Guaranty Financial Group Inc. Q3 2008 (Qtr End 09/30/08) Earnings Call Transcript

Guaranty Financial Group Inc. (GFG)

Q3 2008 Earnings Call

November 5, 2008 2:00 pm ET

Executives

Rusty LaForge – SVP & Director IR

Ken Dubuque – President & CEO

Ron Murff – Sr. EVP & CFO

Analysts

Brian Clark – KBW

Presentation

Operator

Good day ladies and gentlemen, and welcome to the third quarter 2008 Guaranty Financial Group earnings conference call and webcast. (Operator instructions) I would now like to turn your presentation over to your host for today's call, Mr. Rusty LaForge, Director of Investor Relations.

Rusty LaForge

Good afternoon everyone. Welcome to Guaranty Financial Group’s third quarter 2008 conference call. Before we get started, please note that the presentations and commentary that you are about to hear contain forward-looking statements that are subject to numerous risks and uncertainties as described in our Forms 10-K, 10-Q, and other reports filed with the SEC.

You should not place undue reliance on any of these forward-looking statements. Actual outcomes could differ materially from the views expressed today. We may elect to update forward-looking statements at some future point, however we specifically disclaim any obligation to do so.

Here with me today are Ken Dubuque, Chairman, President and CEO and Ron Murff, Chief Financial Officer. I want to call your attention to the slide deck, which we have posted on our website, www.guarantygroup.com, and we will be referring to this over the course of the call.

With that, I’ll turn the call over to Ken.

Ken Dubuque

Thanks Rusty, and good afternoon. Welcome to our third quarter conference call to discuss financial results. Thank you for joining us.

The results that we issued this morning show that for the quarter we had a net loss totaling $162 million which included three non-cash charges totaling $152 million consisting of a $53 million charge for an other then temporary impairment of our mortgage-backed securities, an $85 million charge to income tax expense to establish a valuation allowance on deferred tax assets, and a $14 million charge to reduce the carrying amount of the goodwill and other intangible assets related to our insurance agency that we had determined was impaired.

The results also included provision for credit losses of $78 million. Clearly these several items exceeded otherwise healthy amounts of net interest income, and non-interest income, although both were at lower levels then the prior quarter due to further stresses in the banking market.

In a moment Ron will discuss all of these results in much greater detail. Before Ron addresses these details I want to provide another update on our progress in accomplishing the short-term goals we set earlier this year.

In light of the continued decline in housing market conditions and the lack of liquidity in the mortgage services and securities markets, we mentioned before that we turned to a short-term strategy focused on what we called the three Cs; credit, cost and capital.

First, with respect to credit we saw another increase in non-performing loans and we had additional loan loss provisions during the third quarter principally in the homebuilder and single-family mortgage portfolios.

We are also seeing some softening in certain commercial real estate markets and our reserve levels in those areas have increased somewhat, however corporate and middle market lending are still performing well which we believe is a result of our conservative underwriting standards.

Our energy lending is a good example of the conservative nature of our underwriting. Guaranty Banks energy lending group has been able to manage through significant volatility as a result of conservative lending parameters.

Each quarter we look at our energy underwriting and we consider adjustments. When the price of oil spiked to nearly $150 per barrel, we never exceeded $75 in our near-term forward commodity price assumptions, commonly referred to as our price deck.

And our long-term price assumptions were also below that level. Furthermore we generally limit our energy loans to 65% of that estimated value of the oil and gas reserve collateral and our average advance rate is between 50% and 60%.

We stated last quarter that we anticipated an increase in charge-offs particularly in homebuilder finance. This quarter we took $100 million in charge-offs. As I mentioned we made an additional provision of $78 million for credit losses resulting in an end of period allowance for loan loss of $231 million.

Our team of lenders and credit staff focused solely on loans that need special attention and aggressively identified emerging problem loans, internally classifying them where appropriate and taking action where appropriate to mitigate risks.

Second, with respect to costs we are continuing to see the benefits of our expense reduction efforts. As Ron will discuss in greater detail non-interest expense for the quarter totaled $105 million but $14 million of that amount was for a charge to reduce the carrying amounts of the goodwill and other intangible assets related to our insurance agency which we had mentioned before were impaired.

Remaining non-interest expenses for the quarter were only $91 million which is down from $99 million in the prior quarter or $96 million net of severance costs. One driver of the decrease excluding the goodwill impairment was our decrease in our compensation expense which was down another $2 million for the quarter following last quarter’s $2 million quarter, [inaudible] dropped to $46 million per quarter.

We completed a benchmark study recently and we are finishing up that analysis but we expect to be able to make continued progress on cost reductions. On October 31 the company committed to workforce reduction plans what will involve approximately 4% of the company’s employees, approximately doubling the amount of the reduction made earlier in the year which will further reduce costs and maximize operational efficiency.

The plans were communicated to effected employees in the last several days and are expected to be completed by January 9^th, 2009 which as previously stated will reduce compensated benefits expenses even further.

We are also continuing to limit new hires including not filling opening positions as well as evaluating all our operating units and lines of business through peer comparisons, reducing travel expenses, reevaluating our non-essential marketing expenses, evaluating our real estate and other non-earning assets, reducing planned capital expenditures, and rationalizing our branch system and de novo expansion plan.

And now our third important short-term focus, capital. During the quarter we closed and funded private placements of preferred stock and subordinated debt to bring the total amount of capital raised during this year to approximately $600 million. Our capital ratio now significantly exceeds regulatory standards to be well capitalized.

The capital also reinforced our strong liquidity position. Today excess borrowing capacity is more then $5.7 billion. While we are well capitalized particularly so in light of our recent capital raise, we are also looking closely at the availability of capital through the Treasury’s capital purchase program, also called TARP.

With respect to the other programs available from the government we will also look at the assets purchase plan as details are made available and we will look at any offering of insurance on non-agency mortgage-backed securities. Furthermore through our participation on any extended insurance program for commercial deposits, is dependent on the program features and costs, it is likely we will not opt out.

In addition to the strong focus on these three Cs, we said last quarter that we also have to keep in mind another important C, our customers. Our progressive checking of product with free usage of any ATM without requiring further documentation continues to be well received.

Traditional depositors are also moving additional to the safety of FDIC insured deposits. Ron will get into more detail on these numbers but clearly our long-term customers and new customers have been very responsive to our efforts to attract additional deposits during these unsettling times resulting in an increase of approximately $1.8 billion in the month of October alone.

The Guaranty Bank brand continues to be strong and providing cost effective distinctive customer service is still one of our core strategies. While remaining focused on these three short-term strategies we continue to benefit from attractive franchise with an outstanding branch network in the two fastest growing states in the country; Texas and California.

Now let me turn over the call to Ron to discuss financial results in further detail.

Ron Murff

Thanks Ken and hello everyone. My remarks today will cover our financial results and some of the items on our balance sheet. If you have access to our slides I will be referencing those.

Let’s first go to slide number three, Ken noted that for the third quarter we reported an after-tax net loss of $162 million that is compared to an $85 million after-tax net loss in the second quarter of 2008 and $21 million net income in the third quarter of 2007.

As Ken mentioned during the quarter we did have three primary non-cash charges that totaled $152 million including a $53 million OTTI charge, an $85 million deferred tax asset valuation allowance, and a $14 million goodwill impairment on our insurance agency.

Net interest income was $83 million for the third quarter of 2008, down $17 million from the previous quarter and down $16 million compared to the third quarter of 2007. Our net interest income decreased principally as a result of significant increase in non-accrual homebuilder loans and because of the subordinated debt we issued.

Interest income we would have recorded had the non-accruing loans been performing would have been approximately $8 million. We recorded $7 million in interest expense on the Guaranty Bank’s subordinated debt in the third quarter of 2008.

We recorded $78 million in provision for credit losses in third quarter of 2008 compared to $99 million in the second quarter of 2008 and $19 million in the third quarter of 2007. Significant declines in the financial condition and liquidity of our homebuilder customers as a result of current residential housing conditions were the primary cause of our third quarter provision for credit losses.

We recorded net charge-offs of $100 million in the third quarter of 2008 principally related to impaired and foreclosed homebuilder loans. We foreclosed on a number of homebuilder loans in the third quarter and anticipate it will become necessary for us to foreclose on additional homebuilder loans during the remainder of 2008.

It is likely we will record additional charge-offs and higher levels of foreclosed real estate as we acquire collateral on those loans. Non-interest income showed a negative $19 million for the quarter compared to $41 million in the prior quarter. The wide disparity here is principally the result of the $53 million other then temporary impairment charge on mortgage-backed securities which I’ll discuss in greater detail when I go through slides on our securities. But non-interest income is where this OTTI charge runs through the income statement.

The disparity also includes a $4 million loss on the sale of approximately $400 million of agency securities. Insurance commissions and fees decreased because market policy premiums and the resulting commission for property and casualty insurance, the bulk of the business of our insurance agency, have decreased significantly.

Non-interest expense was $105 million during the quarter, up $6 million from the previous quarter. Non-interest expense was $15 million higher then third quarter of 2007. Like last quarter much of the increase compared to a year ago was driven by increases in many of our direct costs and expense categories because we began to perform many activities ourselves following our separation from Temple Inland.

Increases in compensation costs resulting from performing these activities were more then offset by cost reductions we achieved from our reduction in force earlier this year. More importantly however, the total non-interest expense amount includes the $14 million impairment charge related to our insurance agency. Excluding that charge non-interest expense for the quarter totaled $91 million, down from $96 million in the second quarter net of the $3 million severance cost during that quarter.

On a run rate basis, that $5 million drop from a quarter ago is a $20 million annual decrease in costs resulting in a $364 million total number run rate for the year.

And finally rather then a tax benefit for the quarter we had a $43 million income tax expense as a result of establishing an $85 million valuation allowance on deferred tax assets. In assessing the realizability of deferred tax assets, we consider whether it is more likely then not we’ll be able to realize the deferred tax assets.

The terms of our separation agreements with Temple Inland prohibit us from carrying back any net operating tax losses to periods prior to 2008, therefore our ability to realize deferred tax assets depends upon our planning strategies including holding available for sale securities to maturity and our generation of taxable income in periods after 2008.

And finally as I mentioned the bottom line for the quarter was a net loss of $162 million. In the earnings release we issued this morning, we show a larger net loss applicable to common equity for the quarter at a $218 million net loss. As a brief explanation, the conversion price for the preferred stock at $5.17 per share was below the $6.01 per share market price for our common stock on the effective date of the private placements.

We have presented the difference as a charge against net loss applicable to common equity in third quarter 2008 because the preferred stock was mandatorily convertible upon approval by our stockholders.

This beneficial conversion feature was recognized as a one-time deemed preferred dividend in the third quarter of 2008 upon stockholder approval of the conversion.

If you turn to slide number four, we will show our net interest margin through time compared to the changing average Fed funds rate. We continue our effort to increase our net interest margin over time by allowing mortgage-backed securities to continue to run off and we expect the run off to benefit our net interest margin.

However net interest margin was negatively effected during the third quarter for the reasons discussed on the previous slide, the cost of the sub debt and the non-accruing homebuilder loans. In addition lower interest rates negatively affect our net interest margin.

The Federal Reserve has already lowered interest rates substantially in recent months and if interest rates further change significantly particularly with a further decline our net interest margin may continue to decline.

We reported today that for the third quarter net interest margin was 2.14% compared to 2.54% for the previous quarter. Additional significant increases in non-performing assets will continue to negatively effect our net interest margin. In the meantime we continue to change our loan portfolio mix which we expect to benefit our margin.

In addition we continue to add loans in our consumer lending portfolio which we began offering at the end of 2007 which are higher margin loans. Now please turn to slide number five, which is a summary of our balance sheet.

We allowed our balance sheet to decrease from $16 billion at the end of the second quarter to $15.4 billion at the end of the third quarter due in large part to intentional run off in our single-family mortgage portfolio of nearly $100 million and payoffs in our mortgage-backed securities portfolio of approximately $200 million.

In the third quarter 2008 we also sold agency issued securities totaling approximately $400 million in unpaid principal balance. Some of these securities were held available for sale, some held to maturity.

Each of these securities had a remaining principal balance less then 15% of its original outstanding amount. As allowed by GAAP we have deemed such sales to be maturities for purposes of classification of our remaining securities. On the other hand total loans were up slightly and in a moment we’ll look at a slide showing the change in each of the loan portfolios in the last quarter and we’ll talk more about the securities portfolio.

We utilized Federal home loan bank borrowings significantly less this quarter compared to last as a result of the infusion of new capital as well as a reduction in our level of total assets, even while our total deposits remained flat compared to the previous quarter.

Our level of stockholders equity increased from approximately $800 million to approximately $1 billion this quarter which is the net effect of the infusion of new capital, less the loss for the quarter and other declines that we are discussing today.

We also show here what these numbers look like pro forma based on 108.2 million shares outstanding which reflects the effect of the conversion of Guaranty’s convertible stock to common as it had been converted prior to September 30, 2008.

The conversion occurred on October 1, 2008. The pro forma book equity per share is $9.25 and the pro forma tangible equity per share is $7.82.

Now turn to slide number six, we show a total of $9.2 billion in total deposits as of September 30 and there is a breakdown of the various categories of deposits. The vast majority of these deposits are gathered through our retail franchise. While there is a large concentration of CDs they are almost exclusively held by long-term customers and you can see here only a very small amount of our deposits are broker deposits less then 1%.

In addition on the right hand side of this slide, we provide the amount of total deposits as of one month later at the end of October. You can see that we received a significant inflow of deposits in the month of October alone increasing $1.8 billion to $11 billion. In light of the disruption occurring in the financial markets we recognize that customers desire to move funds to the safety of FDIC insured deposits.

So we took advantage of that situation and the ability to increase our liquidity by offering a competitive rate on CDs. We did not offer rates at the top of the market but enough to draw a significant interest. That resulted in a net inflow of $1.2 billion through Guaranty’s network of approximately 160 branches located in Texas and California, and from our commercial customers.

And we issued approximately $600 million in broker deposits.

On slide number seven we have included information regarding liquidity. We have a variety of liquidity sources including cash on hand, and deposits at the Federal Reserve, operating cash flows, new deposits, ability to borrow from the Federal Home Loan Bank, and a portfolio of assets including marketable mortgage-backed securities which we can pledge as borrowings, sell our securitize if necessary.

Our borrowings from the Federal Home Loan Bank are secured by a blanket floating lien on certain of our loans and by securities we maintain on deposit at the Federal Home Loan Bank. We continue to have sufficient readily available liquidity resources principally borrowing capacity at the Federal Home Loan Bank of Dallas to meet our requirements.

As of September 30, we had the ability to borrow and additional $2.2 billion from the Federal Home Loan Bank, additionally we had other assets not pledged as collateral on Federal Home Loan Bank borrowings which we could pledge as collateral to other lenders, including the Federal Reserve, providing additional liquidity that brought the total to approximately $4.4 billion at September 30, 2008.

And subsequent to September 30 we raised the additional deposits shown on the previous slides and we used these funds to reduce our Federal Home Loan Bank borrowings. This increased our unfunded borrowing capacity with Federal Home Loan Bank and the total excess borrowing capacity is more then $5.7 billion today.

We also provide information here regarding deposits exceeding the FDIC’s new $250,000 insurance limit. As you can see we only have approximately $200 million of non-commercial deposits above the federal deposit insurance limit of $250,000 per individual.

And we only have about $200 million in interest bearing commercial deposits exceeding $250,000. As Ken mentioned it is likely we will not opt out of the extended insurance program for commercial deposits. Accordingly these two amounts combined total approximately $400 million, or less then 4% of our total deposits as of October 31.

Turning to slide number eight, we show our loan mix and we also show how each portfolio changed since the last quarter. Total loans remained relatively stable with only a $67 million net increase in total loans outstanding on a more then $10 billion loan book.

We sold our single-family mortgage company and servicing assets in 2004 and 2005 and we completed the exit from this segment in early 2006. As a result that is a run off portfolio getting smaller each quarter at a rate of approximately $30 million per month. In a moment you’ll see a slide that shows the vintage and the other characteristics of the loans in this run off portfolio.

And our other portfolios like many banks recently we are limiting loan growth in the short-term in order to preserve capital and this gives us the opportunity to rationalize our loan portfolios with the appropriate credit standards, loan pricing and return hurdles. We are continuing to make some new loans but at a slower rate in recent years.

Most of the increases are a result of funding on committed construction loans. You can see here that our multi family and senior housing commercial real estate, commercial and business, and energy loan portfolios had decent growth during the third quarter.

Single-family construction loans declined by more then $100 million again this quarter which I’ll discuss in greater detail in a moment. And again this quarter with respect to consumer loans, while not large by total outstanding amount we did have strong percentage growth in consumer loans with an increase of about 10% of that portfolio following the roll out of consumer lending that was initiated at the end of 2007, which continues as planned and is inline with our goals for that initiative.

On slide number nine we’ve shown which portfolios have experienced an increase in non-performing loans and clearly homebuilder loans continues to account for the majority of the increase. The number of homebuilder loans deemed non-performing increased from $233 million to $295 million which is evidence of the continued weak housing market.

In a moment I will take you through a table showing the non-performing homebuilder loans by collateral type and geography. Single-family mortgage loans that are non-performing increased modestly from $97 million to $108 million and we’ll also take a look at that portfolio in more detail in a moment.

The amount of REO shown here increased $8 million from the previous quarter which was net of approximately $6 million of REO that was sold during the quarter. We expect continued migration of homebuilder loans to REO in the coming quarters. With respect to the other category we include non-performing loans from all the other loan portfolios here. The total of other non-performing loans is $67 million, up from $34 million in the previous quarter.

If you turn to slide number 10 you can see the increases by category in allowance for loan losses. Starting with single-family mortgage the allowance increased from $24 million to $42 million which is a disproportionately large increase compared to the smaller increase in non-performing single-family mortgage loans.

The reason for this increase in the allowance is because we increased our severity assumptions on single-family mortgage loans. And with respect to the drop in the allowance for homebuilder loans, we charged-off some properties foreclosed on and we took additional charge-offs, also being referred to as direction reductions on impaired homebuilder loans that were not yet foreclosed.

Therefore we’ve reduced the loan balance of those loans to the fair value of the underlying collateral as well as the amount of reserves associated with those loans. The decrease in the allowance for energy is due to the sale of a portion of the loan to the Mid Stream Energy Company that caused us to take a $14 million provision in the second quarter which we explained was an unusual item that is not reflective of the general health of our energy portfolio.

On slide number 11 we show an overview of how our provision for credit losses including commitment related reserves decreased from $261 million at the beginning of the quarter to $239 million as of September 30. You can see that the provision was fairly large during the quarter at $78 million however as we forecasted last quarter the amount of loans charged off increased substantially to $100 million for the quarter resulting in a net decrease in the amount of the allowance.

Annualized charge-offs as a percentage of the loans has now risen to a more normal level for this period of substantial weakness. Most of the charge-offs taken in the third quarter related to impaired and foreclosed homebuilder loans and we anticipate we will acquire the underlying collateral for more of our loans to homebuilders and it is likely we will continue to record additional charge-offs and increases in foreclosed real estate.

On slide number 12 you can see the declining outstanding balance of our homebuilder portfolio which we report under the name single-family construction loans. This portfolio consists of loans to finance home building activities including construction and acquisition of developed lots and undeveloped land.

Our total homebuilder-lending portfolio at the end of the third quarter is $1.1 billion, down from $1.2 billion at the end of the second quarter and $1.8 billion last September. Single-family construction loans decreased because of pay downs and payoffs and because we have exited a number of credit relationships to reduce our risk but also because we foreclosed on some homebuilder loans moving the net amount to REO.

It is likely these trends would continue. This portfolio can also be further divided into two groups; national builders and regional builders. We now have approximately $125 million in outstanding loans to national homebuilders, some of which are unsecured lines of credit but are typically governed by a borrowing base of unencumbered assets.

Our regional homebuilder portfolio is down to $1.1 billion in outstanding loans from $1.5 billion 12 months ago. It is in this portfolio where we continue to see the most difficulty. With respect to commitments amounts, while not shown on this slide the total amount of commitments on homebuilder loans both regional and national has decreased from approximately $3.4 billion at the end of the 2007 to $2.3 billion as of September 30.

This decline is principally the result of systematically reducing commitments that we no longer anticipate funding as well as exiting a number of relationships. On the next slide, number 13, we have an update to the slide that we presented in previous quarters which breaks out our regional homebuilder loans by collateral type and by geography.

For those that are not looking at the slides, we show that of our regional homebuilder portfolio our homebuilder loans, approximately 15% are in northern and central California, another approximately 19% in southern California, 10% in Texas, 8% in Florida, 7% Colorado, 6% Arizona, and the remaining 35% spread out in other states.

Again I would direct your attention to the amount of exposure in California where we have seen the most deterioration. On the far right column of this slide, we also show the amount of non-performing regional homebuilder loans by geography. You can see that the amount of non-performing loans in the California markets is high and while the amount of non-performing loans in the northern and central California region has dropped from $52 million last quarter to $45 million this quarter and the amount in the other California regions has dropped from $71 million last quarter to $48 million this quarter that is primarily the result of both pay downs and foreclosure activity.

The total amount of loans outstanding in the two California regions has dropped from $381 million to $324 million for that same reason.

On slide number 14 we have provided another update to the slide we had presented in previous quarters which details our single-family mortgage portfolio. I’m not going to go through this in great detail rather you have the updated information here. As I have mentioned our single-family mortgage portfolio is primarily in run off mode.

We sold our mortgage origination servicing businesses in 2004 and 2005 and have added very little in single-family mortgages through our correspondent program. After reviewing this and our activity since 2006 we have eliminated our correspondent program as a part of our efficiency review we shut down earlier this year.

The overall balance decreased from $1.5 billion at the end of the second quarter 2008 to approximately $1.4 billion at the end of the third quarter. As you can see at the bottom of the slide more then 90% of our single-family mortgage portfolio was originated prior to 2006 and as we have discussed before we have originated or purchased subprime loans.

We have underwritten option [arms] to the fully indexed rated. Average current FICO scores on our first lien loans is estimated at 710. The 90-day plus delinquency rate for all our first liens at June 30 was a little over eight, a slight increase from the 7% level last quarter.

Total delinquencies for all first liens is up to a little over 14%. Many mortgage holders are still clearly experiencing stress however one reason for increases in our delinquency rates is going to be caused by a shrinking portfolio since this is a run off portfolio. We also believe that borrowers may be expressing financial stress as a result of second liens on their homes behind our first lien.

Starting at slide number 15 we have included a few slides with respect to our mortgage-backed securities portfolio. This first slide is a high-level overview which shows that of our $4.4 billion in securities, $2.9 billion or 65% is categorized as held to maturity, the rest in available for sale.

It also shows that $0.9 billion or 21% are agency securities, the rest are non-agency. On slide number 16 we continue to provide this slide to give an understanding of the types of securities we own and see that approximately 82% of the non-agency mortgage-backed securities are traditional option arms, 14% are hybrid option arms, and the remaining 4% are hybrid arms.

Also we show the vintage of our non-agency securities and the geographic dispersion. The next slide shows the amortized cost and the fair values of our mortgage-backed securities as of September 30. In round numbers the combined agency securities available for sale and held to maturity have an amortized cost totaling approximately $1 billion and their total fair value is the same.

This is a decrease of approximately $0.5 billion as a result of both payoffs and the sale of approximately $400 million in agency securities. Of the non-agency securities, those held to maturity have an amortized cost of approximately $2.16 billion and a fair value of approximately $1.38 billion or a difference of approximately $780 million.

The non-agency securities held available for sale have an amortized cost of approximately $1.33 billion and a fair value of approximately $920 million for a difference of approximately $410 million. The total difference between the amortized cost and the fair value of all of these securities is $1.19 billion which is down from approximately $1.4 billion compared to the previous quarter.

Most of the change is the result of our valuation of these securities which is detailed on the next slide. At September 30 we determined it probable that we would not recover all principal and stated interest on one of the non-agency securities we owned. As a result as I mentioned earlier we recorded a charge to other non-interest income and earnings of $53 million to reduce the carrying amount of the security to the estimated fair value of $79 million.

The total unrealized loss on available for sale securities is now $414 million which is recorded net of tax benefit as accumulated other comprehensive loss on our balance sheet and it decreases our book equity by such amount, in our case a total of $269 million to date as of September 30.

Each of the securities are adjustable rate and backed by single-family mortgages. We have not invested in subprime securities, collateralized debt obligations, or subordinated tranches. At September 30 the average total delinquency rate of the underlying collateral for our non-agency securities was 25%.

The average LTV on the underlying loans was 80% based on current loan balance as a percent of the original appraised value. The average original credit score was 707. These securities do not have an insurance wrapper.

On slide number 18 we show that the subordination level on average for all of our non-agency mortgage-backed securities is approximately 16% and on this slide we briefly explain how we come to the conclusion that our significant subordination level of each security provides protection from credit losses.

First in valuing each non-agency security we found that there are currently no observable transactions for our non-agency mortgage-backed securities and little reliable observable evidence. Broker price estimates we received for these securities vary widely from broker to broker. The SEC and FASB both recently addressed fair value measurements when there are few observable transactions for a financial instrument.

As a result of the issuance of the SEC memorandum and the FASB provision 157-3 we place somewhat less weight on non-binding indicative broker quotations for the non-agency securities then we have in previous periods.

Beginning in third quarter 2008 in addition to considering dealer indicative value estimates we incorporated the results of a multiple path valuation approach prepared for us by a third party as a significant input in our determination of the fair value of our internally valued non-agency securities.

We believe the third party valuation approach incorporates market participant assumptions including required return. Then in doing our OTTI analysis, we determined the extent to which each bond’s credit enhancement primarily in the form of subordination is sufficient to absorb the projected losses on the underlying loans.

Our conclusion at September 30 was that the subordination level for each non-agency security except one continues to be sufficient to protect our securities from credit loss. Other then the security for which we recorded an other then temporary impairment to reduce the carrying amount, $43 million to $79 million, we consider the unrealized losses on the securities we own to be temporary. We have the intent and we believe we have the ability to hold them until repayment and we believe based on current estimates of cash flows on these securities we will receive all stated interest and principal.

Each of the non-agency securities is credit enhanced primarily by subordinated tranches not owned by us which will absorb credit losses of the underlying loans until those tranches are depleted. We currently estimate the credit losses on the underlying loans will not exceed those subordinated tranches and therefore our securities will not incur credit loss.

With respect to the one security for which we recorded an other then temporary impairment although we reduced the carrying amount $53 million to $79 million it is very important to recognize that in our analysis the amount that we projected as our best estimate of actual credit loss on the security was only $2.5 million out of a security with an unpaid principal balance well over $100 million.

Nonetheless the accounting rules require that we take an impairment charge of $53 million based on the valuation method discussed above.

Moving now to efficiency on slide 18, non-interest expense was $105 million for the quarter, an increase of 6% compared to the prior quarter. However as we’ve mentioned earlier in this call we expensed $14 million impairments related to our insurance agency. Outside of that charge our non-interest expenses were down significantly from $96 million in the second quarter of this year, net of the severance cost during that quarter to $91 million this quarter excluding the $14 million impairment charge.

As Ken pointed out one of the significant drivers of the decrease was a further drop in compensation and benefit expenses from $48 million last quarter to $46 million this quarter and to further reduce compensation and benefits expenses on October 31 the company committed to workforce reduction plans what will involve approximately 4% of the company’s employees in order to reduce costs and maximize operational efficiency.

And we show a drop in other expenses which includes a $2 million decrease in travel and other employee costs. We have experienced increases compared to prior years because we began to perform many activities ourselves following our separation from Temple Inland.

And as Ken mentioned we are actively looking at further areas where we may operate more efficiently. On slide 20 we have shown our capital ratios as of September 30 all of which exceed the regulatory standards to be deemed well capitalized.

You can see that the new capital infusion strengthened our capital ratios further beyond well-capitalized standards. As of September 30 Guaranty Bank’s regulatory capital ratios or total risk base capital ratio of 12.6%, Tier 1 leverage ratio of 9% and Tier 1 risk based ratio of 9.7%, all of which exceed the well capitalized standards of 5%, 6%, and 10% respectively.

And with that, I’ll turn it back over to Ken.

Ken Dubuque

Clearly this quarter was another very difficult period for the industry as a whole and Guaranty Financial Group in particular. We stated in previous quarters that we expected conditions to continue to be unfavorable for the bank throughout 20085 and that this current cycle will not likely end soon.

While we’re still not seeing broad based weakness beyond homebuilder construction we continue to monitor all portfolios. We feel that we have set appropriate [inaudible] at this time. These are clearly historic times for the banking industry and the financial markets as a whole, here in the US and globally.

Government has taken aggressive action on many fronts, many of these actions should add stability to the mortgage and credit markets which in turn should result in some stability to the economy, which would be very helpful to us.

As I made clear last quarter, long-term our strategy is to still build our commercial lending franchise, grow our retail franchises in Texas and California, increase fee income, provide distinctive customer service, and improve our operating efficiencies while maintaining strong credit and risk standards.

During the short-term however we remain focused on the three Cs; credit, costs and capital including liquidity. At the same time we continue to provide outstanding service to our long-term and new customers.

Thank you for your attention and for your interest in Guaranty Financial Group. Now we’d be glad to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Brian Clark – KBW

Brian Clark – KBW

You did mention in your prepared comments that you were looking closely at the TARP programs and I was wondering if you could expand a bit on what you’ve been able to hear, there’s been so much discussion about the capital purchase program, is there anything that you’re hearing or being able to get more information on from the asset sales program.

Ron Murff

As it relates to the asset purchase part of the TARP plan there has not been a significant amount of detail that has been provided. We are continuing to look at what information has been provided although as you know it hasn’t been, its been relatively sparse at this point in time. I think the other part of that part of the TARP plan that we are looking to get some additional detail on would be the insurance, the assets.

But both of those parts of the Treasury plan we are still waiting to get further detail on.

Ken Dubuque

And just alluding to what you asked being on the Board of the financial services roundtable, and then being involved with the ABA CEO council and of course a number of our people are actively involved in both organizations, we have been part of that process to encourage the administration and its various agencies and also Congress to move along on all of those fronts so we certainly think there’s opportunity there. We just have to remain to see what it works it out to be.

Brian Clark – KBW

Can you talk about the thought process on the capital purchase side, the preferred stock, with the very cheap form of cost of capital, seen a lot of other banks already come out and announce, have you applied yet, or what your thought process is on the capital part of the program.

Ron Murff

I think where we are is we continuously consider whether we need additional capital and we consider all types and sources of capital as you would imagine including the Treasury’s capital purchase program that you just discussed. But consistent with our policy of not discussing pending capital transactions we have no comment on any of our current activities including consideration of the TARP capital.

As we talked about before a couple of times earlier in the comments we raised $600 million earlier this year taking us to levels significantly beyond well capitalized standards which would be a part of and a factor into our consideration as to whether we need the additional capital.

Brian Clark – KBW

But you’re still looking at all aspects of this TARP including the capital.

Ken Dubuque

Absolutely.

Brian Clark – KBW

As far as the debt guarantee part of it how much senior debt do you have maturing between September 30 and June 30 next year that could qualify under that FDIC insurance?

Ron Murff

As we understand the guidelines that have been issued so far you summarized them there, that would actually be zero for us. We have no senior debt outstanding at the holding company level so that part of the program at least in its most basic form would not appear to apply to us.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Ken Dubuque

We again thank you for joining us on this conference call. Have a great day.

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