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Pacific Capital Bancorp (NASDAQ:PCBC)

Q4 2008 Earnings Call

January 29, 2009; 11:00 am ET

Executives

George Leis - President and Chief Executive Officer

Stephen Masterson - Chief Financial Officer

David Porter - Chief Credit Officer

Tony Rossi - Financial Relations Board

Analysts

Aaron Deer - Sandler O'Neill & Partners

Julianna Balicka - KBW

Operator

Good morning ladies and gentlemen. Thank you so much for standing by. Welcome to the Pacific Capital Bancorp fourth quarter 2008 results conference call. During today’s presentation all parties will be in a listen-only mode. Following the presentation the conference will be open for questions. (Operator Instructions)

I’ll now turn the conference over to Mr. Tony Rossi of the Financial Relations Board; please go ahead sir.

Tony Rossi

Thank you, operator. Good morning everyone and thank you for joining us to discuss fourth quarter results with the management of Pacific Capital Bancorp. With us today from management are George Leis, President and Chief Executive Officer; Stephen Masterson, Chief Financial Officer; and David Porter, Chief Credit Officer. Management will provide a brief summary of the results and then open up the call to questions.

During the course of the conference call, management may make forward-looking statements with respect to the financial condition, results of operations and the business of Pacific Capital Bancorp. These include statements that relate to or are dependent upon estimates or assumptions relating to the prospect of loan and deposit growth, credit quality trends, the health of the capital markets, the operating characteristics of the company’s income tax refund program and the economic conditions within its market.

These forward-looking statements involve certain risks and uncertainties, many of which are beyond the company’s control. Forward-looking statements speak only as of the date they are made and Pacific Capital Bancorp does not undertake any obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.

At this time, I would now like to turn the call over to George Leis. George.

George Leis

Thanks Tony. Good morning and thank you all for joining us this morning. I’m going to provide an overview of the fourth quarter of 2008 and then I’ll turn the call over to Stephen Masterson, our Chief Financial Officer, who’ll review our financial results in more detail. Following Stephen’s remarks, I’ll conclude with an outlook of 2009.

Throughout most of 2008, our residential construction portfolio created issues for us, but the housing market continues to weaken in the fourth quarter. We downgraded additional loans in this portfolio and took additional reserves against those credits that were already in our NPA inventory. The elevated charge-offs and provision for credit losses taken this quarter drove the net loss we recorded.

We are aggressively managing our residential construction exposure through continuous reviews and updates of appraisal, so that our loss recognition is early as appropriate and our credit rate is for a current and recent market condition. We are also negotiating for additional collateral or personal guarantees initiating foreclosure when appropriate.

We are disappointed with the performance of this portfolio; however, residential construction loans now represent just 4.4% of our total loans, so their potential effect on our future financial results had certainly diminished. The remainder of our portfolio is exhibiting stress as consistent with the recessionary economy. Unemployment in California is substantially worse in the national rate and we’re certainly seeing this weakness reflected in our portfolio, particularly in commercial real estate and C&I portfolios.

The deterioration is relatively consistent across these portfolios. We’re not seeing any meaningful trends in any particular industry, property type or market. We recorded a $68.8 million provision for credit losses in the fourth quarter, reflecting the weakness in the portfolio.

The components of the provision are as follows: $50.9 million cover the net charge-offs in the quarter, which included approximately $30.8 million in the residential construction portfolio. $18.8 million was added to the allowance for loan losses to reflect an increase in problem loans and higher specific reserves against the impaired loans and we had $900,000 in RAL recoveries during the fourth quarter, which represented a corresponding reduction in our provision expense.

The provision expense in the fourth quarter raised our allowance for loan losses to 2.44% of total loans. Approximately, 87% of our allowance is allocated to loans that are not currently impaired, which we believe positions us to well absorb inherent losses that may materialize.

Clearly, the scenario of a prolonged economic slowdown is becoming more likely. Maintaining the strength of our balance sheet is our highest priority, even if that has negative consequences for the banks near term profitability. We raised approximately $180 million in capital through the U.S. Treasury’s Capital Purchase Program during the fourth quarter. We continue to maintain conservative underwriting criteria, while we’ve begun utilizing this capital to support the banks lending activity.

During the fourth quarter, we originated $197 million in loan, which were distributed across all portfolios. We also continue to make very good progress on our deposit gathering initiatives. One of our goals in 2008 was to create a more aggressive sales culture throughout the organization, particularly with respect to deposit products.

We’re seeing strong evidence of this progress in this area, with increases in NOW, Money Market and Savings Accounts Deposits, by an aggregate amount of $160 million during the fourth quarter. We’re very pleased with how the organization has responded to our mandate for a more aggressive accounting program focused on deposits. We continue to enhance our sales culture and we expect that this will also have a positive impact on the banks cross-selling efforts.

Now I’ll turn the call over to Stephen Masterson for further discussion of our fourth quarter results. Stephen.

Stephen Masterson

Thank you George and good morning everyone. I’d like to start out by talking about our full year earnings for our company as a whole. Our net loss for the year was $23.8 million for the company as a whole. I’d like to point out that $22.1 million of this loss related to non-cash charges for goodwill impairment that we took in the third quarter.

On a normalized basis, without the goodwill impairment, the company basically broke even for the full year 2008, despite providing $218.3 million in loan loss provisions to cover charge-offs and to fortify our balance sheet as George previously mentioned and we did all of this in-light of these challenging economic times.

We are very satisfied with the strength of our balance sheet and are very pleased with the fact that we did not incur significant cash losses for the year 2008. In fact, on a taxable basis we actually incurred approximately $80 million of taxable income under the IRS’s rules.

For the remainder of my comments unless I indicate otherwise, I’ll speak to the results of the Core Bank, which exclude the impact of the RAL and RT programs. The Core Bank’s net interest margin declined to 305 basis points during the fourth quarter of 2008, from 361 basis points in the third quarter of 2008. The decline is due to the impact of the 175 basis point cut in rates that the Federal Reserve made during the fourth quarter.

This had the effect of reducing our yields on earning assets by 60 basis points during the quarter while our cost of interest bearing liabilities increased by 8 basis points. The increase in our cost of interest-bearing liabilities is primarily due to our intentional decision to be more aggressive in deposit pricing, to support our deposit gathering initiatives which we talked about on the previous calls.

Our non-interest income was $11.8 million in the fourth quarter of 2008 compared with $14.2 million last year. The decline primarily reflects a decline in the value of mortgage servicing rights and a decline in the service charges and fees due to lower loan production. We also saw a decline in trust and investment advisory fees due to the decline in asset evaluations over the past year.

Total non-interest expense was $70.9 in the fourth quarter of 2008, compared to $51.3 million in the same period last year. The increase in non-interest expense resulted from the following: An increase in salaries and benefits expense, primarily due to investments and building out our wealth management and advisory business; higher legal expense partially due to credit related issue; and higher consulting expense related to our deposit glaring initiatives and to our initiative to replace our IP core system.

Turning to the balance sheet, our total loans were $5.76 billon at December 31, 2008 compared to $5.72 billion at September 30, 2008. We are continuing to sell certain loans as part of our liquidity and balance sheet management strategies. In fact during the fourth quarter, we sold approximately $103 million of our confirming residential mortgages.

Total deposits were $6.59 billion at December 31, 2008 compared to $4.94 billion at September 30, 2008. Excluding the brokered CDs that we added to fund our 2009 RAL program, total deposits were $5.31 billion at December 31, 2008 compared to $4.81 billion of September 30 as I mentioned earlier.

George mentioned that we had substantial increases in virtually all deposit categories. We were able to generate the strong deposit growth despite the sale of two branches in the City of Santa Paula during the fourth quarter, which held approximately $54 million in deposits. These branches were not a good fit for the combined commercial banking and wealth management offices that are now our part of our core strategy and growth strategies. To sell these branches we’ll reduce our annual operating expense by $933,000.

Turning to asset quality, non-performing assets increased to $241.5 million or 2.65% of total assets at December 31, 2008. This is up from $171.6 million or 2.23% of total assets of September 30. The increase in non-performing assets is primarily due to several small residential construction loans moving to non-performing status. I’ll provide a brief update on our larger non-performing residential construction loans that we’ve discussed in prior quarters.

As we indicated on our last call, we have six relationships with total outstanding balances of approximately $90 million. We charged-off approximately $15 million of this balance during the fourth quarter to reflect the decline in collateral values. We continue to receive pay downs and these six relationships now have total outstanding balances of approximately $67 million.

Our net charge-offs for the fourth quarter was $50.9 million or 3.5% of total average loans. During the quarter, we were successful in selling a problem hotel construction loan for $0.67 in the dollar, which resulted in net charge-off of approximately $5 million.

Our total delinquencies increased to $316 million or 5.49% of total loans at December 31, 2008 from $260 million or 4.55% of total loans at September 30. The increase was primarily due to C&I, commercial real estate and residential real estate portfolios. As a result of the significant provision this quarter, our allowance for loan losses increased to 2.44% of total loans at December 31, 2008, which is up from 2.13% at September 30. Our coverage of non-performance loans was 60% at December 31, compared to 73% at September 30.

To help with the coverage ratio for non-performing loans in the proper context, it’s important to note that the bulk of our non-performing loans are residential construction and land loans, where we have substantial collateral. Accordingly we tend to find lower coverage for non-performing loans in this scenario compared to a situation where the non-performing loans are primarily comprised to commercial loans with fewer opportunities to recover when a loan defaults.

Moving to our capital ratios, we’re still significantly above the well capitalized guidelines. At December 31, we had a Tier 1 ratio of 11.8% and a total capital ratio of 14.6%.

Now, I’ll turn the call back over to George. George.

George Leis

Thanks, Stephen. I’ll begin with an update of our RAL and RT programs. As we announced earlier this month, we were able to secure all of the funding that was required for our 2009 program. We’re using a combination of brokered CDs, wholesale funding and a loan syndication led by one of the largest banks in the United States.

While we are expecting transaction volumes, product mix and loss rates to be relatively similar to last year, we are expecting a lower level of profitability. This is due to funding cost this year, as well as reduced collections of RAL’s outstanding from prior years.

In last year’s program, we had approximately $25 million in collection from prior year, which was partially driven by the higher RAL’s rates we had in the 2007 program. Obviously, higher losses led to more recovery opportunity. With the loss rates cutting half in 2008, we’ll have fuel recovery opportunities during the 2009 program, which will impact the profitability. However, we still expect the 2009 program to generate a significant amount of earnings and capital for the bank.

Turning to the Core Bank, I’d like to talk about our expectation in the few key areas. We expect continued elevated credit losses and until the economy starts to stabilize, I intend to keep our allowance for loan losses at least at their current level. We expect our net interest margin to continue to be under pressure; particularly as we have a full quarter impact of the 175 basis points in rate cuts that occurred in the fourth quarter.

We’re projecting loan growth of about 5% with our focus primarily in the commercial portfolio. We’re projecting deposit growth of 6%, which should be spread evenly throughout our deposit category. We’re expecting expense growth of 2% when you exclude special items that occurred in 2008 such as goodwill impairment charges. We’ve taken a number of steps to reduce expense levels, although these will be partially offset by increases in our FDIC insurance premiums and credit related costs as we deal with our higher level of problem assets.

Given the challenge of this economy, we’ve taken some additional steps to tighten our belt. Headcount in salary expense will be tightly controlled. I have ever intention of staffing to meet our strategic initiatives and we expect to retain and higher key people to achieve our goals. At the same time we’ll be looking to trim back staff when we can. Additionally, there will be no cash bonus or salary increases for me or my executive team in 2009.

In recognition of our reduced profitability, the Board of Directors reduced our quarterly dividend payment for the first quarter of 2009 to $0.11 per share and the declaration of future quarterly dividend will be closely tied to our overall financial performance.

Our priorities for 2009 will be continuing our aggressive deposit gallery, utilizing the additional capital added through the TARP investment to increase our commercial loan production and continuing to build our commercial and wealth management business and of course tightly managing our expense level.

While the near term outlook for profitability in the core bank is someone uncertain, given how difficult it is to accurately project credit loss, we are very, very comfortable with the health and strength of our banks balance sheet. We have a stable and growing deposit base, a substantial allowance for loan losses and a very strong capital position. As a result, we believe we are well position to manage through a prolonged economic slowdown.

We would now be happy to address any questions you might have. In the conferencing today Steve and I are joined by David Porter, our Chief Credit Officer and operator, we are ready for the first question.

Question-and-Answer Session

Operator

Thank you sir. (Operator Instructions) Our first question is from the line of Aaron Deer with Sandler O'Neill & Partners. Please go ahead.

Aaron Deer - Sandler O'Neill & Partners

Hi, good morning everyone. David, I was hopping you could give us some color on what you’re seeing in the 30 to 89 day delinquency trends in each of the different portfolios?

David Porter

Aaron, I can do that. For the bank as a whole, I’ll start with that. Relative to the third quarter, in the two to three payment bucket we had approximately $94 million outstanding in Q3. That same number in Q4 is about $82 million, so about a $14 million reduction in that number; however, you do have to remember we did take some significant charge-off in the fourth quarter, so that impacted it as well. In terms of the individual portfolios, what I’d like to do is probably get back to you and go through those specific numbers if I can.

Aaron Deer - Sandler O'Neill & Partners

Okay, that’s fine. Then, Stephen on the expenses, I guess I was surprised to see comp costs were up and there’s this also big increase in the other expenses. In a lot of folks I guess that we’re seeing reversals, bonus accruals and things like that, that have actually brought expenses down this quarter. What was going on in your fourth quarter and why might we not expect to see expenses actually down next year instead of up 2% recognized and that of course the FDIC premiums are going up?

Stephen Masterson

Well, I think that FDIC premium is part of what you saw in the fourth quarter and I think what George mentioned earlier is true for next year. We do expect to see the expenses going down. What largely drove our salary increases year-over-year was our investment in building out our wealth and advisory services, the registered investment advisors and the wealth management business that we’re building here at the bank.

George Leis

That’s right, Stephen. We bought herein a registered investment advisor in San Luis Obispo, Bob Wacker and Associates. Bob had about $500 million in assets in the management and his salary expense which added to our company in the last two quarters of the year.

Aaron Deer - Sandler O'Neill & Partners

But even quarter-to-quarter I think that Core Bank personals costs were up like from 27/3 to 31/4, or else I missed something.

Stephen Masterson

No, I think you are right. There’s a couple of things in there and some of that was the accrual of certain bonuses for certain employees in regards to their annual goals, but as George mentioned we did eliminate the bonuses for the executive team and the mirrored increases for the executive team and I think the overall increase are nominal for the rest of the employees of the bank.

Aaron Deer - Sandler O'Neill & Partners

Okay, then just one more if I may and then I’ll step back. My expectation would be that a lot of the compression this quarter actually came from the higher brokered CDs that you have in the balance sheet in anticipation of RAL liquidity needs. So, if I’m right in that, can we expect to see a bounce back in the core margin here in the first and second quarter, is those complete off?

Stephen Masterson

Yes, that’s a good observation here and we did put on as we mentioned $1.3 billion in brokered CDs prior to 12/31 and CDs too that are impacting our margin to a slight effect. You also saw the decline in interest rates and we have certain commercial based loans that we set to prime and we saw a decline in our interest income related to that.

Also as we mentioned in the discussion points, we had some increases in our non-performing loans and those non-performing loans go into non-accrual. So we had a reduction in the interest income related to those. So, if you take all of those components together, then you do see that compression in the NIM that you mentioned.

Now on the brokered CDs, we put those on in three to six month increments for the RAL program and that’s for the RAL program only and we stager those to roll-off as the RAL season get its peak and starts to wind itself down through April.

Operator

Mr. Deer, do you have any further questions?

Aaron Deer - Sandler O'Neill & Partners

No, I sort of got cut off, so I missed the end of his comments, but…

George Leis

I’m sorry. I was saying for the brokered CDs, we had a $1.3 billion at the end of December 31 and we put those on in three to six month increments and we stager those to roll-off of our books in unison with the peak of the RAL season down through the end of the RAL season, which is throughout the end of April.

Aaron Deer - Sandler O'Neill & Partners

Okay and I guess what percentage of the decline that we saw maybe this quarter was attributed then just to those brokered CDs that we could expect to comeback on.

George Leis

Probably 10 to 20 basis points.

Aaron Deer - Sandler O'Neill & Partners

Okay, that’s very helpful. Thank you everyone.

George Leis

Thank you.

Operator

Thank you. Julianna Balicka with KBW; please go ahead with your question. Your line is open.

Julianna Balicka - KBW

Good morning. Sorry about that. Sorry, I have the similar questions, but I missed a point in the previous Q&A about the non-accrual loan and the reversal of non-accrual income. How much was that in the margin?

Stephen Masterson

We basically on the non-accruals, we’re basically losing about $1 million a month in interest income based on our non-accrual loans. That was about $3 million for the quarter.

Julianna Balicka - KBW

Okay and then you began the call by talking about additional deterioration in the residential construction portfolio that was already on NPL. Can you just give us a bit more color on what you saw there? How many cents on a dollar are you additionally reserving to those particular homebuilder loans and how the rest of your homebuilder portfolio is performing, the stuff that was not on NPL last quarter?

David Porter

Juliana, this is Dave. The NPL’s increase was primarily associated with the homebuilder portfolio. I think if you look at what occurred in 2008 relative to markdowns, you can probably assume that at maximum we initiated these loans at about a 75% loan-to-value and we probably have marked down between 15% and 20% through the cycle so far, so probably a 40% to 45% markdown at this point.

Also the level of non-problem and non-performing loans in residential real estate is now to a level where it is probably two thirds, maybe 80% of the residential construction portfolio. So, we pretty much tagged everything in that portfolio at this point.

Julianna Balicka - KBW

So, 20% is less performing basically, so pretty much it’s out in the open; it’s over; moving on type of thing?

David Porter

Yes, I wouldn’t say it’s over, because we’re still watching values through the cycle and if they continue to decline further than what they have, obviously we have to be taking charges on that; but certainly they’ve come down a lot and we certainly absorbed a lot of write-downs because of that.

Julianna Balicka – KBW

Okay and then how is your CRE portfolio doing and where was that hotel located?

George Leis

The hotel loan was in the Central Coast area and the CRE portfolio, we’re seeing a little bit of a spike up in delinquencies and a little bit of a spike up in non-performers, but overall it continues to be performing relatively low from look back metric standpoint.

Julianna Balicka – KBW

And how much of your CRE’s out of market?

David Porter

Primarily that’s not an income property lending route and I’d say about 30% of that portfolio. So, that’s roughly let’s say $150 million to $200 million, Julianna.

George Leis

Dave maybe you can just tell Julianna, how that portfolio performs.

David Porter

Yes, actually that portfolio is doing extremely well. We have no charge-offs in that portfolio and currently have only 13 basis points of delinquency.

Julianna Balicka - KBW

And is that the portfolio that you bought from PCCI?

George Leis

Yes.

Julianna Balicka - KBW

And I thought that one was $750 million when you bought it, have you run it down or was that out of market component only a percentage of that?

Stephen Masterson

I was thinking a number of $500 million. You’re right, it’s more or like $700 million Julianna. So the 30% would be about a $200 million and maybe $225 million number.

Julianna Balicka - KBW

Alright, so 30% of the PCCI is out of market.

Stephen Masterson

Yes.

Julianna Balicka - KBW

And have you initiated any reserves against that preemptively?

George Leis

Yes, we have reserves against that portfolio in general in our FAS5 and qualitative factors.

Julianna Balicka - KBW

Okay, well I’ll step back now. Thank you.

Operator

Alright, thank you. Management, there are no further questions at this time. Please continue with any closing comments.

George Leis

Well, we really appreciate your time and we’ll talk to you next quarter. Thank you very much for your attendance.

Operator

Alright, thank you ladies and gentlemen. This does conclude the Pacific Capital Bancorp fourth quarter 2008 conference call. Thank you very much for your participation and have a very pleasant rest of your day. You may disconnect at this time.

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