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SWS Group, Inc. (NYSE:SWS)

F1Q09 (Qtr End 09/26/08) Earnings Call Transcript

November 4, 2008 10:00 am ET

Executives

Meg Gupton – Corporate Communications Coordinator

Don Hultgren – President and CEO

Ken Hanks – CFO

John Holt – President and CEO, Southwest Securities, FSB

Analysts

Joe Jeffrey [ph] – KBW

Chris Mancini [ph]

Meg Gupton

Good morning and welcome to the SWS Group Quarterly Conference Call and Web cast. This is Meg Gupton of the Southwest Securities Corporate Communications staff. We are pleased you could join us today.

The quarterly earnings release can be found on our website at swsgroupinc.com or on the Yahoo Finance website under SWS news. Market professionals on our distribution list should also have received the slides for today’s call via e-mail. If you would like to be added to our e-mail list to receive press releases or to be notified of future quarterly calls, please contact us at 214-859-6351.

This conference call is being web cast live on the Internet along with the accompanying slides at swsgroupinc.com where it will be archived for the next 30 days. (Operator instructions)

This presentation contains forward-looking statements. You are cautioned that any forward-looking statements, including those predicting or forecasting future events or results which depend on future events for their accuracy, embody projections or assumptions, or express the intent belief, or current expectations of the company or its management, are not guarantees of future performance and involve risks and uncertainties.

Actual results may differ materially as a result of various factors, some of which are out of our control, including but not limited to, volume of trading in securities, volatility of securities prices and interest rates, availability of lines of credit, customer margin loan activity, creditworthiness of our correspondents and customers, demand for housing and other factors included in our annual report on Form 10-K and in our other reports filed with and available from the Securities and Exchange Commission.

At this point, it is my pleasure to introduce Mr. Don Hultgren, Chief Executive Officer of SWS. Don?

Don Hultgren

Thank you, Meg and good morning everyone. Thank you for joining us for the discussion of our first quarter conference call.

I would like to introduce the participants on the call today in addition to myself, we have Ken Hanks, who is the Chief Financial Officer of SWS Group; John Holt, who is the President and CEO of Southwest Securities, FSB, our bank; and also to join us for questions and answers is Jim Ross, who is the President and CEO of Southwest Securities and SWS Financial, two of our brokerage firms.

The agenda for today’s call is that first I’ll provide an overview of the first quarter of fiscal 2009, review some noteworthy items, and touch on some important events since our last conference call. Ken will provide a more detailed review of the first quarter. John will provide an update on the activities at the bank. And I will discuss our market position and our three primary growth initiatives. Finally we will open it up to questions and as Meg said if you would like to get into queue, it’s star 1 on your telephone, or if you would like to ask a question over the internet, it’s questions@swst.com.

First a review of the first quarter. Net revenues in the quarter increased from $113 million in last year’s first quarter to $122 million this quarter. Income from continuing operations decreased from $7.7 million in last year’s first quarter to $7 million in this year’s first quarter. This quarter’s net income was negatively affected by the previously announced $3.5 million after tax write-off of the Lehman Brothers counterparty obligation. I would note that you analyze our quarterly results simply adding the write-offs back in would overstate our true results. Because of the write-off accruals for some executive compensation and profit sharing were reduced. Still it would have been a very healthy quarter. In fact I am pleased with the results even with the write-off as many in our industry have struggled in recent quarters.

Earnings per share in the first quarter decreased from $0.28 a share last year to $0.26 a share this year. We ended the quarter with a book value per share of $11.98.

Let me turn to some of the noteworthy items in the quarter. In spite of the very difficult operating environment, I’m proud that all segments of our business were profitable. Retail and clearing have felt the impact of reduced margin balances and trading activity but still they put up a profitable quarter. The environment has been positive for fixed income and the stock loan department.

And the bank’s portfolio growth has helped to counteract some of the difficulty in the builder loan portfolio. Again I’m pleased and proud of the people who operate these segments as they are able to produce profitable results in these difficult times. In this period we added to the loan loss allowance at the bank. We added almost $1 million to the allowance.

Our reserve to loan ratio is up to 77 basis points from 74 basis points that we reported in the last June quarter.

We enjoyed a strong fixed income market. Spreads and volatility have improved the results for the taxable fixed income business, which saw its commission revenues up 68%. Municipal results also improved in the first quarter where we saw our commission revenues up 99%. Focusing on the $5.4 million Lehman charge, as I said we previously released this amount and it is related to an open stock borrow contract with Lehman. Contracts were collateralized by collateral value proved to be inadequate causing the loss.

Stock loan is a very important and profitable business for us. We continue to see very healthy profits in this division and we continue to look forward to its contribution to our overall results.

Let me turn now to important events. We have had a lot going on over at the bank, for example, we opened up our 11th branch in Southwest Fort Worth. In stock loans, we continue to see very good business results. It is interesting that the spreads have widened and the balances have been reduced. The balances have been impacted by market dislocations and short sale limits. The average balance in October was $1.7 billion.

We continue to work with the people at M.L. Stern and we’re on track for their conversion onto the CSS system in mid December. We moved the bank headquarters to Dallas and now based on the deposits that are at our bank, we’re the tenth largest bank in the city of Dallas. The bank also exited the mortgage origination business. This line of business where we were originated and sold residential mortgages was not a core business to ours. New mortgage originations is now limited to the bank’s customer base.

And with that let me turn it over to Ken. Ken?

Ken Hanks

Thanks Don. Today I would like to start by discussing our summary financial results first, moving on to more detailed discussion of our operating results and then concluding with the discussion of our segment results.

First on the income statement. Net revenues for the quarter, that is operating revenues plus interest revenues, less interest expense were up by $21 million or 31% for the quarter, while pre-tax earnings were down by $1.2 million or 10%. Our pre-tax performance was not as good as we hoped due to a $5.4 million press release-tax charge on closing the Lehman Brothers. We have previously discusses loss in our guidance press release on October 16. This expense is included in other expenses.

We’ve also been expanding our banking business which leads to increased headcount and other operating expenses that come from the eventual income (inaudible). Talking of mortgage credits, the credit environment in general and the slowdown in the housing market has led to increased expenses at the bank specifically a larger loan provision and a greater number of REO properties to be maintained pending their ultimate sale.

Also of note, M.L. Stern contributed net revenue of $12.2 million and expenses of $11 million for a pre-tax profit of $1.2 million for the quarter.

Turning to a review of our individual operating revenue item. Net revenues from clearing were down slightly for the quarter. In the quarter, we processed 5.6 million trays down from 7.3 million in the same quarter a year ago.

Both general securities tickets and day trade tickets were down for the quarter. Revenue per ticket was up in the September 2008 quarter and was $0.59 versus $0.46 per ticket in the same quarter last year. This change is primarily attributed to the reduced volume from day traders in the current quarter over last year.

Commission revenue was up $13.6 million or 61% in the quarter with $9.7 million of the increase coming from M.L. Stern. Both taxable and municipal fixed income commissions were up substantially offsetting the decline in commissions from our portfolio of trading units.

Investment banking and advisory fees were up 9% in the quarter. Fees of $1.5 million from M.L. Stern were offset by reduced fees from corporate finance transactions.

Net gains on principal transactions, which are derived principally from trading in fixed income securities, were up $1.4 million in the first quarter as compared to the first quarter of last year. The primary driver of the increase was trading gains in the municipal businesses including stocks.

Other revenue was down 55% for the quarter primarily due to losses recorded on our venture capital fund investments as well as reduced values of the assets in our deferred compensation plan.

Net interest revenue, which is interest revenue less interest expense of $32.2 million, was up 36% from last year’s quarter. The bank’s net interest was up 23% while net interest at the brokerage was up 50%.

The increase in brokerage net interest was driven by our securities lending area where we thought spreads increased by 107 basis points over last year’s first quarter. We also invested in auction rate bonds during the quarter which provided $650,000 in increased net interest. We carried an average of $96.1 million of these securities during the first quarter and currently carry approximately $64 million in these bonds. Reduced spreads on net interest earned on customer balances offset the increases from stock loans and municipals. Net interest at the bank was up due to higher average loan balances.

Average margin balances in the customer side of the brokerage business of $231 million are down 14% from the previous quarter and down 21% from the same quarter last year due to market activities. Credit balances are down 7% from June and 4% from September of last year. Stock loan balances are about even with the June quarter but are down 8% from last year. As discussed this business line benefited primarily from increased spreads rather than balance growth. We have seen significant decreases in our stock loan balances subsequent to the close of the quarter as Don mentioned earlier.

Many institutions have (inaudible) win their stock to increase their investment returns have discontinues this practice.

Average gross loans at the he bank were flat over the June quarter but up 38% over the prior year. The contraction in our construction loan portfolio has been more than offset by growth in commercial loans.

Turning to operating expenses. Operating expenses were up $22 million from the prior year's quarter. M.L. Stern accounts for about half of the increase. Compensation increases other than Stern account for $3.9 million of the increase in operating expenses. Variable commissions and incentive compensation in the institutional segment accounted for $3.7 million of the increase while the bank’s compensation expenses were up $1.4 million due to branch expansion. These increases were offset by reduced variable compensation in the retail segment other than Sterns.

The increases in occupancy and equipment expense, communication and promotional expenses were mainly driven by the M.L. Stern acquisition. The $7.6 million increase in other expenses was the other main driver of increased operating expenses. This increase related primarily to the Lehman loss mentioned earlier. Additionally, we recorded an increase of 883,000 in loan loss reserves as well as additional expenses related to REO and legal fees.

This next slide presents operating results by segment for the first quarter. Our first segment is clearing. This business encompasses our share of all of the fee revenue collected from our correspondents or their customers as well as the net interest earned on correspondent and correspondent customer accounts. For the first quarter, this segment earned $2.3 million, down from $4.5 million last year. Clearing fees were down only slightly from last year but compressed interest spreads and reduced customer margin balances have reduced interest in this segment.

The retail segment encompasses our private client group as well as our independent contractor/brokers that are housed in SWS Financial Services along with our M.L. Stern business. This segment also includes the product lines that directly support these sales forces.

As we indicated previously, M.L. Stern contributed $12.2 million in net revenue and $1.2 million in pretax income to this segment. Excluding Stern, the retail segment posted net revenues down 9%. Contribution to revenues from our -- contribution from our independent contractor business was down approximately $1 million from reduced revenue while the private client contribution was down about $600,000 from reduced net interest revenue and increased expenses from new offices.

The institutional segment consists of our brokerage businesses that service institutional customers including fixed income sales and trading, public and corporate finance, equity and portfolio trading, as well as stock loans. Pretax for this segment was up 57% for the quarter as substantially all of the business units in this segment showed improved results over last year. Both taxable and municipal units improved dramatically as volatility and a more normalized yield curve helped to increase volume. We kept taxable inventories light but continued to selectively invest in municipal auction rate bonds in the quarter due to the attractive yields.

Stock loan continued to post improved results despite the loss on the Lehman contract. The equity side of the institutional businesses was up 28% over last year as reduced expenses contributed to better pretax profits. The banking segment produced an increase in net revenues of 23%; however, a $934,000 addition to the provision for loan losses in the first quarter, higher compensation costs, and increased cost of REO properties reduced pretax income by 17%.

John Holt, the CEO of the bank, will provide additional color on the banking environment a little later in the call. The other segment includes corporate investments as well as the unallocated corporate administration expenses. This is where we record the results of our venture capital investments as well as the administrative cost of accounting, legal, and other corporate shared services.

Finally, changes this year over last year include a write-down of $1.6 million in the value of our venture capital investments as well as losses in the value of our deferred compensation plan investments.

Lastly, I would like to discuss the few operating statistic for the quarter.

Tickets processed decrease 23% from last year's quarter, while dropping 24% over June. Activity from day trading customers is a primary driver of these changes. PCG reps are up significantly from last year and include the 105 reps from M. L. Stern. The total employee headcount increase includes over 200 from Stern with the rest mainly in the banking area.

Our next slide present average loan deposits and capital balances at the bank. We also highlight the amount of deposits provided to the bank by brokerage customers, which averaged $902 million in the first quarter versus $751 million last year. Our reserve to loan ratio is up 77 basis points, while our percentage of nonperforming loans to total assets was up slightly to 2.5% from 2.45% in June.

Net charge-offs of $304,000 were down $402,000 versus the June quarter. As nonperforming loans moved to foreclosure status, we require updated appraisals and estimates of selling costs on the properties. This determines the charge-off amount that reduces our loan loss allowance. At the end of the period, we updated our loan loss allowance computation to determine the amount needed to state the reserve at an appropriate level, which is what generates the loan loss provision that hits the income statement. In the September 2008 quarter, the provision for loan loss allowance was $934,000.

Our net yield on earning assets improved 14 basis points from June but will likely be under pressure again due to the recent Fed interest rate reduction.

I would now like to turn it over to John Holt, the CEO of Southwest Securities, FSB, our banking subsidiary.

John Holt

Thanks, Ken. In addition to updating our listeners on the bank's three primary lines of business, I would like to discuss the FDIC Temporary Liquidity Guarantee Program. The bank plans to participate in both components of the FDIC Temporary Liquidity Guarantee Program. One component as a guarantee on noninterest bearing transaction accounts with no limits on dollar amount insured. The cost of this portion of the program is 10 basis points per fund in excess of the basic $250,000 FDIC coverage. The other component is a guarantee of certain newly issued senior unsecured debt issued on or before the June 30 of 2009. This guarantee is based on outstanding balances as of September 30, 2008. Our bank had zero outstanding balances as of September 30, 2008, but we have an agreement with our correspondent bank for $30 million and as such has asked the Office of Thrift Supervision to recommend $37.5 million guarantee to FDIC, which represents 125% agreement. The cost of this guarantee is 75 basis points from that issue.

Regarding performance for the quarter, the banking segment reported pretax net income of $4.5 million with strong loan growth of nearly 10% in the linked quarter in our commercial banking portfolio. We are committed to growing our commercial banking franchise and are focused on new growth in this line of business. As for credit quality initiatives nonperforming assets remain relatively flat at 2.5% of assets or $34 million and are primarily concentrated in construction and land development loans. Additionally, we have further increased our allowance for loan loss from $6.9 million in June 30, 2008, to $7.6 million at September of 2008.

While these still do not anticipate a recovery of the housing market in the near term we believe we are perfectly reserved at this time to handle the continued deterioration in our residential construction portfolio. Market metrics in North Texas indicate drop growth in excess of 59,000 net new jobs for the 12 months ending August 2008. Despite the Dallas, Fort Worth has the number one brokering market [ph] in the United States for nonfarm payroll. However, there continues to remain an excess supply of finished vacant housing as inventories represent 3.1 months supply, which is slightly over the 2.5 months that is considered equilibrium.

We continue to work through our residential construction portfolio and are managing credit quality proactively. During the quarter, we opened a new full-service banking center located in Southwest Fort Worth with a team of seasoned bankers. And additionally we’re expanding our geographic reach into El Paso, Texas, with the opening of new loan production office. I’m very pleased to have recruited local bankers in El Paso and I am looking forward to our entry in this growing city. Again we are focused on growing our commercial banking franchise by hiring experienced lenders in geographies across Texas and the southwest.

As Don mentioned earlier the bank exited the retail mortgage origination business during the quarter. Our closure of the retail mortgage origination business is purely strategic in nature and centered on allowing aligning the bank’s growth goals around its 3 core businesses.

Mortgage and purchase lending ended the quarter with average loans outstanding of $256 million, with funding in excess of $1.7 billion for the quarter. Our focus has remained on controlled growth and credit quality as we actively manage our customer list and prudent investors.

A reduction in average outstanding for linked quarter is attributable to our focus on credit initiatives and tightening of our underwriting guidelines. In all I am encouraged by our operating results in this volatile market and excited about our expansion into Southwest Forth Worth and El Paso, Texas.

And with this I will turn it back to Don.

Don Hultgren

Thank you, John. Let me again remind those of who are listening as we get closer to the questions, if you would like to ask a question on the telephone, you simply punch star 1, if you are on the Internet and submit your question through questions@swst.com. Let me go over our current market position.

The management team here has worked very hard over the years to get this company focused on battles that it can win. We have exited a variety of business and has focused in on the three you see on this slide.

Today we’re the largest brokerage firm headquartered in the Southwest. We’re the largest broker bank headquartered in the Southwest. By that I mean a brokerage firm that owns a bank. And we’re one of the largest clearing firms in the United States based on the number of clients. In terms of our target markets going forward in the past I’ve tried to explain this verbally and was told that I probably should use the map.

And so this is that map and what it shows you is that much of our businesses is international business. Our institutional businesses are national and you can see that here with the locations of those operations. But when it comes to the private client group and for the bank we’re very much focused on the Southwest part of the country. We will continue to try to both make acquisitions and to find bankers and brokers in those states where we can build out our footprint and continue to grow and maintain our leadership in the Southwest part of the country.

In terms of our corporate direction, we really have three agendas. Not in the order they are shown on the slide. Those are to grow the broker dealer, grow the bank, and grow the clearing business.

In terms of growing the broker dealer, I believe we offer a very good alternative to financial professionals in today’s environment. To make it clear the brokers are our customers. It is our job to provide the brokers with the tools that they need to take care of their customers in the best way that they see fit. The addition M. L. Stern is a significant step in growing but we also have three in-house recruiters working to grow both the private client group and SWS Financial. I always enjoyed talking to the potential financial associates. I think we offer a dynamic environment to work with your customers. While you can make a contribution to building the biggest regional farm in the southwest, which is an exciting opportunity for you and it is an exciting opportunity for us. I’d emphasize that our growth of the broker dealer is not just focused on our retail operation. We have been aggressively growing our institutional ranks of bankers, sales people, and traders. We recently hired a new managing director of corporate finance. This had been a slot that had been open for quite some time. I’m excited about the leadership in corporate finance. It is a business that as you know has not had a material effect on the overall corporation in prior years but I think the opportunity exists in this marketplace for us to have a very robust corporate finance program and I think that we’re just now embarking on addressing that opportunity.

Growing the bank. The environment has probably played well for us in terms of growing the bank. It has reduced the attractiveness of de novo banks. This has been a challenge for us in the past as the model had been to attract bankers with equity and then have cash out in a number of years, made it difficult to bring people to a more mature platform like ours. That alternative is a not attractive. It also has created an opportunity for our focused and talented management team to continue to look for bankers. And as John pointed out we have been successful with that. We have a new office in South Fort Worth. We have a new loan production office in El Paso. So the management team at the bank continues to take advantage of a difficult environment and bring new bankers and talented bankers on to our team and it is exciting to watch that growth as we go forward.

And finally growing the clearing business. We’ve been talking for a long time about the excess capacity that we have in clearing. This means that there is tremendous operating leverage as we grow clearing. We have a fixed cost structure and as we bring on our customers we’re able to leverage that fixed cost. We have invested in many new professionals in the clearing side, new management, a completely new sales force, and new product professionals.

The clearing team is working with our IT department. We continue to develop new products and services for our customers both to attract new customers and to service the needs of our existing customers.

Finally, acquisition opportunities. This is a time of great opportunities for SWS Group. In recent years, we have succeeded in focusing the firm on those business areas where we have the ability to capture market share.

We have brought in professionals with fresh ideas and energy to help us grow the bank, the broker dealer and our clearing business. Our balance sheet also remains strong. We are positioned to grow at a time when many in our industry are struggling.

I believe this confluence of conditions means that fiscal 2009 is a year in which we should be able to expand through acquisitions in our core businesses. Hopefully, the credit markets will loosen and provide greater access to capital. We would like to put some leverage on our balance sheet to improve the returns to the shareholders.

I look forward in the quarters ahead to be able to talk with you about both our internal growth and any other potential external opportunities that we can successfully identify.

Finally in closing, as I said these are exciting times for SWS Group. We have the strategies and the people to achieve our objectives of growth. Thank you to our employees who go above and beyond the call of duty to help us execute these strategies. SWS Group has great employees, and I’m proud to be on their team. Thank you to our customers. You are the reason we are here, and we strive to earn new business everyday. And finally thank you to our shareholders for your confidence and support. I look forward to sharing our progress with you in upcoming quarters. And I wrote in here on the bottom of my notes to (inaudible) today it is obviously a big election and this one (inaudible).

Question-and-Answer Session

Operator

(Operator instructions) Sir, we do have a question over the phone, would you like to take that?

Don Hultgren

Yes. Please.

Operator

Comes from Joe Jeffrey [ph] of KBW, your line is open.

Don Hultgren

Hello Joe. How are you this morning?

Joe Jeffrey – KBW

I’m all right. How are you guys doing?

Don Hultgren

Good.

Joe Jeffrey – KBW

Wondering if you could comment a little bit on the pull back in the high volume traders that you saw over the quarter. It seems pretty pronounced and I’m just wondering it is sort of a start of them getting out of the market given the conditions or it is just a seasonal event.

Don Hultgren

While Joe, I guess, you know where we saw some pullback was when we started to have limitations on short sale loans. It made it difficult for a lot of our high volume customers and specifically their customers, the traders, to get the stock loans [ph] that they needed to do their business. And so, you know, I think much of what we saw in the quarter was related to some of the aggressive regulation that we saw in the short sale rules. So at this point it will be difficult to say if that was a trend one way or another but I will say it certainly isn’t surprising given the way the rules in the game are moving at this time.

Ken Hanks

Joe, one of four top five day traders also left during the quarter. Very slowly the accounts were just transferred out and that accounted for some of the reduction as well.

Joe Jeffrey – KBW

All right. And then I know the said M.L. Stern conversion was going to start in sort of mid December, can you remind us again what that impact is going to be to our earnings?

Don Hultgren

What we have said in the past is that we thought the total impact to cost converting M.L. Stern would be about $0.06 a share, probably over about a two quarter period. Now that being said I have been more than pleased with the contribution that M.L. Stern has been making to the bottom lines. Apparently municipal securities are a very attractive in the current California environment. They’re doing extremely well. And so -- but we will have costs associated with the conversion, costs associated with terminating some contracts and such. And again we haven’t revised $0.06 number that we provided at the time we announced that.

Ken Hanks

Now if you are talking, this is Ken. If you are talking about the impact going forward, I think we originally believed that what would be about $0.02 per quarter positive impact obviously, like made over $1 million pre-tax in the last two quarters, which would be the $0.02 would be conservative.

Joe Jeffrey – KBW

Okay. Just looking through the Q you guys put up today as well, looks like there was a large increase in loans past due 90 days. It looks like it amounted to $8.3 million from $330,000. Can you just add a little color on that?

John Holt

Joe this is John Holt, and there is one primary loan that was past due at the end of the quarter. The payment was made on October 3rd and that accounted for about $5 million, to say loan on a condo that we have talked about in the past.

Joe Jeffrey – KBW

All right. And then staying with the bank, I know you guys did mention that you are pulling out of the, I guess the residential origination business. You know, if the Dallas market continues to stay strong. I know you guys said it was a strategic call only. But I mean is there any other color you can give us as to sort of why are you seeing a greater deterioration in the Dallas market or is it just purely that this is not a business you want to be in.

John Holt

Joe this is John again. I really look at it as a low margin business and a lot of the large institutions, Wells, Bank of America et cetera are going to be your primary lenders in that market. So a lot of it has to do with margin and that being a high volume low margin business.

Joe Jeffrey – KBW

All right. And then just lastly maybe a more positive question for you. You guys have talked about looking for acquisitions, is there any one space that you are most interested in right now?

Don Hultgren

Well, Joe I think that probably the most likely space would be the on the banks side. You know, in the past bank assets have gotten to be very expensive and so I think that we’re seeing some price expectation adjustments on the part of owners of those banks. Against staying the course, the M.L. Stern acquisition was a very attractive acquisition to us. Frankly, we didn’t even know it was (inaudible) until it was brought to our attention and so another brokerage firm with employee brokers as opposed to independent contractors would be attractive. A clearing firm would be very attractive. There are number of other broker dealers for whom the clearing business is not a core competency for them and we continue to try to talk them into considering selling those assets to us. And finally we do see things that people on the institutional side that would become available. I would say that if I was going to have to target the likely next acquisition would probably be a bank, and then maybe a clearing firm, then a retail firm, then institutional. But that can change based on what the investment bankers turn up. But it will be in our core competency. You won’t see us running off in another direction.

Joe Jeffrey – KBW

All right, great. Thanks for taking my questions.

Don Hultgren

Joe, thank you.

Operator

The next question comes from Chris Mancini [ph]. Your line is open.

Don Hultgren

Good morning Chris. How are you?

Chris Mancini

I am okay. How are you?

Don Hultgren

Good.

Chris Mancini

Good. Just a quick question on slide 19 regarding the bank statistics. Just on a sequential basis it shows that your net charge-offs were down from 706 to 304 and your provisions also declined. Can you just comment of that? Is that a function of your pulling back to some degree or having pulled back in the past on some of your lending or do you actually see credit quality improving amongst your customers. Can you just comment a little bit on that?

Don Hultgren

I think what you are seeing is this when we you sell these properties that we take back on the residential construction site. Until they’re sold we don’t actually have the charge-offs. So those are going to be (inaudible) when those occur, when the actual sales occur. So -- but I think overall you see a flattening of credit quality and that is primarily in the residential construction area in north Texas.

Chris Mancini

Okay. So even -- but then on the provision side you guys provisioned this quarter than last quarter. I guess what was the reasoning for that and what can we infer from it.

Don Hultgren

Well we actually increased the allowance, so if you’re looking at the basis points we increased it --

Chris Mancini

I see.

Don Hultgren

By 30 basis points to 77 basis points.

Chris Mancini

Now I understand. Okay, and so your loan book just got a little smaller.

Ken Hanks

Yes and that is primarily because of the mortgage purchase business. If you look at that that is a conduit line and so, it was substantially lower so on the loan side.

Chris Mancini

Okay, thanks a lot.

Meg Gupton

We now have a couple of questions from the Internet via e-mail and I will read them out loud. They are both for the bank. One says I know you have more than enough suite deposit potential from the retail brokerage to fund the bank’s loan growth but as you are hiring new loan officers are you placing any emphasis on hiring people who know how to bring in the lower cost business deposits.

John Holt

(inaudible) this is John Holt and in that regard the answer is yes. We just converted on our core operating systems to (inaudible) products and we are also focusing on the remote capture products and are absolutely going after business accounts that are noninterest bearing in that regard and also the full relationship as opposed to pools of loans we originate our loans. And those customers we do want their deposits. So, yes as we bring on the new offices we’re focused on bringing the total banking relationship, which includes the low-cost business deposits.

Operator

The next question is remind us why 77 basis points are enough to cover 250 basis points nonperforming assets. Are there any prices in the market that would give you comfort that your charge-off severity assumptions are reasonable?

John Holt

There is three things. We use a historical average on this and then the other thing that I would say in regards to that is that is all of our loans are secured and so these loans tend to be sold without having the severity of the charge-offs that you might otherwise get if they were either unsecured on secured by their collateral. And I guess the real key is North Texas has not experienced the same severity as maybe the coast of California, Florida, and Nevada and some of the other markets have.

Don Hultgren

(Operator instructions) Okay we are not hearing any additional questions. Again, I would thank you all for participating in our call. I would again thank the employees for an outstanding job and finally encourage you all to get out there and vote today. Thanks and have a great day.

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