Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

PNC Financial Services Group, Inc. (NYSE:PNC)

Q3 2008 Earnings Call

October 16, 2008 9:00 am ET

Executives

William H. Callihan - Director of Investor Relations

James E. Rohr - Chairman and Chief Executive Officer

Richard J. Johnson – Chief Financial Officer

Analysts

Edward Najarian - Merrill Lynch

Matthew O’Connor - UBS

Michael Mayo - Deutsche Bank Securities

Nancy Bush – NAB Research

Brian Foran – Goldman Sachs

Matt [Shulfes] – Boeing

David Knudsen – Legal Engine

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Girard Cassidy – RBC Capital Markets

Operator

I would like to welcome everyone to the PNC Financial Services Group third quarter 2008 earnings conference call. (Operator Instructions) I will now turn the call over to the Director of Investor Relations, Bill Callihan.

Sir please go ahead.

William Callihan

Welcome to today's conference call for The PNC Financial Services Group. Participating on this call will be PNC's Chairman and Chief Executive Officer, Jim Rohr and Rick Johnson, the company's Chief Financial Officer.

The following statements contain forward-looking information. Actual results and future events could differ possibly materially from those that we anticipated in our statements and from our historical performance due to a variety of factors, including those described in today's conference call, in today’s press release and related materials and in our 10-K, 10-Q and various other SEC reports available on our corporate website.

These statements speak only as of October 16, 2008 and PNC undertakes no obligation to update them. We also provide details of reconciliation to GAAP and non-GAAP financial measures we may discuss in today's conference call, in today’s press release and financial supplement, in our presentation slides and the appendix for our call, and various SEC reports and other documents. These are all available on our corporate website at www.pnc.com in the Investor Relations section.

Now I'd like to turn the call over to Jim Rohr.

James Rohr

Good morning. Thank you for joining us today. The environment we are facing today is clearly as volatile and as extreme as I have seen. In the space of a few weeks the financial services industry has been completely transformed. Several large investment banks are gone and the pendulum has now swung back to traditional banking as the business model for stability in this industry. I think that was recently confirmed by the extraordinary government intervention and support of the banks.

On a blink of these changes financial companies are being liquidated, consolidated and merged and governments worldwide are taking extraordinary measures to stabilize these economies. In short, every financial services company is meeting its balance sheet and the quality of that balance sheet is determining the future of many companies.

Many consumers have lost confidence and the ramifications are extraordinary. We support the efforts of the Treasury to restore confidence in the financial industry and PNC is currently evaluating the Treasury initiative and as we get full details we will review it with our board.

Overall, we are seeing renewed respect for the importance of the fundamentals; balance sheet strength, solid capital and liquidity position and a focus on customers. That is where PNC has been all along. We continue to take the long view, investing in products and markets where we see opportunities for growth.

During a time of great uncertainty, PNC we believe has posted solid results, reflecting the performance of our core business activities. Let me go through those core items for you. Our net interest income grew 31% compared to the same period last year. That is very much in line with the full-year guidance we provided. Our Treasury team had our balance sheet well balanced from a credit and interest rate perspective.

Moving on secondly to credit quality. This reflects our moderate risk profile and our third quarter results are well within the parameters we projected last quarter. For example, our third quarter total net charge offs which were marginally above our second quarter results should continue to be among the best in the industry. As you have come to expect, our expenses were well managed in the quarter.

As we told you in September, we expected market volatility to affect several non-interest items in the quarter. The impact of this volatility affected corporations such as Fannie Mae and Freddie Mac and other valuations in our portfolio. On the valuation side we had some valuation changes for our commercial mortgage loans held for sale. These valuation adjustments did not represent credit quality concerns with the underlying assets as the credit quality remains excellent.

Blackrock’s share price was up late quarter increasing the quarterly valuation of our [inaudible] obligations. Reflecting volatility on the corporate side we took some other-than-temporary impairment charges during the quarter primarily related to the ownership of Freddie and Fannie preferred stock but we also had losses in our trading position. Rick will discuss these in more detail in just a moment.

Moving to our businesses, PNC had 36,000 net new consumer and business checking relationships through organic growth during the third quarter, a 160% increase over the growth in the second quarter reflecting a flight to quality. Virtual Wallet, our banking product designed for Gen Y customers helped drive that account growth. We started marketing this online banking tool in early August and generated 15,000 accounts by the end of September. These are high quality accounts with deposit balances that are nearly 20% higher than we expected.

Retail banking also saw strong growth in consumer loans and transaction deposits compared to the same period a year ago. When we look at our corporate and institutional banking segment we also saw significant growth in the quarter as more large corporate, middle market and municipal customers are turning to us for a banking relationship that includes credit and fee based products and services.

While softness in the real estate market remains, we are seeing very good returns on our new customer relationships and spreads are better. We continue to allocate capital based upon risk adjusted return opportunities.

Our third business, servicing revenue and global investment services was up compared to the same period last year. Despite experiencing outflow of funds due to the dislocation of the global equity markets we saw net new customer growth in the third quarter as a result of our acquisition of Albridge Solutions and Coates Analytics and the pipeline for new customers is strong.

In this very volatile market we are pleased with the performance of our balance sheet from an interest rate and a credit quality point of view. Our expense management remains strong for the quarter and our strategic focus on maintaining moderate risk profile continued to serve us well.

Now Rick will provide you with additional insight into our financial results with particular focus on the quality of our balance sheet. Rick?

Richard Johnson

Good morning everyone. PNC generated solid results in the third quarter particularly considering the current economic environment. Our results were characterized by strong net interest income growth, solid fee income performance, disciplined expense management and manageable credit cost migration.

However, as we explained in the 8K we filed in September, our results were also affected by the Blackrock LTIP loss of $51 million, $82 million of valuation adjustments related to market dislocation on commercial mortgage loans and net security losses driven by our $80 million investment in Fannie Mae and Freddie Mac preferred stock. In addition, we recorded a $44 million charge of other than temporary impairment losses in the quarter which should have been recorded in the second quarter.

As a result, PNC reported $248 million net income or $0.71 diluted earnings per share for the quarter. While these results are below the quarterly expectations, we still remain comfortable with our full-year guidance. That is my first key message for today.

My second message is we continue to maintain strong capital and liquidity positions. Third, our moderate risk profile has provided with a differentiated balance sheet resulting in high quality securities portfolio and manageable risk from our credit folks.

Now let’s take a look at the second key message as capital and liquidity are critical differentiators in these tumultuous times. Our disciplined approach to capital management has resulted in a tier one capital ratio of 8.2%. We intend to continue to work to build capital flexibility to retain earnings growth to provide the support our customers need during this period of uncertainty. However, we are also reviewing the government program and will consider this as another potential source of further capital for strength.

We also take a very proactive approach to liquidity management. We regularly stress test our liquidity forecast for extreme market events beyond the current market environment. For funding contingencies such as our outstanding commitments, our conduit and our VRDN programs. We remain comfortable that our liquidity forecasts are more than adequate under these stress scenarios. Further to my point, government actions continue to provide additional sources to our liquidity position.

Now let’s turn to slide five and talk about our differentiated balance sheet. In the current environment balance sheet strength is critical to the long-term management of capital and liquidity and PNC’s balance sheet is strong and well diversified. We have grown non-interest bearing and interest bearing deposits. In fact, total deposits grew 8% year-over-year. In addition to acquisitions, much of this growth was the result of a flight to quality and we were not under as much pricing pressure as many of our peers.

In our retail segment we have seen core growth and demand in money market deposits, partially offset by lower CD deposits, reflecting our focus on relationship customers. We also saw loan growth of 14% year-over-year. With less access to the capital markets more companies are looking to banks to meet their needs. We are seeing higher utilization rates by some of our existing commercial customers. Further, we have had opportunities to grow new customers as we have had the products and capital flexibility to respond to opportunities that meet our moderate risk profile.

Now let’s take a look at our securities portfolio. As shown on slide six, our $31 billion securities available for sale portfolio represented 21% of our balance sheet at September 30 and this is a high quality portfolio. First of all, $12 billion of the securities are agency backed. Second, 95% of the non-agency securities are AAA rated with 98% greater than single A, all with relatively high levels of subordination. Third, the remainder of the portfolio is both granular and well diversified.

While the net unrealized losses on this portfolio have increased from $2 billion to $3.6 billion in the third quarter, this increase was primarily driven by market liquidity factors and was not representative of credit quality concerns on the underlying assets. In addition, the expected weighted average life of these fixed income securities was 4.7 years at quarter end which we believe is one of the shortest in the industry. Clearly we have the liquidity to be patient as the short-dated assets pulled apart and we recapture the market valuations.

However, as you would expect we did take some charges during the quarter related to this portfolio the most significant being a $74 million charge related to our ownership of $80 million of Fannie and Freddie preferred stock reported in net security losses.

Now turning to other balance sheet assets, our loans held for sale represents 1% of our balance sheet and declined 36% year-over-year. As you know, the securitization market is essentially frozen in the third quarter. Despite the lingering softness, our goal is to continue to reduce our position. In fact we reduced our inventory by approximately $90 million during the quarter due to individual loan sales. However, we did incur $82 million of valuation losses this quarter in this category due to market illiquidity. Overall, this portfolio is comprised of high quality assets and the largest portion of this portfolio is $1.5 billion of commercial mortgage loans with less than $15 million of delinquencies.

Other assets of $30 billion includes our investment in Blackrock and other equity investments, trading positions, good will and other intangible assets. We did have some valuation impairments to our equity investments in the quarter the largest of which was the additional other than temporary impairment of $30 million to our investment in GMAC and $23 million of mark-to-market adjustments in our private equity portfolio. In addition, we reported $54 million of trading losses during the quarter driven primarily by significant widening of credit spreads in extremely illiquid markets. As we have been doing all year, we continued and we will continue to reduce our risk in this portfolio.

Now let’s look at our credit portfolio and our overall charge off and reserve trends. Now, slide seven shows our credit quality metrics on a consolidated basis. Our loans make up only 52% of our balance sheet at quarter end. Relative to our peers we have fewer credit assets overall and the performance of these assets on a relative basis has been better than most. In these challenging markets, deterioration was to be expected. In the third quarter we saw a manageable migration of $142 million in assets to nonperforming status.

As you can see from the recent trends our net charge offs of 66 basis points continue to be relatively stable and should be among the lowest in the industry. The allowance to loans ratio continued to increase to 1.4% representing another form of capital in this challenging period.

On the capital side our residential real estate development loans continue to be the concentration of our commercial credit deterioration. These loans are primarily located in Maryland, Virginia, Delaware and New Jersey. This $1.8 billion portfolio represents less than 2% of our total assets. The average size of these outstanding is about $1.4 million per loan. We believe this gives us greater flexibility in dealing with these credits during this difficult market. However, we do expect further growth in nonperforming assets and charge offs in this category for the foreseeable future.

On the consumer side our largest position is in home equity loans. This nearly $15 billion portfolio is comprised of 39% first lien positions and the rest are second lien positions. Both portions are performing well at this stage in the cycle. Nearly all these loans are in our footprint and our strategy did not involve targeting the sub prime market.

In the third quarter net charge offs in our home equity portfolio were 58 basis points compared to 53 basis points in the second quarter. While I expect this to be significantly below our peers, I do expect this charge off rate to increase modestly in the periods ahead. However, the 90-day delinquency rate of 46 basis points remained flat compared to the second quarter. Overall our credit trends remain manageable and our loan portfolio continued to perform well in this difficult market. We believe our moderate risk profile and the adequacy of our reserves differentiated our balance sheet from our peers.

Looking ahead we continue to see our full-year provision to be around $750 million with the outcome largely dependent on the strength and weakness of the U.S. economy. I hope you get the sense that our long-term approach to business and our moderate risk profile is delivering a balance sheet for all economies.

Now I’d like to turn to our diversified quality revenue streams, another reason why we are succeeding in this challenging environment. One of PNC’s differentiating strengths it the diversity of our revenue streams. For example, we generated 49% of our revenues from non-interest income and over 80% of our year-to-date revenue from non-interest income and deposits. As a result and despite the isolated revenue volatility due to the illiquid markets we have seen our year-to-date total revenue grow 9% compared to the same period last year.

Now turning to the drivers of revenue, our liability sensitive balance sheet was well positioned for the rapid decline in short-term rates that took place earlier in the year and reduced our overall cost of funds resulting in strong net interest income growth of 31% compared to the same quarter last year. Net interest income also increased 2% on a linked quarter basis.

Looking at our non-interest income, two revenue streams you would expect to be affected most by current market volatility were fund servicing and asset management. Despite these challenges, fund servicing revenue was essentially flat late quarter and grew 12% compared to the same period last year driven primarily by growth from existing global investment servicing clients and new business from our emerging products.

Our asset management revenues were down linked quarter and year-over-year due to lower asset values in the broader markets. Nevertheless we continue to have strong sales in our wealth management business and tremendous amount of referrals through our branch distribution network.

Clearly asset valuation and outflows will put pressure on these revenue streams. However, our focus remains on deepening client relationships and developing products to create long-term value. Together, consumer service fees and service charges on deposits were up 4% from the linked quarter primarily due to increased debit card usage as the result of higher activation levels and the acceptance of our products and services in new markets. Year-over-year revenues were down due to the impact of the Hilliard Lyons sale. Corporate service revenue increased 7% linked quarter primarily due to higher merger and acquisition advisory fees offset by lower capital market revenues from fixed income derivatives and loan syndications.

Our other non-interest income was affected by losses mentioned earlier. Approximately $285 million due to the Blackrock LTIP shares adjustment, commercial mortgage loans held for sale, valuation net security losses and trading and equity management losses, partially offset by a $61 million reversal of a legal contingency reserve that resulted from settlement.

Overall we are pleased with the growth of our fee based businesses and we see opportunities for further growth for our investments in new products and markets.

On slide nine you can see we created positive operating leverage on a year-to-date basis with a 9% growth in revenue and a 7% increase in expenses primarily driven by investing in new products and new markets including acquisitions. Based on our economic assumptions as we look to the full year we expect full-year total revenue growth to exceed 10% on a year-over-year basis.

We still expect non-interest expense growth will remain in the low to mid single digits resulting in significant positive operating leverage, more than enough to cover the increased cost of credit.

We also expect our effective tax rate to be approximately 32% for the full year.

Now all in all we believe our business model, which focuses on the long-term, continues to serve us well. Our full-year guidance has not changed. Our capital liquidity positions are strong. Our balance sheet is well positioned and credit quality migration continues to be manageable reflecting our moderate risk profile.

We believe this strategic focus positions us to deliver a very solid year.

With that I’ll turn it back to Jim.

James Rohr

We believe this was a good quarter for PNC during an extremely volatile time for the financial services industry and I am particularly pleased with the results of our core business activities. We posted strong net interest income growth. Our asset quality remained manageable in a very challenging market. Our capital and liquidity position remains strong and many of our fee businesses did well, growing clients and revenues. Clearly market volatility affected some of our fair value assets.

Overall we remain focused on the long-term and it is working for us. We are investing in products, retaining and increasing our customer relationships and developing markets where we see opportunities for growth. Our fundamental approach has emphasized balance sheet strength, expense management and a moderate risk profile.

This business model focused on the long-term has served us well and we believe we have the momentum and the initiatives in place to capitalize on market opportunities and continue to create value for our shareholders.

With that we would be pleased to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Edward Najarian - Merrill Lynch.

Edward Najarian - Merrill Lynch

My question relates to equity and capital raising. Bigger, unrealized loss in the bond portfolio now took the tangible ratio down under 4%. You did sort of allude to the fact you might access the government preferred equity plan. Could you give us maybe a little more color with respect to what your thoughts are on capital raising? First off if the government plan is preferable to doing some kind of private common raising and then approximately what your thoughts are in terms of how much capital raising you might consider.

James Rohr

First off we are pleased with where our capital position is today with the tier one ratio being over 8 we are very comfortable. We think the capital position we have today given the quality of the balance sheet is fine. So we are pleased with that. I think the balance sheet quality is the key issue there. Clearly we are in difficult times and I think raising capital is something a number of people have done. They have increased their capital position based upon the quality of their balance sheet. I think that environment might say raising more capital is probably not a bad idea. The government program I think we have done an awful lot of work in order to provide an opportunity to provide what appears to be relatively inexpensive capital. Some of the issues are still coming out. As a matter of fact we were talking about it last night. Actually they are still drafting some of the particulars of how it would actually work. I think those particulars we are trying to gather as quickly as we can and we have got to discuss them with our board before we would make a decision on that. We think it is obviously a very attractive plan they have put together and we are considering it very seriously.

Richard Johnson

The tangible common equity ratio you mentioned at 3.6%, I think I took you through the quality of the securities portfolio because it is that one item that is causing it and it is a very high quality book. If you remove that we would be well over 5%.

Edward Najarian - Merrill Lynch

It sounds like then from a capital raising perspective you are comfortable taking the tier one ratio up with a form of preferred equity that would not positively impact tangible common [E to A] is perhaps the best way to proceed?

Richard Johnson

We are evaluating all those choices at the moment. I think it would be inappropriate to go into details on that right now.

James Rohr

We are comfortable, as Rick said, with the quality of those securities in the securities book, just over a moderate period of time they do pull to par so the credit quality is quite extraordinary there.

Operator

The next question comes from Matthew O’Connor – UBS.

Matthew O’Connor - UBS

Many think we are in a wave of bank M&A in part due to the environment we are in as well as the Treasury infusion of capital. Can you just give us an update on where PNC sits in on this?

James Rohr

I’m not sure I agree with that. There is a fair amount of speculation. I think the thing that hasn’t been addressed and can’t really be addressed by the government is the fact housing prices continue to decline. The fact housing prices continue to decline, I think most of the estimates I have seen think it is going to go down another 10-15%. Those are government estimates. Those issues quite frankly will mean there will be more losses in the portfolios. We are also seeing rising unemployment. The government estimates are the unemployment numbers will rise from 6% to 7.5% early next year. Those kinds of issues will tell you consumer credit, whether it be credit cards or other, will continue to deteriorate as well as housing prices. I think in terms of acquisitions you have got to be as careful as you have ever been in terms of acquiring someone else’s balance sheet. I’m not certain the capital opportunity will cause a great deal of M&A activity.

Matthew O’Connor - UBS

Specifically, in the media PNC has been linked to speaking with National City about a combination. Any comment you can provide on that?

James Rohr

I don’t think we can make a comment on any particular rumor. We don’t comment on rumors.

Matthew O’Connor - UBS

Maybe just bigger picture, basically on your earlier comments about the credit environment I would think you wouldn’t be open to taking on a lot of risk but we have seen some Fed assisted deals. There obviously is opportunity to offload riskier assets. How do you weigh in terms of distracting yourself from what you have been able to accomplish organically in the quarters with the opportunity that may provide?

James Rohr

Let me first say the business opportunity of running the business has probably never been this good in my career. The demand deposit growth, we are actually being very judicious in terms of looking at risk adjusted or terms on capital on the corporate and institutional side. We have got opportunities there that have a backlog, I’m not saying it is [inaudible] but we’ve got an awful lot of opportunities there and that is without touching the municipal business which continues at this time to be an enormous opportunity. So, the opportunity to just run the business, I mentioned the 36,000 new accounts, the Virtual Wallet opportunity, that is our first and foremost opportunity. Acquisitions and I think I have been quoted you have to be very careful. You don’t want to catch a falling knife. To take on someone else’s balance sheet that has a great deal of risk on it you just have to frankly be awfully comfortable that you can manage that risk. That is not easily done. Government transactions those are all…you have to look at those one at a time because if we look at the recent past they take so many different forms I think you just have to look at them one at a time. I think in terms of the M&A space the old fashion way to acquire customers is the best way and it would be a unique opportunity where we could understand how we would manage the risk then we could consider it but we would be very careful in this space.

Operator

The next question comes from Michael Mayo - Deutsche Bank Securities.

Michael Mayo - Deutsche Bank Securities

You have $41 billion of commercial loans or $31 billion not real estate related. Are things generally fine, though the non-accruals went up some? Can you comment on your general exposure to your retailers and kind of what is moving up on your watch list or what you are concerned about? As the rest of the economy gets weaker is it inevitable we see a lot more problems in the commercial portfolio?

James Rohr

I think we are pretty concerned about the retail market but the good news is the place you have to be concerned most is the consumer debt. We are very small in that space. Our credit card business is extremely small and quite frankly our number one key item on the consumer side is our home equity portfolio and that has performed, as Rick pointed out, extremely well. So the consumer play I think is the place that will be most difficult last year. Credit as well, especially with the loss of AIG who was a big guarantor of leasing residuals. We are out of that. I think that is the place that is most difficult.

Richard Anderson

Less than 20% of our commercial real estate exposure is in retail. It is actually about 17% of the total. You are right. We are watching that very carefully. I think we are watching lodging, hotels and those kinds of areas. Those are where we would expect to have some stress moving forward. Also, office space. We are keeping a close eye on each one of them. Right now we are feeling pretty comfortable as to what pace they are migrating.

Michael Mayo - Deutsche Bank Securities

A related question, either this is good news or bad news…you tell me. You don’t have a whole lot of reported loan growth. I know there are a lot of in’s and outs there. Some might say, Wells Fargo might say hey you need to get loan growth in an environment like this. Spreads are a lot better. But if you are extremely cautious on credit you say we don’t want loan growth. Can you just explain why your loans aren’t growing more or whether you want them to grow less?

James Rohr

Our loans grew fairly well on a year-over-year basis but I would say we are really still using a risk adjusted return on capital versus other opportunities. We have grown a number of relationships, taking market share in literally every one of our markets. As a matter of fact if you look at our markets, every single market we are in is over plan on sales and we will almost, I’m not certain this will be true, but we are very close to having every market over plan in every business segment. I think one of the things we can say is we could grow loans a lot faster if we wanted to.

Michael Mayo - Deutsche Bank Securities

I was referring to linked quarter.

James Rohr

On a credit basis we are being very judicious in a declining economic environment.

Michael Mayo - Deutsche Bank Securities

I was looking linked quarter. Loans didn’t grow a whole lot. I didn’t know if that was intentional or what.

Richard Anderson

Not at all. I think if you are looking linked quarter you are seeing commercial lending is up almost $2 billion. What is really flat overall is a lot of the consumer activity as well as the fact we have taken down some of our residential mortgage exposure.

Michael Mayo - Deutsche Bank Securities

Just to follow-up to the other one, how would you not want to do a merger in this environment if you got some government protection from problem loans and maybe some other government assistance. Isn’t this the moment you have been waiting for to do another deal?

James Rohr

As I mentioned, government deals are unique in their very case. We would certainly consider one if we could understand the downside risk. I think that is something we would be interested in.

Operator

The next question comes from Nancy Bush – NAB Research.

Nancy Bush – NAB Research

First, on the trading loss, you guys have kind of struggled with trading over several quarters here and I kind of felt like you felt you had gotten some of the issues on your trading desk straightened out. I’m just wondering if the trading losses in Q3 were of a different nature than the ones maybe we saw a couple of three quarters ago.

James Rohr

The issues on trading losses again were just widening of the spreads on quality assets and we were very disappointed with that. We have taken that risk down now by 75% and in this environment trading is an extraordinarily difficult opportunity. I think that is why we have taken that risk down by 75% effectively right now.

Nancy Bush – NAB Research

So it wasn’t a positioning issue as much as it was just a…

James Rohr

The spreads went out of the high quality assets were worth less. Trying to figure that out in today’s environment is extraordinarily difficult.

Richard Anderson

We had to balance as we do that taking down the risk and taking it down to the right value as opposed to giving away value but at the same time trying to reduce the volatility as that impacts our income statement.

Nancy Bush – NAB Research

On the utilization rate you had mentioned that utilization rates had gone up. Could you just give us some color on that? Sort of where they have moved over the past year or sequentially. What kind of level of magnitude you are seeing in the utilization rates?

James Rohr

I would say it is just a few percentage points. It is not dramatically different than it was but it has moved up. We had a period of probably 10 years where it didn’t move at all so we are seeing some companies take the credit risk down but most of the people we do business with are clearly comfortable with where we are. We’ll see if we have a number for that.

Richard Anderson

We don’t have a specific percentage but I would say corporate finance would be increasing and those real estate finance would be up as well. Corporate banking is pretty much flat. I don’t have specific percentages but that is where people are actually utilizing the lines we have outstanding more than they have in the past.

Nancy Bush – NAB Research

On Virtual Wallet, which seems like a very interesting product but seems aimed at the Gen Y generation, whatever that may be, whenever I hear about these products that are aimed at the kids I always want to say to banks what am I, chopped liver? I guess I want to ask if there is going to be a virtual wallet seniors or something like it coming down the pipe.

James Rohr

You are exactly right. Us Gen Y seniors are very important. We are a very important product group. What you will see is as all customers continue to evolve their use of banks, for example online bill pay is up 35% a year each of the last three years, by 2011 more than 50% of all payments will be made by cards. So people behind the scenes, we talk about housing prices and whatever, but behind the scenes our customer base is changing dramatically how they use banks. The Gen Y was initially targeted at people between 20 and 30 years old and the acceptance appears to be quite acceptable. The other thing we have to hook onto that is our investment in a retirement module which we are working on right now. You know if you look at the product the calendar is the key development in bill pay because as you put your bills in there it shows in your calendar exactly the dates you have to pay bills and also you program in there the dates you receive money as well. So you get notifications on danger days and you can understand what you can save. That same thing is true for retirees who are on fixed income or some form of fixed income and who have regular payments. That calendar applies to them as well. So we are building a retirement module that we will put on the Virtual Wallet and as you know the people who use the internet the most, the age group is people under 30. The second largest user of the internet are people over 70. They email their grandchildren. They do a lot of research and they have extra time. So I think quite frankly that piece will be equally as valuable. It may even have some more money tied to it when we get that rolled out for us other Gen Y’ers.

Operator

The next question comes from Brian Foran – Goldman Sachs.

Brian Foran – Goldman Sachs

I just want to come back to capital because I think there is a lot of confusion about what is the appropriate level of capital for a bank today and even more basically what is the right ratio to focus on. So, is there any minimum common equity ratio that you have to manage to?

Richard Anderson

First of all let me just point around what capital ratio we do manage. We do manage to economic capital. That is how we manage the institution. From a regulatory point of view we focus on the tier one ratio and we moved to that about a year and a half ago. For exactly the situation we are in today, which is the fact it is a better reflection of the risk related assets of the entire balance sheet as opposed to just cherry picking one component of the balance sheet and putting a mark on that. To the point before, I think Ed raised the question originally, we talk about the tangible ratio and we talk about the valuation securities portfolio. What we don’t put in there is the value of our Blackrock stake which is actually just as much. The value we have not recognized is just as much as the value we have marked down on our securities portfolio as well as the value of our deposit base. So there are a lot of factors that don’t go into tangible common equity that we think is very misleading about the overall capital health of the company.

Brian Foran – Goldman Sachs

Is there any breakdown you can give us about how much of the OCI is coming from agency MBS which presumably we could take off the table?

Richard Anderson

A large portion of it is coming from non-agency residential mortgages. Spreads there have widened dramatically.

Brian Foran – Goldman Sachs

The commercial mortgage held for sale, I guess it is kind of hard with the in-flow and outflow and pay downs and mark downs you have taken, is there an average carrying value you can give us for the loans at this point?

Richard Anderson

Right now we are probably $0.85 on the dollar.

Brian Foran – Goldman Sachs

On the residential construction side, appreciating that it is not a very big portfolio, the NPL’s and charge off’s are very high this quarter. Is there any sense you can give us of loss expectations or some kind of lifetime credit metric?

Richard Anderson

I couldn’t help you there but I will tell you the vast majority of the nonperforming loan increase is coming from residential development. We are recognizing the risk in that area and we are marking them to nonperforming and setting the reserves for that.

James Rohr

I’ll also mention the concentration is in the Mid-Atlantic States with the real softness being in Northern Virginia and the eastern shore of Maryland. While those developments are struggling and housing prices are down in those markets they are not down to the extent you see in Florida and California and Nevada and places like that.

Operator

The next question comes from Matt [Shulfes] – Boeing.

Matt [Shulfes] – Boeing

Getting back to the capital issue, you issued $500 million of preferred stock and that counts towards your tier one ratio as I recall. Correct?

Richard Anderson

That is correct.

Matt [Shulfes] – Boeing

Why don’t I see that on your balance sheet reflected on page two of your supplement?

Richard Anderson

Capital surplus. It is not broken out as a separate item. The par value is very low so that gets rounded. You don’t even see that. It is the capital surplus it creates and that goes into that account.

Matt [Shulfes] – Boeing

You also had some losses on low income housing. Can you give us a dollar figure on low income housing and I assume it is basically a tax adjustment and adjustment to what you guys thought you would receive over time. Can you provide a dollar figure and exactly what that was?

Richard Anderson

It is not that material. It is probably less than $15 million. What you are seeing there is the write off on the investment which is a path of loss coming in early and then the tax benefits come at a later date.

Operator

The next question comes from David Knudsen – Legal Engine.

David Knudsen – Legal Engine

I noticed the deposits increased kind of smartly in the quarter, up 8% versus 1%. You mentioned a couple of the types of deposits. I was wondering if you could give us any more information regarding, obviously they had to leave somewhere else, was it primarily smaller community banks? Regional banks? Thrifts? Maybe you can help a little bit on that.

James Rohr

We asked the same question. We were wondering whether we were getting it from one bank or two banks. Frankly, the deposits have come in across the board from all kinds of competitors and I think that was most evident when we looked at our market by market sales success where every single market is over plan and the plans were set aggressively. So every single one is over plan. So when you look at who we compete with we compete with different people in different parts of our franchise. When you look to the West you see National City, JP Morgan Chase and when you look to the East you see Bank of America and Wachovia. All across the board there is small banks everywhere. This success has run across the board.

David Knudsen – Legal Engine

Has it been driven by kind of reallocating to get underneath an insurance limit or has it just been a change in better marketing? What are you attributing it to?

James Rohr

All of the above. I think people clearly have moved money to get under insurance. I think people have also; we like to think our marketing has been particularly good and clearly we like to think the flight to quality has been positive for us as well. We are seeing this continue. I personally don’t think the deposit guarantee will stop all of the changes in deposit flows because I think confidence is clearly the issue. We have lost confidence in a lot of our institutions and if you think of each and every one of our businesses confidence is a key component. Once you have changed your mind about having confidence in your bank I think quite frankly the ultimate answer is that you will move your accounts. I think we will continue to see success in that space.

David Knudsen – Legal Engine

That is a little bit different than one of your eastern competitors; Sovereign mentioned in their 8K that their deposit redistribution has calmed down particularly in October after some of these measures were introduced.

James Rohr

One of the other things you have to watch is that we are letting CD’s run down. We’re not particularly competitive at all in terms of pricing longer term CD’s and those go into some of the FDIC reports. We are much more interested in the demand deposit account and the money market accounts. I think that has worked out very well for us.

Richard Anderson

Even in that space, the CD space, even though we are pricing down as we re-price the portfolio we are seeing retention rates that are very, very high which again comes back to the point people are coming in for quality not just for price.

David Knudsen – Legal Engine

On the NIM, a slight decline in the quarter. I guess from what you said on price why aren’t we seeing a greater expansion of NIM and maybe in conjunction with that question is there substantial undrawn commitments? I know you talked about the utilization rates going up a bit but are there commitments out there that will kind of drag on NIM going forward? Do you have a size or magnitude?

Richard Anderson

I think what we need to see in that space is we need to see Libor rates come down a bit. You can reduce that fund all you like and certainly you get a benefit from that but until Libor comes down as well, and as you know that is trading like 300 over, and until that comes down you are not going to see the full benefit of that re-pricing of your liabilities.

Operator

The next question comes from Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

I’d be curious to know where you are taking on risk. What is your appetite and where do you see opportunity now given obviously what is going on in the market?

James Rohr

There is a few places where we like the risk return. In our business credit portfolio we are the third largest secured lender for traditional asset financing, receivables and inventory. There is a lot of opportunity in that space and the returns are quite exceptional. I think that opportunity is really great and we are working on that. We have municipalities that are coming to us remarkably every day. We are able to get the entire relationship and they don’t come with just the borrowings they had in the past. So the bulk of those play for high quality municipalities. Again, the risk adjusted return and the relationship is pretty extraordinary.

In the middle market space is a place we have been dominant. We have been the number one middle market player in the northeast and number one middle market indicator over the years so that has been a place we have focused and we continue to get opportunities to bring the entire relationship into the company. In cases where we tried for years to get certain customers to join us. I think across the board we have excellent opportunities and we are actually being very diligent in terms of making sure we aren’t taking undue credit risk because we don’t have to in order to get the good return today.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

My second question really ties into that. The fee income component of your business has obviously been a huge driver of the revenue model in the past but given the considerable changes we are seeing in the financial marketplace do you see that strategy modifying at all in the next couple of years? Those kind of three segments to me seem to be more kind of on the spread business and on the core banking business. Do you see the overall pie changing a little bit as opportunities change?

James Rohr

One of the keys to our business is that we do have a number of fee businesses and we also cross-sell our customers with fee businesses. So that strategy isn’t going to change. Just the fact we have opportunities to move into relationships that have higher spread relationships I think could increase our net interest income as a percent of our total revenue but it won’t stop us from continuing to cross-sell products to customers to make sure we are growing fee income aggressively because we like the diversification of revenue streams. I think that allows us not to have to double down on certain types of credit risk when margins are lower than they might be today.

Operator

The next question comes from Girard Cassidy – RBC Capital Markets.

Girard Cassidy – RBC Capital Markets

I have a couple of questions on credit. You touched upon what some of the forecasts are calling for on the economy and more economic data did come out this morning that did suggest the economy is in a recession. Clearly recessions bring on credit problems. I noticed in your top ten nonperforming assets from the second quarter which 9 out of the 10 were construction related, this quarter it is now 6 out of 10, are you guys starting to see a migration of credit deterioration into the broader commercial book or just the broader book of business from what was originally a residential construction problem maybe 6-12 months ago?

James Rohr

That is a great question and we ask it every day around here. If I ask every day about the commercial, the CNBS portfolio and that is unbelievably clean. I have been very pleased with that. Residential real estate, as you pointed out, is what it is. The corporate banking stuff we are diminutive in the automotive and automotive supply side so we have kind of got out of that business for the most part a number of years ago. So we are not very big in that. The one place that did show up in the non-performers this quarter is that we are a large business credit lender. So you would expect that in a recessionary environment you would have more non-performing loans coming from secured borrowers if you will. I mean, that’s just kind of part of the business. Nonetheless, we have a much, much, much lower loss given the fault ratio there. So the losses in the business credit aren’t anywhere related to a great part by the non-performing assets. So we have seen a little deterioration in that portfolio but other than real estate the residential portfolio I would say business credit is the only one that has shown any deterioration quite frankly.

Girard Cassidy – RBC Capital Markets

On acquisitions, you guys over the years have done a number of acquisitions. I know you are not going to specifically name names, I don’t mean to ask that, but is there a geographic preference? You have started to move into that Northern Virginia/D.C. market with the Rigs and the Mercantile acquisitions. Is your preference to move further into Virginia and South into the Carolinas? Or would you go Midwest? Mid-Atlantic up toward Boston? Any color there?

James Rohr

Every acquisition is unique in its own right. Banks are sold, not bought. You have to look at how it would fit you in many ways. I wouldn’t have normally told you that York, Pennsylvania was a place we were interested although Sterling fit particularly well and we were able to take all the costs out and it fit kind of like a cog in the picture. I’ll tell you Washington D.C. has been an unbelievable success. The greater Washington, including the Mercantile acquisition, is 160% of plan this year in sales and sales were up 100% last year. So the idea that we moved into that marketplace and said it has the highest net income per household and the highest education per household and the estimates say Washington D.C. is now greater than Philadelphia that has worked out extraordinarily well for us. So when you look at an acquisition you have got to look at what the cost opportunity is, what the revenue opportunity is, what the risk is and you have to look at all of those things before you can make a decision. In this environment you just have to be very careful. As you mentioned, the economy is headed south an you don’t want to catch that falling knife.

Richard Anderson

Jim do you have any closing remarks?

James Rohr

Thank you very much for joining us and supporting us. I think this was a very solid quarter for PNC. The items we have given you guidance on with net interest income, credit quality and expenses I think came right in as we had expected. Market volatility in the quarter was extraordinary and I think that is true for everyone. As we said in the call in the second quarter and to many of you personally we are not immune to those things but quite frankly I think a number of the things we took this quarter will be managed better in the fourth quarter. Thank you very much.

Operator

Thank you for participating in today’s PNC Financial Services Group conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: PNC Financial Services Group, Inc. Q3 2008 Earnings Call Transcript
This Transcript
All Transcripts