FORM 10-Q

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

 

(Mark one)

(X)      QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2006

 

OR

( )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 001-15185

 

CIK number 0000036966

 

FIRST HORIZON NATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Tennessee

62-0803242

 

 

(State or other jurisdiction of

(I.R.S. Employer

 

incorporation or organization)

Identification No.)

 

 

 

165 Madison Avenue, Memphis, Tennessee

38103

 

 

(Address of principal executive offices)

(Zip Code)

 

(901) 523-4444

(Registrant's telephone number, including area code)

 

(Former name, former address and former fiscal year,

if changed since last report)

 

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

 

 

Yes x   No___

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

 

 

x  

Large accelerated filer

____ Accelerated filer

____ Non-accelerated filer

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

 

 

Yes       

No x    

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

 

Common Stock, $.625 par value
Class


                 123,230,240
Outstanding on March 31, 2006

 



 

FIRST HORIZON NATIONAL CORPORATION

 

INDEX 

 

 

 

Part I. Financial Information

 

 

Part II. Other Information

 

 

Signatures

 

Exhibit Index

 

2

 



PART I.

 

FINANCIAL INFORMATION

 

 

 

Item 1.

Financial Statements

 

 

The Consolidated Condensed Statements of Condition

 

 

The Consolidated Condensed Statements of Income

 

 

The Consolidated Condensed Statements of Shareholders’ Equity

 

 

The Consolidated Condensed Statements of Cash Flows

 

 

The Notes to Consolidated Condensed Financial Statements

 

This financial information reflects all adjustments that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented. On March 1, 2006, FHN sold its national merchant processing business. This divestiture was accounted for as a discontinued operation, and accordingly, current and prior periods were adjusted to exclude the impact of merchant operations from the results of continuing operations. Additionally, FHN adopted SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS No. 123-R) in first quarter 2006 and retroactively applied the provisions of the standard. Accordingly, results for periods prior to 2006 have been adjusted to reflect expensing of share-based compensation.

  

 

3



CONSOLIDATED CONDENSED STATEMENTS OF CONDITION     First Horizon National Corporation
March 31 December 31
(Dollars in thousands)(Unaudited)     2006 2005 2005
Assets:
Cash and due from banks  $      887,539   $      770,844   $      945,547 
Federal funds sold and securities
  purchased under agreements to resell              1,347,577           1,598,995           1,485,199 
    Total cash and cash equivalents              2,235,116           2,369,839           2,430,746 
Investment in bank time deposits               25,319                10,731                10,687 
Trading securities           2,508,615           1,826,595           2,133,428 
Loans held for sale          3,604,010           5,277,158           4,435,343 
Securities available for sale          2,944,443           2,899,474           2,912,103 
Securities held to maturity (fair value of $388 on March 31, 2006; $454 on 
   March 31, 2005; and $390 on December 31, 2005)                    383                     442                     383 
Loans, net of unearned income        21,186,991         17,183,781         20,600,922 
  Less:  Allowance for loan losses                 195,011              164,195              189,705 
    Total net loans            20,991,980         17,019,586         20,411,217 
Mortgage servicing rights, net          1,475,448           1,135,645           1,314,629 
Goodwill             281,475              260,517              281,440 
Other intangible assets, net               76,666                78,104                76,647 
Capital markets receivables             858,072  2,435,505  511,508 
Premises and equipment, net             422,346              377,887              408,539 
Real estate acquired by foreclosure               48,959                25,695                27,410 
Discontinued assets               56,712              126,213              163,545 
Other assets     1,771,431      1,314,032      1,461,436 
Total assets      $ 37,300,975   $ 35,157,423   $ 36,579,061 
Liabilities and shareholders' equity:
Deposits:
  Checking interest and money market  $   4,834,547   $   4,338,516   $   4,425,664 
  Savings 287,894  298,958  279,408 
  Certificates of deposit under $100,000 and other time 2,692,046  2,145,312  2,478,946 
  Certificates of deposit $100,000 and more     8,228,543  10,781,020  10,931,695 
     Interest-bearing        16,043,030         17,563,806         18,115,713 
  Noninterest-bearing              5,474,017           5,444,485           5,201,844 
     Total deposits            21,517,047         23,008,291         23,317,557 
Federal funds purchased and securities
  sold under agreements to repurchase          4,337,243           2,788,158           3,735,742 
Trading liabilities             766,479              924,027              793,638 
Commercial paper and other short-term borrowings             749,979              967,701              802,017 
Term borrowings          4,299,539           2,591,354           3,437,643 
Other collateralized borrowings     299,800                                                   
  Total long-term debt     4,599,339           2,591,354           3,437,643 
Capital markets payables 941,911  1,283,766  591,404 
Discontinued liabilities 233,402  77,926  122,026 
Other liabilities              1,460,693           1,095,542           1,136,221 
    Total liabilities            34,606,093         32,736,765         33,936,248 
Preferred stock of subsidiary                  295,274              295,858  295,274 
Shareholders' equity
Preferred stock - no par value (5,000,000 shares authorized,  but unissued)                                                                           
Common stock - $.625 par value (shares authorized - 400,000,000;
   shares issued and outstanding - 123,230,240 on March 31, 2006;
  124,131,336 on March 31, 2005; and 126,222,327 on December 31, 2005)               77,019                77,582  78,889 
Capital surplus             269,564              331,779              404,964 
Undivided profits          2,065,285           1,751,618           1,905,930 
Accumulated other comprehensive loss, net                  (12,260)              (36,179)              (42,244)
    Total shareholders' equity              2,399,608           2,124,800           2,347,539 
Total liabilities and shareholders' equity      $ 37,300,975   $ 35,157,423   $ 36,579,061 
See accompanying notes to consolidated condensed financial statements.
Certain previously reported amounts have been reclassified to agree with current presentation.

 

4



 

CONSOLIDATED CONDENSED STATEMENTS OF INCOME First Horizon National Corporation
             Three Months Ended
              March 31      
(Dollars in thousands except per share data)(Unaudited)         2006 2005 
Interest income:
Interest and fees on loans $   363,483  $   231,558 
Interest on investment securities  35,855           29,703 
Interest on loans held for sale  76,342           79,085 
Interest on trading securities  38,515           33,649 
Interest on other earning assets          19,174           10,881 
    Total interest income          533,369         384,876 
Interest expense:
Interest on deposits:
  Savings   105                  77 
  Checking interest and money market account  20,792           11,206 
  Certificates of deposit under $100,000 and other time   25,338           17,172 
  Certificates of deposit $100,000 and more  119,296           64,782 
Interest on trading liabilities  18,347           16,807 
Interest on short-term borrowings  56,244           26,600 
Interest on long-term debt  47,526           20,785 
    Total interest expense          287,648         157,429 
Net interest income  245,721         227,447 
Provision for loan losses          17,799           13,109 
Net interest income after provision for loan losses          227,922         214,338 
Noninterest income:
Mortgage banking  88,815         118,763 
Capital markets  92,858           95,162 
Deposit transactions and cash management  38,023           33,255 
Insurance commissions  14,686           14,749 
Revenue from loan sales and securitizations  11,357           13,234 
Trust services and investment management  10,657           11,164 
Equity securities losses, net  (1,003)               (66)
Debt securities losses, net  (79,278)                    
All other income and commissions          29,629           36,617 
    Total noninterest income          205,744         322,878 
Adjusted gross income after provision for loan losses          433,666         537,216 
Noninterest expense:
Employee compensation, incentives and benefits  260,141         240,297 
Occupancy  30,102           24,011 
Operations services  17,440           16,445 
Equipment rentals, depreciation and maintenance  20,264           17,485 
Communications and courier  14,912           12,468 
Amortization of intangible assets  2,888             2,536 
All other expense          97,468           71,295 
    Total noninterest expense          443,215         384,537 
Pre-tax (loss)/income   (9,549)        152,679 
(Benefit)/provision for income taxes          (12,959)          49,864 
Income from continuing operations  3,410         102,815 
Income from discontinued operations, net of tax          210,273             3,015 
Income before cumulative effect of changes in accounting principle  213,683         105,830 
Cumulative effect of changes in accounting principle, net of tax  1,345                     
Net income            215,028 $   105,830 
Earnings per common share from continuing operations $           .03   $           .82 
Earnings per common share from discontinued operations, net of tax  1.67        .03 
Earnings per common share from cumulative effect of changes in accounting principle, net of tax    .01                     
Earnings per common share  (Note 8)         $         1.71   $           .85 
Diluted earnings per common share from continuing operations $           .03   $           .80 
Diluted earnings per common share from discontinued operations, net of tax  1.63        .03 
Diluted earnings per common share from cumulative effect of changes in accounting principle, net of tax  .01                     
Diluted earnings per common share  (Note 8)         $         1.67   $           .83 
Weighted average common shares (Note 8)          125,489         124,717 
Diluted average common shares (Note 8)          129,100         128,032 
See accompanying notes to consolidated condensed financial statements.
Certain previously reported amounts have been reclassified to agree with current presentation.

 

5



 

CONSOLIDATED CONDENSED STATEMENTS OF SHAREHOLDERS' EQUITY

First Horizon National Corporation

(Dollars in thousands)(Unaudited)                2006                 2005
Balance, January 1  $  2,347,539   $  2,040,983 
Adjustment to reflect change in accounting for employee share-based compensation 33,151 
Net income                215,028  105,830 
Other comprehensive income:
  Unrealized fair value adjustments, net of tax
    Cash flow hedges                       613 
    Securities available for sale                  29,371                 (26,251)
Comprehensive income                  245,012    79,579 
Cash dividends declared                (55,673) (53,315)
Common stock repurchased              (159,734)                     (488)
Common stock issued for:
  Stock options and restricted stock                  21,795  13,061 
  Acquisitions                       185  3,895 
Change in tax benefit from incentive plans                    3,592                        (22)
Adjustment to reflect change in accounting for employee stock option forfeitures (1,780)
Stock-based compensation expense                  (1,328)                    7,958 
Other     (2)
Balance, March 31    $  2,399,608     $  2,124,800 
See accompanying notes to consolidated condensed financial statements.
Certain previously reported amounts have been reclassified to agree with current presentation.

 

6



 


CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS First Horizon National Corporation
Three Months Ended March 31
(Dollars in thousands)(Unaudited) 2006  2005 
Operating  Net income $     215,028  $   105,830 
Activities Adjustments to reconcile net income to net cash provided/(used) by operating activities:
 Provision for loan losses 17,799  13,109 
 Provision for deferred income tax/(deferred income tax benefit) 12,826  (322)
 Depreciation and amortization of premises and equipment 12,983  12,261 
 Amortization and impairment of mortgage servicing rights 58,713 
 Amortization of intangible assets 3,113  3,362 
 Net other amortization and accretion 25,625  20,675 
 Decrease in derivatives, net 35,236  114,235 
 Market value adjustment on mortgage servicing rights (95,175) -
 Provision for foreclosure reserve 7,051  2,588 
 Cumulative effect of changes in accounting principle (1,345) -
 Gain on divestiture (208,488) -
 Stock-based compensation (benefit)/expense (1,328) 6,359 
 Excess tax (benefit)/expense from stock-based compensation arrangements (3,592) 22 
 Equity securities losses, net 1,003  66 
 Debt securities losses, net 79,278  -
 Net losses on disposal of fixed assets 983  168 
 Net (increase)/decrease in:
  Trading securities (375,187) (149,404)
  Loans held for sale 830,448  (86,305)
  Capital markets receivables (346,564) (2,159,208)
  Interest receivable (2,138) (27,123)
  Other assets (305,913) (222,184)
 Net increase/(decrease) in:
  Capital markets payables 350,584  893,443 
  Interest payable 12,064  35,369 
  Other liabilities 295,908  (56,130)
  Trading liabilities (27,159) 497,684 
    Total adjustments 318,012  (1,042,622)
Net cash provided/(used) by operating activities 533,040  (936,792)
Investing Available for sale securities:
Activities  Sales 2,208,878  21,630 
 Maturities 198,781  98,023 
 Purchases (2,470,650) (382,915)
Premises and equipment:
 Purchases (27,443) (17,691)
Net increase in loans (663,817) (772,187)
Net increase in investment in bank time deposits (14,632) (5,402)
Proceeds from divestitures, net of cash and cash equivalents 421,737  -
Acquisitions, net of cash and cash equivalents acquired (186) (843,543)
Net cash used by investing activities (347,332) (1,902,085)
Financing Common stock:
Activities  Exercise of stock options 21,275  13,043 
 Cash dividends paid (56,680) (53,020)
 Repurchase of shares (159,734) (488)
 Excess tax benefit/(expense) from stock-based compensation arrangements 3,592  (22)
Long-term debt:
 Issuance 1,179,137  -
 Payments (113) (69)
Issuance of preferred stock of subsidiary - 295,400 
Net increase/(decrease) in:
 Deposits (1,919,152) 3,290,286 
 Short-term borrowings 549,463  345,658 
Net cash (used)/provided by financing activities (382,212) 3,890,788 
Net (decrease)/increase in cash and cash equivalents (196,504) 1,051,911 
Cash and cash equivalents at beginning of period 2,431,620  1,320,499 
Cash and cash equivalents at end of period 2,235,116  2,372,410 
Cash and cash equivalents from discontinued operations at beginning of period, included above $              874  $       1,115 
Cash and cash equivalents from discontinued operations at end of period, included above 2,571 
Total interest paid 275,147  121,896 
Total income taxes paid 1,329  3,290 
See accompanying notes to consolidated condensed financial statements.
Certain previously reported amounts have been reclassified to agree with current presentation.

7



Note 1 - Financial Information

The unaudited interim consolidated financial statements of First Horizon National Corporation (FHN), including its subsidiaries, have been prepared in conformity with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. This preparation requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates and assumptions are based on information available as of the date of the financial statements and could differ from actual results. In the opinion of management, all necessary adjustments have been made for a fair presentation of financial position and results of operations for the periods presented. The operating results for the interim 2006 periods are not necessarily indicative of the results that may be expected going forward. For further information, refer to the audited consolidated financial statements in the 2005 Annual Report to shareholders.

 

Real Estate Acquired by Foreclosure. Prior to 2006, properties acquired by foreclosure in compliance with HUD servicing guidelines were classified as receivables in “Other assets” on the Consolidated Condensed Statements of Condition. Beginning in 2006, these loans are included in “Real estate acquired by foreclosure” and are carried at the estimated amount of the underlying government insurance or guarantee. On March 31, 2006, FHN had $19.9 million in these foreclosed properties. All other real estate acquired by foreclosure consists of properties that have been acquired in satisfaction of debt. These properties are carried at the lower of the outstanding loan amount or estimated fair value less estimated cost to sell the real estate. Losses arising at foreclosure are charged to the appropriate reserve. Required developmental costs associated with foreclosed property under construction are capitalized and included in determining the estimated net realizable value of the property, which is reviewed periodically, and any write-downs are charged against current earnings.

 

Loans Held for Sale and Securitization and Residual Interests. FHN's mortgage lenders originate first-lien mortgage loans (the warehouse) for the purpose of selling them in the secondary market, primarily through proprietary and agency securitizations, and to a lesser extent through loan sales. In addition, FHN evaluates its liquidity position in conjunction with determining its ability and intent to hold loans for the foreseeable future and sells certain of the second-lien mortgages and home equity lines of credit (HELOC) it produces in the secondary market through securitizations and loan sales. Loan securitizations involve the transfer of the loans to qualifying special purposes entities (QSPE) that are not subject to consolidation in accordance with Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (SFAS No. 140). FHN generally retains the right to service the transferred loans.

 

Loans held for sale include loans originated or purchased for resale, together with mortgage loans previously sold which loans may be unilaterally called by FHN. Loans held for sale are recorded at the lower of aggregate cost or fair value. The carrying value of loans held for sale is net of deferred origination fees and costs. Net origination fees and costs are deferred on loans held for sale and included in the basis of the loans in calculating gains and losses upon sale. Also included in the lower of cost or fair value analysis are the estimated costs and fair values of first-lien mortgage loan commitments. The cost basis of loans qualifying for fair value hedge accounting under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS No. 133), is adjusted to reflect changes in fair value. Gains and losses realized from the sale of these assets, whether sold directly or through securitization, and adjustments to fair value are included in noninterest income.

 

Mortgage loans insured by the Federal Housing Administration (FHA) and mortgage loans guaranteed by the Veterans Administration (VA) are generally securitized through GNMA. Conforming conventional loans are generally securitized through government-sponsored enterprises (GSE) such as the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). In addition, FHN has completed proprietary securitizations of nonconforming first-lien and second-lien mortgages and HELOC, which do not conform to the requirements for sale or securitization through government agencies or GSE. Most of these securitizations are accounted for as sales; those that do not qualify for sale treatment are accounted for as financing arrangements.

 

Interests retained from the sales include mortgage servicing rights (MSR) and various financial assets. Prior to 2006, all of these retained interests were initially valued by allocating the total cost basis of the loan between the security or loan sold and the retained interests based on their relative fair values at the time of securitization or sale. The retained interests, other than MSR, were carried at fair value as a component of trading securities on the Consolidated Condensed Statements of Condition, with realized and unrealized gains and losses included in current earnings as a component of noninterest income on the Consolidated Condensed Statements of Income. With the adoption of SFAS No. 156, MSR are initially valued at fair value, and the remaining retained interests are initially valued by allocating the remaining cost basis of the loan between the security or loan sold and the remaining retained interests based on their relative fair values at the time of securitization or sale. All retained interests, including MSR, are carried at fair value. The financial assets retained are included as a component of trading securities on the Consolidated Condensed Statements of Condition, with realized and unrealized gains and losses included in current earnings as a component of noninterest income on the Consolidated Condensed Statements of Income.

 

 

8



 

 

Note 1 - Financial Information (continued)

 

Financial assets retained in a securitization may include certificated residual interests, excess interest (structured as interest-only strips), interest-only strips, principal-only strips, or subordinated bonds. Residual interests represent rights to receive earnings to the extent of excess income generated by the underlying loans. Excess interest represents rights to receive interest from serviced assets that exceed contractually specified rates. Principal-only strips are principal cash flow tranches and interest-only strips are interest cash flow tranches. Subordinated bonds are bonds with junior priority. All financial assets retained from a securitization are recognized on the balance sheet in trading securities at fair value.

 

The fair values of the certificated residual interests, the excess interest, and the interest-only strips are determined using market prices from closely comparable assets such as MSR that are tested against prices determined using a valuation model that calculates the present value of estimated future cash flows. To determine the fair value of the principal-only strips, FHN uses the market prices from comparable assets such as publicly traded FNMA trust principal-only strips that are adjusted to reflect the relative risk difference between readily marketable

securities and privately issued securities. The fair value of subordinated bonds is determined using a spread to an interpolated Treasury rate, which is supplied by broker dealers. The fair value of these retained interests typically changes based on changes in the discount rate and differences between modeled prepayment speeds and credit losses and actual experience.

 

On January 1, 2006, FHN began initially recognizing all classes of MSR at fair value and elected to irrevocably continue application of fair value accounting to its MSR. Classes of MSR are determined in accordance with FHN’s risk management practices and market inputs used in determining the fair value of the servicing asset. Since sales of MSR tend to occur in private transactions and the precise terms and conditions of the sales are typically not readily available, there is a limited market to refer to in determining the fair value of MSR. As such, like other participants in the mortgage banking business, FHN relies primarily on a discounted cash flow model to estimate the fair value of its MSR. This model calculates estimated fair value of the MSR using predominant risk characteristics of MSR such as interest rates, type of product (fixed vs. variable), age (new, seasoned, or moderate), agency type and other factors. FHN uses assumptions in the model that it believes are comparable to those used by brokers and other service providers. FHN also periodically compares its estimates of fair value and assumptions to brokers, service providers, and recent market activity and against its own experience.

 

Prior to 2006, MSR were initially valued by allocating the total carrying value of the loan between the loan, MSR and other retained interests based on their relative fair values, and were thereafter valued at the lower of cost or fair value. MSR were amortized over the period of and in proportion to the estimated net servicing revenues. The cost basis of MSR qualifying for SFAS No. 133 fair value hedge accounting was adjusted to reflect changes in fair value. MSR were periodically evaluated for impairment. Impairment occurred when the current fair value of the servicing right was less than its recorded value. A quarterly value impairment analysis was performed using a discounted cash flow analysis which was disaggregated by strata representing predominant risk characteristics, including fixed rate and adjustable loans. Impairment, if any, was recognized through a valuation allowance for individual strata. However, if the impairment was determined to be other than temporary, a direct write-off of the asset was made. With the adoption of SFAS No. 156, MSR are valued at fair value, both initially and prospectively; impairment tests are no longer performed.

 

Equity Compensation. FHN accounts for its employee stock-based compensation plans using the grant date fair value of an award to determine the expense to be recognized over the life of the award. For awards with service vesting criteria, expense is recognized using the straight-line method over the requisite service period (generally the vesting period) and is adjusted for anticipated forfeitures. For awards vesting based on a performance measure, anticipated performance is projected to determine the number of awards expected to vest, and the corresponding aggregate expense is adjusted to reflect the elapsed portion of the performance period. The fair value of equity awards with cash payout requirements, as well as awards for which fair value cannot be estimated at grant date, are remeasured each reporting period through vesting date.

 

For all stock option awards granted prior to adoption of SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123-R), FHN permits vesting of the option to continue after retirement. To account for these stock option awards, FHN uses the nominal vesting period approach. Under the nominal vesting period approach, awards granted to employees near retirement eligibility are expensed over the option’s normal vesting period until an employee’s actual retirement date, at which point all remaining unamortized compensation expense is immediately accelerated. Awards granted after the adoption of SFAS No. 123-R will be amortized using the nonsubstantive vesting methodology. The nonsubstantive vesting methodology requires that expense associated with options that continue vesting after retirement be recognized over a period ending no later than an employee’s retirement eligibility date. Had FHN followed the nonsubstantive vesting period method for all awards previously granted, the effect of the change in expense attribution on earnings and per share amounts would have been negligible.


9



Note 1 - Financial Information (continued)

 

Accounting Changes. Effective January 1, 2006, FHN elected early adoption of Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets” (SFAS No. 156). This amendment to SFAS No. 140 requires servicing rights be initially measured at fair value. Subsequently, companies are permitted to elect, on a class-by-class basis, either fair value or amortized cost

accounting for their servicing rights. FHN elected fair value accounting for its MSR. Accordingly, FHN recognized the cumulative effect of a change in accounting principle totaling $.2 million, net of tax, representing the excess of the fair value of the servicing asset over the recorded value on January 1, 2006.

 

FHN also adopted SFAS No. 154, “Accounting Changes and Error Corrections” (SFAS No. 154), as of January 1, 2006. SFAS No. 154 requires retrospective application of voluntary changes in accounting principle. A change in accounting principle mandated by new accounting pronouncements should follow the transition method specified by the new guidance. However, if transition guidance is not otherwise specified, retrospective application will be required. SFAS No. 154 does not alter the accounting requirement for changes in estimates (prospective) and error corrections (restatement). The adoption of SFAS No. 154 did not affect FHN’s reported results of operations.

 

FHN adopted SFAS No. 123-R as of January 1, 2006. SFAS No. 123-R requires recognition of expense over the requisite service period for awards of share-based compensation to employees. The grant date fair value of an award will be used to measure the compensation expense to be recognized over the life of the award. For unvested awards granted prior to the adoption of SFAS No. 123-R, the fair values utilized equal the values developed in preparation of the disclosures required under the original SFAS No. 123. Compensation expense recognized after adoption of SFAS No. 123-R will incorporate an estimate of awards expected to ultimately vest, which requires estimation of forfeitures as well as projections related to the satisfaction of performance conditions that determine vesting. As permitted by SFAS No. 123-R, FHN retroactively applied the provisions of SFAS No. 123-R to its prior period financial statements. The Consolidated Condensed Statements of Income were revised to incorporate expenses previously presented in the footnote disclosures. The Consolidated Condensed Statements of Condition were revised to reflect the effects of including equity compensation expense in those prior periods. Additionally, all deferred compensation balances were reclassified within equity to capital surplus. Since FHN’s prior disclosures included forfeitures as they occurred, a cumulative effect adjustment, as required by SFAS No. 123-R, of $1.1 million net of tax, was made for unvested awards that are not expected to vest due to anticipated forfeiture. The following table summarizes the effect of adoption of SFAS No. 123-R on the income statement for the three months ended March 31, 2006 and 2005:

 

       Three Months Ended
            March 31
(Dollars in thousands except per share data)         2006   2005
Income before income taxes $(2,976) $(5,391)
Income from continuing operations (1,812) (3,379)
Net income            (708)   (3,379)
Earnings per common share from continuing operations $    (.01) $    (.03)
Earnings per common share      (.01)     (.03)
Diluted earnings per common share from continuing operations     (.01)     (.02)
Diluted earnings per common share              (.01)       (.02)

 

Effective December 31, 2005, FHN adopted FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47). FIN 47 requires recognition of a liability at the time of acquisition or construction for assets that will require certain remediation expenditures when the assets are removed from service. FIN 47 clarified that future expenses to remove asbestos from buildings should be estimated and accrued as a liability at the time of acquisition with an offset to increase the cost of the associated structure. FHN currently owns certain buildings that contain asbestos. As a result of adopting FIN 47, FHN recognized a cumulative effect of a change in accounting principle equaling $3.1 million, net of tax. FHN increased the value of its recorded tangible assets by $4.5 million at the time it recognized an associated conditional retirement obligation in the amount of $9.4 million.

 

Effective January 1, 2005, FHN adopted AICPA Statement of Position 03-3, “Accounting for Loans or Certain Debt Securities Acquired in a Transfer” (SOP 03-3), which modifies the accounting for certain loans that are acquired with evidence of deterioration in credit quality since origination. SOP 03-3 does not apply to loans recorded at fair value or to mortgage loans classified as held for sale. SOP 03-3 limits the yield that may be accreted on applicable loans to the excess of the cash flows expected, at acquisition, to be collected over the investor’s

 

10



 

Note 1 - Financial Information (continued)

 

initial investment in the loan. SOP 03-3 also prohibits the “carrying over” of valuation allowances on applicable loans. The impact of adopting SOP 03-3 was immaterial to the results of operations.

 

In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (FSP FAS 115-1), which supercedes the previously deferred recognition guidance of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-1). FSP FAS 115-1 was effective January 1, 2006, and references previously existing GAAP. Therefore, adoption of FSP FAS 115-1 did not impact FHN’s accounting for other-than-temporary impairment of investments.

 

Accounting Changes Issued but Not Currently Effective. In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, which permits fair value remeasurement for any hybrid financial instruments that contain an embedded derivative that otherwise would require bifurcation. Additionally, SFAS No. 155 clarifies the accounting guidance for beneficial interests in securitizations. SFAS No. 155 is effective for fiscal years beginning after September 15, 2006. Since FHN accounts for its beneficial interests in securitizations as trading securities, the adoption of SFAS No. 155 is not expected to have a significant impact on the results of operations.

 

 

11



  

Note 2 - Acquisitions/Divestitures

 

On March 1, 2006, FHN sold substantially all the assets of its national merchant processing business conducted primarily through First Horizon Merchant Services, Inc. (FHMS) and Global Card Services, Inc. The sale was to NOVA Information Systems (NOVA), a wholly-owned subsidiary of U.S. Bancorp. This transaction resulted in a pre-tax gain of approximately $340 million. In addition, a supplement to the purchase price may be paid to FHN if certain performance goals are achieved during a period following closing. This divestiture was accounted for as a discontinued operation, and prior periods were adjusted to exclude the impact of merchant operations from the results of continuing operations. In conjunction with the sale, FHN entered into a transitional service agreement with NOVA to provide or continue on-going services such as telecommunications, back-end processing and disaster recovery until NOVA converts the operations to their systems. On March 31, 2006, discontinued assets and liabilities primarily consist of operating account balances remaining from operations prior to the sale, operating receivables due from NOVA from post-sale activity and federal tax liabilities recognized on the gain on the sale.

 

On December 9, 2005, First Tennessee Bank National Association (FTBNA) sold three financial centers in Dyersburg, Tennessee, to First South Bank. This transaction resulted in a divestiture gain of $7.0 million. Immediately preceding the sale, the financial centers had loans of approximately $80 million and deposits of approximately $70 million.

 

On August 26, 2005, FHN acquired West Metro Financial Services Inc. (West Metro), a Georgia bank holding company. West Metro was merged with and into FHN. At the same time West Metro’s subsidiary, First National Bank West Metro, with total assets of approximately $135 million, loans of approximately $115 million, and deposits of approximately $120 million, was merged with and into FTBNA. Total consideration of $32 million, consisting of approximately $11 million in cash and $21 million in FHN shares (approximately 518,000 shares of common stock), exceeded the estimated fair value of tangible assets and liabilities acquired by approximately $16 million. Intangible assets totaling approximately $3 million have been identified and are being amortized over their expected useful lives. The acquisition was immaterial to FHN.

 

On April 1, 2005, FTBNA acquired substantially all of the assets of MSAver Resources, L.L.C. of Overland Park, Kansas, a national leader in administering health savings accounts. The acquisition was immaterial to FHN.


On March 1, 2005, First Horizon Home Loan Corporation, a subsidiary of FTBNA, acquired Greenwich Home Mortgage Corporation of Cedar Knolls, New Jersey, for an initial payment of approximately $7.8 million in cash and FHN common stock. Net assets purchased, combined with the operating performance of the acquired business, will impact future payments owed to the sellers. The acquisition was immaterial to FHN. In first quarter 2006 an additional payment of approximately $ .4 million in cash and FHN common stock was made.

 

On January 7, 2005, FHN’s capital markets division, FTN Financial, completed the acquisition of the assets and operations of the fixed income business of Spear, Leeds & Kellogg (SLK), a division of Goldman Sachs & Co. for approximately $150.0 million in cash. Total consideration paid exceeded the estimated fair value of tangible and identified intangible assets and liabilities acquired by approximately $97 million. Intangible assets totaling approximately $55 million have been identified and are being amortized over their expected useful lives. The acquisition was immaterial to FHN.

 

In addition to the acquisitions mentioned above, FHN also acquires assets from time to time in transactions that are considered business combinations but are not material to FHN individually or in the aggregate.

 

12



  

Note 3 - Loans


The composition of the loan portfolio is detailed below:

  March 31 December 31
(Dollars in thousands)                2006                2005           2005 
Commercial:    
   Commercial, financial and industrial  $   6,538,798   $   5,781,307   $   6,578,117 
   Real estate commercial          1,232,021           1,030,052              1,213,052 
   Real estate construction          2,277,825           1,427,955              2,108,121 
Retail:
   Real estate residential          8,486,345           7,358,940              8,357,143 
   Real estate construction          2,001,916           1,190,155              1,925,060 
   Other retail             161,617              160,457                 168,413 
   Credit card receivables             194,908              234,915                 251,016 
   Real estate loans pledged against other collateralized 
     borrowings                   293,561                                                        
  Loans, net of unearned income     21,186,991         17,183,781            20,600,922 
Allowance for loan losses                 195,011                164,195                 189,705 
Total net loans        $ 20,991,980     $ 17,019,586   $ 20,411,217 
The following table presents information concerning nonperforming loans:
  March 31 December 31
(Dollars in thousands)                  2006                2005           2005 
Impaired loans  $ 45,912   $ 34,701   $ 36,635 
Other nonaccrual loans*                   19,420                  14,723  15,624 
Total nonperforming loans      $ 65,332     $ 49,424   $ 52,259 
* On March 31, 2006 and 2005, and on December 31, 2005, other nonaccrual loans included $16.0 million, $9.3 million, and
  $11.5 million, respectively, of loans held for sale. 

On March 31, 2006, $3.8 billion of real estate residential qualifying loans were pledged to secure potential Federal Home Loan Bank borrowings. Qualifying loans are comprised of residential mortgage loans secured by first and second liens and home equity lines of credit. In addition, $5.6 billion of commercial, financial and industrial loans were pledged to secure potential discount window borrowings from the Federal Reserve Bank.

Nonperforming loans consist of loans which management has identified as impaired, other nonaccrual loans and loans which have been restructured. On March 31, 2006 and 2005, there were no outstanding commitments to advance additional funds to customers whose loans had been restructured. The following table presents nonperforming loans on March 31:


 

             Three Months Ended
            March  31

(Dollars in thousands)           2006   2005
Total interest on impaired loans  $        179  $      284 
Average balance of impaired loans          43,806    36,072 
An allowance for loan losses is maintained for all impaired loans.  Activity in the allowance for loan losses related to non-impaired loans, impaired loans, and for the total allowance for the three months ended March 31, 2006 and 2005, is summarized as follows:
(Dollars in thousands)       Non-impaired     Impaired   Total  
Balance on December 31, 2004 $ 147,672  $   10,487  $ 158,159 
Provision for loan losses  12,951   158    13,109 
Charge-offs  (9,189)  (1,833)  (11,022)
Recoveries         2,572     1,377        3,949 
    Net charge-offs  (6,617)  (456)    (7,073)
Balance on March 31, 2005     $ 154,006    $   10,189    $ 164,195 
Balance on December 31, 2005 $ 179,635  $   10,070  $ 189,705 
Provision for loan losses    14,849    2,950     17,799 
Adjustment due to divestiture   (1,195)             (1,195)
Charge-offs    (12,381)  (2,410)    (14,791)
Recoveries          2,666       827       3,493 
    Net charge-offs        (9,715)     (1,583)      (11,298)
Balance on March 31, 2006     $ 183,574    $   11,437    $ 195,011 

 

13



 

Note 4 - Mortgage Servicing Rights

 

On January 1, 2006, FHN elected early adoption of SFAS No. 156, which requires servicing rights be initially measured at fair value. Subsequently, companies are permitted to elect, on a class-by-class basis, either fair value or amortized cost accounting for their servicing rights. Accordingly, FHN began initially recognizing all its classes of mortgage servicing rights (MSR) at fair value and elected to irrevocably continue application of fair value accounting to all its classes of MSR. Classes of MSR are determined in accordance with FHN’s risk management practices and market inputs used in determining the fair value of the servicing asset. FHN recognized the cumulative effect of a change in accounting principle totaling $.2 million, net of tax, representing the excess of the fair value of the servicing asset over the recorded value on January 1, 2006. The balance of MSR included on the Consolidated Condensed Statements of Condition represents the rights to service approximately $96.3 billion of mortgage loans on March 31, 2006, for which a servicing right has been capitalized. Following is a summary of changes in capitalized MSR for first quarter 2006:

 

First      Second 
(Dollars in thousands)     Liens     Liens   HELOC  
Fair value on January 1, 2006 $1,318,219  $  5,470  $14,384 
Addition of mortgage servicing rights 95,624  6,360  1,971 
Reductions due to loan payments (58,641) (797) (2,317)
Changes in fair value due to:
  Changes in current market interest rates 94,249  49  506 
  Other changes in fair value 21  (20) 370 
Fair value on March 31, 2006     $1,449,472  $11,062  $14,914 

 

In 2005 these amounts were included at the lower of cost, net of accumulated amortization, or fair value. The cost basis of MSR qualifying for SFAS No. 133 fair value hedge accounting was adjusted to reflect changes in fair value. MSR were amortized over the period of and in proportion to the estimated net servicing revenues. MSR were periodically evaluated for impairment. Impairment occurred when the current fair value of the servicing right was less than its recorded value. A quarterly value impairment analysis was performed using a discounted cash flow analysis which was disaggregated by strata representing predominant risk characteristics, including fixed and adjustable rate loans. Impairment, if any, was recognized through a valuation allowance for individual strata. However, if the impairment was determined to be other than temporary, a direct write-off of the asset was made. With the adoption of SFAS No. 156, MSR are valued at fair value, both initially and prospectively; impairment tests are no longer performed. Following is a summary of changes in capitalized MSR for first quarter 2005:

 

(Dollars in thousands)          
Balance on December 31, 2004         $1,036,458 
Addition of mortgage servicing rights                 85,339 
Amortization               (48,338)
Market value adjustments                 72,561 
Permanent impairment               (11,632)
Decrease in valuation allowance                   1,257 
Balance on March 31, 2005         $1,135,645 

 

MSR on March 31, 2005, had an estimated market value of approximately $1,149.3 million. This balance represents the rights to service approximately $85.1 billion of mortgage loans on March 31, 2005, for which a servicing right has been capitalized. On March 31, 2005, valuation allowances due to temporary impairment of $3.0 million were required. Following is a summary of changes in the valuation allowance for first quarter 2005:


(Dollars in thousands)          
Balance on December 31, 2004 $  4,231 
Permanent impairment (11,632)
Servicing valuation provision         10,375 
Balance on March 31, 2005          $  2,974 

 

Since sales of MSR tend to occur in private transactions and the precise terms and conditions of the sales are typically not readily available, there is a limited market to refer to in determining the fair value of MSR. As such, like other participants in the mortgage banking business,

14


 

Note 4 - Mortgage Servicing Rights (continued)

 

FHN relies primarily on a discounted cash flow model to estimate the fair value of its MSR. This model calculates estimated fair value of the MSR using predominant risk characteristics of MSR, such as interest rates, type of product (fixed vs. variable), age (new, seasoned, or moderate), agency type and other factors. FHN uses assumptions in the model that it believes are comparable to those used by brokers and other service providers. FHN also periodically compares its estimates of fair value and assumptions to brokers, service providers, and recent market activity and against its own experience.

 

The sensitivity of the current fair value of all retained or purchased interests for MSR to immediate 10 percent and 20 percent adverse changes in assumptions on March 31, 2006, are as follows:


(Dollars in thousands First    Second   
except for annual cost to service)     Liens   Liens      HELOC    
March 31, 2006
Fair value of retained interests  $1,449,472    $11,062    $14,914  
Weighted average life (in years)  6.8    2.9    2.0  
Annual prepayment rate 11.3% 30.0% 49.0%
  Impact on fair value of 10% adverse change  $    (53,989)   $    (537)   $    (913) 
  Impact on fair value of 20% adverse change  (104,182)   (1,017)   (1,738) 
Annual discount rate on servicing cash flows 10.5% 14.0% 18.0%
  Impact on fair value of 10% adverse change  $    (59,670)   $    (297)   $    (342) 
  Impact on fair value of 20% adverse change  (114,684)   (580)   (666) 
Annual cost to service (per loan) *  $            55    $       50    $       50  
  Impact on fair value of 10% adverse change        (14,988)         (226)         (237) 
  Impact on fair value of 20% adverse change  (26,976)   (451)   (474) 
Annual earnings on escrow 4.6% 2.5% 4.4%
  Impact on fair value of 10% adverse change  $    (34,541)   $    (176)   $    (600) 
  Impact on fair value of 20% adverse change      (68,331)   (351)   (1,199) 

* The annual cost to service includes an incremental cost to service delinquent loans. Historically, this fair value sensitivity disclosure has not included this incremental cost. The annual cost to service loans without the incremental cost to service delinquent loans was $49 as of March 31, 2006.


FHN uses assumptions and estimates in determining the fair value allocated to retained interests at the time of initial securitization or sale. The key economic assumptions used to measure the fair value of the MSR at the date of securitization or loan sale were as follows:


First Second 
      Liens Liens HELOC
March 31, 2006
Weighted average life (in years) 6.1-6.9 2.7-2.9 1.7-2.0
Annual prepayment rate 13.9%-15.9% 30% 45%-55%
Annual discount rate 9.9%-11.4% 14% 18%
Annual cost to service (per loan) * $56-$57 $50 $50
Annual earnings on escrow     4.2%-4.6% 2.0%-4.6% 2.0%-4.4%


* The annual cost to service includes an incremental cost to service delinquent loans. Historically, the disclosure of annual cost to service assumptions has not included this incremental cost. The range of annual cost to service loans without the incremental cost to service delinquent loans was $49-$50 for MSR capitalized during first quarter 2006.


15


Note 5 - Intangible Assets

 

The following is a summary of intangible assets, net of accumulated amortization, included in the Consolidated Condensed Statements of Condition:

 

      Other
    Intangible
(Dollars in thousands)       Goodwill          Assets*
December 31, 2004         $160,067      $22,520   
Amortization expense   -      (2,536)  
Acquisitions**     100,450     58,120   
March 31, 2005         $260,517      $78,104   
December 31, 2005   $281,440      $76,647   
Amortization expense   -      (2,888)  
Acquisitions**  1,145     3,000   
Divestitures   (1,110)     (93)  
March 31, 2006         $281,475      $ 76,666   
 * Represents customer lists, acquired contracts, premium on purchased deposits, covenants not to compete
    and assets related to the minimum pension liability.
** Preliminary purchase price allocations on acquisitions are based upon estimates of fair value and are
    subject to change.
Certain previously reported amounts have been reclassified to agree with current presentation.

 

The gross carrying amount of other intangible assets subject to amortization is $141.9 million on March 31, 2006, net of $65.3 million of

accumulated amortization. Estimated aggregate amortization expense for the remainder of 2006 is expected to be $7.8 million and is expected to be $9.8 million, $8.5 million, $6.8 million and $6.4 million for the twelve-month periods of 2007, 2008, 2009, and 2010 respectively.

 

The following is a summary of goodwill detailed by reportable segments for the three months ended March 31:

 

Commercial Mortgage Capital 
(Dollars in thousands)   Banking    Banking  Markets Total    
December 31, 2004   $  87,208  $  55,214  $  17,645  $160,067 
Acquisitions*        3,936    96,514    100,450 
March 31, 2005   $  87,208  $  59,150  $114,159  $260,517 
December 31, 2005 $104,781  $  61,593  $115,066  $281,440 
Acquisitions*   30    1,115       1,145 
Divestitures (1,110)         (1,110)
March 31, 2006    $103,701   $  62,708   $115,066   $281,475 
* Preliminary purchase price allocations on acquisitions are based upon estimates of fair value and
  are subject to change.
Certain previously reported amounts have been reclassified to agree with current presentation.



16


  

Note 6 – Long-Term Debt

 

The following table presents information pertaining to long-term debt (debt with original maturities greater than one year) for FHN and its subsidiaries:

 

March 31   December 31
(Dollars in thousands)   2006   2005   2005  
First Tennessee Bank National Association:
Subordinated notes (qualifies for total capital under the Risk-Based Capital guidelines):
    Matures on January 15, 2015 -- 5.05%  $   380,242   $   391,246   $   392,279 
    Matures on May 15, 2013 -- 4.625%        244,572         252,065  251,135 
    Matures on December 1, 2008 -- 5.75%        135,784         137,358  136,847 
    Matures on April 1, 2008 -- 6.40%          89,859           89,789  89,841 
    Matures on April 1, 2016 -- 5.65%        247,014                                       
Bank notes*     1,504,674      1,249,960  874,672 
Extendible notes**
    Final maturity of November 17, 2010 -- 4.7425% on March 31, 2006, and 
       4.36% on December 31, 2005     1,249,148                     1,249,110 
Federal Home Loan Bank borrowings***            4,297  4,648  4,381 
Other****                               1,322                    
First Horizon National Corporation:
Subordinated capital notes (qualifies for total capital under the Risk-Based Capital guidelines):
    Matures on May 15, 2013 -- 4.50% 97,860        100,882  100,478 
    Matured on November 15, 2005 -- 6.75%                             22,881                    
Subordinated notes:
    Matures on January 6, 2027 -- 8.07%        100,356         100,332  99,737 
    Matures on April 15, 2034 -- 6.30%        200,431         195,637  193,878 
FT Real Estate Securities Company, Inc.
Cumulative preferred stock (qualifies for total capital under the Risk-Based Capital guidelines):
    Matures on March 31, 2031 -- 9.50%          45,302           45,234  45,285 
First Horizon ABS Trust 
Other collateralized borrowings
    Matures on October 25, 2034--5.01%        299,800                                       
Total      $4,599,339   $2,591,354   $3,437,643 
    * The bank notes were issued with variable interest rates and have remaining terms of 1 to 5 years. These bank notes had weighted
       average interest rates of 4.91
 percent and 2.88 percent on March 31, 2006 and 2005, respectively and 4.66 percent on December 31,
       2005.
   ** As of March 31, 2006, the extendible notes had a contractual maturity of April 17, 2007, but are extendible at the investors' option to the
       final maturity date of November 17, 2010.
 *** The Federal Home Loan Bank (FHLB) borrowings were issued with fixed interest rates and have remaining terms of 3 to 23 years.
      These borrowings had weighted average interest rates of 3.36
percent and 3.53 percent on March 31, 2006 and 2005, respectively
       and 3.40 percent on December 31, 2005. 
**** Other long-term debt was comprised of an unsecured obligation issued with a fixed interest rate of 5.00 percent on March 31, 2005.

 

Annual principal repayment requirements as of March 31, 2006, are as follows:

(Dollars in thousands)              
2006  $   350,254 
2007     1,400,338 
2008        606,963 
2009        220,321 
2010               138 
2011 and after                 2,068,987 

 

All subordinated notes are unsecured and are subordinate to other present and future senior indebtedness. FTBNA’s subordinated notes and FHN’s subordinated capital notes qualify as Tier 2 risk-based capital under the Office of the Comptroller of the Currency and Federal Reserve Board guidelines for assessing capital adequacy. Prior to February 2005, FTBNA had a bank note program under which the bank was able to borrow funds from time to time at maturities of 30 days to 30 years.  This bank note program was terminated in connection with



17


 

Note 6 – Long-Term Debt (continued)

 

the establishment of a new program.  That termination did not affect any previously issued notes outstanding.  In February 2005, FTBNA established a new bank note program providing additional liquidity of $5.0 billion.  This bank note program provides FTBNA with a facility under which it may continuously issue and offer short- and medium-term unsecured notes.  On March 31, 2006, $3.7 billion was available under current conditions through the bank note program. 

 

In November 2005, FTBNA entered into a $3.0 billion floating rate extendible note program. The extendible note program provides FTBNA with a facility under which it may issue and offer unsecured and unsubordinated notes with initial maturities of thirteen months and final maturities of five years. On March 31, 2006, $1.7 billion was available under current conditions through the extendible note program.


18


  

Note 7 - Regulatory Capital

 

FHN is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on FHN's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines that involve quantitative measures of assets, liabilities and certain derivatives as calculated under regulatory accounting practices must be met. Capital amounts and classification are also subject to qualitative judgment by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require FHN to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets (leverage). Management believes, as of March 31, 2006, that FHN met all capital adequacy requirements to which it was subject.

 

The actual capital amounts and ratios of FHN and FTBNA are presented in the table below. In addition, FTBNA must also calculate its capital ratios after excluding financial subsidiaries as defined by the Gramm-Leach-Bliley Act of 1999. Based on this calculation FTBNA’s Total Capital, Tier 1 Capital and Leverage ratios were 12.18 percent, 8.24 percent and 6.71 percent, respectively, on March 31, 2006, and were 12.35 percent, 8.73 percent and 6.95 percent, respectively, on March 31, 2005.


       First Horizon National       First Tennessee Bank
              Corporation          National Association
(Dollars in thousands) Amount   Ratio             Amount   Ratio
On March 31, 2006:
Actual:
Total Capital $ 3,902,841  13.38%  $ 3,725,324  12.50%  
Tier 1 Capital  2,558,302  8.77  2,480,785  8.33
Leverage  2,558,302  6.86  2,480,785  6.70
For Capital Adequacy Purposes:
Total Capital  2,333,344  > 8.00  2,383,592  > 8.00
Tier 1 Capital  1,166,672  > 4.00  1,191,796  > 4.00
Leverage  1,492,581  > 4.00  1,481,261  > 4.00
To Be Well Capitalized Under Prompt                                                                                 
    Corrective Action Provisions:                                  
Total Capital  2,979,491  >     10.00
Tier 1 Capital  1,787,694  > 6.00
Leverage          1,851,576  > 5.00
On March 31, 2005:
Actual:
Total Capital $ 3,433,186  13.34%  $ 3,307,677  12.61%  
Tier 1 Capital  2,324,346  9.03  2,298,837  8.77
Leverage  2,324,346  6.90 2,298,837  6.87
For Capital Adequacy Purposes:
Total Capital  2,058,937  > 8.00  2,097,716  > 8.00
Tier 1 Capital  1,029,468  > 4.00  1,048,858  > 4.00
Leverage  1,347,401  > 4.00  1,337,566  > 4.00
To Be Well Capitalized Under Prompt                                                                                 
    Corrective Action Provisions: 
Total Capital  2,622,145  >     10.00
Tier 1 Capital  1,573,287  > 6.00
Leverage          1,671,958  > 5.00

Certain previously reported amounts have been reclassified to agree with current presentation.


19


                                                                                               

 

Note 8 - Earnings Per Share
The following table shows a reconciliation of earnings per common share to diluted earnings per common share:
Three Months Ended
March 31
(In thousands, except per share data)         2006 2005
Net income from continuing operations  $     3,410   $ 102,815 
Income from discontinued operations, net of tax   210,273    3,015 
Cumulative effect of changes in accounting principle, net of tax       1,345                           
Net income          $ 215,028   $ 105,830 
Weighted average common shares                125,489                124,717 
Effect of dilutive securities                           3,611                    3,315 
Diluted average common shares                       129,100                128,032 
Earnings per common share:
Net income from continuing operations  $         .03   $         .82 
Income from discontinued operations, net of tax           1.67            .03 
Cumulative effect of changes in accounting principle, net of tax           .01                           
Net income          $       1.71   $         .85 
Diluted earnings per common share:
Net income from continuing operations  $         .03   $         .80 
Income from discontinued operations, net of tax         1.63          .03 
Cumulative effect of changes in accounting principle, net of tax           .01                           
Net income          $       1.67   $         .83 
Outstanding stock options of 5,656 and 3,014 with weighted average exercise prices of $42.76 and $45.46 per share as of March 31, 2006 and 2005, respectively, were not included in the computation of diluted earnings per common share because such shares would have had an antidilutive effect on earnings per common share.
Certain previously reported amounts have been reclassified to agree with current presentation.


On March 1, 2006, FHN purchased 4 million shares of its common stock to minimize the potentially dilutive effect of the merchant divestiture on future earnings per share. This share repurchase was accomplished through an accelerated share repurchase program for an initial purchase price of approximately $158 million in first quarter 2006. The final settlement, after the repurchase period, is expected to occur in second quarter 2006.


20


Note 9 - Contingencies and Other Disclosures

Contingencies. Contingent liabilities arise in the ordinary course of business, including those related to litigation. Various claims and lawsuits are pending against FHN and its subsidiaries. Although FHN cannot predict the outcome of these lawsuits, after consulting with counsel, management has been able to form an opinion on the effect all of these lawsuits, except the matter mentioned in the paragraph below, will have on the consolidated financial statements. It is management’s opinion that when resolved, these lawsuits will not have a material adverse effect on the consolidated financial statements of FHN.

In November 2000, a complaint was filed in state court in Jackson County, Missouri against FHN’s subsidiary, First Horizon Home Loans. The case generally concerns the charging of certain loan origination fees, including fees permitted by Kansas law but allegedly restricted or not permitted by Missouri law, when First Horizon Home Loans or its predecessor, McGuire Mortgage Company, made certain second-lien mortgage loans. Among other relief, plaintiffs seek a refund of fees, a repayment and forgiveness of loan interest, prejudgment interest, punitive damages, and loan rescission. In response to pre-trial motions, the court has ruled that Missouri law governs the loan transactions and has certified a statewide class action involving approximately 4,000 loans. Discovery is ongoing and additional pre-trial motions are pending. Trial is currently scheduled for November 2006. FHN believes that it has meritorious defenses and intends to continue to protect its rights and defend this lawsuit vigorously, through trial and appeal, if necessary.

 

Other disclosures – Indemnification agreements and guarantees. In the ordinary course of business, FHN enters into indemnification agreements for legal proceedings against its directors and officers and standard representation warranties for underwriting agreements, merger and acquisition agreements, loan sales, contractual commitments, and various other business transactions or arrangements. The extent of FHN’s obligations under these agreements depends upon the occurrence of future events; therefore, it is not possible to estimate a maximum potential amount of payouts that could be required with such agreements.

 

First Horizon Home Loans services a first-lien mortgage loan portfolio of approximately $97.3 billion as of March 31, 2006, a significant portion of which is held by GNMA, FNMA, FHLMC or private security holders. In connection with its servicing activities, First Horizon Home Loans guarantees the receipt of the scheduled principal and interest payments on the underlying loans. In the event of customer non-performance on the loan, First Horizon Home Loans is obligated to make the payment to the security holder. Under the terms of the servicing agreements, First Horizon Home Loans can utilize payments received from other prepaid loans in order to make the security holder whole. In the event payments are ultimately made by First Horizon Home Loans to satisfy this obligation, for loans sold with no recourse, all funds are recoverable from the government agency at foreclosure sale.

 

First Horizon Home Loans is also subject to losses in its loan servicing portfolio due to loan foreclosures and other recourse obligations. Certain agencies have the authority to limit their repayment guarantees on foreclosed loans resulting in certain foreclosure costs being borne by servicers. In addition, First Horizon Home Loans has exposure on all loans sold with recourse. First Horizon Home Loans has various claims for reimbursement, repurchase obligations, and/or indemnification requests outstanding with government agencies or private investors. First Horizon Home Loans has evaluated all of its exposure under recourse obligations based on factors, which include loan delinquency status, foreclosure expectancy rates and claims outstanding. Accordingly, First Horizon Home Loans had an allowance for losses on the mortgage servicing portfolio of approximately $22.1 million and $16.5 million as of March 31, 2006 and 2005, respectively. First Horizon Home Loans has sold certain mortgage loans with an agreement to repurchase the loans upon default. As of March 31, 2006 and 2005, First Horizon Home Loans had single-family residential loans with outstanding balances of $150.6 million and $190.5 million, respectively that were sold on a recourse basis. For the single-family residential loans, in the event of borrower nonperformance, First Horizon Home Loans would assume losses to the extent they exceed the value of the collateral and private mortgage insurance, FHA insurance or VA guarantees. As of March 31, 2006 and 2005, the outstanding principal balance of loans sold with limited recourse and serviced by First Horizon Home Loans was $3.1 billion and $3.4 billion, respectively.

 

FHN has securitized and sold HELOC and second-lien mortgages which are held by private security holders, and on March 31, 2006, the outstanding principal balance of these loans was $555.8 million and $130.0 million, respectively. On March 31, 2005, the outstanding principal balance of securitized and sold HELOC and second-lien mortgages was $1.1 billion and $210.3 million, respectively. In connection with its servicing activities, FTBNA does not guarantee the receipt of the scheduled principal and interest payments on the underlying loans but does have residual interests of $57.2 million and $61.1 million on March 31, 2006 and 2005, respectively, which are available to make the security holder whole in the event of credit losses. FHN has projected expected credit losses in the valuation of the residual interest.


21


  

Note 10 – Pension and Other Employee Benefits

 

Pension plan. FHN provides pension benefits to employees retiring under the provisions of a noncontributory, defined benefit pension plan. Employees of FHN’s mortgage subsidiary and certain insurance subsidiaries are not covered by the pension plan. Pension benefits are based on years of service, average compensation near retirement and estimated social security benefits at age 65. The annual funding is based on an actuarially determined amount using the entry age cost method. FHN also maintains a nonqualified supplemental executive retirement plan that covers certain employees whose benefits under the pension plan have been limited under Tax Code Section 415 and Tax Code Section 401(a)(17), which limit compensation to $210,000 for purposes of benefit calculations. Compensation is defined in the same manner as it is under the pension plan. Participants receive the difference between the monthly pension payable, if tax code limits did not apply, and the actual pension payable. All benefits provided under this plan are unfunded and payments to plan participants are made by FHN.

 

Other employee benefits. FHN provides postretirement medical insurance to full-time employees retiring under the provisions of the FHN Pension Plan. The postretirement medical plan is contributory with retiree contributions adjusted annually. The plan is based on criteria that are a combination of the employee’s age and years of service and utilizes a two-step approach. For any employee retiring on or after January 1, 1995, FHN contributes a fixed amount based on years of service and age at time of retirement. FHN’s postretirement benefits include prescription drug benefits. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) introduces a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. FSP FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” requires a plan sponsor to determine if benefits offered through a postretirement health care plan are actuarially equivalent to Medicare Part D. Plan benefits were determined to be actuarially equivalent in 2005.

 

The components of net periodic benefit cost for the three months ended March 31 are as follows:

 

Pension Benefits Postretirement Benefits
(Dollars in thousands) 2006   2005   2006   2005
Components of net periodic benefit cost
Service cost  $  4,520   $  3,945   $    83   $    199 
Interest cost          5,486          5,318           279           438 
Expected return on plan assets        (8,945)       (8,123)        (421)        (417)
Amortization of prior service cost/(benefit)             211             207           (44)          (44)
Recognized losses/(gains)          1,769          1,014         (140)               
Amortization of transition obligation                                               247           247 
Net periodic cost $  3,041     $  2,361     $          $    423 

 

FHN plans to contribute approximately $20 million to the pension plan in second quarter 2006, and does not anticipate making any further contributions to this plan during the remainder of 2006. FHN does not anticipate making a contribution to the other employee benefit plan in 2006.


22


 

Note 11 - Stock Option, Restricted Stock Incentive, and Dividend Reinvestment Plans

 

Stock option plans. FHN issues non-qualified stock options under various plans to employees, non-employee directors, and bank advisory board members. The plans provide for the issuance of FHN common stock at a price equal to its fair market value at the date of grant. However, if the grantee agreed to receive the options in lieu of compensation, the exercise price was less than the fair market value. The foregone compensation plus the exercise price equaled the fair market value of the stock on the date of grant. This deferral program was discontinued in 2005, and any options issued below market on the date of grant during 2005 were related to 2004 salary deferrals for employees and 2004 board compensation for directors. All options vest within 3 to 5 years and expire 7 years or 10 years from the date of grant, except for those options that were previously part of compensation deferral, which vest immediately or after 6 months and expire 20 years from the date of grant. After January 2, 2004, stock options granted that are part of the compensation deferral vest immediately or after 6 months and expire 10 years from the date of grant. There were 1,596,761 shares available for option or share grants on March 31, 2006.

 

The summary of stock option activity during quarter ended March 31, 2006, is shown below:


Weighted 
Weighted Average Aggregate
 Options Average Remaining Intrinsic Value
  Outstanding   Exercise Price  Contractual Term   (thousands)
January 1, 2006 20,289,455  $32.87       
Options granted                   -    -       
Options exercised (876,896)    25.58       
Options canceled (193,148)    41.13       
March 31, 2006 19,219,411       33.12        7.09   $174,204 
Options exercisable 14,169,967    $29.91        7.64   $168,354 


The total intrinsic value of options exercised during the quarters ended March 31, 2006 and 2005, was $12.7 million and $7.6 million, respectively. As of March 31, 2006, there was $16.6 million of unrecognized compensation cost related to nonvested stock options. That cost is expected to be recognized over a weighted-average period of 2.85 years. The following data summarizes information about stock options granted during quarters ended March 31:

 

Weighted 
Average Fair
  Number Value per Option
         Granted   at Grant Date
2006:            
Options granted             N/A    N/A 
2005:
Options granted                    87,302    $  19.81         


FHN used the Black-Scholes Option Pricing Model to estimate the fair value of stock options granted in the quarters ended March 31, 2006 and 2005, with the following assumptions:

 

Three months ended
March 31,
        2006   2005    
Expected dividend yield N/A 3.98%
Expected lives of options granted N/A 5.29 years
Expected volatility N/A 21.65%
Risk-free interest rates       N/A   3.68%


23



Note 11 - Stock Option, Restricted Stock Incentive, and Dividend Reinvestment Plans (continued)

Expected lives of options granted are determined based on the vesting period, historical exercise patterns and contractual term of the options. Expected volatility is estimated using average of daily high and low stock prices, excluding swings in volatility caused by unique infrequent circumstances. Expected volatility assumptions are determined over the period of the expected lives of the options.

 

Restricted stock incentive plans. FHN has authorized the issuance of its common stock for awards to executive employees who have a significant impact on the profitability of FHN under a performance accelerated restricted stock program. The performance stock units vest only if predetermined performance measures are met. Additionally, one of the plans allows stock awards to be granted to non-employee directors upon approval by the board of directors. It has been the recent practice of the board to grant 8,000 shares of restricted stock to each new non-employee director upon election to the board, with restrictions lapsing at a rate of ten percent per year. FHN also grants restricted stock awards to management employees which typically vest over 3 and 4 years. The summary of restricted stock activity during the quarter ended March 31, 2006, is presented below:


                  Weighted
                  average
                Share grant date
                Units fair value
Nonvested at January 1, 2006               1,228,282    $41.10       
Share units granted                            52,950  38.58       
Share units vested                             (8,522) 21.61       
Share units canceled                         (133,930) 41.97       
Nonvested at March 31, 2006               1,138,780    $41.03       

 

As of March 31, 2006, there was $14.4 million of unrecognized compensation cost related to nonvested restricted stock plans. That cost is expected to be recognized over a weighted-average period of 3.34 years. The total fair value of shares vested during the quarter ended March 31, 2006, was $.3 million. No restricted stock shares vested during the quarter ended March 31, 2005.

 

The board of directors approved amendments to the restricted stock plan during 1998 permitting deferral by participants of the receipt of restricted stock prior to the lapse of restrictions. Due to deferred compensation legislation passed in 2004, participants are no longer allowed to make voluntary deferral elections under the stock programs.

 

The compensation (benefit)/cost that has been included in income from continuing operations pertaining to both stock option and restricted stock plans was ($1.3) million and $6.4 million for the quarters ended March 31, 2006 and 2005, respectively. The corresponding total income tax (expense)/benefit recognized in the income statement was ($.5) million and $2.4 million for the quarters ended March 31, 2006 and 2005, respectively.

 

Consistent with Tennessee state law, only new shares may be utilized in connection with any issuance of FHN common stock which may be required as a result of share based compensation awards. FHN historically obtains authorization from the Board of Directors to repurchase any shares that may be issued at the time a plan is approved or amended. Repurchases are authorized to be made in the open market or through privately negotiated transactions and will be subject to market conditions, accumulation of excess equity, and prudent capital management. FHN does not currently expect to repurchase a material number of shares related to the plans during the next annual period.

 

Dividend reinvestment plan. The Dividend Reinvestment and Stock Purchase Plan (the Plan) authorizes the sale of FHN’s common stock from shares acquired on the open market to shareholders who choose to invest all or a portion of their cash dividends and make optional cash payments of $25 to $10,000 per quarter without paying commissions. The price of shares purchased on the open market is the average price paid.


24


 

Note 12 – Business Segment Information

 

FHN has four business segments, Retail/Commercial Banking, Mortgage Banking, Capital Markets and Corporate. The Retail/Commercial Banking segment offers financial products and services, including traditional lending and deposit taking, to retail and commercial customers. Additionally, Retail/Commercial Banking provides investments, insurance, financial planning, trust services and asset management, credit card, cash management, check clearing, and correspondent services. On March 1, 2006, FHN sold its national merchant processing business. The divestiture was accounted for as a discontinued operation which is included in the Retail/Commercial Banking segment. The Mortgage Banking segment consists of core mortgage banking elements including originations and servicing and the associated ancillary revenues related to these businesses. The Capital Markets segment consists of traditional capital markets securities activities, equity research and investment banking. The Corporate segment consists of unallocated corporate expenses, expense on subordinated debt issuances and preferred stock, bank-owned life insurance, unallocated interest income associated with excess equity, net impact of raising incremental capital, funds management and venture capital. Periodically, FHN adapts its segments to reflect changes in expense allocations between segments. In 2005, FHN adapted its segments to reflect the reclassification of certain trust preferred assets and related net interest income to the Capital Markets segment from Retail/Commercial Banking. Previously reported amounts have been reclassified to agree with current presentation. Effective January 1, 2006, FHN adopted SFAS No. 123-R and retroactively applied the provisions of the standard. Accordingly, results for prior periods have been adjusted to reflect expensing of share-based compensation.

 

Total revenue, expense and asset levels reflect those which are specifically identifiable or which are allocated based on an internal allocation method. Because the allocations are based on internally developed assignments and allocations, they are to an extent subjective. This assignment and allocation has been consistently applied for all periods presented. The following table reflects the amounts of consolidated revenue, expense, tax, and assets for each segment for the three months ended March 31:


Three Months Ended
March 31
(Dollars in thousands)                          2006         2005
Total Consolidated
Net interest income   $      245,721    $      227,447 
Provision for loan losses        17,799         13,109 
Noninterest income        205,744         322,878 
Noninterest expense                 443,215          384,537 
   Pre-tax (loss)/income               (9,549)        152,679 
(Benefit)/provision for income taxes                       (12,959)                49,864 
Income from continuing operations                3,410             102,815 
Income from discontinued operations, net of tax                  210,273                   3,015 
Income before cumulative effect            213,683             105,830 
Cumulative effect of changes in accounting principle, net of tax                    1,345                           
Net income     $      215,028      $      105,830 
Average assets             $ 37,689,523      $ 34,091,441 
Retail/Commercial Banking
Net interest income   $      224,869    $      198,653 
Provision for loan losses        18,026         13,069 
Noninterest income        106,493         100,859 
Noninterest expense                 215,555          179,750 
   Pre-tax income        97,781         106,693 
Provision for income taxes                        27,899                 33,857 
Income from continuing operations              69,882               72,836 
Income from discontinued operations, net of tax                  210,273                   3,015 
Income before cumulative effect            280,155               75,851 
Cumulative effect of changes in accounting principle, net of tax                       522                           
Net income             $      280,677      $        75,851 
Average assets             $ 23,045,183      $ 19,793,641 
Certain previously reported amounts have been reclassified to agree with current presentation.


25


   

Note 12 – Business Segment Information (continued)

 

Three Months Ended
March 31
(Dollars in thousands)                          2006         2005
Mortgage Banking
Net interest income   $        25,415    $        33,248 
Provision for loan losses                  (227)        40 
Noninterest income        94,704         122,575 
Noninterest expense                 125,699          109,900 
   Pre-tax (loss)/income   (5,353)        45,883 
(Benefit)/provision for income taxes                         (2,114)                16,458 
(Loss)/income before cumulative effect               (3,239)              29,425 
Cumulative effect of changes in accounting principle, net of tax                       414                           
Net (loss)/ income            $         (2,825)     $        29,425 
Average assets             $   6,206,548      $   5,662,802 
Capital Markets
Net interest expense  $         (5,563)  $         (5,225)
Noninterest income        98,903         96,427 
Noninterest expense                 86,379          81,813 
   Pre-tax income        6,961         9,389 
Provision for income taxes                          1,745                   4,049 
Income before cumulative effect                5,216                 5,340 
Cumulative effect of changes in accounting principle, net of tax                       179                           
Net income             $          5,395      $          5,340 
Average assets             $   4,867,762      $   5,396,616 
Corporate
Net interest income   $          1,000    $             771 
Noninterest (expense)/ income             (94,356)                3,017 
Noninterest expense                        15,582                 13,074