UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the Fiscal Year Ended December 31, 2010 — Commission File No. 0-2989

 

COMMERCE BANCSHARES, INC.

 

(Exact name of registrant as specified in its charter)

 

 

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

 

 

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

 

NONE

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Yes þ  No o

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

 

Yes o  No þ

 

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 þ  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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

 

 

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

 

Yes o     No þ

 

As of June 30, 2010, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $2,604,000,000.

 

As of February 11, 2011, there were 86,958,563 shares of Registrant’s $5 Par Value Common Stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

 

Portions of the Registrant’s definitive proxy statement for its 2011 annual meeting of shareholders, which will be filed within 120 days of December 31, 2010, are incorporated by reference into Part III of this Report.

 

 

Commerce Bancshares, Inc.

 

Form 10-K

 

 

 

General

 

Commerce Bancshares, Inc. (the “Company”), a bank holding company as defined in the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Missouri on August 4, 1966. The Company owns all of the outstanding capital stock of one national banking association, Commerce Bank, N.A. (the “Bank”), which is headquartered in Missouri. The Bank engages in general banking business, providing a broad range of retail, corporate, investment, trust, and asset management products and services to individuals and businesses. The Company also owns, directly or through the Bank, various non-banking subsidiaries. Their activities include underwriting credit life and credit accident and health insurance, selling property and casualty insurance (relating to consumer loans made by the Bank), private equity investment, securities brokerage, mortgage banking, and leasing activities. The Company owns a second tier holding company that is the direct owner of the Bank. A list of the Company’s subsidiaries is included as Exhibit 21.

 

The Company is one of the nation’s top 50 bank holding companies, based on asset size. At December 31, 2010, the Company had consolidated assets of $18.5 billion, loans of $9.5 billion, deposits of $15.1 billion, and equity of $2.0 billion. All of the Company’s operations conducted by subsidiaries are consolidated for purposes of preparing the Company’s consolidated financial statements. The Company does not utilize unconsolidated subsidiaries or special purpose entities to provide off-balance sheet borrowings or securitizations.

 

The Company’s goal is to be the preferred provider of targeted financial services in its communities, based on strong customer relationships. It believes in building long-term relationships based on top quality service, high ethical standards and safe, sound assets. The Company operates under a super-community banking format with a local orientation, augmented by experienced, centralized support in select critical areas. The Company’s local market orientation is reflected in its financial centers and regional advisory boards, which are comprised of local business persons, professionals and other community representatives, that assist the Company in responding to local banking needs. In addition to this local market, community-based focus, the Company offers sophisticated financial products available at much larger financial institutions.

 

The Bank’s facilities are located throughout Missouri, Kansas, and central Illinois, and in Tulsa, Oklahoma and Denver, Colorado. Its two largest markets include St. Louis and Kansas City, which serve as the central hubs for the entire company.

 

The markets the Bank serves, being located in the lower Midwest, provide natural sites for production and distribution facilities and also serve as transportation hubs. The economy has been well-diversified in these markets with many major industries represented, including telecommunications, automobile, aircraft and general manufacturing, health care, numerous service industries, food production, and agricultural production and related industries. In addition, several of the Illinois markets are located in areas with some of the most productive farmland in the world. The real estate lending operations of the Bank are centered in its lower Midwestern markets. Historically, these markets have generally tended to be less volatile than in other parts of the country. While the decline in the national real estate market resulted in significantly higher real estate loan losses during 2008, 2009 and 2010 for the banking industry, management believes the diversity and nature of the Bank’s markets has resulted in lower real estate loan losses in these markets and is a key factor in the Bank’s relatively lower loan loss levels.

 

The Company regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions eligible for bank holding company ownership or control. In addition, the Company regularly considers the potential disposition of certain of its assets and branches. The Company seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services. For additional information on acquisition and branch disposition activity, refer to page 75.

Operating Segments

 

The Company is managed in three operating segments. The Consumer segment includes the retail branch network, consumer installment lending, personal mortgage banking, consumer debit and credit bank card activities, and student lending. It provides services through a network of 209 full-service branches, a widespread ATM network of 408 machines, and the use of alternative delivery channels such as extensive online banking and telephone banking services. In 2010, this retail segment contributed 35% of total segment pre-tax income. The Commercial segment provides a full array of corporate lending, merchant and commercial bank card products, leasing, and international services, as well as business and government deposit and cash management services. In 2010, it contributed 50% of total segment pre-tax income. The Wealth segment provides traditional trust and estate tax planning services, brokerage services, and advisory and discretionary investment portfolio management services to both personal and institutional corporate customers. This segment also manages the Company’s family of proprietary mutual funds, which are available for sale to both trust and general retail customers. Fixed income investments are sold to individuals and institutional investors through the Capital Markets Group, which is also included in this segment. At December 31, 2010, the Wealth segment managed investments with a market value of $14.3 billion and administered an additional $10.7 billion in non-managed assets. Additional information relating to operating segments can be found on pages 53 and 99.

 

Supervision and Regulation

 

General

 

The Company, as a bank holding company, is primarily regulated by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (BHC Act). Under the BHC Act, the Federal Reserve Board’s prior approval is required in any case in which the Company proposes to acquire all or substantially all of the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company. The BHC Act also prohibits, with certain exceptions, the Company from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any non-banking company. Under the BHC Act, the Company may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries and may not acquire voting control of non-banking companies unless the Federal Reserve Board determines such businesses and services to be closely related to banking. When reviewing bank acquisition applications for approval, the Federal Reserve Board considers, among other things, the Bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (CRA). The Bank has a current CRA rating of “outstanding”.

 

The Company is required to file with the Federal Reserve Board various reports and such additional information as the Federal Reserve Board may require. The Federal Reserve Board also makes regular examinations of the Company and its subsidiaries. The Company’s banking subsidiary is organized as a national banking association and is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC). The Bank is also subject to regulation by the Federal Deposit Insurance Corporation (FDIC). In addition, there are numerous other federal and state laws and regulations which control the activities of the Company and the Bank, including requirements and limitations relating to capital and reserve requirements, permissible investments and lines of business, transactions with affiliates, loan limits, mergers and acquisitions, issuance of securities, dividend payments, and extensions of credit. If the Company fails to comply with these or other applicable laws and regulations, it may be subject to civil monetary penalties, imposition of cease and desist orders or other written directives, removal of management and, in certain circumstances, criminal penalties. This regulatory framework is intended primarily for the protection of depositors and the preservation of the federal deposit insurance funds, and not for the protection of security holders. Statutory and regulatory controls increase a bank holding company’s cost of doing business and limit the options of its management to employ assets and maximize income.

 

In addition to its regulatory powers, the Federal Reserve Bank affects the conditions under which the Company operates by its influence over the national supply of bank credit. The Federal Reserve Board employs open market operations in U.S. government securities, changes in the discount rate on bank

borrowings, changes in the federal funds rate on overnight inter-bank borrowings, and changes in reserve requirements on bank deposits in implementing its monetary policy objectives. These instruments are used in varying combinations to influence the overall level of the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets and the level of inflation. The monetary policies of the Federal Reserve have a significant effect on the operating results of financial institutions, most notably on the interest rate environment. In view of changing conditions in the national economy and in the money markets, as well as the effect of credit policies of monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels or loan demand, or their effect on the financial statements of the Company.

 

Subsidiary Bank

 

Under Federal Reserve policy, the Company is expected to act as a source of financial strength to its bank subsidiary and to commit resources to support it in circumstances when it might not otherwise do so. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

 

Substantially all of the deposits of the Bank are insured up to the applicable limits by the Bank Insurance Fund of the FDIC, generally up to $250,000 per depositor, for each account ownership category. Through December 31, 2012, all non-interest bearing transaction accounts are fully guaranteed by the FDIC for the entire amount of the account. The Bank pays deposit insurance premiums to the FDIC based on an assessment rate established by the FDIC for Bank Insurance Fund member institutions. The FDIC has established a risk-based assessment system under which institutions are classified and pay premiums according to their perceived risk to the federal deposit insurance funds. The Bank’s premiums had been relatively low prior to the 2008 economic crisis. These rose significantly in 2009 due to higher fees charged by the FDIC in order to replenish its insurance fund, which had been depleted by high levels of bank failures across the country. The Bank’s FDIC expense totaled $19.2 million in 2010 and $27.4 million in 2009, compared to $2.1 million in 2008. In late 2009, the FDIC Board ruled that insured institutions must prepay their quarterly risk-based assessments for the fourth quarter of 2009 and subsequent years 2010 through 2012, in order to cover the costs of future expected bank failures. The Bank’s pre-payment on December 30, 2009 totaled $68.7 million. In November 2010, under the provisions of the Dodd-Frank Act (mentioned below), the FDIC proposed changing its assessment base from total domestic deposits to average total assets minus average tangible equity. The proposal alters other adjustments in the current assessment system for heavy use of unsecured liabilities, secured liabilities and brokered deposits, and adds an adjustment for holdings of unsecured bank debt. The proposal is expected to increase assessments on banks with more than $10 billion in assets, raising their share of overall FDIC assessments from the present 70% to 80%. The assessment increase would be in place by the second quarter of 2011. Also, for banks with more than $10 billion in assets, the FDIC has proposed changing the assessment rate. The proposal would abandon the current method for determining premiums, which are based on bank supervisory ratings, debt issuer ratings and financial ratios. Instead, the proposed assessment would rely on a scorecard designed to measure financial performance and ability to withstand stress, in addition to measuring the FDIC’s exposure should the bank fail. This proposal would be effective beginning in the second quarter of 2011. The Company expects that the effect of these proposals, if adopted, would be to reduce FDIC insurance expense in 2011 in the range of $4 to $5 million.

 

Payment of Dividends

 

The principal source of the Company’s cash revenues is dividends paid by the Bank. The Federal Reserve Board may prohibit the payment of dividends by bank holding companies if their actions constitute unsafe or unsound practices. The OCC limits the payment of dividends by the Bank in any calendar year to the net profit of the current year combined with the retained net profits of the preceding two years. Permission must

be obtained from the OCC for dividends exceeding these amounts. The payment of dividends by the Bank may also be affected by factors such as the maintenance of adequate capital.

 

Capital Adequacy

 

The Company is required to comply with the capital adequacy standards established by the Federal Reserve. These capital adequacy guidelines generally require bank holding companies to maintain minimum total capital equal to 8% of total risk-adjusted assets and off-balance sheet items (the “Total Risk-Based Capital Ratio”), with at least one-half of that amount consisting of Tier I, or core capital, and the remaining amount consisting of Tier II, or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common shareholders’ equity, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill and other non-qualifying intangible assets. Tier II capital generally consists of hybrid capital instruments, term subordinated debt and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics.

 

In addition, the Federal Reserve also requires bank holding companies to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier I capital to its total consolidated quarterly average assets (as defined for regulatory purposes), net of the allowance for loan losses, goodwill and certain other intangible assets. The minimum leverage ratio for bank holding companies is 4%. At December 31, 2010, the Bank was “well-capitalized” under regulatory capital adequacy standards, as further discussed on page 102.

 

In December 2010, the Basel Committee on Banking Supervision presented to the public the Basel III rules text, which proposes new global regulatory standards on bank capital adequacy and liquidity. The Basel Committee seeks to strengthen global capital and liquidity rules with the goal of promoting a more resilient banking sector. The framework sets out tougher capital requirements, higher risk-weighted assets, the introduction of a leverage ratio, and higher requirements for minimum capital ratios. Basel III also establishes two minimum standards for liquidity to promote short-term resilience, as well as resilience over a longer period of time through a stable maturity structure of assets and liabilities. Banks are required to begin phasing in Basel III requirements beginning in 2013. The Company continues to evaluate the impact of this framework on its operations and reporting.

 

Legislation

 

The financial industry operates under laws and regulations that are under constant review by various agencies and legislatures, and are subject to sweeping change. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLB Act) contained major changes in laws that previously kept the banking industry largely separate from the securities and insurance industries. The GLB Act authorized the creation of a new kind of financial institution, known as a “financial holding company”, and a new kind of bank subsidiary, called a “financial subsidiary”, which may engage in a broader range of investment banking, insurance agency, brokerage, and underwriting activities. The GLB Act also included privacy provisions that limit banks’ abilities to disclose non-public information about customers to non-affiliated entities. Banking organizations are not required to become financial holding companies, but instead may continue to operate as bank holding companies, providing the same services they were authorized to provide prior to the enactment of the GLB Act. The Company currently operates as a bank holding company.

 

The Company must also comply with the requirements of the Bank Secrecy Act (BSA). The BSA is designed to help fight drug trafficking, money laundering, and other crimes. Compliance is monitored by the OCC. The BSA was enacted to prevent banks and other financial service providers from being used as intermediaries for, or to hide the transfer or deposit of money derived from, criminal activity. Since its passage, the BSA has been amended several times. These amendments include the Money Laundering Control Act of 1986 which made money laundering a criminal act, as well as the Money Laundering Suppression Act of 1994 which required regulators to develop enhanced examination procedures and

increased examiner training to improve the identification of money laundering schemes in financial institutions.

 

In 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT Act) was signed into law. The USA PATRIOT Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department issued a number of regulations implementing the USA PATRIOT Act that apply certain of its requirements to financial institutions such as the Company’s broker-dealer subsidiary. The regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.

 

The Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (the Credit CARD Act) was signed into law in May 2009. It is comprehensive credit card legislation that aims to establish fair and transparent practices relating to open end consumer credit plans. The first phase of the legislation began in August 2009, under which the payment period (with no late fees) was extended from 14 days to 21 days, the advance warning period for significant changes to credit card accounts was extended from 15 days to 45 days, and opt-out provisions were made available to customers. A second phase began in February 2010, which included provisions governing when rate increases can be applied on late accounts, requirements for clearer disclosures of terms before opening an account, prohibitions on charging over-limit fees and double-cycle billing, and various other restrictions. Additional rules became effective in July 2010, which deal with interest rate reinstatements on former overdue accounts, and gift card expiration dates and inactivity fees.

 

In late 2009, the Federal Reserve issued new regulations, effective July 1, 2010, which prohibited financial institutions from assessing fees for paying ATM and one-time debit card transactions that overdraw consumer accounts unless the consumer affirmatively consents to the financial institution’s overdraft practices. The Company has implemented new procedures to solicit and capture required customer consents and, effective July 1, 2010, prohibited such ATM and one-time debit card transactions causing overdrafts, unless an opt-in consent has been received. As not all customers provided such consent, these new regulations resulted in lower deposit fee income in the second half of 2010. Overdraft fees decreased $7.8 million in the second half of 2010 compared to the first half. The Company estimates that the effect of these regulations will reduce annualized pre-tax revenue by $15 to $16 million. As a means to mitigate some of the impact to revenue, the Company is also developing other products and has begun offering some deposit accounts with monthly fees.

 

In March 2010, legislation was passed which expanded Pell Grants and Perkins Loan programs and required all colleges and universities to convert to direct lending programs with the U.S. government as of July 1, 2010. Previously, colleges and universities had the choice of participating in either direct lending with the U.S. government or a program whereby loans were originated by banks, but guaranteed by the U.S. government. The Company terminated its guaranteed student loan origination business effective July 1, 2010.

 

In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was signed into law. The Dodd-Frank Act is sweeping legislation intended to overhaul regulation of the financial services industry. Its goals are to establish a new council of “systemic risk” regulators, create a new consumer protection division within the Federal Reserve, empower the Federal Reserve to supervise the largest, most complex financial companies, allow the government to seize and liquidate failing financial companies, and give regulators new powers to oversee the derivatives market. The provisions of the Dodd-Frank Act are so extensive and overreaching that full implementation may require several years, and an assessment of its full effect on the Company is not possible at this time.

 

Under the provisions of the Dodd-Frank Act, the Federal Reserve proposed changes in December 2010 that would significantly limit the amount of debit card interchange fees charged by banks. The proposal outlines two alternatives for computing a “reasonable and proportional” fee. Industry analysts have estimated that revenues from debit card interchange may be reduced by as much as 70% under either approach.

The proposal also seeks to limit network exclusivity, requiring issuers to ensure that a debit card transaction can be carried on several unaffiliated networks. The new rules would apply to bank issuers with more than $10 billion in assets and would take effect in July 2011. The Federal Reserve’s proposal did not include a specific adjustment for fraud prevention costs, which it intends to separately consider at a future date. The Company’s fees from debit card interchange subject to the proposed rule were $57 million in 2010.

 

Competition

 

The Company’s locations in regional markets throughout Missouri, Kansas, central Illinois, Tulsa, Oklahoma, and Denver, Colorado, face intense competition from hundreds of financial service providers. The Company competes with national and state banks for deposits, loans and trust accounts, and with savings and loan associations and credit unions for deposits and consumer lending products. In addition, the Company competes with other financial intermediaries such as securities brokers and dealers, personal loan companies, insurance companies, finance companies, and certain governmental agencies. The passage of the GLB Act, which removed barriers between banking and the securities and insurance industries, has resulted in greater competition among these industries. The Company generally competes on the basis of customer service and responsiveness to customer needs, interest rates on loans and deposits, lending limits and customer convenience, such as location of offices.

 

Employees

 

The Company and its subsidiaries employed 4,389 persons on a full-time basis and 616 persons on a part-time basis at December 31, 2010. The Company provides a variety of benefit programs including a 401K plan as well as group life, health, accident, and other insurance. The Company also maintains training and educational programs designed to prepare employees for positions of increasing responsibility.

 

Available Information

 

The Company’s principal offices are located at 1000 Walnut, Kansas City, Missouri (telephone number 816-234-2000). The Company makes available free of charge, through its Web site at www.commercebank.com, reports filed with the Securities and Exchange Commission as soon as reasonably practicable after the electronic filing. These filings include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports.

 

Statistical Disclosure

 

The information required by Securities Act Guide 3 — “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.

 

 

Making or continuing an investment in securities issued by Commerce Bancshares, Inc., including its common stock, involves certain risks that you should carefully consider. The risks and uncertainties described below are not the only risks that may have a material adverse effect on the Company. Additional risks and uncertainties also could adversely affect its business and financial results. If any of the following risks actually occur, its business, financial condition or results of operations could be negatively affected, the market price for your securities could decline, and you could lose all or a part of your investment. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause the Company’s actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of Commerce Bancshares, Inc.

 

Difficult market conditions have adversely affected the Company’s industry and may continue to do so.

 

Given the concentration of the Company’s banking business in the United States, it is particularly exposed to downturns in the U.S. economy. The economic trends which began in 2008, such as declines in the housing market, falling home prices, increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as major commercial and investment banks. These write-downs, initially of mortgage-backed securities and other complex financial instruments, but spreading to various classes of real estate, commercial and consumer loans in turn, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. The weak U.S. economy and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has adversely affected the Company’s business, financial condition and results of operations through higher levels of loan losses and lower loan demand. While there have been some recent indications of stabilization, management does not expect significant economic improvement in the near future. In particular, the Company may face the following risks in connection with these market conditions:

 

 

 

Significant changes in banking laws and regulations could materially affect the Company’s business.

 

Increased regulation of the banking industry is being demanded by the current political administration. Certain regulation has already been imposed during the past year, and much additional regulation has been proposed. Such regulation, along with possible changes in tax laws and accounting rules, may have a significant impact on the ways that financial institutions conduct business, implement strategic initiatives, engage in tax planning and make financial disclosures. Compliance with such regulation may increase costs and limit the ability to pursue business opportunities.

 

The performance of the Company is dependent on the economic conditions of the markets in which the Company operates.

 

The Company’s success is heavily influenced by the general economic conditions of the specific markets in which it operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides financial services primarily throughout the states of Missouri, Kansas, and central Illinois, and has recently begun to expand into Oklahoma, Colorado and other surrounding states. Since the Company does not have a significant presence in other parts of the country, a prolonged economic downtown in these markets could have a material adverse effect on the Company’s financial condition and results of operations.

 

Significant changes in federal monetary policy could materially affect the Company’s business.

 

The Federal Reserve System regulates the supply of money and credit in the United States. Its polices determine in large part the cost of funds for lending and investing by influencing the interest rate earned on loans and paid on borrowings and interest bearing deposits. Credit conditions are influenced by its open market operations in U.S. government securities, changes in the member bank discount rate, and bank reserve requirements. Changes in Federal Reserve Board policies are beyond the Company’s control and difficult to predict.

 

The soundness of other financial institutions could adversely affect the Company.

 

The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institution counterparties. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. The Company has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual funds, and other institutional clients. Transactions with these institutions include overnight and term borrowings, interest rate swap agreements, securities purchased and sold, short-term investments, and other such transactions. As a result of this exposure, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the Company or by other institutions. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client, while other transactions expose the Company to liquidity risks should funding sources quickly disappear. In addition, the Company’s credit risk may be exacerbated when the collateral held cannot be realized upon or is liquidated at

prices not sufficient to recover the full amount of the financial instrument exposure due to the Company. Any such losses could materially and adversely affect results of operations.

 

The Company’s asset valuation may include methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to asset valuations that may materially adversely affect its results of operations or financial condition.

 

The Company uses estimates, assumptions, and judgments when financial assets and liabilities are measured and reported at fair value. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices and/or other observable inputs provided by independent third-party sources, when available. When such third-party information is not available, fair value is estimated primarily by using cash flow and other financial modeling techniques utilizing assumptions such as credit quality, liquidity, interest rates and other relevant inputs. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact the Company’s future financial condition and results of operations.

 

During periods of market disruption, including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain assets if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, certain asset valuations may require more subjectivity and management judgment. As such, valuations may include inputs and assumptions that are less observable or require greater estimation. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of assets as reported within the Company’s consolidated financial statements, and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on results of operations or financial condition.

 

The Company’s investment portfolio values may be adversely impacted by changing interest rates and deterioration in the credit quality of underlying collateral within mortgage and other asset-backed investment securities.

 

The Company generally invests in securities issued by government-backed agencies or privately issued securities that are highly rated by credit rating agencies at the time of purchase, but are subject to changes in market value due to changing interest rates and implied credit spreads. Recently, budget deficits and other financial problems in a number of states and political subdivisions have been reported in the media. While the Company maintains rigorous risk management practices over bonds issued by municipalities, further credit deterioration in these bonds could occur and result in losses. Certain mortgage and asset-backed securities represent beneficial interests which are collateralized by residential mortgages, credit cards, automobiles, mobile homes or other assets. While these investment securities are highly rated at the time of initial investment, the value of these securities may decline significantly due to actual or expected deterioration in the underlying collateral, especially residential mortgage collateral. Market conditions have resulted in a deterioration in fair values for non-guaranteed mortgage-backed and other asset-backed securities. Under accounting rules, when the impairment is due to declining expected cash flows, some portion of the impairment, depending on the Company’s intent to sell and the likelihood of being required to sell before recovery, must be recognized in current earnings. This could result in significant non-cash losses.

 

The Company is subject to interest rate risk.

 

The Company’s net interest income is the largest source of overall revenue to the Company, representing 61% of total revenue. Interest rates are beyond the Company’s control, and they fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the purchase of investments, the generation of deposits, and the rates received on loans and investment securities and paid on deposits. Management believes it has implemented effective

asset and liability management strategies to reduce the potential effects of changes in interest rates on the Company’s results of operations. However, any substantial, prolonged change in market interest rates could have a material adverse effect on the Company’s financial condition and results of operations.

 

Future loan losses could increase.

 

The Company maintains an allowance for loan losses that represents management’s best estimate of probable losses that have been incurred at the balance sheet date within the existing portfolio of loans. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. In recent years the Company has seen significant increases in losses in its loan portfolio, particularly in residential construction, consumer, and credit card loans, due to the deterioration in the housing industry and general economic conditions. Until the housing sector and overall economy begin to recover, it is likely that these losses will continue. While the Company’s credit loss ratios remain below industry averages, continued economic deterioration and further loan losses may negatively affect its results of operations and could further increase levels of its allowance. In addition, the Company’s allowance level is subject to review by regulatory agencies, and that review could result in adjustments to the allowance. See the section captioned “Allowance for Loan Losses” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this report for further discussion related to the Company’s process for determining the appropriate level of the allowance for possible loan loss.

 

The Company operates in a highly competitive industry and market area.

 

The Company operates in the financial services industry, a rapidly changing environment having numerous competitors including other banks and insurance companies, securities dealers, brokers, trust and investment companies and mortgage bankers. The pace of consolidation among financial service providers is accelerating, and there are many new changes in technology, product offerings and regulation. New entrants offering competitive products continually penetrate our markets. The Company must continue to make investments in its products and delivery systems to stay competitive with the industry as a whole, or its financial performance may suffer.

 

The Company’s reputation and future growth prospects could be impaired if events occur which breach its customers’ privacy.

 

The Company relies heavily on communications and information systems to conduct its business, and as part of its business, the Company maintains significant amounts of data about its customers and the products they use. While the Company has policies and procedures designed to prevent or limit the effect of failure, interruption or security breach of its information systems, there can be no assurances that any such failures, interruptions or security breaches will not occur; or if they do occur, that they will be adequately addressed. Should any of these systems become compromised, the reputation of the Company could be damaged, relationships with existing customers may be impaired, the compromise could result in lost business and as a result, the Company could incur significant expenses trying to remedy the compromise.

 

The Company may not attract and retain skilled employees.

 

The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people can be intense, and the Company spends considerable time and resources attracting and hiring qualified people for its various business lines and support units. The unexpected loss of the services of one or more of the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, and years of industry experience, as well as the difficulty of promptly finding qualified replacement personnel.

 

 

None

 

The main offices of the Bank are located in the larger metropolitan areas of its markets in various multi-story office buildings. The Bank owns its main offices and leases unoccupied premises to the public. The larger offices include:

 

 

The Bank leases offices in Omaha, Nebraska which house its credit card operations. Additionally, certain other installment loan, trust and safe deposit functions operate out of leased offices in downtown Kansas City. The Company has an additional 203 branch locations in Missouri, Illinois, Kansas, Oklahoma and Colorado which are owned or leased, and 158 off-site ATM locations.

 

 

The information required by this item is set forth in Item 8 under Note 19, Commitments, Contingencies and Guarantees on page 116.

 

 

Executive Officers of the Registrant

 

The following are the executive officers of the Company as of February 25, 2011, each of whom is designated annually. There are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was designated an executive officer.

 

 

 

Commerce Bancshares, Inc.

Common Stock Data

 

The following table sets forth the high and low prices of actual transactions for the Company’s common stock and cash dividends paid for the periods indicated (restated for the 5% stock dividend distributed in December 2010).

 

 

Commerce Bancshares, Inc. common shares are listed on the Nasdaq Global Select Market (NASDAQ) under the symbol CBSH. The Company had 4,284 shareholders of record as of December 31, 2010.

Performance Graph

 

The following graph presents a comparison of Company (CBSH) performance to the indices named below. It assumes $100 invested on December 31, 2005 with dividends invested on a Total Return basis.

 

 

The following table sets forth information about the Company’s purchases of its $5 par value common stock, its only class of stock registered pursuant to Section 12 of the Exchange Act, during the fourth quarter of 2010.

 

 

The Company’s stock purchases shown above were made under a 3,000,000 share authorization by the Board of Directors on February 1, 2008. Under this authorization, 1,758,578 shares remained available for purchase at December 31, 2010.

 

The required information is set forth below in Item 7.

 

 

Overview

 

Commerce Bancshares, Inc. (the Company) operates as a super-community bank offering an array of sophisticated financial products delivered with high-quality, personal customer service. It is the largest bank holding company headquartered in Missouri, with its principal offices in Kansas City and St. Louis, Missouri. Customers are served from approximately 370 locations in Missouri, Kansas, Illinois, Oklahoma and Colorado using delivery platforms which include an extensive network of branches and ATM machines, full-featured online banking, and a central contact center.

 

The core of the Company’s competitive advantage is its focus on the local markets it services and its concentration on relationship banking, with high service levels and competitive products. In order to enhance shareholder value, the Company grows its core revenue by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction.

 

Various indicators are used by management in evaluating the Company’s financial condition and operating performance. Among these indicators are the following:

 

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. The historical trends reflected in the financial information presented below are not necessarily reflective of anticipated future results.

 

Key Ratios

 

 

Selected Financial Data

 

 

Results of Operations

 

 

Net income for 2010 was $221.7 million, an increase of $52.6 million, or 31.1%, compared to $169.1 million in 2009. Diluted income per share was $2.52 in 2010 compared to $1.97 in 2009. The increase in net income resulted from a $60.7 million decrease in the provision for loan losses coupled with growth of $10.4 million in net interest income and $8.9 million in non-interest income. The growth in income was partly offset by an increase of $9.4 million in non-interest expense. Several significant items of non-interest income and non-interest expense affected results for 2010. During 2010, the Company paid off $125.0 million in Federal Home Loan Bank (FHLB) borrowings with high interest coupons prior to maturity and incurred a pre-payment penalty of $11.8 million. The Company also sold its held to maturity portfolio of student loans, totaling $311.0 million, for a gain of $6.9 million. During 2010, Visa, Inc. (Visa) indemnification obligation liabilities were reduced by $4.4 million, decreasing expense. The combined effect of these items was a reduction in pre-tax net income of $465 thousand. The return on average assets was 1.22% in 2010 compared to .96% in 2009, and the return on average equity was 11.15% compared to 9.76%. At December 31, 2010, the ratio of tangible equity to assets improved to 10.27% compared to 9.71% at year end 2009.

 

During 2010, net interest income increased $10.4 million, or 1.6%, compared to 2009. This growth was mainly the result of lower rates paid on deposits and higher average balances in investment securities, but partly offset by lower yields on loans and investment securities and declining loan balances. The provision for loan losses totaled $100.0 million in 2010, a decrease of $60.7 million from the prior year. The Company incurred lower loan losses in nearly all categories, notably construction, consumer and business.

 

Non-interest income in 2010 increased $8.9 million, or 2.2%, over amounts reported in the previous year, mainly due to growth in bank card and trust fees, which rose $26.8 million and $4.1 million, respectively. Bank card fees increased due to strong growth in corporate card revenues, resulting from both new customer transactions and increased volumes from existing customers as the Company continued to expand this product on a national basis. Offsetting this growth was a decline in deposit account fees of $13.7 million, or 12.9%, due largely to the effect of new regulations on overdraft fees, in addition to lower brokerage and bond trading revenue. Non-interest expense increased $9.4 million, or 1.5%, over 2009. The growth in expense included a pre-payment penalty to the FHLB of $11.8 million, partly offset by an $8.2 million reduction in FDIC insurance expense. Reductions in a Visa indemnification obligation, discussed further in Note 19 to the consolidated financial statements, were recorded in both 2010 and 2009. Income tax expense amounted to $96.2 million in 2010 and $73.8 million in 2009. The effective tax rate was 30.3% in 2010 compared to 30.4% in the previous year.

 

Net income for 2009 was $169.1 million, a decline of $19.6 million, or 10.4%, compared to $188.7 million in 2008. The decline in net income resulted from a $51.8 million increase in the provision for loan losses and a $37.5 million decrease in investment securities gains, but was partly offset by increases of $42.8 million in net interest income and $20.5 million in non-interest income. Diluted income per share was $1.97 in 2009 compared to $2.24 in 2008. Several significant items of non-interest income and non-interest expense affected results for 2009 and 2008. During 2009, FDIC insurance expense rose to $27.4 million compared to $2.1 million in 2008. Results for 2008 included a $22.2 million gain on the redemption of Visa stock, a loss

of $33.3 million relating to purchases of auction rate securities, and a $6.9 million gain on a bank branch sale. Reductions in the Visa indemnification obligation were $2.5 million in 2009 compared to $9.6 million in 2008. The return on average assets was .96% in 2009 compared to 1.15% in 2008, and the return on average equity was 9.76% compared to 11.81%. At December 31, 2009, the ratio of tangible equity to assets improved to 9.71% compared to 8.25% at year end 2008.

 

During 2009, net interest income increased $42.8 million, or 7.2%, compared to 2008. Similarly to the trend in 2010, growth in 2009 was largely due to lower rates paid on deposits and borrowings coupled with a higher average balance in investment securities, but partly offset by lower yields on loans and investment securities and lower loan balances. The provision for loan losses totaled $160.7 million in 2009, an increase of $51.8 million over the prior year and indicative of the general economic decline. The Company incurred higher net loan charge-offs in all loan categories, with the largest increases in construction, consumer, consumer credit card, and business loans.

 

Non-interest income in 2009 increased $20.5 million, or 5.5%, over amounts reported in 2008, mainly due to growth in bank card and student lending fees, which rose $8.3 million and $20.8 million, respectively. Student lending (included in loan fees and sales) included higher gains on loan sales and the reversal of certain impairment charges which had been recorded in 2008. Non-interest expense increased $6.4 million, or 1.0%, over 2008. This expense growth included increases of $25.3 million in FDIC insurance expense and $12.2 million in salaries and employee benefits expense, in addition to a $7.1 million decline in reductions to the Visa indemnification obligation. These increases in expense were largely offset by the 2008 loss of $33.3 million on the purchase of auction rate securities, discussed further in the Non-Interest Expense section. Income tax expense declined 13.3% in 2009 and resulted in an effective tax rate of 30.4%, which was slightly lower than the effective tax rate of 31.1% in the previous year. The decrease in income tax expense in 2009 compared to 2008 was mainly due to changes in the mix of taxable and non-taxable income on lower pre-tax income.

 

The Company continually evaluates the profitability of its network of bank branches throughout its markets. As a result of this evaluation process, the Company may periodically sell the assets and liabilities of certain branches, or may sell the premises of specific banking facilities. In February 2009, the Company sold its branch in Lakin, Kansas. In this transaction, the Company sold the bank facility and certain deposits totaling approximately $4.7 million and recorded a gain of $644 thousand. During the second quarter of 2008, the Company sold its banking branch, including the facility, in Independence, Kansas. In this transaction, approximately $23.3 million in loans, $85.0 million in deposits, and various other assets and liabilities were sold. A gain of $6.9 million was recorded.

 

The Company distributed a 5% stock dividend for the seventeenth consecutive year on December 20, 2010. All per share and average share data in this report has been restated to reflect the 2010 stock dividend.

 

Critical Accounting Policies

 

The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 to the consolidated financial statements. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s reported results and financial position for the current period or future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Current economic conditions may require the use of additional estimates, and some estimates may be subject to a greater degree of uncertainty due to the current instability of the economy. The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses, the valuation of certain investment securities, and accounting for income taxes.

Allowance for Loan Losses

 

The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, lease, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal loans, including personal mortgage, credit card and consumer loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Further discussion of the methodology used in establishing the allowance is provided in the Allowance for Loan Losses section of this discussion and in Note 1.

 

Valuation of Investment Securities

 

The Company carries its investment securities at fair value and employs valuation techniques which utilize observable inputs when those inputs are available. These observable inputs reflect assumptions market participants would use in pricing the security and are developed based on market data obtained from sources independent of the Company. When such information is not available, the Company employs valuation techniques which utilize unobservable inputs, or those which reflect the Company’s own assumptions about market participants, based on the best information available in the circumstances. These valuation methods typically involve cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, estimates, or other inputs to the valuation techniques could have a material impact on the Company’s future financial condition and results of operations. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Under the fair value measurement hierarchy, fair value measurements are classified as Level 1 (quoted prices), Level 2 (based on observable inputs) or Level 3 (based on unobservable, internally-derived inputs), as discussed in more detail in Note 16 on Fair Value Measurements. Most of the available for sale investment portfolio is priced utilizing industry-standard models that consider various assumptions observable in the marketplace, or can be derived from observable data. Such securities totaled approximately $6.7 billion, or 91.5% of the available for sale portfolio at December 31, 2010, and were classified as Level 2 measurements. The Company also holds $150.1 million in auction rate securities. These were classified as Level 3 measurements, as no market currently exists for these securities, and fair values were derived from internally generated cash flow valuation models which used unobservable inputs significant to the overall measurement.

 

Changes in the fair value of available for sale securities, excluding credit losses relating to other-than-temporary impairment, are reported in other comprehensive income. The Company periodically evaluates the available for sale portfolio for other-than-temporary impairment. Evaluation for other-than-temporary impairment is based on the Company’s intent to sell the security and whether it is likely that it will be required to sell the security before the anticipated recovery of its amortized cost basis. If either of these conditions is met, the entire loss (the amount by which the amortized cost exceeds the fair value) must be recognized in current earnings. If neither condition is met, but the Company does not expect to recover the amortized cost basis, the Company must determine whether a credit loss has occurred. This credit loss is the amount by which the amortized cost basis exceeds the present value of cash flows expected to be collected from the security. The credit loss, if any, must be recognized in current earnings, while the remainder of the loss, related to all other factors, is recognized in other comprehensive income.

 

The estimation of whether a credit loss exists and the period over which the security is expected to recover requires significant judgment. The Company must consider available information about the collectability of the security, including information about past events, current conditions, and reasonable forecasts, which includes payment structure, prepayment speeds, expected defaults, and collateral values. Changes in these factors could result in additional impairment, recorded in current earnings, in future periods.

 

At December 31, 2010, non-agency guaranteed mortgage-backed securities with a par value of $184.3 million were identified as other-than-temporarily impaired. The credit-related impairment loss on

these securities amounted to $7.5 million, which was recorded in the consolidated income statement in investment securities gains (losses), net. The noncredit-related loss on these securities, which was recorded in other comprehensive income, was $12.2 million on a pre-tax basis.

 

The Company, through its direct holdings and its Small Business Investment subsidiaries, has numerous private equity investments, categorized as non-marketable securities in the accompanying consolidated balance sheets. These investments are reported at fair value, and totaled $58.2 million at December 31, 2010. Changes in fair value are reflected in current earnings and reported in investment securities gains (losses), net in the consolidated income statements. Because there is no observable market data for these securities, their fair values are internally developed using available information and management’s judgment and are classified as Level 3 measurements. Although management believes its estimates of fair value reasonably reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments.

 

Accounting for Income Taxes

 

Accrued income taxes represent the net amount of current income taxes which are expected to be paid attributable to operations as of the balance sheet date. Deferred income taxes represent the expected future tax consequences of events that have been recognized in the financial statements or income tax returns. Current and deferred income taxes are reported as either a component of other assets or other liabilities in the consolidated balance sheets, depending on whether the balances are assets or liabilities. Judgment is required in applying generally accepted accounting principles in accounting for income taxes. The Company regularly monitors taxing authorities for changes in laws and regulations and their interpretations by the judicial systems. The aforementioned changes, and changes that may result from the resolution of income tax examinations by federal and state taxing authorities, may impact the estimate of accrued income taxes and could materially impact the Company’s financial position and results of operations.

Net Interest Income

 

Net interest income, the largest source of revenue, results from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.

 

 

Net interest income totaled $645.9 million in 2010, representing an increase of $10.4 million, or 1.6%, compared to $635.5 million in 2009. On a tax equivalent basis, net interest income totaled $666.1 million and increased $11.9 million, or 1.8%, over the previous year. This increase was mainly the result of lower average deposit and borrowing balances and lower rates paid on these liabilities, which were partly offset by lower average loan balances and yields, coupled with lower rates earned on the investment securities portfolio. The net yield on earning assets (tax equivalent) was 3.89% in 2010 compared with 3.93% in the previous year.

 

During 2010, interest income on loans (tax equivalent) declined $48.0 million from 2009 due to lower average balances on most loan categories, coupled with lower rates earned on personal real estate and other personal banking loan products. The average rate earned on the loan portfolio was 5.28% compared to 5.27% in the previous year. Rates on consumer credit cards were impacted by new regulations on interest and service charges, while lower rates on personal real estate loans reflected the overall lower rate environment in the industry this year. Rates increased on business and construction loans, reflecting some increase in risk based pricing obtained earlier in the year. Total average loan balances decreased $931.2 million, or 8.8%, reflecting declines of $346.8 million in business and business real estate loans, $182.6 million in construction loans, $109.2 million in personal real estate and $214.1 million in consumer loans. The decrease in business,

business real estate and personal real estate loans was the result of loan principal pay downs and lower line of credit utilization, which exceeded new loan originations due to lower loan demands. The decline in construction loans was mainly due to the weak housing economy and the Company’s efforts to reduce this portfolio. The decrease in average consumer loans was reflective of lower customer demand for automobile financing, coupled with the fact that the Company ceased most marine and recreational vehicle lending in 2008, while pay downs on the existing balances continued. In October 2010, the Company sold its entire held to maturity student loan portfolio, which totaled approximately $311.0 million, to another loan servicer. Total average loans held for sale, which are mainly federally guaranteed student loans, declined $39.1 million. In the second half of 2010, the Company sold most of these loans, and new regulations prohibit the Company from originating new federally guaranteed student loans in the future. Tax equivalent interest earned on investment securities decreased by $10.3 million, or 4.3%, due to lower rates earned, partly offset by higher average balances of securities. The average rate earned on the investment securities portfolio declined from 4.54% in 2009 to 3.40% in 2010, resulting in a decline in interest income of approximately $61.4 million due to lower rates. Average balances of mortgage and other asset-backed securities increased $1.1 billion, or 28.2%, while the average rate earned decreased 130 basis points to 3.17%. Average balances of U.S. government and federal agency securities increased $269.9 million during the year, while average rates earned decreased 179 basis points to 2.20%. Average state and municipal obligations balances increased $93.1 million, while average rates earned decreased 32 basis points to 4.70%. During the second half of 2010, in order to diversify its investment portfolio, the Company purchased long-term resell agreements. The average balance of these long-term resell agreements in 2010 was $150.2 million, and earned interest at an average rate of 1.70%. Most of the purchases were made in the later half of the year, and the year end balance grew to $450.0 million. Average rates (tax equivalent) earned on total interest earning assets in 2010 decreased to 4.38% compared to 4.85% in the previous year, or a decline of 47 basis points.

 

During 2010, interest expense on deposits decreased $52.8 million, or 44.4%, compared to 2009. This was mainly the result of lower rates on all deposit products coupled with a $930.1 million decline in average certificate of deposit balances, but partly offset by the effects of higher average balances of money market and interest checking accounts, which grew by $1.4 billion. Average rates paid on deposit balances declined 43 basis points in 2010 to .49%. Interest expense on borrowings declined $17.7 million, mainly the result of lower rates paid on total debt and lower average balances outstanding of FHLB borrowings. The average balance of FHLB borrowings decreased $383.7 million, partly due to scheduled maturities of advances and partly due to the early pay off of $125.0 million in advances prior to maturity. The average rate paid on total interest bearing liabilities decreased to .56% compared to 1.04% in 2009.

 

During 2009, interest income on loans (tax equivalent) declined $98.1 million from 2008 due to lower rates earned on most lending products coupled with lower loan balances, especially in business, business real estate and consumer loans. The average rate earned on the loan portfolio decreased 75 basis points to 5.27% compared to 6.02% in the previous year. Average loan balances decreased $306.0 million, or 2.8%, reflecting lower line of credit usage, lower demand and pay downs. Tax equivalent interest earned on investment securities increased by $54.7 million, or 29.8%, due to higher average balances of securities, partially offset by a decrease in rates earned on these investments. Average balances of mortgage and asset-backed securities increased 51.4% to $3.7 billion, and state and municipal obligations increased 25.6%. Additionally, average balances of U.S. government and federal agency securities increased 67.8% during the year to $307.1 million, primarily a result of purchases of U.S. Treasury inflation-protected securities during the last six months of 2009. Interest earned on federal funds sold and resell agreement assets declined $8.1 million, mainly due to a $381.5 million decrease in average balances coupled with much lower overnight rates. Average rates (tax equivalent) earned on interest earning assets in 2009 decreased to 4.85% compared to 5.63% in the previous year, or a decline of 78 basis points.

 

Interest expense on deposits decreased $75.3 million in 2009 compared to 2008. The decline resulted from much lower rates paid on all deposit products, but was partly offset by the effects of higher average balances of money market accounts and certificates of deposit of $100,000 and over. Average rates paid on deposit balances declined 76 basis points from 1.68% in 2008 to .92% in 2009. Interest expense on borrowings declined $27.8 million, or 44.1%, as a result of lower rates paid and lower average balances of federal funds

purchased and repurchase agreement borrowings. The average rate paid on interest bearing liabilities decreased to 1.04% compared to 1.83% in 2008.

 

Provision for Loan Losses

 

The provision for loan losses totaled $100.0 million in 2010, which represented a decrease of $60.7 million from the 2009 provision of $160.7 million. Net loan charge-offs for the year totaled $96.9 million compared with $138.8 million in 2009, or a decrease of $41.9 million. The decrease in net loan charge-offs from the previous year was mainly the result of lower construction, consumer and business losses, which declined $19.1 million, $11.7 million, and $8.3 million, respectively. The allowance for loan losses totaled $197.5 million at December 31, 2010, an increase of $3.1 million over the prior year, and represented 2.10% of outstanding loans. The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed adequate by management based on the factors mentioned in the following “Allowance for Loan Losses” section of this discussion.

 

Non-Interest Income

 

 

 

Non-interest income totaled $405.1 million, an increase of $8.9 million, or 2.2%, compared to $396.3 million in 2009. Bank card fees increased $26.8 million, or 21.9%, due to growth of 50.2%, 13.2%, and 15.6% in corporate card, debit card and merchant transactions, respectively. During 2010, debit card fees totaled $57.0 million and comprised 38.3% of total bank card fees, while corporate card fees totaled $48.3 million and comprised 32.4% of total fees. Trust fee income increased $4.1 million, or 5.4%, as a result of growth in personal and institutional trust fees, partly offset by lower corporate fees. While most of the growth in trust fees came from private client business, fees from institutional trust services also grew $1.5 million, or 10.2%, in 2010. Because of the low interest rate environment this year, the Company waived trust fees on certain short-term client assets in money market investments. It is estimated that these waived fees amounted to approximately $6 million. The market value of total customer trust assets (on which fees are charged) totaled $25.1 billion at year end 2010, and grew 13.5% over year end 2009. Deposit account fees declined $13.7 million, or 12.9%, from the prior year as a result of a $13.6 million decline in overdraft fee revenue. Overdraft fees comprised 55.2% of total deposit account fee income in 2010, down from 60.9% in 2009. The lower overdraft fees resulted from the Company’s implementation on July 1, 2010 of new overdraft regulations on debit card transactions. Also, corporate cash management fees, which comprised 35.7% of total deposit account fees in 2010, declined 1.9% this year on lower sales/activity. Bond trading income declined $1.3 million, or 5.9%, due to lower sales of fixed income securities to correspondent banks and corporate customers, while consumer brokerage services revenue declined $1.6 million, or 15.2%, mainly due to lower fees earned on mutual fund sales. Loan fees and sales increased by $1.8 million over 2009. This increase included a $6.9 million gain recorded on the sale of the Company’s held to maturity portfolio of student loans in late 2010, partly offset by a $5.3 million decline in gains on sales of loans held for sale and adjustments to related impairment reserves. Other non-interest income decreased by $7.2 million partly due to impairment charges of $2.0 million on certain bank premises, coupled

with other fixed asset retirements. Also included were declines in cash sweep commissions and equipment rental income, partially offset by higher fees on letters of credit and foreign exchange transactions.

 

During 2009, non-interest income increased $20.5 million, or 5.5%, over 2008 to $396.3 million. Deposit account fees declined $4.0 million, or 3.6%, as a result of lower overdraft fee revenue, which fell $6.8 million, or 9.5%. Partly offsetting this decline was an increase in cash management fees, which grew $3.2 million, or 10.6%, over the prior year. Bank card fee income rose $8.3 million, or 7.3% overall, due to growth in transaction fees earned on corporate card, debit card and merchant transactions, which increased 24.1%, 4.6% and 3.4%, respectively, but was negatively impacted by lower retail sales affecting credit card fees. Trust fees decreased $3.5 million, or 4.3%, mainly in institutional and corporate fees and reflected the impact that lower markets had on trust asset values during 2009, as well as the effects of low interest rates on money market assets held in trust accounts. The market value of total customer trust assets totaled $22.1 billion at year end 2009 and grew 14.0% over year end 2008. Bond trading income rose $6.8 million due to higher sales volume, while consumer brokerage services revenue declined $1.3 million due to lower fees earned on sales of annuity and mutual fund products. Loan fees and sales increased by $23.7 million, as gains on student loan sales increased $20.8 million. The 2009 gains included the reversal of impairment reserves of $8.6 million on certain held for sale student loans, through sales of the related loans and recoveries in the fair value of most of the remaining outstanding loans. The impairment had originally been established in 2008 due to liquidity concerns, which at year end 2009 were largely alleviated. In addition, mortgage banking revenue and loan commitment fees both increased over 2008. The decrease in other non-interest income of $9.4 million from 2008 was mainly due to a gain of $6.9 million recorded in the second quarter of 2008 on the sale of a banking branch in Independence, Kansas. Other declines were reported in cash sweep commissions, equipment rental income and fees on interest rate swap sales. Partly offsetting these declines was an impairment charge of $1.1 million recorded in 2008 on a Kansas City office building.

 

Investment Securities Gains (Losses), Net

 

Net gains and losses on investment securities during 2010, 2009 and 2008 are shown in the table below. Included in these amounts are gains and losses arising from sales of bonds from the Company’s available for sale portfolio, including credit-related losses on debt securities identified as other-than-temporarily impaired. Also included are gains and losses on sales of publicly traded common stock held by the holding company, Commerce Bancshares, Inc. (the Parent). Gains and losses relating to non-marketable private equity investments, which are primarily held by the Parent’s majority-owned venture capital subsidiaries, are also shown below. These include fair value adjustments, in addition to gains and losses realized upon disposition. Portions of the fair value adjustments attributable to minority interests are reported as non-controlling interest in the consolidated income statement and resulted in income of $108 thousand and $1.1 million in 2010 and 2009, respectively, and expense of $299 thousand in 2008.

 

Net securities losses of $1.8 million were recorded in 2010. Included in these losses are credit-related impairment losses of $5.1 million on certain non-agency guaranteed mortgage-backed securities which have been identified as other-than-temporarily impaired. These securities had a par value of $184.3 million at December 31, 2010. The cumulative credit-related impairment loss on these securities, recorded in earnings, amounted to $7.5 million, while the cumulative noncredit-related loss on these securities, which has been recorded in other comprehensive income (loss), was $12.2 million. Offsetting these losses were net gains of $3.5 million recorded on sales of investment securities (mainly mortgage-backed and municipals) from the bank portfolio.

Net securities losses of $7.2 million were recorded in 2009, compared to net gains of $30.3 million in 2008. Most of the loss recorded in 2009 resulted from a $5.0 million net decline in fair value of various private equity securities. In addition, credit-related other-than-temporary impairment (OTTI) losses of $2.5 million were recorded on the non-agency mortgage-backed securities mentioned above. The net gain in 2008 included a $22.2 million gain resulting from the redemption of Visa Class B stock in conjunction with an initial public offering by Visa. In addition, during 2008 certain auction rate securities were sold in exchange for student loans, resulting in a gain of $7.9 million.

 

 

Non-Interest Expense

 

 

Non-interest expense was $631.1 million in 2010, an increase of $9.4 million, or 1.5%, over the previous year. Non-interest expense included a debt pre-payment penalty of $11.8 million in 2010, in addition to reductions in a Visa indemnification obligation of $4.4 million and $2.5 million in 2010 and 2009, respectively. Excluding these items, non-interest expense would have amounted to $623.8 million in 2010, a decrease of $478 thousand from the prior year. Salaries and benefits grew by $771 thousand, or .2%, mainly as a result of higher costs for incentives and 401K plan contributions, but lower costs for base salaries, pension and

medical plans. Total salaries expense was up $2.4 million, or .8%, and full-time equivalent employees totaled 4,979 and 5,125 at December 31, 2010 and 2009, respectively, a decline of 2.8%. Occupancy costs increased $1.1 million, or 2.3%, primarily resulting from higher real estate taxes and utilities expense. Equipment costs decreased $2.1 million mainly due to lower depreciation on data processing equipment. Supplies and communication expense declined $5.0 million, or 15.7%, which reflected certain initiatives to reduce paper supplies, customer checks and courier costs. Data processing and software costs grew $6.1 million, primarily due to higher bank card processing costs, which have increased in proportion to the growth in bank card revenues. Deposit insurance decreased $8.1 million mainly due to a special assessment levied by the FDIC in 2009 which did not reoccur in 2010. Other non-interest expense increased $6.9 million and included foreclosed property expense of $6.3 million, which increased due to higher write-downs to fair value and additional holding costs, in conjunction with higher levels of such assets held by the Company. Also included were higher costs for professional services, partially offset by lower operating losses.

 

In 2009, non-interest expense was $621.7 million, an increase of $6.4 million, or 1.0%, over the previous year. FDIC insurance expense, including normal deposit premiums and special assessments, increased $25.3 million compared to 2008, as the FDIC began a program to replenish its insurance fund. During 2009, salaries and benefits expense increased by $12.2 million, or 3.6%, over 2008 due to merit increases and higher pension and medical costs. Occupancy expense decreased slightly, while equipment expense increased $903 thousand, or 3.7%, mainly due to higher data processing equipment depreciation expense. Supplies and communication expense decreased $3.2 million, or 9.0%, as a result of lower supplies and courier expense. Data processing and software costs grew by $5.4 million, or 9.6%. Core data processing expense increased $3.5 million due to several new software and servicing systems, in addition to higher bank card processing costs. Marketing expense decreased $1.8 million, or 8.8%. Other non-interest expense decreased $6.0 million, or 8.1%, partly due to declines in travel and entertainment expense and impairment charges on foreclosed property. Other decreases occurred in leased asset depreciation, professional fees and recruiting expense, which were partly offset by a decline in loan origination cost deferrals. Total non-interest expense in 2008 included a $33.3 million non-cash loss related to the purchase of auction rate securities from customers, which represented the amount by which the purchase price (at par) exceeded estimated fair value on the purchase date.

 

Income Taxes

 

Income tax expense was $96.2 million in 2010, compared to $73.8 million in 2009 and $85.1 million in 2008. Income tax expense in 2010 increased 30.5% over 2009, compared to a 31.4% increase in pre-tax income. The effective tax rate, including the effect of non-controlling interest, was 30.3%, 30.4% and 31.1% in 2010, 2009 and 2008, respectively. The Company’s effective tax rates in those years were lower than the federal statutory rate of 35% mainly due to tax-exempt interest on state and local municipal obligations.

Financial Condition

 

Loan Portfolio Analysis

 

Classifications of consolidated loans by major category at December 31 for each of the past five years are shown in the table below. This portfolio consists of loans which were acquired or originated with the intent of holding to their maturity. Loans held for sale are separately discussed in a following section. A schedule of average balances invested in each loan category below appears on page 60.

 

 

In December 2008, the Company elected to reclassify certain segments of its real estate, business, and consumer portfolios. The reclassifications were made to better align the loan reporting with its related collateral and purpose. Amounts reclassified to real estate construction and land pertained mainly to commercial or residential land and lots which were held by borrowers for future development. Amounts reclassified to personal real estate related mainly to one to four family rental property secured by residential mortgages. The table below shows the effect of the reclassifications on the various lending categories as of the transfer date. Because the information was not readily available and it was impracticable to do so, periods prior to 2008 were not restated.

 

The contractual maturities of loan categories at December 31, 2010, and a breakdown of those loans between fixed rate and floating rate loans are as follows:

 

 

 

Total loans at December 31, 2010 were $9.4 billion, a decrease of $734.3 million, or 7.2%, from balances at December 31, 2009. The decline in loans during 2010 occurred principally in construction, consumer and student loans. Business loans increased $79.1 million, or 2.7%, reflecting growth in commercial and tax free loans, while lease balances, which are also included in the business category, decreased $37.9 million, or 13.5%, compared with the previous year end balance, as demand for equipment financing weakened. Business real estate loans were lower by $38.2 million, or 1.8%, and construction loans decreased $204.3 million, or 30.7%. The decline in construction loans reflected continued uncertain economic conditions in the real estate markets and lower overall demand. Personal real estate loans and consumer loans declined $97.3 million and $169.4 million, respectively, as loan pay downs exceeded new loan originations. Consumer loans declined primarily because the Company ceased most marine and recreational vehicle lending from that portfolio several years ago. Revolving home equity loans decreased $12.0 million due to fewer new account activations. Consumer credit card loans increased by $31.5 million, or 3.9%. The student loan portfolio, which was originally acquired in 2008, was sold in October 2010 as discussed below.

 

Period end loans decreased $1.1 billion, or 10.8%, in 2009 compared to 2008, resulting from decreases in business, construction, personal real estate and consumer loans.

 

The Company currently generates approximately 31% of its loan portfolio in the St. Louis market, 29% in the Kansas City market, and 40% in various other regional markets. The portfolio is diversified from a business and retail standpoint, with 58% in loans to businesses and 42% in loans to consumers. A balanced approach to loan portfolio management and an historical aversion toward credit concentrations, from an industry, geographic and product perspective, have contributed to low levels of problem loans and loan losses.

 

Commercial Loans

 

Business

 

Total business loans amounted to $3.0 billion at December 31, 2010 and include loans used mainly to fund customer accounts receivable, inventories, and capital expenditures. This portfolio also includes direct financing and sales type leases totaling $243.5 million, which are used by commercial customers to finance capital purchases ranging from computer equipment to office and transportation equipment. These leases comprise 2.6% of the Company’s total loan portfolio. Also included in this portfolio are corporate card loans,

which totaled $175.9 million at December 31, 2010. These loans, which grew by 13.9% in 2010, are made in conjunction with the Company’s corporate card business, which assists the increasing number of businesses that are shifting from paper checks to a credit card payment system in order to automate payment processes. These loans are generally short-term, with outstanding balances averaging between 7 to 13 days in duration, which helps to limit risk in these loans.

 

Business loans are made primarily to customers in the regional trade area of the Company, generally the central Midwest, encompassing the states of Missouri, Kansas, Illinois, and nearby Midwestern markets, including Iowa, Oklahoma, Colorado and Ohio. The portfolio is diversified from an industry standpoint and includes businesses engaged in manufacturing, wholesaling, retailing, agribusiness, insurance, financial services, public utilities, and other service businesses. Emphasis is upon middle-market and community businesses with known local management and financial stability. The Company participates in credits of large, publicly traded companies when business operations are maintained in the local communities or regional markets and opportunities to provide other banking services are present. Consistent with management’s strategy and emphasis upon relationship banking, most borrowing customers also maintain deposit accounts and utilize other banking services. Net loan charge-offs in this category totaled $4.6 million in 2010 and $12.8 million in 2009. Non-accrual business loans were $8.9 million (.3% of business loans) at December 31, 2010 compared to $12.9 million at December 31, 2009. Included in these totals were non-accrual lease-related loans of $887 thousand and $3.3 million at December 31, 2010 and 2009, respectively. Growth opportunities in business loans will largely depend on the speed and sustainability of economic recovery. Such growth is dependent on market conditions which enable businesses to grow and invest in new capital, in addition to the Company’s own solicitation efforts in attracting new, high quality loans.

 

Real Estate-Construction and Land

 

The portfolio of loans in this category amounted to $460.9 million at December 31, 2010 and comprised 4.9% of the Company’s total loan portfolio. These loans are predominantly made to businesses in the local markets of the Company’s banking subsidiary. Commercial construction loans, comprising 33.0% of the portfolio at December 31, 2010, are made during the construction phase for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, apartment complexes, shopping centers, hotels and motels, and other commercial properties. Exposure to larger, speculative commercial properties remains low. Commercial land and land development loans relate to land owned or developed for use in conjunction with business properties. Residential construction and land development loans at December 31, 2010 totaled $193.5 million. The largest percentage of residential construction and land development loans are for projects located in the Kansas City and St. Louis metropolitan areas. Credit risk in this sector has risen over the last few years, especially in residential land development lending, as a result of the slowdown in the housing industry and worsening economic conditions. Over the last two years, net charge-offs on construction and land loans have remained at elevated levels. However, in 2010 net loan charge-offs decreased 56.0% to $15.0 million, compared to net charge-offs of $34.1 million in 2009. The net charge-offs in 2010 were mainly comprised of $11.2 million in charge-offs on loans to three specific borrowers, and the largest portion of total 2010 charge-offs occurred in the first quarter. Construction and land development loans on non-accrual status declined to $52.8 million at year end 2010 compared to $62.5 million at year end 2009, with approximately 40% of the non-accrual balance at year end 2010 comprised of loans to three individual borrowers. The Company’s watch list, which includes special mention and substandard categories, included $37.0 million of residential land and construction loans which are being closely monitored.

 

Real Estate-Business

 

Total business real estate loans were $2.1 billion at December 31, 2010 and comprised 22.0% of the Company’s total loan portfolio. This category includes mortgage loans for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, shopping centers, hotels and motels, and other commercial properties. Emphasis is placed on owner-occupied and income producing commercial real estate properties, which present lower risk levels. The borrowers and/or the properties are generally located in local and regional markets. Additional information about loans by type is presented on page 39. At December 31, 2010, non-accrual balances amounted to $16.2 million, or .8%, of the loans in this category, down from

$21.8 million at year end 2009. The Company experienced net charge-offs of $4.1 million in 2010, compared to net charge-offs of $5.2 million in 2009.

 

Personal Banking Loans

 

Real Estate-Personal

 

At December 31, 2010, there were $1.4 billion in outstanding personal real estate loans, which comprised 15.3% of the Company’s total loan portfolio. The mortgage loans in this category are mainly for owner-occupied residential properties. The Company originates both adjustable rate and fixed rate mortgage loans. The Company retains adjustable rate mortgage loans, and may from time to time retain certain fixed rate loans (typically 15 and 20-year fixed rate loans) as directed by its Asset/Liability Management Committee. Other fixed rate loans in the portfolio have resulted from previous bank acquisitions. The Company does not purchase these types of loans from outside parties or brokers, and has never maintained or promoted subprime or reduced document products. At December 31, 2010, 51% of the portfolio was comprised of adjustable rate loans while 49% was comprised of fixed rate loans. Levels of mortgage loan origination activity decreased slightly in 2010 compared to 2009, with originations of $197 million in 2010 compared with $199 million in 2009. Growth in mortgage loan originations continued to be constrained in 2010 as a result of the weakened economy, slower housing starts, demand for fixed rates, and lower re-sales within the Company’s markets. The Company has experienced lower loan losses in this category than many others in the industry, and believes this is partly because of its conservative underwriting culture and the fact that it does not offer subprime lending products or purchase loans from brokers. Net loan charge-offs for 2010 amounted to $2.1 million, compared to $2.8 million in the previous year. The non-accrual balances of loans in this category decreased to $7.3 million at December 31, 2010, compared to $9.4 million at year end 2009.

 

Consumer

 

Consumer loans consist of auto, marine, tractor/trailer, recreational vehicle (RV), fixed rate home equity, and other consumer installment loans. These loans totaled $1.2 billion at year end 2010. Approximately 66% of consumer loans outstanding were originated indirectly from auto and other dealers, while the remaining 34% were direct loans made to consumers. Approximately 28% of the consumer portfolio consists of automobile loans, 46% in marine and RV loans and 11% in fixed rate home equity lending. As mentioned above, total consumer loans declined $169.4 million in 2010 as a result of a decrease of $135.8 million in marine and RV loans, due to the Company’s decision in 2008 to cease most marine and RV lending. In addition, auto lending declined $40.8 million, or 11.0%. Net charge-offs on consumer loans were $20.5 million in 2010 compared to $32.2 million in 2009. Net charge-offs decreased to 1.6% of average consumer loans in 2010 compared to 2.2% in 2009. Consumer loan net charge-offs included marine and RV loan net charge-offs of $14.8 million, which were 2.5% of average marine and RV loans in 2010, compared to 3.0% in 2009.

 

Revolving Home Equity

 

Revolving home equity loans, of which 99% are adjustable rate loans, totaled $477.5 million at year end 2010. An additional $657.8 million was available in unused lines of credit, which can be drawn at the discretion of the borrower. Home equity loans are secured mainly by second mortgages (and less frequently, first mortgages) on residential property of the borrower. The underwriting terms for the home equity line product permit borrowing availability, in the aggregate, generally up to 80% or 90% of the appraised value of the collateral property at the time of origination.

 

Student

 

In December 2008, the Company acquired a portfolio of federally guaranteed student loans from a student loan agency. The loans were acquired in exchange for certain auction rate securities issued by that agency, which were purchased earlier in the year by the Bank from its customers. The loans, which had an average estimated life of approximately seven years at purchase date, were recorded at fair value, which resulted in a discount from their face value of approximately 2.5%. At the time of the purchase, the Company intended to hold the loans until their maturity. However, in October 2010, the agency, as allowed under the

original exchange contract, elected to repurchase the loans. The carrying amount of the loans sold totaled approximately $311.0 million, and the Company recorded a gain of $6.9 million.

 

Consumer Credit Card

 

Total consumer credit card loans amounted to $831.0 million at December 31, 2010 and comprised 8.8% of the Company’s total loan portfolio. The credit card portfolio is concentrated within regional markets served by the Company. The Company offers a variety of credit card products, including affinity cards, rewards cards, and standard and premium credit cards, and emphasizes its credit card relationship product, Special Connections. Approximately 63% of the households in Missouri that own a Commerce credit card product also maintain a deposit relationship with the subsidiary bank. At December 31, 2010, approximately 56% of the outstanding credit card loan balances had a floating interest rate, compared to 92% in the prior year. This decline is due to the provisions of the Card Act, which went into effect in 2009, under which certain credit card balances that previously had variable rates were changed to non-variable rates. Net charge-offs amounted to $47.7 million in 2010, compared to $49.3 million in 2009. The annual ratio of net credit card loan charge-offs to total average credit card loans totaled 6.3% in 2010 compared to 6.8% in 2009. These ratios, however, remain below national loss averages.

 

Loans Held for Sale

 

Total loans held for sale at December 31, 2010 were $63.8 million, a decrease of $281.3 million, from $345.0 million at year end 2009. Loans classified as held for sale consist of student loans and residential mortgage loans.

 

Most of the portfolio is comprised of originated loans to students attending colleges and universities. These loans are normally sold to the secondary market when the student graduates and the loan enters into repayment status. Nearly all of these loans are based on variable rates. The Company has historically sold these loans under agreements with the Department of Education and various student loan servicing agencies, including the Missouri Higher Education Loan Authority, the Student Loan Marketing Association and others. However, because of recent legislation which required the Company to terminate its guaranteed student loan origination business effectively July 1, 2010, student loan balances declined to $53.3 million at year end 2010, compared to $334.5 million at year end 2009.

 

The student loans outstanding at year end 2010 have associated purchase commitments from various student loan agencies. However, certain agencies have been unable to make purchases under contractual terms and uncertainties exist about their future ability. These loans are carried at fair value and totaled $12.1 million at December 31, 2010, including an associated impairment allowance of $569 thousand.

 

The remainder of the held for sale portfolio consists of fixed rate mortgage loans, which are sold in the secondary market, generally within three months of origination. The loans are sold primarily to other financial institutions and federal agencies under industry-standard contracts which require various representations by the Company as to ownership, tax status, document delivery, and compliance with selection criteria underwriting standards, and may obligate the Company to repurchase such loans if these representations cannot be satisfied. The Company did not receive any repurchase requests in 2010, and does not believe there are any significant risks or uncertainties associated with its sales. Mortgage loans held for sale totaled $10.4 million and $10.5 million at December 31, 2010 and 2009, respectively.

 

Allowance for Loan Losses

 

The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. This process provides an allowance consisting of a specific allowance component based on certain individually evaluated loans and a general component based on estimates of reserves needed for pools of loans.

 

Loans subject to individual evaluation generally consist of business, construction, commercial real estate and personal real estate loans on non-accrual status. These impaired loans are evaluated individually for the impairment of repayment potential and collateral adequacy, and in conjunction with current economic

conditions and loss experience, allowances are estimated. Loans which are not individually evaluated are segregated by loan type and sub-type, and are collectively evaluated. These include certain troubled debt restructurings, which are collectively evaluated because they have similar risk characteristics. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic factors, loan risk ratings and industry concentrations.

 

The Company’s estimate of the allowance for loan losses and the corresponding provision for loan losses rests upon various judgments and assumptions made by management. Factors that influence these judgments include past loan loss experience, current loan portfolio composition and characteristics, trends in portfolio risk ratings, levels of non-performing assets, and prevailing regional and national economic conditions. The Company has internal credit administration and loan review staffs that continuously review loan quality and report the results of their reviews and examinations to the Company’s senior management and Board of Directors. Such reviews also assist management in establishing the level of the allowance. The Company’s subsidiary bank continues to be subject to examination by the Office of the Comptroller of the Currency (OCC) and examinations are conducted throughout the year, targeting various segments of the loan portfolio for review. In addition to the examination of the subsidiary bank by the OCC, the parent holding company and its non-bank subsidiaries are examined by the Federal Reserve Bank. Refer to Note 1 to the consolidated financial statements for additional discussion on the allowance and charge-off policies.

 

At December 31, 2010, the allowance for loan losses was $197.5 million compared to a balance at year end 2009 of $194.5 million. Total loans delinquent 90 days or more and still accruing were $20.5 million at December 31, 2010, a decrease of $22.2 million compared to year end 2009. Approximately $13.8 million of this decrease was due to the sale of the held to maturity student loan portfolio in the fourth quarter of 2010. Non-accrual loans at December 31, 2010 were $85.3 million, a decrease of $21.3 million from the prior year, and were mainly comprised of construction and business real estate loans totaling $52.8 million and $16.2 million, respectively. The Company’s analysis of the allowance considered the impact of the economic downturn experienced in 2009 on the current portfolio, which resulted in a slight increase in the allowance balance during the first quarter of 2010. The percentage of allowance to loans increased to 2.10% at December 31, 2010 compared to 1.92% at year end 2009 as a result of the slight increase in the allowance balance, coupled with a decrease in period end loan balances of 7.2%.

 

Net loan charge-offs totaled $96.9 million in 2010, representing a $41.9 million decrease compared to net charge-offs of $138.8 million in 2009. Net charge-offs related to business loans were $4.6 million in 2010 compared to $12.8 million in 2009. Construction and land loans incurred net charge-offs of $15.0 million in 2010 compared to $34.1 million in 2009. Net charge-offs related to consumer loans decreased $11.7 million to $20.5 million at December 31, 2010, representing 21.1% of total net charge-offs during 2010. Additionally, net charge-offs related to consumer credit cards were $47.7 million in 2010 compared to $49.3 million in 2009. Approximately 49.2% of total net loan charge-offs during 2010 were related to consumer credit card loans compared to 35.5% during 2009. Net consumer credit card charge-offs decreased to 6.3% of average consumer credit card loans in 2010 compared to 6.8% in 2009.

 

The ratio of net charge-offs to total average loans outstanding in 2010 was 1.00% compared to 1.31% in 2009 and .64% in 2008. The provision for loan losses in 2010 was $100.0 million, compared to a provision of $160.7 million in 2009 and $108.9 million in 2008.

 

The Company considers the allowance for loan losses of $197.5 million adequate to cover losses inherent in the loan portfolio at December 31, 2010.

The schedules which follow summarize the relationship between loan balances and activity in the allowance for loan losses: