Raymond James Financial Inc. F1Q09 (Qtr End 12/31/08) Earnings Call Transcript

| About: Raymond James (RJF)

Raymond James Financial Inc. (NYSE:RJF)

F1Q09 (Qtr End 12/31/08) Earnings Call

January 22, 2008 8:15 am ET


Tom James - Chairman and CEO, Raymond James Financial

Steve Raney - President and CEO, Raymond James Bank

Chet Helck - President and COO

Jennifer Ackart - Controller and CAO


Joel Jeffrey - KBW

Steve Stelmach - FBR Capital Markets

Devin Ryan - Sandler O'Neill

[Call Starts Abruptly]

Speaking of freezes and cold weather, clearly the markets suffered in this December quarter and they have continued to suffer going into January where we had reminiscences of what occurred in October again two days ago in the stock market with another onslaught on financial services industry, particularly the banks, experiencing declines in the stock prices of 20% and more as investors seemed to lose confidence in the whole system.

Just as an overview comment, I thought it might be appropriate for me to comment that I actually think that while we are in this second wave of recession-driven earnings disappointments and perhaps some additional credit losses, and I think the efforts on the part of the government to resuscitate the financial system have actually begun to be felt not just in lower spreads in the marketplace, but also in some renewed effort on lending some more stability at the banks.

I will remind everybody, again, that as you can see in our numbers in the December quarter, the public mortgage-backed security market, principally the private-branded labels in that segment were hit once again with tremendous valuation reductions not necessarily real declines in the quality of the underlying merchandise. We really have not seen here trends that are particularly frightening in that particular arena.

I am not sure that this quarter's declines were justified by underlying facts, and, as you know, we stress test everything. Therefore, what you saw as a microcosm on our statement is actually occurring all over the financial system. That impacted earnings, and then you had added to it some of this radiation into other areas of the economy beginning to be felt.

I would tell you that the second wave like the aftershock on earthquake is actually going to be less serious than the first one as the institutions have been strengthened. I think that is what you see in Jamie Dimon and Ken Lewis' purchases; not last-ditch efforts a lá JPMorgan to turn around the depressionary market declines.

I think this is favorable, but it is still very early in the game because of the Phase II recessionary activities coursing through the economy today and everyone is still looking for debottoms. There is not going to be a debottom on the general economy. The general economy is going to take all year to really clear up. You all can make your own forecasts on market action. I know analysts are not much better at that than market strategists.

It is pretty hard to forecast when a market will begin to foretell future turns in the economy. I know that everyone is tired of this. I know everyone would like to have it over, but I think that you actually need in the healing phase of this a little more period of adjustment than you would normally have and we are clearly not through this recessionary impact a lot of which is generated by the pure response of corporations to a fearsome market condition where sales in the Christmas season, et cetera, and every other element of business activity measurement is trending down.

Everyone is trying to react to that, which of course only heightens the degree of decline. I think all of us have to often step back from what is happening at the moment to try to get a better feel for what this general outlook might be.

I might comment that since I talked about that markdown in securities, particularly related to this private branding, by which I mean that the percentage of write-downs in this particular class of small class of securities that we have at our bank is enormous. I would tell you if you could buy portfolios at these valuations at the end of December, you ought to lock them up because my guess is the returns will be in excess of 25% on those securities.

A lot of them are actually priced at lower than an IO, might be with the same securities in the marketplace. This is a time when I would tell you that there are tremendous opportunities in those securities and of course most of your financial institutions simply can't buy them. They do not want to buy them. Unfortunately, as I will remark later, there are buyers of them, which impacts our own financial results. Of course that $85 million additional write-down had the impact of dropping our book value per share since it goes directly to the balance sheet.

That and the currency translation that occurred during that quarter hurt the book value calculation, but as near as I can tell of my comment in the press release about it being an emotional reaction and not a substantive event, I still think we are on the money and that we will see some leveling out in the malaise in the real estate mortgage-related side of this. I have reminded you consistently that we are very focused in the higher-end credit client marketplace in those securities.

Any concerns I have with respect to banking relate more to corporate lending where we have been knock on wood so far largely totally unscathed. It is only the real estate commercial banks that we have talked about before that has impacted us.

Now, when you look at these results, clearly revenues are down. The gross revenues by a large amount as interest rates have hopefully they have bottomed out. I do not know how you get the negative rates from the standpoint of our numbers, but clearly the decline there of 16% was more than the 3% net revenue decline.

You need to pay attention to the fact that that decline in gross revenues was largely focused in interest even though clearly there were movements on the revenue front that we'll discuss in the segments as we go through.

The profit increase, as I point out in my report, as you will see is largely focused in the fixed income segment, which is mainly institutional in nature and on the banking side obviously where comparisons are extremely dramatic in terms of net interest earnings as they were the preceding quarter as we have benefited from that three to five-year ramp-up in loans over the period.

As you know, we have attempted to slow down the growth of the bank to make it correspond more to the internal growth rate of the bank's capital and the long-term historical rates of growth in the rest of our securities activities. The reason for that is principal-based. It is not really any other consideration that is driving this.

I am a controlled growth person and I also very much like the business mix that we currently have. We are not attempting to transform ourselves a lá, say Legg Mason, from a Private Client Group-oriented business to one which is, in Legg Mason's case, the asset management and in our case would have been the bank that you would be discussing because of this rapid growth.

We actually like the diversification of business activities we are involved in and it has worked out very well. You did see book value drop to 15.96. That is really, as I say, a result of some of these direct effects on net worth and I have seen some of your early comments on our release which asked about that. I wanted to clarify that.

When you go to the Private Client Group, you should note that over this period, we have essentially generated 321 new financial advisers in total. This is not just Private Client Group. This is total adviser count which is a 7% increase. The vast majority of that is in the Private Client Groups and it's pretty much across the board US, even our independent contractor operation, our employee operation, are both contributing to growth.

When you look in Canada, you see growth even though it's smaller absolute numbers and you also see growth in our UK adviser operations. I do not see any slowdown in the pipeline. As you might guess, the continued chaos, the announced merger of Morgan Stanley and Citi Smith Barney, will only create more opportunity for recruiting. To be frank, we are bound by two considerations. One we budget the amount we spend on costs for acquisition of new financial advisers. At the rate we are going, we will have spent our budget which we probably will enhance somewhat but not dramatically for the remainder of this year.

This is mainly in terms of controlling profitability effects of that growth, but also as a practical matter, recognizing that we are straining the resources of all our people in transitions as well as in the recruiting process itself; where virtually every one here gets involved. As you know, we have these home office visits, where prospective financial advisers come here and they meet with numerous people so there is an impact throughout the organization. For the last four months of this fiscal year, we have essentially been operating basically at capacity.

We are being very selective. We are focusing on not opening new offices and indeed filling vacancies in offices that are either long-term offices or those certainly that have been opened in the last couple of years. Even some of those are operating at capacity now.

We are going to continue to hire into those higher return, what I would describe as bigger need focused areas. Since we have financial advisers and branch managers who often tune into these calls to listen to our conversations with you, the analysts, our message is that we are going to be very focused during these times.

The second consideration is just in terms of capital expenditure limitations. Since this is largely intangible capital expenditure that reduces liquidity and reduces the amount of net capital available in our organization, we clearly do control this expense or this capital expenditure just the way we would with anything like new buildings and equipment and those kinds of purchase decisions.

We are a budget-driven organization with a goal of trying to grow under similar market conditions, 15% to 20% a year. That is the picture and clearly we added to the sales force over this last year not counting the productivity enhancement associated with the higher quality hiring, an increase of 7% in the field forces here.

I did mention that some of it was outside the area of Private Client Group and that is principally in taxable fixed income where we have added substantially to many of our offices both meeting business opportunity that are presented us and in terms of being able to fill out some of these newer offices that we had opened on the fixed income side. We intend to again continue some controlled growth on this side as high quality institutional salesmen are available in the marketplace. We think we are filling a need there.

One other thing in that report I would focus you on is, probably the assets, the client assets under administration, which is probably the most important statistic I could point to you for longer-term trends and things of that nature. We essentially show a decline of $217 billion to $170 billion over the last year and a lot of that is dramatically in the quarter. Often we forget how you could have a 14% or 15% decline in assets in one quarter and what impact that has on business capacity because we are limited in those terms.

We have also added numerous assets from these net acquisitions of financial advisers to our force. You can also see the conservative nature of the clients reflected in the statistic underneath that which is the decline in client margin balances where with declines in the market and the negative effects of leverage occurring clients are wisely reducing exposure. I would not be surprised that you may see some increases in that if you would describe what recently occurred in the marketplace as maybe another element of capitulation and attack on the financial security side.

I am not saying that I know that we are finished with downside. It would not surprise me if the market goes through lows. I am making these comments to get you focused on what the revenue generation side of this is. As you know, we have a high fee-based compensation component in our total comp. Needless to say, all of those fees are driven down by declining assets and they are really based on the preceding or the last quarter-end's valuations the way we bill.

You would see this big decline in the December quarter being reflected in revenues in the March quarter. This is still ongoing as these valuations change. When you go to segment reporting here and look at the Private Client Group, you can see the dramatic decline in income a lot of which is interest-related, but we had a substantial decline in commissions for the reasons I have just reported, not because anything else is impacting us except to say that you can tell we have an absence of underwriting businesss, as does the industry.

Therefore, that necessarily reduces both retail and institutional commission activity since those commission rates are generally at premiums to the secondary transactions, and often might be viewed as incremental to normal business activity. When you look at the profit effect you see profits drop by 42% and actually if you go underneath that some of you asked about compensation, we always have this impact of bonus reversals in the first quarter that reflect accruals that do not get dispensed and this year, it was larger than normal because we have both reduced the overall bonus awards by about a 10% factor to recognize the malaise in the marketplace.

It was kind of more to feel the pain along with everyone else. While our profits were down somewhat, they weren't down very much, last year the 7% range kind of a number. Everybody is crying for no bonuses and Wall Street being overcompensated, and I would never say we have bonuses anything like the major investment banks, but the fact is we did make a revision like that and then we never totally award accruals.

Therefore, that resulted in about $11 million or $12 million reversal in the period, and then you have some of the other impacts here like price valuations on stocks that get involved in these transactions, in the compensation calculations.

In the mix of business activities, changes, it makes it very difficult to just assume based on gross revenues, some sort of a percentage payout to comp, not just on a quarter-to-quarter basis, but just as a general principle making comparisons to even the prior year.

You need to pay some attention to that, because this is sort of a consistent thing that occurs in the first quarter. We are actually comparing to a similar effect, albeit somewhat smaller last year that occurred. I do not like to think we are doing better on a profit basis because our stock went down.

Somehow the logic of that is antithetical. I would like to think we should be able to eliminate that from operating earnings reporting; but that is not consistent with GAAP.

So that is sort of the result there, and to carry that forward on the Private Client Group, because of the comments I have already made in my outlook for the marketplace sort of extending this through fiscal 2009 and maybe even through calendar 2009.

I would say I do not expect the comparisons on the Private Client Group to be particularly attractive, because the other thing that is going on here is the impact of all that recruiting where the amortization of front money and the actual direct costs of [ACATS] office openings, payments to outside broker-dealers, all those kinds of effects that attend the normal recruiting process are still being felt in spite of the fact that our management team in the Private Client Group is actively engaged in reducing costs at the branch system, and at the home office.

Our operating personnel are doing the same thing in all operations. We are in effect, a microcosm of what I spoke about earlier, that we are doing everything in light of an outlook for flat to declining revenues in the security side of our business going forth this year, with the exception of perhaps fixed income that we are cutting all these costs.

In fact, if you were an attendee at our operating committee meetings the last two weeks, you would come out of there saying, that seems to be the principal focus of the firm, they are indeed dealing with these issues. My comment in the press release reflected that a good deal of that gets offset by all of these costs attended through recruiting.

You need to understand that the process is also ongoing. It is not that we are not dealing with direct operating costs, quite the contrary. We are doing that and it's just that you have this impact of very high levels of recruiting going on currently.

When you go to the capital market segment of our business, it's clearly two pieces today. Normally they are operating in a little more sync, but they do have these contra business impacts in these kinds of environments. What is really happened, of course, with only three underwritings in the period and again, those focused generally in energy or REIT financings, which were yield-sensitive retail products, I do not see that changing in the near future.

We have had pretty good M&A activity on the equity capital markets side, and while commissions weren't particularly good this quarter, that we generally have been running higher than the preceding year, offsetting a little bit of the decline in the investment banking side.

While M&A makes up some of it, it does not make up for a total absence of underwriting activity. I think you can generalize that across the marketplace. I suspect that the near breakeven results of equity capital markets are actually good.

Now, when you look at the fixed income side, contrary to the observations I just made, what you have seen is a dramatic increase in comparative commissions. Just off the top of my head, it was around 160%, some kind of number like that, that showing this continuing interest of clients and trying to buy some of these mortgage-backed securities where they can get intelligence on the quality of the underlying portfolios and recognizing the high yields that are available in this marketplace.

At the same time, you have sellers that are either required for some reason to sell positions into the marketplace at unseemingly low prices, or you have just their absence of participation as buyers enabling some of these more speculative activities to go on in the marketplace, which usually are not retail activities at all. They are more fund-driven activities.

You can imagine with the hedge funds generally sellers, as they have calls on their capital, you essentially are in a very good position to move assets to more stable buyers, and I think that is continuing in the marketplace. I do not see any end of that during this fiscal year. I think this is going to be a real good period.

As financial institutions begin to ride their ships and recapitalize their balance sheets and become more active, they will indeed begin to buy more of these securities because they recognize these values too, but they are constrained in the current marketplace while they de-leverage.

That is sort of the outlook in fixed income and the trading implication of that, while very volatile, depending on daily market moves in these, is generally, I would say favorable, to what normal conditions would be.

The spreads are up. The value of this research and analysis that enables you to differentiate amongst the different pools of mortgage-backed securities allows the opportunity for more trading profit, and you see that in our trading results for the month.

Net trading profits of $9.2 million versus $1.1 million last year in this quarter, obviously a dramatic increase and an even more dramatic contrast to the $7 million loss in the prior quarter, which depressed last year's fourth quarter.

Basically, these results I think are perhaps slightly better than you might have in the succeeding quarters on average. I expect fixed income to continue to carry anemic equity capital markets activity for at least the next two or three quarters. That is my outlook there.

Now, the Asset Management Group, as you can see revenues were down 21%. This is a direct reflection of perhaps lower net sales and lower gross sales of new money being raised, just because people do not invest when markets are down no matter what your benchmarks are, how well you are beating benchmarks. That does not mean a whole lot to you when you are losing money. I have not seen anybody spend benchmarks lately.

We are suffering mainly from just a net decline in the value of the securities under management. You see that statistic dropping down now from $37 billion to $27 billion or $28 billion year-to-year. That is a dramatic decline, and you can see the effect in the quarter, which was almost the majority of that decline.

Clearly, they are focused on reducing expenses in all facets of the business because it's pretty hard to predict that you are going to increase your rate of raising money in the face of a market that is not going up. That is my own industry analysis perspective.

Then you go to the bank and, of course, revenues were only up slightly because gross interest rates were way down, but, net interest earnings were dramatically higher here at the bank.

That is why my comment on industry operating cash flow dynamic is that the government has done everything it can to reduce the cost of funds, thereby increasing the spreads available to banks to encourage them to lend, but also to enable them to make a lot of money, so that they can offset these continuing write-downs in public securities and indeed in whole loans as you have impairments occurring in the industry as we have seen in some of the recent reports.

I actually think this is great for the banks. I do not foresee it changing much during the remainder of the year. Those of you who were surprised by the level of profitability by the bank, I would tell you, you should not be surprised.

If you look at the amount of reserves we set up during the quarter, they more than comprehend the volume growth, which was around over $500 million in loans over the quarter. Indeed, we are making loans, Mr. President.

I think there are tremendous opportunities for high-quality loans in the marketplace. Maybe we have never seen anything like this in our history. Of course, we have only been a bank for 13 years.

We took additions to that, we established some more subcategories in terms of our reserves where we would take geographic markets, where we would write off a higher percentage of loans in the marketplace, take your California, Florida, Texas, Arizona, Nevada loan portfolio.

While we have managed the geographic dispersion of the portfolio well, the fact is those are still large originating areas that tend to have a little more in loans than other parts of the country and more problems by far. We have increased some of those reserves.

Actually, our performance and Steve Raney is here with me, so when we go to question-and-answers, if you want more depth on that, I would suggest that you refer those questions to him. We are being very cautious in terms of our outlook in the marketplace.

I have repeatedly said that our reserves have exceeded our stressed levels of expected actual charge-offs by lots, but none of us really know, I certainly have my own comfort zone of where I think economic activity in the United States and the rest of the world is going to sort of bottom out, and you do not want to be too negative in this viewpoint, otherwise you probably wouldn't make any loans, and I think that would be as wrong as some of the stupidity that went on when everyone made every loan available.

The outlook then, as you see that contribution from the bank, $54 million pretax after those large reserves yielded a 270% increase in pretax contribution. As I said, I do not see any conditions for the remainder of our fiscal year that are going to change that a whole lot. It would take some big surprises.

We intend, as a matter of business policy, to grow the bank roughly consistent, and not all this stuff is under our control, with the rate of retained earnings, which exceeded $30 million after-tax during that quarter; if you continue to expect that, that really does imply a fairly rapid rate of growth in earnings.

I have said that none of us know what spreads are going to do. There seems to be some decline in spreads occurring, but I can tell you, in our grade of corporate loan, B, BB. Even though we are focused on the very high-quality cash flow coverage loans, I would suspect that no one is going to lend to these individuals at loan spreads.

I actually still think that our performance with those loans is going to be very good. We continue to direct both our internal bank people who do very high-quality analysis of our loan portfolio, and we actually have a team that is doing additional work on the portfolio currently trying to see if we can see any trends or develop any softer spots or whatever it is that is going on in that portfolio that would be of a concern to us and so far, I do not have anything to report on that.

That is not the reason that we increased reserves. It is just I think appropriate recognition of the fact that there are, in this kind of an environment, more risks associated with surprises than there normally are, and I have consistently said, and still say that we expect higher charge-offs in these environments. That is what reserves are for, but I do not think that we are going to have the kind of surprises that many of you have forecast for us.

Hopefully, some of you are better able to review these portfolios and determine what happens, and I know it is very difficult to do it on an individual company basis, but the fact is you need to be doing that because these bank portfolios differ one from another by lots, and you have to also be careful.

That is why when I see markets where every single bank goes down 20%, I say to myself what are these guys doing? I mean it's not like what you read about for one, two or three of the largest banks is representative of what is going on in the rest of the industry because it is not in spite of what the press would lead you to believe.

I expect the bank will continue to have good contributions going forward for the rest of the year, which is good because the outlook for the security side is for more weakness, not more strength. I look forward to being surprised on the upside, but I do not expect it in the next couple of quarters.

While I do not go to bed and not sleep worrying about business activities, I am also not exuberant about the outlook. This is the time when managements earn their keep, and spend a lot of time managing all these costs, managing risk, and when you come out of this tunnel, you have tremendous operating leverage.

The one point I want to make to you all that I think is extremely important is this business is not all about half-empty glasses. This business has a half-full glass associated with it. It just happens to be down the road a little bit, and when all of us come out of this; the banks, the securities firms, the rest of American industry, and we have pared our expense budgets and we have really gotten down to the bone and the sinew of the capability of American industry. I think what you are going to see; you are going to see dramatic productivity enhancement; you are going to see dramatic earnings improvements.

I would say the security side of our business is operating on three out of eight cylinders. If we can earn what we earn in this environment, I do not need to project what happens when you come out the other end. I think one of your jobs, I probably shouldn't say this, is to have the discipline to give people longer-term perspectives.

Sometimes you don't know exactly when things are going to happen, but you do know where the great opportunities are for them to invest. When you see stocks virtually go to low single digits that we are selling above 50, you begin to wonder if everyone has lost sight of what is really occurring here and what should be rational behavior.

When you look at our other segments that are reported, many of them are small, but a lot of the impacts that I have talked about affecting our major segments are also affecting these. Consequently, you do not get any major changes in these numbers, but generally the pressure is on the downside. You need to understand that.

There are opportunities in all of these businesses too that we are focused on and trying not to neglect. Clearly, the main focus is on the bigger parts of the business, but I think you need to have those circumspect kinds of behavior too.

Just to give you one other anecdotal piece of evident to what is going on regarding the governmental side. The government is clearly in a position of forcing cash trust out of the business, because the yields that they can earn overnight, or even in 30 or 45-day paper without taking any kind of risk, and you do not dare take a risk to break a dollar, will not yield any kind of management fee income to the firm, much less cover payments to brokerage firms and pay adequate yields to clients at the same time in a lot of these cash alternatives.

Another negative here on the cash side is by having gone to virtually zero on overnight rates; you have these anomalies where you drive down the street and you see 2.5% or 3% interest rates on money market funds by various community banks. That forces money out of cash trusts. Cash trusts here the money where we were -- in a real world of identifying those which we must be in the intermediate term, the fact is that we will have to pay higher returns in the brokerage industry to these people.

Today, if you did that you might be running a negative interest spread to retain assets. I would foresee that you are going to see cash trusts shut down. You are going to see money whether they shut down or not, money moving out of those cash trusts into the banks, and other forms of income generation. I do not have to remind you. I had a customer that I gave a list of securities in my portfolio.

I have this special sub-segment of my own portfolio where I buy things that have very high yields or potentials for high yields. In the REITs and MLPs, and other similar securities, you can find pretty high-quality portfolios of assets that are selling at less than half NAV and have high double-digit rates of return. Therefore, there are options for these clients.

At some point, they want to take some risk to get their returns up. They have lost a lot of money, so they have lost their income generating capacity and somehow they need to replace that while they rate out this market and they can not do it in cash. This is a very interesting dynamic in which we are involved.

All of our product areas and research are focused on trying to identify special opportunities within those segments for our clients so that they can still have a reasonably safe harbor; more risks than the cash trusts by far. But, they can get the income that will allow them to live their current lifestyles.

The tax rate; COLI adjustments have a tax rate at a higher level than you would have expected. Generally, I would just conclude that the ROE at the bank is at unprecedented levels because of these spreads. The ROE of the firm overall in the lower than 15 range is not within our norm objectives. Under the circumstances, this is exemplary.

We are all working hard. There are a lot of cars here on weekends and late at night trying to deal with all these issues. We will be here when we get out. We are still in the process of waiting to hear on final TARP approval. We still anticipate we will be approved, but no one knows in these times of inaugurations and great debates and changes in terms.

I think we need to guard against putting too many restrictions on these things. We are not going to take a lot of this. We are still in process on the bank conversion, which we have examined now and we do not think anything went badly. But, who knows.

I anticipate that we will get that done later this year. I do not know how long the wheels of government usually grind, and unless you are about to go out of business, we do not qualify. We are also in the final stages of reformulating some kind of a revolver line with our group of banks. We have adequate capital and cash to operate just as we are. Any additional capital that we employ will be generated to the bank just to continue this growth.

We still have fairly high cash balances in the bank that we would like to invest. I think we will get a better feel about what "hot" money there is there and be able to figure out exactly what we should be buying and not buying in the bank. I do foresee that the growth will roughly parallel that of the retained earnings growth at the bank.

I will open it up for questions. We have Jeff Julien, our CFO, Steve Raney, Head of the Bank, Chet Helck, who is both the Chief Operating Officer of the firm and directly heads our Private Client Group with me, and we have Jennifer Ackart, who I always like to refer to as being the one that we will refer all the hard questions to when we do not know the answer from reading reports.

So with that, I will open it up for questions.

Question-And-Answer Session


Thank you, ladies and gentlemen. (Operator Instructions). We are going to the line of Joel Jeffrey with KBW. Please go ahead.

Joel Jeffrey - KBW

Good morning.

Tom James

Hi, Joel.

Joel Jeffrey - KBW

Can you give us the most updated capital ratios at the bank?

Steve Raney

Joel, this is Steve Raney. We are actually finalizing our true financial report, which is due next week. We are still finalizing all those numbers, but we are in a well capitalized status as of 12/31. Approximately, our risk-weighted capital ratio is going to be in the 10.2% range, as an example. Once again, we are finalizing that, and we will have it all filed next week.

Tom James

Our goal, just giving you some forward, is to move that up to the 11% range in the not-too-distant future. We will be continuing on that process over the quarter.

Steve Raney

Adding some cushion in the bank, as you know, Joel, we have been managing the capital on a just-in-time basis and all feel that it is appropriate and prudent to have a little bit more cushion in the capital ratios in the bank.

Joel Jeffrey - KBW

Okay, great. In terms of the net interest margin; do you see any possibilities for expansion in the upcoming quarter, given the timing of the Fed cuts in the last quarter?

Steve Raney

I would say that probably will not happen, Joel. These are record margins already. Our cost of funds is extremely low right now, with really no ability to take them lower. We do enjoy wide margins both in our residential portfolio and in our corporate borrowers as well. If it was to improve, it would only be nominally. There is probably more risk of margin compression than expansion.

Tom James

Because responses to the client yield concerns, we may have to increase yield to depositors from current levels in spite of what is going on in the marketplace, just because there are these anomalies that allow customers to be able to find higher yields. I would not look for that, and as I said, I do not foresee much change in terms of net earning contributions from the bank going forward. However, that would be the negative part of that formula.

Joel Jeffrey - KBW

Okay, great. Lastly, if you guys could just expand a little bit on the strength of the fixed income business in the quarter, and was it purely tied to the mortgage-backed securities? Or were there other asset classes within that that were driving this?

Tom James

All fixed income institutional activities are at high levels. In addition, we have a retail-driven trading book for the industry as well as for ourselves. The retail interest in fixed income securities is also high. The trading jolts that we have received have often been muni generated heretofore. What I would say is that the muni business has had a rally in these securities. The spreads are all positive on the carries at inventory. It does not make a big difference to us, because we do not carry large inventories.

We are not a proprietary bet shop. The fact is those are all incremental, and that is why I say, I do not see that changing here. I expect those levels, you might not have quite the volume of institutional commissions we had in the December quarter going forward, but they are still going to be very good. They should be above what we internally budget.

Joel Jeffrey - KBW

Okay, great. Lastly I apologize, because I think I missed your comments on the status of the TARP filing.

Tom James

We are proceeding through the process.

Unidentified Company Representative

We have been in front of the committee and we are just waiting to hear; the call might come any day soon.

Tom James

These guys have other concerns. They have been going to a lot of parties this week.

Joel Jeffrey - KBW

All right, great. Thanks for taking my questions.


Thank you. We will go to the line of Steve Stelmach with FBR Capital Markets.

Steve Stelmach - FBR Capital Markets

Hi. Good morning.

Tom James

Good morning.

Steve Stelmach - FBR Capital Markets

Congratulations on managing through a pretty tough three-month period. Count me as one of the surprised by the magnitude of the margin expansion at the bank. I think you touched on the cost of funds side and how it is probably at a base level and may migrate higher in terms of deposit cost competition. But, we are at the asset side. How should we think about the lag in terms of asset yields relative to cost of funds? Is that a couple quarter event or a year-long event? How should we think about the asset yield side?

Steve Raney

Well, Steve, our residential portfolio as you know are primarily 5/1, 3/1 and a handful of 7/1 ARMs.

Steve Stelmach - FBR Capital Markets


Steve Raney

With the rate reductions lately, we are anticipating an increase in prepayments across the mortgage portfolio, but that portfolio is pretty stable at this point. Prepayments, although we are anticipating them to pick up, are really at historically low levels right now. Our corporate portfolio continues the opportunities that we are adding on to the portfolio. Currently, they are at widening spreads. Corporate borrowers are paying more. There are more fees being added to yields.

In terms of the lag, the corporate portfolio continues to widen but I would say the residential portfolio based on the prepayment speeds will probably be negatively impacted.

Steve Stelmach - FBR Capital Markets

So you think asset yields, and I know it is not the forecast, but asset yields probably in the year about where they started and is it mostly a function of the cost of funds side of the margin?

Steve Raney

Cost of funds-related. Jeff, were you going to add?

Jeff Julien

Yes. The increase in cost of funds, the corporate side, is pretty much a floating rate portfolio. That is not very much impacted by movements in rates in general, but the mortgage portfolio is pretty much a static rate right now. An increase in cost of funds would likely be spread there.

Steve Stelmach - FBR Capital Markets

Okay, great.

Jeff Julien

A third of the portfolio is in residential and two-thirds in corporate.

Steve Stelmach - FBR Capital Markets


Steve Raney

$2.8 billion of the $7.7 billion is in residential loans.

Steve Stelmach - FBR Capital Markets

Yeah. That is helpful. Just turning to credit real quick; I guess no one expects NPAs to be going down anytime soon, but what about your watch list? Is that developing at about the same pace as your non-performers, the stuff that you think that has not gone non-perform yet, but are sort of on the watch list for you guys? How is that developing?

Steve Raney

Part of the additional provision expense approaching $25 million for the quarter is related to downgrades in the portfolio. Credit size loans are up, watch loans are up.

We are being very rigorous with how we are going through the portfolio and trying to be as forward-looking as we can be in terms of what we think may happen to the portfolio loan by loan.

We have seen increases in those credit-sized loan categories, and the provision expense reflects that.

Jeff Julien

About 70% of the provision expense for the quarter related to credit re-grading as opposed to new loan production.

Tom James

A lot of that re-grading is generated by our own views. What I would say, since you do not have as much experience in dealing with the mentality of our general accounting principles here, is that we are an extremely conservative organization with respect to evaluating reserves and trying to put ourselves in a situation where we do not get unexpected surprises, and that has always been true of the company and it certainly is reflected in what we do in the loan portfolio at the bank.

Steve Stelmach - FBR Capital Markets

Just one last question; in terms of your discussions surrounding TARP, what seems to be the bogies that the regulators of the government is looking for? What is the nature of the discussions and what is the hold-up if you get any sort of body language from them?

Tom James

Actually, I would not point to any individual fact. We got very high recommendations from our own regulator. They did not have any exceptions and things like that they asked for. I am not quite sure I can tell you how they think related to individual classes of applicants.

I do think that perhaps savings and loans are looked at closer than banks because there is more confidence, I think on the part of the FDIC, as well as clearly the banking side of the business in terms of the regulation.

I would tell you, we have had very good regulation in terms of the quality of supervision by the OTS. The reason we are moving does not have anything to do with that.

It has much more to do with the fact that we are clearly more comfortable at this size of the institution managing a more corporate loan-directed portfolio than we are in a mortgage portfolio, and we never liked commercial development much.

They just do not pay you for it, for taking the risk. We like where we are going here in terms of our own allocation of assets on our own balance sheet.

Steve Stelmach - FBR Capital Markets

Great. Thanks very much for the time.


Thank you. We will go to Devin Ryan with Sandler O'Neill. Please go ahead.

Devin Ryan - Sandler O'Neill

Yeah. Good morning.

Steve Raney

Yeah. We got you.

Devin Ryan - Sandler O'Neill

Most of my questions have been answered, but just a few here. On the provision, it sounds like you are being conservative, but based on kind of what you are seeing today, and I know that this is difficult.

But, is it at least reasonable to expect that the provision level should be increasing from this quarter's level, especially if credit losses are increasing?

Tom James

That is a very hard question to answer, because it is very sensitive to whatever is going on in the portfolio. If you ask me, I would tell you that while they may stay in the range they are in, with the same logic that we are applying now. If anything, at the rate of growth we are forecasting, which is slightly less than the $500 million plus addition to loans, I would think the provision will be lower.

Devin Ryan - Sandler O'Neill

Thanks. Just a general question here; can you just talk a little bit about the general health of the retail investor today, kind of relative to prior downturns? Are they still engaged, and what has changed in recent months? Just trying to get a sense of where we are today versus some prior downturns that you have seen.

Tom James

I would tell you after reading their December statements, and probably again after two days ago, they are nearing a state of shock and a lot of them have already changed their life plans because of this.

They are looking hard at their portfolios. They are very concerned about the institutions with which they are doing business. The icons of finance in the United States are clearly no longer icons in their eyes.

I had a call from a client of mine who is an American that lives in France, asking me if he should move his money out of his Bank of America checking account. That is the state of the American consumer investor.

One of the things that we are most sensitive to, while we are doing cost cuts, is not reducing the level of service to our financial advisers, and to our clients, because we know their level of concern, we know their level of need for high touch. High service has probably never been any higher than it is, at least not since the 70s.

I would not be surprised to see branches open for business on Saturday mornings as they were in those timeframes here during 2009. I actually think, and that is one of my reasons for forecasting that securities activity as a result of this, you will mobilize decision-making.

You don't have the resources to necessarily redeploy, although there is a lot of money on the sidelines. Even Jamie Dimon doesn't have as much as he did two days ago.

The fact is I am going down to speak tomorrow at a meeting in Miami to pretty wealthy individual clients. I can tell you the attendance is doubled, and what was expected at the meeting. The reason for that is there is this very high level of concern in looking for guidance in the marketplace.

You can forget about the bounces, you can forget about exuberant results here in the near term for the securities firms. They are just not going to have that happen. Average productivity will be off 25% in 2009.

Devin Ryan - Sandler O'Neill

In terms of the clients, are they actually just sitting on cash today or are they pulling money out of their accounts?

Tom James

They did pull money out of their accounts in the fourth calendar quarter, our first quarter. They did not pull them out of the firm; they moved them to cash alternatives; they moved out of both managed and unmanaged asset classes.

They do have cash on the sidelines, and one of my biggest concerns is they miss. As you know, rallies, they occur in these discrete short periods, and I am deathly afraid that they are going to miss the opportunity for recovery because they tend to always get out at the worst times.

My guess is, although I haven't seen the cash flows yet from sales of securities two days ago, but I would bet you that there is going to be a high cash movement during that period just as there was in the month of October.

So, it was nice to see a rally the next day, but I see the futures when I came in. I don't know what has happened now. We are going to opening at the moment. I don't know what's going to go on, but I don't think this volatility is totally gone yet in the marketplace.

Devin Ryan - Sandler O'Neill

Okay, that is helpful. And then just lastly, Jeff, I am not sure if I missed this, but what drove the minority interest line in the quarter?

Jeff Julien

Must be our diversity program. The two things that I know drove it were additional losses in Turkey that we are reserving for shutting that operation. They are still the minority owner there.

Devin Ryan - Sandler O'Neill

Right. Okay.

Jeff Julien

And the other thing is there are some write-downs in some of the Raymond James tax credit funds, which we own only a very small percentage of, but some of which are consolidated under VIE rules.

So they are really partnership that we own only a very, very small percentage of that had some net partnership losses because those partnerships fell off ongoing operating losses as part of their benefits to the investors.

Devin Ryan - Sandler O'Neill

Okay, thanks for taking my questions.

Jeff Julien

Thank you.


Thank you. We have no further questions.

Tom James

I would like to take this opportunity to thank you for sitting through a long quarterly call. As you might guess, we are pleased with the results in the quarter.

As you can tell, I am making plenty of cautionary statements going forward, but I still think that the major income generators that affected the first quarter are still healthy and will continue to do so in the succeeding quarters.

And I wish all of you good luck in navigating through these difficult times that we are bound to still have to go through for a while. And I look forward to talking to you again next quarter, if not sooner. Thank you.


Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.

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