financial review

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following financial review presents an analysis of the asset and liability structure of Charter One Financial, Inc. and a discussion of the results of operations for each of the periods presented in the Annual Report. The data presented in the following pages should be read in conjunction with the audited Consolidated Financial Statements contained elsewhere in this Annual Report.

Holding Company Business

Headquartered in Cleveland, Ohio, Charter One Financial, Inc., hereafter referred to as “Charter One” or the “Company,” is a financial holding company. Charter One is a Delaware corporation and owns all of the outstanding capital stock of Charter Michigan Bancorp, Inc. and Charter One Commercial. Charter Michigan Bancorp, Inc. owns all of the outstanding capital stock of Charter One Bank, F.S.B., a federally chartered thrift. The primary business of Charter One is operating these financial institutions which we sometimes refer to in this document collectively as the “Bank.” The Bank’s primary business is providing consumer banking services to certain major markets in Ohio, Michigan, Illinois, New York, Vermont and in some markets of Massachusetts. At the end of 2001, the Bank and its subsidiaries were doing business through 456 full-service branches and 29 loan production offices.

  On January 7, 2002, Charter One Bank, F.S.B. filed an application with the Office of the Comptroller of the Currency to convert to a national bank. During the past five years, our business strategy has been to shift our product mix away from that of a traditional thrift into a product mix more closely associated with that of a regional bank. The conversion to a national bank charter is another natural step in completing that migration. We expect the conversion to be effective during the first quarter of 2002. Given the Bank’s capital levels and asset mix, management does not anticipate any significant financial or regulatory impact from the switch in regulators. See Note 5 to the Notes to Consolidated Financial Statements for information on our loan and lease portfolio and the changes in product mix during the past five years. See Note 7 to the Notes to Consolidated Financial Statements for information on our deposit products during the past three years.

Recent Acquisitions

On July 2, 2001, Charter One completed its acquisition of Alliance Bancorp, the holding company of Liberty Federal Bank in Hinsdale, Illinois. At June 30, 2001, Alliance had assets of $2.0 billion and deposits of $1.3 billion. Charter One issued 6.9 million shares in conjunction with the merger, and paid $50.2 million in cash consideration. The Company recorded $138.8 million of goodwill based on a determination of the estimated fair values of the assets and liabilities acquired as a result of this transaction. The merger was treated as a tax-free reorganization under Section 368 of the Internal Revenue Code and accounted for as a purchase.

  As of the close of business on November 19, 2001, the Bank completed its acquisition of the branches and retail deposits of Superior Federal Bank, F.S.B. Illinois-based Superior Federal Bank, F.S.B. was the conservatorship established by the Federal Deposit Insurance Corporation (“FDIC”) after Superior Bank, F.S.B. was closed on July 27, 2001. Superior Federal had 17 branches and $1.0 billion in deposits. In its agreement with the FDIC, the Bank paid $52.5 million in cash for the franchise. In addition to assuming all the deposits, the Bank acquired $40.9 million of Superior’s assets. These assets consisted mainly of home equity lines of credit and cash and cash equivalents. The Company recorded $56.0 million of goodwill based on a determination of the estimated fair values of the assets and liabilities acquired as a result of this transaction.

  On January 11, 2002, the Boards of Directors of the Company and Charter National Bancorp, Inc. announced a definitive agreement pursuant to which the Company will acquire Charter National in a cash-out merger. Charter Bank, the principal subsidiary of Charter National, is a state-chartered commercial bank headquartered in Wyandotte, Michigan with approximately $300 million in assets, $250 million in deposits, and eight branch offices located south of Detroit, Michigan. The merger, which will be accounted for as a purchase, is expected to close in the second or third quarter of 2002. The transaction is subject to required bank regulatory approvals and approval by Charter National shareholders.

Results of Operations

For the year ended December 31, 2001, Charter One reported net income of $500.7 million, compared to $434.0 million and $334.0 million for the years ended December 31, 2000 and 1999, respectively. On a diluted per share basis, net income was $2.21, $1.90 and $1.39 in 2001, 2000 and 1999, respectively. Operating results were affected by the following merger-related and other special charges in 2000 and 1999:

2000 Merger-Related Charges:

1999 Merger-Related and Other Special Charges:

Back to Top

Net Interest Income – Net interest income is the difference between the interest and dividend income earned on our loans and investments and the interest expense on our deposits and borrowings. Net interest income is our principal source of earnings. Net interest income is affected by a number of factors including the level, pricing and maturity of interest-earning assets and interest-bearing liabilities, interest rate fluctuations and asset quality, as well as general economic conditions and regulatory policies.

  The following table shows average balances, interest earned or paid and average interest rates for the years indicated. Nonaccrual loans and leases are included in the average balance of loans and leases. The mark-to-market adjustments on securities available for sale are included in noninterest-earning assets. The cost of liabilities includes the annualized effect of interest rate risk management instruments.

Back to Top

The following rate/volume analysis shows the approximate relative contribution of changes in average interest rates and volume to changes in net interest income for the years indicated. Changes not solely attributable to volume or rate have been allocated in proportion to the changes due to volume and rate. Amortization of net deferred loan costs and automobile dealer reserves included as a reduction in interest income was $81.0 million, $55.1 million, and $45.7 million in 2001, 2000 and 1999, respectively.

Rate/Volume Analysis

Our net interest income for the year ended December 31, 2001 was $990.4 million, an increase of $87.4 million, or 9.7%, over the $903.0 million for 2000. The yield on interest-earning assets declined to 7.19% in 2001 from 7.51% in 2000. However, interest-earning assets increased $3.2 billion in 2001 due to acquisitions and internal growth. The increase in interest-earning assets more than offset the downward pricing of assets in this lower interest rate environment. The increase in net interest income was also attributed to the reduction in the cost of interest-bearing liabilities from 4.67% in 2000 to 4.35% in 2001.

Our net interest income for the year ended December 31, 2000 was $903.0 million, a decrease of $31.1 million, or 3.3%, over the $934.1 million of net interest income for the year ended December 31, 1999. The net yield on interest-earning assets during the year ended December 31, 2000 declined to 3.02% from 3.19% for the year ended December 31, 1999. The compression in the net yield on interest-earning assets was primarily attributed to the fact that our liabilities repriced more quickly than our assets, as well as the effect of our stock buyback program. Interest rates rose considerably during 2000. This increase was accompanied by a flattening of the yield curve. Given this interest rate environment, management decided to slow balance sheet growth, with particular emphasis on accelerating the shift away from residential loans and securities by selling more of those portfolios. See “Financial Condition — Loans and Leases” for a summary of our loan securitizations for each of the past three years.

Back to Top

  The following table sets forth Charter One’s yields and costs at period end for the dates indicated. The yields on leases exclude the impact of the related tax benefit. The cost of liabilities includes the annualized effect of interest rate risk management instruments.

Yields and Costs At End of Period

Back to Top

Provision for Loan and Lease Losses – The provision for loan and lease losses in 2001 was $100.8 million, an increase of $46.6 million from 2000. The increased provision during 2001 was necessary to cover higher charge-offs and maintain the allowance for loan and leases losses at a level considered adequate to absorb losses inherent in the loan and lease portfolio. Net charge-offs totaled $68.7 million in 2001, compared to $51.0 million in 2000. The ratio of net charge-offs as a percent of average loans and leases increased 6 basis points to .27% in 2001 from .21% in 2000. At December 31, 2001, nonperforming assets, net of government guaranteed loans, were $244.4 million, an increase of $54.0 million from December 31, 2000. This resulted in a ratio of nonperforming assets to total assets of .64%, an increase of 6 basis points from the 2000 ratio of .58%. The increase in net charge-offs and nonperforming assets was primarily attributed to a general weakening in the national economy. Additionally, the provision for loan and lease losses was increased to reflect the continuing change in our loan mix. Over the past few years, we have continued our emphasis in originating consumer and commercial loans and leases due to the higher yields and shorter terms provided by these loans and leases. The consumer and commercial loan and lease portfolio, before the allowance for loan and lease losses, represented 60.8% of loans and leases at December 31, 2001, compared to 55.0% at December 31, 2000. Despite the increases in net charge-offs and nonperforming assets, our lending strategy, which includes emphasis on a well-diversified and collateralized portfolio of loans and leases, has produced above average credit quality, as measured by the relative levels of net charge-offs and nonperforming assets to industry averages. See “Financial Condition — Loans and Leases” below and Note 5 to the Notes to Consolidated Financial Statements for further information regarding our allowance for loan and lease losses.

  The provision for loan and lease losses in 2000 was $54.2 million, up from $35.2 million in 1999. The increase in the provision for loan and lease losses of $19.0 million, or 53.8%, was primarily attributable to increased inherent losses in the loan and lease portfolio and a change in the loan mix related to growth in loans and leases with higher risk/reward profiles.

Back to Top

Other Income – Other income for 2001 was $473.6 million, compared to $392.9 million for 2000. This $80.8 million, or 20.6%, increase was primarily attributable to income from retail banking and net gains on sales. Retail banking income increased $48.3 million, or 19.9%, over 2000. The growth was attributed to successful integration of our acquisitions together with ongoing franchise development initiatives. Additionally, we experienced increases in debit card and transaction-related revenues. Net gains on sales were $114.3 million in 2001, compared to $9.3 million in 2000. The mortgage-backed securities sold during the year consisted primarily of bank-originated, fixed-rate residential mortgage and consumer products, as we generated significantly more residential mortgage and consumer loans than we needed to meet our balance sheet size and mix objectives. We did not utilize any special-purpose entities for the sale of any of our mortgage-backed securities. The increases in retail banking and net gains on sales were partially offset by a $53.0 million, or 68.1%, decrease in mortgage banking income. This decline in mortgage banking income resulted primarily from an increase of $24.6 million to the valuation allowance on loan servicing assets in response to faster prepayment speeds resulting from higher levels of refinancing.

  Other income for 2000 was $392.9 million, compared to $230.6 million for 1999. This $162.3 million, or 70.4%, increase was primarily attributable to increases in income from retail banking, mortgage banking and net gains on sales. Retail banking income increased $46.3 million, or 23.5%, over 1999. The growth in income from retail banking was driven by mergers, account acquisition in mature markets and continual product development. Mortgage banking income increased $29.3 million, or 60.4%, during 2000 and was primarily attributable to a $21.3 million gain resulting from a $3.0 billion sale of mortgage servicing. Net gains on sales were $9.3 million in 2000, compared to net losses of $57.0 million in 1999.

Back to Top

Administrative Expenses – Administrative expenses were $629.7 million for 2001, an increase of $25.7 million from 2000. There were $29.5 million in merger-related expenses recorded in 2000 related to the St. Paul acquisition. Excluding the merger-related charges, our administrative expenses were $574.5 million for 2000. The increase in administrative expenses was primarily attributable to costs associated with the operational integration of recent acquisitions and $12.2 million in higher marketing costs as we implemented various programs geared to support sales efforts throughout the Bank. Additionally, during the fourth quarter of 2001, Charter One contributed $7.5 million to a newly formed charitable foundation. Despite the increase in administrative expenses, our efficiency ratio (excluding merger-related charges) improved to 41.91% for 2001 from 43.39% in 2000 and our ratio of administrative expenses to average assets (excluding merger-related charges) improved to 1.77% in 2001 from 1.81% in 2000.

  Administrative expenses were $604.0 million for 2000, a decrease of $29.4 million, or 4.6%, from 1999. Each year included significant merger-related expenses. There were $29.5 million in merger-related expenses recorded in 2000 related to the St. Paul acquisition, and $63.5 million in 1999 related to the St. Paul and ALBANK acquisitions. Excluding the merger-related charges, our administrative expenses were $574.5 million for 2000 and $569.8 million for 1999. This resulted in a ratio of administrative expenses to average assets of 1.81% for 2000 and 1.84% for 1999. Our efforts to control overhead costs were illustrated by an efficiency ratio (excluding merger-related and other special charges) of 43.39% for 2000, an improvement when compared to 45.49% for 1999.

Back to Top

Income Tax Expense – The provision for income taxes was $232.9 million, $203.8 million and $160.6 million for the years ended December 31, 2001, 2000, and 1999, respectively. The effective tax rates were 31.7%, 32.0%, and 32.4% for the years ended December 31, 2001, 2000, and 1999, respectively. For a further analysis of our income taxes, see Note 12 to the Notes to Consolidated Financial Statements.

Financial Condition

At December 31, 2001, total assets were $38.2 billion, an increase of $5.2 billion, or 15.8%, from $33.0 billion at December 31, 2000. Contributing to the increase in total assets were our Alliance and Superior acquisitions. Additionally, we experienced an increase in our mortgage-backed securities available for sale portfolio, as well as growth in our loans and leases. The mortgage-backed securities portfolio increased primarily due to the residential mortgage and consumer loan securitizations that occurred in 2001. See “Loans and Leases” below for further discussion regarding our loan and lease activity.

Loans and Leases – Total loans and leases at December 31, 2001 were $25.7 billion, compared to $24.0 billion at December 31, 2000. The increase of $1.7 billion was attributable to the Alliance merger in which we acquired $1.4 billion of loans. Additionally, as illustrated in the table below, we originated $17.8 billion of loans and leases during 2001, compared to $11.8 billion of loan and lease originations in 2000. Offsetting the originations in 2001 were $6.7 billion of residential mortgage and consumer loan securitizations, as we generated significantly more residential mortgage and consumer loans than we needed to meet our balance sheet size and mix objectives. These residential mortgage and consumer loans were exchanged for government agency mortgage-backed securities. We did not retain any credit enhancing residual interests, nor are we subject to any significant recourse obligations.

Loan and Lease Activity

Our lending operations are primarily concentrated in Ohio, Michigan, New York, Illinois, Vermont and Massachusetts. As a result, our financial condition and results of operations will be subject to general economic conditions prevailing in those states. If economic conditions in those states worsen, we may experience higher default rates in our existing portfolio as well as a reduction in the value of collateral securing individual loans. Separately, our ability to originate the volume of loans or achieve the level of deposits currently anticipated could be affected.

Back to Top

  The following table sets forth certain information concerning our nonperforming assets for the periods reported. Nonperforming assets consist of (1) nonaccrual loans and leases, (2) loans and leases past due 90 days or more as to principal or interest, (3) restructured real estate mortgage loans and (4) real estate acquired through foreclosure and other collateral owned. See Note 1 to the Notes to Consolidated Financial Statements for further discussion regarding our nonperforming assets.