and 2003 were as follows:

 
| ** **                 | ** ** | **2004**        | ** **     | **2003**        | ** ** |
|----------------------------|------------|-----------------|----------------|-----------------|------------|
| **(Dollars in thousands)** | ** ** | **Book  Value** | ** **     | **Fair  Value** | ** ** | **Book  Value** | ** ** | **Fair  Value** | ** ** |
| **Financial Assets**       |       |            |           |            |       |   |   |   |   |
| Loans held-for-sale        | ** ** | **$**           | **11,000**     | ** **      | **$**      | **11,000** |   | $ | 14,925 |   | $ | 14,925 |   |
| Loans                      | ** ** | **10,228,433**  | ** **     | **10,280,155**  |       | 9,272,160 |   | 9,272,709 |   |
| Nonmarketable investments  | ** ** | **214,502**     | ** **     | **214,502**     |       | 200,001 |   | 200,001 |   |
|                       |       |            |           |            |       |   |   |   |   |
| **Financial Liabilities**  |       |            |           |            |       |   |   |   |   |
| Deposits                   | ** ** | **$**           | **10,799,199** | ** **      | **$**      | **9,421,832** |   | $ | 10,262,553 |   | $ | 10,269,135 |   |
| Long-term debt             | ** ** | **690,955**     | ** **     | **718,995**     |       | 647,722 |   | 641,110 |   |

 

The following methods and assumptions were used toestimate the fair value disclosures for financial instruments as of December31, 2004 and 2003:

 

*Cash and Short-Term Investments*

 

 The amountsreported in the balance sheet approximate the fair values of these assets.Short-term investments include interest-bearing deposits in other banks andfederal funds sold.

 

*Investment Securities*

 

 Fair values ofinvestment securities are based on quoted market prices and are reported inNote No. 3.

 

*Loans Held-for-Sale*

 

 Loansheld-for-sale are based on what secondary markets are currently offering forportfolios with similar characteristics.

 

*Loans*

 

 The fair valuecalculation of loans differentiates loans based on their financialcharacteristics, such as product classification, loan category, pricingfeatures and remaining maturity. Prepayment estimates are evaluated by productand loan rate.

 

 The fair valueof commercial loans, commercial real estate loans and real estate constructionloans is calculated by discounting contractual cash flows using discount ratesthat are believed to reflect current credit quality and other related factors.

 

 For real estate1-4 family first and junior lien mortgages, fair value is calculated bydiscounting contractual cash flows, adjusted for prepayment estimates, usingdiscount rates based on current industry pricing for loans of similar size,type, remaining maturity and re-pricing characteristics.

 

 For consumerloans, the fair value is calculated by discounting the contractual cash flows,adjusted for prepayments, based on the current rates we offer for loans withsimilar characteristics.

 

83

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 Loancommitments and letters of credit not included in the above table hadcontractual values of $4.2 billion and $379.8 million, respectively, at December31, 2004, and $3.6 billion and $281.4 million, respectively, at December 31,2003. These instruments generate ongoing fees at our current pricing levels.Since many of the commitments are expected to expire without being drawn upon,the total commitments do not necessarily represent future cash requirements.Unamortized fees on letters of credit totaled $1.3 million and $1.0 million atDecember 31, 2004 and 2003, respectively. Carrying cost estimates fair valuefor these fees.

 

*Nonmarketable Investments*

 

 There aregenerally restrictions on the sale and/or liquidation of nonmarketablesecurities. The carrying value of Federal Reserve Bank stock, Federal Home LoanBank stock, private equity investments and the cash surrender value of BOLIapproximates fair value. Hedge funds are carried at fair value based on currentmarket valuations.

 

*Deposits*

 

 The fair valueof demand deposits, savings accounts and money market deposits is the amountpayable on demand at the reporting date. The fair value of fixed-maturitycertificates of deposit is estimated using a discounted cash flow calculationthat applies interest rates and remaining maturities for currently offeredcertificates of deposit.

 

*Short-Term Borrowings*

 

 The amountsreported in the balance sheet approximate the fair values because of the shortduration of those instruments.

 

*Long-Term Debt*

 

 The fair valueof the long-term debt associated with the interest rate swap is based on quotedmarket prices. For all other long-term debt, fair value is estimated bydiscounting the future cash flows using estimates of rates currently availableto Bankshares and its affiliates for debt with similar terms and remainingmaturities.

 

*Derivatives*

 

 The fair valueof derivatives at December 31, 2004 and 2003 are reported in Note No. 18.

 

*Limitations*

 

The valuation techniques employed above involveuncertainties and are affected by assumptions used and by judgments regardingprepayments, credit risk, future loss experience, discount rates, cash flowsand other factors. Therefore, derived fair values cannot be substantiated bycomparison with independent markets or with other financial institutions. Thereported fair values do not necessarily represent what Bankshares would realizein immediate sales or other dispositions. Changes in assumptions couldsignificantly affect the reported fair values. The information presented isbased on fair value calculations and market quotes as of December 31, 2004 and2003. These amounts have not been updated since year end; therefore, the valuationmay have changed significantly since that point in time.

 

 As discussedabove, some of our asset and liability financial instruments are short-term,and therefore, the carrying amounts on the Consolidated Balance Sheetapproximate fair value. Other significant assets and liabilities, which are notconsidered financial assets or liabilities and for which fair values have notbeen determined, include premises and equipment, goodwill and otherintangibles, deferred and other liabilities.

 

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18. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

 Banksharesmaintains an overall interest rate risk management strategy that incorporatesthe use of derivative instruments to minimize significant unplanned fluctuationsin earnings that are caused by interest rate volatility. Derivative instrumentsthat are used as part of the interest rate risk management strategy have beenrestricted to interest rate swaps. Interest rate swaps generally involve theexchange of fixed-rate and variable-rate interest payments between two parties,based on a common notional principal amount and maturity date. At December 31,2004, Bankshares has interest rate swaps to convert a portion of itsnonprepayable fixed-rate debt to floating-rate debt.

 

 Bankshares alsoarranges interest rate swaps, caps and swaptions for commercial loan customersthrough its Capital Markets Group. Derivative transactions done with loan customers are hedged by means ofan off-setting derivative trade with a third party.  In this way, Bankshares manages the marketrisk arising from capital markets related derivative activity.  The increase in the number of contracts sinceDecember 31, 2003 is related to the Capital Markets Group activities.

 

 The fair valueof derivative instruments relating to hedging activities recorded in otherassets was $7.1 million (notional $294.5 million) and $6.6 million (notional$203.1 million) at December 31, 2004 and 2003, respectively. The fair value ofderivative instruments relating to hedging activities recorded in otherliabilities was $6.8 million (notional $136.0 million) and $8.0 million(notional $150.0 million) at December 31, 2004 and 2003, respectively.  The fair-value hedges of nonprepayablefixed-rate debt were effective for the reported periods.  The impact of the hedges decreased interestexpense $10.2 million and $8.5 million in 2004 and 2003, respectively.

 

The following tables summarize the gross position ofderivatives relating to hedging activities at December 31, 2004 and 2003:

 
| ** **                           | ** ** | **2004**                             | ** **  | **2003**                     | ** ** |
|--------------------------------------|------------|--------------------------------------|-------------|------------------------------|------------|
| **(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                                | ** ** | **$**                                | **350,000** | ** **                   | **$**      | **6,297** | ** ** | **$** | **(143** | **)** | $ | 353,108 |   | $ | 6,594 |   | $ | (1,430 | ) |
|                                 |       |                                 |        |                         |       |   | ** ** |   |   |   |   |   |   |
| *Customer Accommodations*            |       |                                 |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Interest Rate Contracts:             |       |                                 |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                | **68,575**  | ** **                   | **$**      | **684** | ** ** | **$** | **398** | ** ** | $ | — |   | $ | — |   | $ | — |   |
| Swaptions/Caps Purchased             | ** ** | **5,971**                            | ** **  | **80**                       | ** ** | **80** | ** ** | — |   | — |   | — |   |
| Swaptions/Caps Sold                  | ** ** | **5,971**                            | ** **  | **—**                   | ** ** | **(80** | **)** | — |   | — |   | — |   |

 

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(1) Credit risk amounts reflect the replacement costfor those contracts 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 sell and fundindividual fixed-rate and variable-rate mortgage loans that are reported atfair value. At December 31, 2004, the fair value adjustment to loans was$(13.7) thousand with the offset to other assets.

 

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19. INTANGIBLE ASSETS

 

 The FinancialAccounting Standards Board issued SFAS No. 142, “Goodwill and Other IntangibleAssets,” which discontinues the amortization of goodwill and intangible assetswith indefinite lives. Instead, these assets are subject to at least an annualimpairment review and more frequent review if certain impairment indicators arein evidence.

 

 The followingtable discloses the gross carrying amount and accumulated amortization ofintangible assets subject to amortization at December 31, 2004 and December 31,2003:

 
| ** **                 | ** ** | **December 31, 2004**      | ** ** | **December 31, 2003**         | ** ** |
|----------------------------|------------|----------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Core deposits              | ** ** | **$**                      | **49,881** | ** **                    | **$**      | **(15,014** | **)** | **$** | **34,867** |   | $ | 49,881 |   | $ | (9,546 | ) | $ | 40,335 |   |
| Mortgage servicing         | ** ** | **1,597**                  | ** ** | **(1,240**                    | **)**      | **357** |   | 2,351 |   | (1,790 | ) | 561 |   |
| Customer lists and other   | ** ** | **17,010**                 | ** ** | **(4,008**                    | **)**      | **13,002** |   | 17,010 |   | (1,683 | ) | 15,327 |   |
| Total                      | ** ** | **$**                      | **68,488** | ** **                    | **$**      | **(20,262** | **)** | **$** | **48,226** |   | $ | 69,242 |   | $ | (13,019 | ) | $ | 56,223 |   |

 

 The projectionsof amortization expense shown for mortgage servicing rights are based on assetbalances and the interest rate environment as of December 31, 2004. Futureamortization expense may be significantly different depending on changes in themortgage servicing portfolio, mortgage interest rates and market conditions.

 

 Identifiable intangible assets areamortized based on useful lives of up to 15 years. Bankshares recorded $36.0million of core deposit intangibles and $17.0 million in customer list andother intangible assets in connection with the Acquisitions in 2003. Managementreviews identifiable intangibleassets for impairment yearly (except mortgage servicing rights, which arereviewed monthly), or whenever events or changes in circumstances indicate thattheir carrying amounts may not be recoverable. For those intangible assetssubject to amortization, impairment is indicated if the sum of undiscountedestimated future net cash flow is less than the carrying amount of the asset.Impairment is recognized by accelerating the write-off of the asset to theextent that the carrying value exceeds the estimated fair value.

 

 The followingtable shows the current period and estimated future amortization expense foramortized intangible assets:

 
| **(Dollars in thousands)**           | ** ** | ** ** | ** ** | **Core  deposit  intangibles** | ** ** | **Mortgage  servicing  intangibles** | ** ** | **Customer lists  and other  intangibles** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|------------|------------|--------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|-----------|------------|
| Year ended December 31, 2004         | ** ** | ** ** | ** ** | **$**                          | **5,467**  | ** **                           | **$**      | **331**                                    | ** ** | **$**     | **2,344**  | ** ** | **$** | **8,142** | ** ** |
|                                 |       |       |       |                           |       |                                 |       |                                       |       |      |       |
| Estimate for year ended December 31, |       | 2005       |       | 5,467                          |       | 242                                  |       | 2,326                                      |       | 8,035     |       |
|                                 |       | 2006       |       | 5,467                          |       | 111                                  |       | 2,083                                      |       | 7,661     |       |
|                                 |       | 2007       |       | 5,209                          |       | 4                                    |       | 1,890                                      |       | 7,103     |       |
|                                 |       | 2008       |       | 4,344                          |       |                                 |       | 1,708                                      |       | 6,052     |       |
|                                 |       | 2009       |       | 4,120                          |       |                                 |       | 985                                        |       | 5,105     |       |
|                                      |            |            |            |                                |            |                                      |            |                                            |            |           |            |  |  |  |  |

 

 SFAS No. 142requires that goodwill be tested annually for impairment using a two-stepprocess. The first step is to identify potential impairment and the second stepis to measure the amount of the impairment loss, if any. No impairment chargesfor goodwill impacted either the 2004 or 2003 financial statements.

 

 The followingtable discloses the gross carrying amount and accumulated amortization ofgoodwill at December 31, 2004 and December 31, 2003 by segment. Banksharesrecorded $403.9 million of goodwill in connection with the acquisitions in2003. During 2004, goodwill related to the Farmers acquisition was adjusted$14.4 million.

 
| ** **                 | ** ** | **December 31, 2004**      | ** **  | **December 31, 2003**         | ** ** |
|----------------------------|------------|----------------------------|-------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross carrying  amount** | ** **  | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| IWM                        | ** ** | **$**                      | **18,061**  | ** **                    | **$**      | **—** | ** ** | **$** | **18,061** |   | $ | 18,061 |   | $ | — |   | $ | 18,061 |   |
| Banking                    | ** ** | **529,511**                | ** **  | **(39,781**                   | **)**      | **489,730** |   | 543,893 |   | (39,781 | ) | 504,112 |   |
| Total                      | ** ** | **$**                      | **547,572** | ** **                    | **$**      | **(39,781** | **)** | **$** | **507,791** |   | $ | 561,954 |   | $ | (39,781 | ) | $ | 522,173 |   |

 

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20.  MERCANTILEBANKSHARES CORPORATION (PARENT CORPORATION ONLY) FINANCIAL INFORMATION

 

**BALANCE SHEET**

 
| **December 31,  (Dollars in thousands, except per share data)**                            | ** ** | **2004**      | ** **    | **2003**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------|---------------|------------|------------|
| **Assets**                                                                                 |       |          | ** **    |       |       |
| Cash                                                                                       | ** ** | **$**         | **2,502**     | ** ** | $          | 13,597 |   |
| Interest-bearing deposits with bank affiliates                                             | ** ** | **176,000**   | ** **    | 56,000     |       |
| Securities purchased under resale agreements with bank  affiliates                         | ** ** | **86,630**    | ** **    | 60,880     |       |
| Cash and cash equivalents                                                                  | ** ** | **265,132**   | ** **    | 130,477    |       |
| Investment in bank affiliates                                                              | ** ** | **1,776,209** | ** **    | 1,369,101  |       |
| Investment in bank-related affiliates                                                      | ** ** | **10,033**    | ** **    | 22,341     |       |
| Loans and advances to affiliates                                                           | ** ** | **358,076**   | ** **    | 359,520    |       |
| Investment securities available-for-sale                                                   | ** ** | **18,580**    | ** **    | 19,610     |       |
| Building premises and equipment, net                                                       | ** ** | **13,629**    | ** **    | —     |       |
| Goodwill, net                                                                              | ** ** | **—**    | ** **    | 400,307    |       |
| Other assets                                                                               | ** ** | **123,295**   | ** **    | 101,925    |       |
| Total                                                                                      | ** ** | **$**         | **2,564,954** | ** ** | $          | 2,403,281 |   |
| **Liabilities and Shareholders’  Equity**                                             |       |          | ** **    |       |       |
| Liabilities:                                                                               |       |          | ** **    |       |       |
| Commercial paper                                                                           | ** ** | **$**         | **216,630**   | ** ** | $          | 190,880 |   |
| Accounts payable and other liabilities                                                     | ** ** | **36,399**    | ** **    | 29,636     |       |
| Long-term debt                                                                             | ** ** | **394,242**   | ** **    | 341,324    |       |
| Total Liabilities                                                                          | ** ** | **647,271**   | ** **    | 561,840    |       |
| Shareholders’ Equity:                                                                 |       |          | ** **    |       |       |
| Preferred stock, no par value; authorized 2,000,000  shares; issued and outstanding - None |       |          | ** **    |       |       |
| Common stock, $2 par value; authorized 130,000,000  shares;                                |       |          | ** **    |       |       |
| issued 79,300,506 shares in 2004 and 79,772,705 shares  in 2003                            | ** ** | **158,601**   | ** **    | 159,545    |       |
| Capital surplus                                                                            | ** ** | **530,705**   | ** **    | 548,664    |       |
| Retained earnings                                                                          | ** ** | **1,231,102** | ** **    | 1,110,748  |       |
| Accumulated other comprehensive income (loss)                                              | ** ** | **(2,725**    | **)**         | 22,484     |       |
| Total shareholders’ equity                                                            | ** ** | **1,917,683** | ** **    | 1,841,441  |       |
| Total                                                                                      | ** ** | **$**         | **2,564,954** | ** ** | $          | 2,403,281 |   |

 

**STATEMENT OF INCOME**

 
| ** **                                                                             | ** ** | **(Dollars in thousands)** | ** **  |
|----------------------------------------------------------------------------------------|------------|----------------------------|-------------|
| **For the Years Ended December 31,**                                                   | ** ** | **2004**                   | ** **  | **2003** | ** ** | **2002** | ** ** |
| **Income**                                                                             |       |                       |        |   |   |   |   |
| Dividends from bank affiliates                                                         | ** ** | **$**                      | **145,841** |   | $ | 309,980 |   | $ | 134,838 |   |
| Dividends from bank-related affiliates                                                 | ** ** | **767**                    |        | 863 |   | 905 |   |
| Interest on interest-bearing deposits with bank  affiliates                            | ** ** | **710**                    |        | 1,460 |   | 819 |   |
| Interest on securities purchased under resale  agreements with bank affiliates         | ** ** | **362**                    |        | 526 |   | 1,224 |   |
| Interest on loans to affiliates                                                        | ** ** | **13,685**                 |        | 5,920 |   | 2,383 |   |
| Other income                                                                           | ** ** | **9,467**                  |        | 6,215 |   | 198 |   |
| Total income                                                                           | ** ** | **170,832**                |        | 324,964 |   | 140,367 |   |
| **Expenses**                                                                           |       |                       |        |   |   |   |   |
| Interest on short-term borrowings                                                      | ** ** | **893**                    |        | 1,099 |   | 2,732 |   |
| Interest on long-term debt                                                             | ** ** | **13,846**                 |        | 12,128 |   | 4,243 |   |
| Other expenses                                                                         | ** ** | **4,984**                  |        | 6,042 |   | 2,269 |   |
| Total expenses                                                                         | ** ** | **19,723**                 |        | 19,269 |   | 9,244 |   |
| Income before income tax benefit and equity in  undistributed net income of affiliates | ** ** | **151,109**                |        | 305,695 |   | 131,123 |   |
| Income tax expense (benefit)                                                           | ** ** | **1,807**                  |        | (1,959 | ) | (310 | ) |
| ** **                                                                             |       | **149,302**                |        | 307,654 |   | 131,433 |   |
| Equity in undistributed net income of:                                                 |       |                       |        |   |   |   |   |
| Bank affiliates                                                                        | ** ** | **79,637**                 |        | (110,984 | ) | 58,269 |   |
| Bank-related affiliates                                                                | ** ** | **468**                    |        | 144 |   | 536 |   |
| **Net Income**                                                                         | ** ** | **$**                      | **229,407** |   | $ | 196,814 |   | $ | 190,238 |   |

 

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**STATEMENT OF CASH FLOWS**

 
| **Increase (decrease) in cash and cash equivalents**                               | ** ** | **(Dollars in thousands)** | ** **  |
|------------------------------------------------------------------------------------|------------|----------------------------|-------------|
| **For the Years Ended December 31,**                                               | ** ** | **2004**                   | ** **  | **2003** | ** ** | **2002** | ** ** |
| **Cash Flows from Operating  Activities**                                          |       |                       |        |   |   |   |   |
| Net Income                                                                         | ** ** | **$**                      | **229,407** | ** ** | $ | 196,814 |   | $ | 190,238 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                       | ** **  |   |   |   |   |
| Equity in undistributed net income of affiliates                                   | ** ** | **(80,105**                | **)**       | 110,840 |   | (58,805 | ) |
| Depreciation                                                                       | ** ** | **102**                    | ** **  | — |   | — |   |
| Investment securities gains                                                        | ** ** | **(1,295**                 | **)**       | (380 | ) | — |   |
| Net increase in other assets                                                       | ** ** | **(8,574**                 | **)**       | (6,390 | ) | (83,772 | ) |
| Net increase (decrease) in liabilities:                                            |       |                       | ** **  |   |   |   |   |
| Interest payable                                                                   | ** ** | **478**                    | ** **  | 3,377 |   | — |   |
| Accrued expenses                                                                   | ** ** | **2,831**                  | ** **  | 2,424 |   | (582 | ) |
| Taxes payable                                                                      | ** ** | **1,714**                  | ** **  | (1,615 | ) | (15,065 | ) |
| Net cash provided by operating activities                                          | ** ** | **144,558**                | ** **  | 305,070 |   | 32,014 |   |
| **Cash Flows from Investing  Activities**                                          |       |                       | ** **  |   |   |   |   |
| Net (increase) decrease in loans to affiliates                                     | ** ** | **1,444**                  | ** **  | (299,115 | ) | 74,445 |   |
| Proceeds from sales of investment securities  available-for-sale                   | ** ** | **27,224**                 | ** **  | 2,380 |   | 500 |   |
| Purchases of investment securities available-for-sale                              | ** ** | **(25,933**                | **)**       | (14,995 | ) | (1,000 | ) |
| Capital expenditures                                                               | ** ** | **(13,629**                | **)**       | — |   | — |   |
| Investment in affiliates                                                           | ** ** | **63,074**                 | ** **  | (171,609 | ) | — |   |
| Net cash provided by (used in) investing activities                                | ** ** | **52,180**                 | ** **  | (483,339 | ) | 73,945 |   |
| **Cash Flows from Financing  Activities**                                          |       |                       | ** **  |   |   |   |   |
| Net increase (decrease) in commercial paper                                        | ** ** | **25,750**                 | ** **  | (67,888 | ) | 14,017 |   |
| Proceeds from issuance of long-term debt                                           | ** ** | **51,250**                 | ** **  | 300,000 |   | — |   |
| Repayment of long-term debt                                                        | ** ** | **—**                 | ** **  | (8,400 | ) | (8,300 | ) |
| Proceeds from issuance of shares                                                   | ** ** | **14,322**                 | ** **  | 11,369 |   | 8,784 |   |
| Repurchase of common shares                                                        | ** ** | **(44,110**                | **)**       | (212 | ) | (53,953 | ) |
| Dividends paid                                                                     | ** ** | **(109,295**               | **)**       | (95,842 | ) | (81,909 | ) |
| Net cash (provided by) used in financing activities                                | ** ** | **(62,083**                | **)**       | 139,027 |   | (121,361 | ) |
| Net increase (decrease) in cash and cash equivalents                               | ** ** | **134,655**                | ** **  | (39,242 | ) | (15,402 | ) |
| Cash and cash equivalents at beginning of year                                     | ** ** | **130,477**                | ** **  | 169,719 |   | 185,121 |   |
| Cash and cash equivalents at end of year                                           | ** ** | **$**                      | **265,132** | ** ** | $ | 130,477 |   | $ | 169,719 |   |

 

21.   SUBSEQUENTEVENT

 

 On January 25,2005, Bankshares, Mercantile-Safe Deposit and Trust Company, a wholly ownedsubsidiary of Bankshares and a Maryland Bank (“MSD&T”), and Community Bankof Northern Virginia, a Virginia Bank (“CBNV”) entered into an Agreement andPlan of Merger. At December 31, 2004, CBNV had $880 million in assets, $654million in gross loans and $649 million in deposits. The merger, which is subjectto regulatory and CBNV shareholder approval and certain bank regulatoryapprovals, among other conditions, is expected to be completed by the end ofthe second quarter of 2005.

 

 At theeffective time and as a result of the Merger, each outstanding share of CBNV’scommon stock (the “Bank Shares”) will be converted into the right to receiveeither (i) $20.375 in cash without interest (the “Cash Election Price”), or(ii) .4005 of Bankshares’ common stock (the “Exchange Ratio,” and together withthe cash Election Price, the “Merger Consideration”). Each shareholder of CBNVwill be entitled to elect the number of its Bank Shares to be exchanged for theCash Election Price or to make no election, subject to a proration which willprovide that the aggregate Merger Consideration exchanged for Bank Sharesoutstanding at the closing of the Merger will be allocated as 40% cash and 60%Bankshares’ common stock. The Merger is anticipated to be tax free to theshareholders of CBNV, as to the portion of the Merger Consideration received asBankshares common stock. Outstanding CBNV stock options will be converted intostock options of Bankshares.

 

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ITEM 9.                             CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

There was no matterwhich is required to be disclosed in this Item 9 pursuant to the instructionscontained in the form for this Report.

 

ITEM 9A.                   CONTROLSAND PROCEDURES

 

We have carried out anevaluation, under the supervision and with the participation of our managementincluding our principal executive officer and principal financial officer, ofthe effectiveness of the design and operation of our disclosure controls andprocedures, as that term is defined in Rule 13a-15(e) under the Securities andExchange Act of 1934, as amended. Based on that evaluation, our principalexecutive officer and principal financial officer concluded that as of December31, 2004, which is the end of the period covered by this Annual Report on Form10-K, our disclosure controls and procedures are effective.

 

There have been nochanges in our internal controls over financial reporting in the fiscal quarterended December 31, 2004 that have materially affected, or are reasonably likelyto materially affect, our internal controls over financial reporting.

 

Management has issuedits report on internal control over financial reporting as of December 31,2004, which appears in Item 8 of this Report.

 

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ITEM 9B.                                             OTHERINFORMATION

 

There was no informationrequired to be disclosed in a report on Form 8-K during the fourth quarter of2004, but not reported.

 

PART III

 

ITEM 10.                                               DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT

 

Bankshares has adopted acode of ethics that applies to its chief executive officer, chief financialofficer, and controller.  The code ofethics is an exhibit to this Annual Report on Form 10-K.  The text of the code is posted on Bankshares’website at www.mercantile.com. Bankshares will provide to any person, without charge, upon request acopy of the code of ethics.  Requests fora copy of the code of ethics can be made in writing to: Mercantile BanksharesCorporation, P.O. Box 1477, Baltimore, MD 21203, Attn: Investor Relations.  Any future amendments to, or waivers from,the provisions of the code of ethics that require disclosure under applicablerules of the Securities and Exchange Commission will be disclosed in a currentreport on Form 8-K

 

The information requiredby this Item 10 with respect to the Executive Officers of Registrant appears inPart I of this Annual Report on Form 10-K.

 

The remaininginformation required by this Item 10 is incorporated by reference to thedefinitive proxy statement of Registrant to be filed with the Securities andExchange Commission under Regulation 14A not later than 120 days after the endof the fiscal year covered by this Annual Report on Form 10-K.

 

ITEM 11.                                               EXECUTIVECOMPENSATION

 

The information requiredby this Item 11 is incorporated by reference to the definitive proxy statementof Registrant to be filed with the Securities and Exchange Commission underRegulation 14A not later than 120 days after the end of the fiscal year coveredby this Annual Report on Form 10-K.

 

ITEM 12.                                               SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The information requiredby this Item 12 is incorporated by reference to the definitive proxy statementof Registrant to be filed with the Securities and Exchange Commission underRegulation 14A not later than 120 days after the end of the fiscal year coveredby this Annual Report on Form 10-K.

 

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ITEM 13.                                               CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

 

The information requiredby this Item 13 is incorporated by reference to the definitive proxy statementof Registrant to be filed with the Securities and Exchange Commission underRegulation 14A not later than 120 days after the end of the fiscal year coveredby this Annual Report on Form 10-K.

 

ITEM 14.                       PRINCIPALACCOUNTANT FEES AND SERVICES

 

The information requiredby this Item 14 is incorporated by reference to the definitive proxy statementof Registrant to be filed with the Securities and Exchange Commission underRegulation 14A not later than 120 days after the end of the fiscal year coveredby this Annual Report on Form 10-K.

 

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PART IV

 

ITEM 15.                       EXHIBITSAND 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)  | Articles of  Incorporation effective May 27, 1969 (Incorporated by reference to  Registrant’s Registration Statement on Form S-1, No. 2-39545, Exhibit  3-A(1)).                                           |
|--------|------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | (2)  | Articles of Amendment  effective June 6, 1969 (Incorporated by reference to Registrant’s  Registration Statement on Form S-1, No. 2-39545, Exhibit 3-A)(2)).                                               |
|   | (3)  | Articles Supplementary  effective August 28, 1970 (Incorporated by reference to Registrant’s Registration  Statement on Form S-1, No. 2-39545, Exhibit 3-A)(3)).                                           |
|   | (4)  | Articles of Amendment  effective December 14, 1970 (Incorporated by reference to Registrant’s  Registration Statement on Form S-1, No. 2-39545, Exhibit 3-A(4)).                                           |
|   | (5)  | Articles Supplementary effective  May 10, 1971 (Incorporated by reference to Registrant’s Registration  Statement on Form S-1, No. 2-39545, Exhibit 3-A(5)).                                               |
|   | (6)  | Articles Supplementary  effective July 30, 1971 (Incorporated by reference to Registrant’s  Registration Statement on Form S-1, No. 2-41379, Exhibit 3-A(6)).                                              |
|   | (7)  | Articles of Amendment  effective May 8, 1986 (Incorporated by reference to Registrant’s Annual  Report on Form 10-K for the year ended December 31, 1993, Exhibit 3-A(7),  Commission File No. 0-5127).    |
|   | (8)  | Articles of Amendment  effective April 27, 1988 (Incorporated by reference to Registrant’s Annual  Report on Form 10-K for the year ended December 31, 1993, Exhibit 3-A(8),  Commission File No. 0-5127). |
|   | (9)  | Articles Supplementary  effective September 13, 1989 (Incorporated by reference to Registrant’s Form  8-K filed September 27, 1989, Exhibit B attached to Exhibit 4-A, Commission  File No. 0-5127).       |
|   | (10) | Articles Supplementary  effective January 3, 1990 (Incorporated by reference to Registrant’s Form 8-K  filed January 9, 1990, Exhibit B attached to Exhibit 4-A, Commission File No.  0-5127).             |

 

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|   | (11)                                                                                                                                                                                                        | Articles of Amendment  effective April 26, 1990 (Incorporated by reference to Registrant’s Annual  Report on Form 10-K for the year ended December 31, 1990, Exhibit 3-A(11),  Commission File No. 0-5127).                                                        |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | (12)                                                                                                                                                                                                        | Articles of Amendment  effective April 30, 1997 (Incorporated by reference to Registrant’s  Registration Statement on Form S-4, No. 333-43651, Exhibit 3(i)(L)).                                                                                                   |
|   | (13)                                                                                                                                                                                                        | Articles Supplementary  effective June 9, 1999 (Incorporated by reference to Registrant’s  Registration Statement on Form S-8, No. 333-90307, Exhibit 4.1.M).                                                                                                      |
|   | (14)                                                                                                                                                                                                        | Articles  Supplementary effective September 30, 1999 (Incorporated by reference to  Registrant’s Registration Statement on Form S-8, No. 333-90307, Exhibit  4.1.N).                                                                                               |
|   | (15)                                                                                                                                                                                                        | Certificate  of Correction effective July 3, 2002, concerning Articles of Amendment  effective May 8, 1986 (Incorporated by reference to Registrant’s Quarterly  Report for the quarter ended September 30, 2002, Exhibit 3A(15), Commission  File No. 0-5127).    |
|   | (16)                                                                                                                                                                                                        | Certificate of  Correction effective July 3, 2002, concerning Articles of Amendment effective  April 26, 1990 (Incorporated by reference to Registrant’s Quarterly Report  for the quarter ended September 30, 2002, Exhibit 3A(16), Commission File No.  0-5127). |
| B.     | By-Laws of the  Registrant, as amended to date (Incorporated by reference to Registrant’s  Annual Report on Form 10-K for the year ended December 31, 2003, Exhibit 3.B,  Commission File No. 0-5127). |

 

(4)                                  Instrumentsdefining the rights of security holders, including indentures, Charter andby-laws:  See Item 15(a)(3) above.

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,Commission File 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 through March 10, 1998 (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 1997, Exhibit 10 A,Commission File No. 0-5127).

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).

 

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D.                                    MercantileBankshares Corporation Employee Stock Purchase Dividend Reinvestment Plan datedFebruary 13, 1995 (Incorporated by reference to Registrant’s Annual Report onForm 10-K for the year ended December 31, 1994, Exhibit 10 I, Commission FileNo. 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 Balance ExecutiveRetirement Plan, dated April 27, 1994, effective January 1, 1994 (Incorporatedby reference to Registrant’s Annual Report on Form 10-K for year ended December31, 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 Retainer Stock Plan For Non-Employee Directors datedMarch 12, 1996 (Incorporated by reference to Registrant’s Annual Report on Form10-K for the year ended December 31, 1995, Exhibit 10 R, 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 onForm 10-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).

 

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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 BanksharesCorporation, Mercantile-Safe Deposit and Trust Company and John L. Unger(incorporated by reference to Registrant’s Form 8-K filed April 3, 2002 Exhibit10Y, Commission File No. 0-5127).

R.                                     ExecutiveSeverance Agreement dated March 19, 2002, among Mercantile BanksharesCorporation, Mercantile-Safe Deposit and Trust Company and John L. Unger(incorporated by reference to Registrant’s Form 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,dated April 29, 2002 (incorporated by reference to Registrant’s QuarterlyReport for the 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).

 

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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).

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 endedDecember 31, 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.                           ExecutiveEmployment Agreement effective as of January 11, 2005 by and among Registrant,Mercantile-Safe Deposit and Trust Company and Jay M. Wilson (Incorporated byreference to Registrant’s Form 8-K, filed January 14, 2005, Exhibit 10.1,Commission File No. 0-5127).

OO.                           ExecutiveSeverance Agreement effective as of January 11, 2005 by and among Registrant,Mercantile-Safe Deposit and Trust Company and Jay M. Wilson (Incorporated byreference to Registrant’s Form 8-K, filed January 14, 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, 2004(filed herewith).

QQ.                           MembershipInterests Purchase Agreement (MBC Realty, LLC) by and between Registrant andHarbor Group International L.L.C. dated as of October 20, 2004 (filedherewith).

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 (filed herewith).

SS.                               Formof Option Agreement for grants made under the Mercantile Bankshares Corporation1999 Omnibus Stock Plan (filed herewith).

TT.                             Formof Restricted Stock Award Agreement for grants made under the MercantileBankshares Corporation 1999 Omnibus Stock Plan (filed herewith).

 

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UU.                           MercantileBankshares Corporation 2004 Restricted Stock Program (filed herewith).

VV.                             ExecutiveSeverance Agreement effective as of November 5, 2003 by and between Registrantand Alexander T. Mason (filed herewith).

WW.                   ExecutiveSeverance Agreement effective as of August 15, 2002 by and between Registrantand Kevin A. McCreadie (filed herewith).

XX.                           ExecutiveEmployment Agreement effective as of August 15, 2002 by and among Registrant,Mercantile Capital Advisors, Inc. and Kevin A. McCreadie (filed herewith).

(14)                            Codeof Ethics (Incorporated by reference to Registrant’s Annual Report on Form 10-Kfor the year ended December 31, 2003, Exhibit 14, Commission File No. 0-5127).

(21)                            Subsidiariesof the Registrant (filed herewith).

(23)                            Consentof Independent Accountants (filed herewith).

(24)                            Powerof Attorney dated March 8,  2005 (filedherewith).

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

A.                                   Certificationof the Chief Executive Officer of Mercantile Bankshares Corporation (filedherewith).

B.                                     Certificationof the Chief Financial Officer 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).

 

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**INDEX TO FINANCIAL STATEMENTS**

 

Management’sReport on Internal Control Over Financial Reporting is included in Item 8 ofthis Annual Report on Form 10-K.

 

TheReport of Independent Registered Public Accounting Firm on the ConsolidatedFinancial Statements of Mercantile Bankshares Corporation and on MercantileBankshares Corporation’s internal control over financial reporting is includedin Item 8 of this Annual Report on Form 10-K.

 

ConsolidatedFinancial Statements and related notes are included in Item 8 of this AnnualReport on Form 10-K, as follows:

 

Consolidated BalanceSheets, December 31, 2004 and 2003

 

Statement of ConsolidatedIncome for the years ended December 31, 2004, 2003, and 2002

 

Statement of ConsolidatedCash Flows for the years ended December 31, 2004, 2003 and 2002

 

Statement of Changes inConsolidated Stockholders’ Equity for the years ended December 31, 2004, 2003and 2002

 

Notes to ConsolidatedFinancial Statements

 

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** **

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| MERCANTILE BANKSHARES  CORPORATION |
|------------------------------------|
|                               |
|                               |
| By:                                | /s/ Edward J. Kelly,  III |   | March 14, 2005 |
|                               | Edward J. Kelly, III |   |
|                               | President and Chief  Executive Officer |   |

 

Pursuant to therequirements of the Securities Act of 1934, this report has been signed belowby the following persons on behalf of the Registrant and in the capacities andon the dates indicated:

 
| Principal Executive  Officer                          |
|-------------------------------------------------------|
|                                                  |
|                                                  |
| /s/  Edward J. Kelly, III                        |   | March 14, 2005 |
| Edward J. Kelly, III                                  |   |
| Chairman, President and  Chief Executive Officer      |   |
|                                                  |
|                                                  |
| Principal Financial  Officer                          |
|                                                  |
|                                                  |
| /s/  Terry L. Troupe                             |   | March 14, 2005 |
| Terry L. Troupe                                       |   |
| Executive Vice  President and Chief Financial Officer |   |
|                                                  |
|                                                  |
| Principal Accounting  Officer                         |
|                                                  |
|                                                  |
| /s/  William T. Skinner, Jr.                     |   | March 14, 2005 |
| William T. Skinner, Jr.                               |   |
| Controller                                            |   |
|                                                       |  |  |  |

 

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A majority of the Board of Directors:

 

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

 
|   |
|--------|
|   |
|   |
| By:    | /s/ Edward J. Kelly,  III |   | March 14, 2005 |
|   | Edward J. Kelly, III |   |
|   | For Himself and as  Attorney-in-Fact |   |

 

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