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Executives

David Zalman - Chairman, Chief Executive Officer

Dan Rollins - President, Chief Operating Officer

David Hollaway - Chief Financial Officer

Tim Timanus - Vice Chairman

Analysts

John Pancari - Fox-Pitt Kelton

Jon Arfstrom - RBC Capital Markets

Joe Stieven - Stieven Capital

Brett Rabatin - Sterne, Agee

Jennifer Demba - SunTrust Robinson Humphrey

Bain Slack - KBW

Terry McEvoy - Oppenheimer

Andy Stapp - B. Riley & Company

Carl Dorf - Dorf Asset Management

Dave Bishop - Stifel Nicolaus

Prosperity Bancshares Inc. (PRSP) Q2 2009 Earnings Call July 17, 2009 10:30 AM ET

Operator

Good day. All sites are on the conference line in a listen-only mode. Later you’ll have the opportunity to ask questions during the question-and-answer session and please note this call is being recorded. It is now my pleasure to turn the conference over to Mr. Dan Rollins. Please go ahead.

Dan Rollins

Thank you, Tasha. Good morning, ladies and gentlemen. Welcome to Prosperity Bancshares second quarter 2009 earnings conference call. This call is being broadcast live over the Internet at prosperitybanktx.com and will be available for replay at the same location for the next few weeks.

I am Dan Rollins, President and Chief Operating Officer of Prosperity Bancshares and here with me today is David Zalman, our Chairman and Chief Executive Officer, Tim Timanus, our Vice Chairman and David Hollaway, our Chief Financial Officer. David Zalman will lead off with the review of the highlights of the recent quarter. He will be followed by David Hollaway, who will spend a few minutes reviewing some of the financial statistics. Tim Timanus will discuss our lending activities including asset quality and finally we will open the call for questions.

During the call, interested parties may participate live by following the instructions that will be provided by our call moderator Tasha or you may email questions to investor.relations@prosperitybanktx.com. I assume you have all received a copy of the earnings announcement we released earlier this morning. If not, please call [Lee Kressmann] at 281-269-7216 and she will fax a copy to you. Before we begin, let me make the usual disclaimers.

Certain of the matters discussed in this presentation may constitute forward-looking statements for the purposes of federal securities laws and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Prosperity Bancshares to be materially different from future results performance or achievements expressed or implied by such forward-looking statements.

Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in Prosperity Bancshares filings with the Securities and Exchange Commission, including its Forms 10-Q and 10-K and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements.

Let me turn our call over to David.

David Zalman

Thank you, Dan. I’m very pleased to be able to announce the results of another very successful quarter for our bank. Some of our successes this quarter include our second quarter earnings were up 13.1% to $26.5 million compared to $23.4 million for the same period last year, an increase of $3.1 million.

Our diluted earnings per share were up 9.1% up to $0.57 for the second quarter of 2009 compared to $0.52 for the same period last year. Our non-performing assets remained low at 26 basis points of average earning assets. This is a slight increase from last quarter, but remains within our target range. Additionally, the net charge-offs actually declined on a linked-quarter basis.

Our tangible common equity ratio increased to 4.84%. Our total risk-based capital increased to 12.28%. Our return on average assets for the quarter increased to 1.2% compared to 1.15% for the prior quarter. Our return on average tangible equity on an annualized basis was 27.98% and last our efficiency ratio decreased to 48.98% from 49.47% for the prior quarter.

Our deposits at June 30, 2009, were $7.3 billion, an increase of $2 billion or 37.3% increase from June 30 of 2008. Our deposits were impacted by the deposits assumed in our FDIC assisted acquisition of Franklin Bank on a linked-quarter basis, we saw our Legacy deposits or deposits not acquired as part of our recent acquisitions increased $206 million were it will been 16.2% on an annualized basis.

Talking about loans on a linked-quarter basis, excluding loans from the acquisitions, loans reduced less than 1.5% or 1%. At the same time, we continued to reduce our exposure to construction and development loans in the quarter by $30 million.

As I mentioned earlier, our nonperforming assets to total assets increased to 26 basis points from 22 basis points one year ago and nonperforming assets to loans increased to 57 basis points from 36 basis points last quarter, but still within the boundaries we expressed on previous calls.

We provisioned $5.6 million more than our net charge-offs during the first half of 2009. This increased our allowance for credit losses to 1.23% of totaled loans at June 30, 2009, compared with 1.03% of June 30, 2008.

Talking a little bit about extraordinary expenses in this quarter, our FDIC insurance premium for 2008 was approximately $1.4 million. We currently expect our full year 2009 FDIC insurance premium to be between $8 million and $9 million. Additionally, the FDIC imposed in emergency special assessment as of June 30, 2009, totaling $4.2 million were approximately $0.6 per diluted share.

The Texas economy is the second largest in the Nation and the 12th largest in the world. Texas has home to 102 of the counties largest 1,000 companies and 56 of the Fortune 500, which is more than any other state over 10%. As I mentioned before, we started seeing signs of a slowing economy in 2008, they did not experienced the slowing until the last quarter of 2008.

The first quarter of 2009 indicated a slower economy than we have had last year at the same time and this trend continues into the second quarter. The Texas unemployment rate was 6.9% in May. We continue to expect unemployment in Texas to increase throughout the rest of 2009. We continue to believe that improvements in the world financial markets in overall economic growth should enhance the growth prospects for Texas, particularly like this year and early next year.

While the first and second quarter outlook was weaker, longer term prospects remained healthy. Long term job growth, low business and living cost in a young fast growing labor force remain positive that will help in recovery. As you all know, Texas enjoys a very large and diverse economy, while we acknowledge a slower economy and we have had in the past, we feel our future is very bright and we feel optimistic going forward.

We feel the risk of the economic fear of the 1980’s occurring again are remote at best, but with higher unemployment, it would be imprudent not to continue to build our reserve for loan losses and not to expect elevated loan charge-offs. We believe we are well positioned for the current environment.

Thanks again for your support of our company. Let me turn over the discussion to David Hollaway, our Chief Financial Officer to discuss some of the specific financial results we achieved. David.

David Hollaway

Thank you, David. Just a few quick details, net interest income for the quarter ended June 30, 2009 increased 39.9% to $75.5 million compared to $54 million for the same period last year. This increase was primarily due to a 40.8% increase in earning assets.

The tax equivalent net interest margin was 4.04% for the three months ended June 30, 2009, compared to 4.10% for the same period in 2008 and up from the first quarter number of 3.98%. Noninterest income increased $2.1 million or 15.8% to $15.1 million for the three months ended June 30, 2009 compared with $13.1 million for the same period in 2008. This was primarily due to the Franklin transaction.

Noninterest expense increased $13.4 million or 43.6% to $44.3 million for the three months ended June 30, 2009 compared with $30.9 million for the same period in 2008 and again this was mainly attributable to the Franklin transaction, as well as increased FDIC assessments. As mentioned before, the efficiency ratio was 48.98%, slightly down from first quarter of 49.47%.

However, if we adjust out the special one-time FDIC assessment, that would have put our ratio back into the mid 40% range, which would put us back to our efficiency ratio levels pre-Franklin deal. The bond portfolio metrics at 6/30/09 reflected a weighted-average life of 3.3 years and an effective duration of 3.1 years and the projected annual cash flow is approximately $1 billion.

With that, let me turn over the presentation to Tim Timanus for some detail on loans and asset quality.

Tim Timanus

Thank you, Dave. Nonperforming assets at quarter end June 30, ‘09 totaled $19,587,000 or 0.57% of loans and other real estate. This is compared to $12,525,000 or 0.36% at March 31, ‘09. This represents a 56% increase in nonperforming assets. The June 30, ‘09 nonperforming asset total consisted of $8,143,000 in loans, $343,000 in repossessed assets and $11,101,000 in other real estate. Approximately $2,900,000 or 15% of the June 30, ‘09 nonperforming asset total are at this time under contract for sale, but there can be no assurance that any of these contracts will close.

Net charge-offs for the three months ended June 30, ‘09 were $3,526,000 compared to net charge-offs of $3,857,000 for the three months ended March 31, 2009. This represents a 9% decrease. $6,900,000 was added to the allowance for credit losses during the quarter ended June 30, ‘09 compared to $6,125,000 for the quarter ended March 31, ‘09.

The average monthly new loan production for the quarter ended June 30, ‘09 was $76 million, compared to $64 million for the second quarter ended March 31, ‘09. Loans outstanding at June 30, ‘09 were $3.451 million compared to $3.501 million at March 31 ‘09. The June 30 ‘09 loan total is made up of 41% fixed rate loans, 27% floating rate loans and 32% at variable rates that reset at specific times.

I will now turn it over to Dan Rollins.

Dan Rollins

Thanks Tim. While I am sure everybody would like to hear us drone on for several hours I think we’ll skip that and we will go straight to questions. Tasha, can you assist us with questions.

Questions and Answers

Operator

(Operator instructions).Your first question comes from John Pancari - Fox-Pitt Kelton.

John Pancari - Fox-Pitt Kelton

Can you talk a little bit about the runoff of Franklin deposits during the quarter? I know the runoff was trending a little bit less than what you had thought as of last quarter I wanted to see if that is still the case in the second quarter.

Dan Rollins

Yes, I think that we’re down $100 something million in the quarter. We continue to see high cost, what we refer to as hot money CDs, higher cost CD money and non-relationship money, customers that have just one CD or two CDs with us with no other relationship in the bank.

We are not paying up for that money. We don’t have a desire to have non-relationship type customers like that and we continue to be on track. I think if you look at where we are today, we are at $1.7 billion and change and what you heard us say when we made the transaction was we thought we would be at $1.5 billion give or take at year end. I think David actually thought we maybe even substantially lower than that. So, I think where we are today...

David Zalman

Yes, Dan, I would say that I’m kind of really impressed with where we are at, Dan and I disagreed a little bit, but I thought we could drop as low as $1.2 billion to $1.4 billion. So at $1.7 billion today, I think we are still doing a whole lot better than we thought we would and having said that, though, we still see maybe a couple $100 million or more in roll-off as some of these 3% and 4% CDs roll-off.

Dan Rollins

That’s right. I think we are still ahead of target, you saw it speed up a little bit. What that is, John, is there’s buckets of money Franklin was a high rate payer with several retail promotions rolling throughout the year. So, when they would have their big retail promotion and promote 4% money for whatever the term was, as we get to those we are holding some of that money.

We are doing as we said a better job than we thought we would be, but there’s still some lumps coming through the pipeline here that when we get to a place that there was a big slug of 3.5% or 4% money we are going to lose some of that and quite frankly, I think we want to.

John Pancari - Fox-Pitt Kelton

Okay. Good and then on the expense side, the decline in the comp expense and if you would just talk about a little bit of that, solely the consolidation of the Franklin branches and if you can talk a little bit about a run rate going forward that you think is likely?

Dan Rollins

I will let Dave try the run rate piece, but let me talk about what is out there. Headcount was down 50 people from 12/31 to March 31 and what we talked about on the last quarter call was that the large majority of those 50 people were predominantly in the number for the quarter. There was a big drop-off at the very end of last quarter. So, a piece of this quarter’s expense say is the headcount reduction from last quarter and in addition we had another 50% headcount in this quarter that was probably more evenly spread across the quarter.

So, that is what is driving your comp expense down is just reduction in headcount and it is expense saves coming through the acquisition in the first quarter. Remember we didn’t convert the Franklin group over to our computer system and bring them into our operating environment until March 1. That means that, prior to March 1 or the full first two months, we ran two separate deposit operations. We ran two separate loan operations. We ran two separate computer systems.

We ran two separate networks for our systems, all of that expense was basically doubled in the first quarter and even though we turned it off on March 1, it then took basically the month of March to kind of line everything down and clean everything up. So, we really ran both banks for the first quarter. For the second quarter, I think you are seeing the expense saves across the Board put words in Dave’s mouth, but I think that, from an expense save standpoint, we are substantially there on the transaction.

David Hollaway

Right and I would just add when you’re looking forward so, again this is all absent these extra FDIC extra assessments, but when you’re looking at a normal bank run rate and we’ve got our efficiency ratio back into the mid-40s. I think that’s kind of where we want it to be and to start driving it lower, you have to start being cognizant are you really cutting fat at that point or are you cutting into muscle?

I mean, there are expenses that we need to incur to make sure the bank can service its customers. So the short answer to that is, I don’t foresee us dropping our expenses significantly in the next two quarters.

John Pancari - Fox-Pitt Kelton

Okay, great. One last question actually and I know it’s off of a low base and going to a low base, but I have got to ask it, the increase in the commercial real estate 90 day past dues, if you could talk a little bit about the types of [multiple speakers].

Dan Rollins

I lost money, John. I said that was going to be, question number one and you made it question number three.

John Pancari - Fox-Pitt Kelton

You have a question, part three, question one.

Dan Rollins

Okay. Yes. Let’s dive in there a little bit. Several things, Tim kind of touched on it. NPAs as a whole, in our press release, the way we account for them went from $12.5 million to $19.5 million, that’s up $7 million. However, 30 to 89 days past due credits during the quarter dropped more than that.

So, if you look at total 30 day past due plus, NPAs plus over 30 days, the number is actually down a little bit from last quarter in a consolidated number. So we’ve got more problems over 90 days and in ORE, but less problems in the 30 to 89 day bucket than we had before. So it is hard to see a trend in some of that.

Specifically, you’re asking on commercial real estate, so let’s try to dive into there a little deeper. There were five credits in that bucket last quarter, there are nine credits in that bucket this quarter. Three of those credits represent $5 plus million of that were not there last time, so there’s your increase. Of those three credits, one is roughly $1 million at quarter end and it is currently current. It is not nonperforming and it is out of that bucket today.

Another one is about $1.5 million. That is a hotel, a hospitality industry piece. We have been working with those customers for some time. That piece of property is under contract to sell for $3.3 million and the borrowers basically filed bankruptcy a while back that will slow the process down, but they owe us $1.5 million and the hotel is under contract for over $3 million.

The final piece is a medical-related development type piece that we foreclosed on and it is in our ORE. It’s in the ORE at $2.5 plus million. We took a loss on that so when you look at the commercial real estate loss or at the charge-off table that’s in the press release, the $1 million loss in commercial real estate, the lion’s share of that loss is off of this piece of property, it’s on our ORE, at again over $2.5 million.

We had a contract working for a little over $3 million on that property that fell through. We’ve still got multiple people looking in the $3 plus million range. So again we expect no loss there. I think really the question you are asking is this the first signs of a trend?

I think when you had a portfolio that’s as granular as ours that has as many small credits as we have, we had three bigger ticket items kicked up this time that kind of move your numbers. You’re right, from $1 million to $6 million, percentage-wise is huge, but it’s really three credits and so, I don’t think we really feel concerned that this is the beginning of a trend.

David Zalman

I would add too, John, that it’s not like these three credits were identified previously either we’ve watched these credits over the last couple of years and working them so they finally, finally have come through attrition really. We’re well aware of them and I would add that I’ve seen throughout the quarter, nonperforming loans go from $10 million to over $20 million.

So overall, I think we are still within the guidance that we gave. We also met with our senior management yesterday just to get a good feel from what they saw out in the fields. For the most part, where we’ve had this trend up a little bit, they still feel cautiously optimistic.

Operator

Your next question comes from Jon Arfstrom - RBC Capital Markets.

Jon Arfstrom - RBC Capital Markets

Tim, could you repeat that number that you said? I missed it, but it was just related to this last topic. How much is under contract in the current NPA total?

Tim Timanus

$2,900,000.

Jon Arfstrom - RBC Capital Markets

Okay. David Zalman, you talked a little bit about the core deposits up $200 million and in going through the release it looks like it is money market driven?

David Zalman

Right.

Jon Arfstrom - RBC Capital Markets

Did you do anything special there or do you expect that type of growth to continue?

David Zalman

It’s hard to believe that, that could continue at that pace, but first let me answer the first part of your question. We didn’t do anything different in fact if anything, we’ve lowered rates.

Dan Rollins

We haven’t run any special promotions, if that’s the question.

David Zalman

So, I think it must be in money that is finally coming in. If competitors that probably might have been in money market funds, somewhere else and is finally coming back to the bank or maybe out at the market.

Again, I would say I don’t want to be so optimistic to say that you can grow at that kind of pace $200 million a quarter, because I do think when the economy turns around some of the money that is sitting on the sidelines is obviously going to go back out, but it is nice right now.

Jon Arfstrom - RBC Capital Markets

Then I know you spend a lot of your time on the securities portfolio and I think that everybody maybe assumes that longer term rates are going to go up maybe not prime, but treasury yields will go up. I’m just wondering if you’ve changed your approach at all in terms of how you manage the portfolio. Have become more defensive or anything different in the way you’re thinking about that?

David Zalman

Absolutely, we do it. Probably one of the questions later on is going to be a lot of people are going to put a pencil to the CDs and they’re going to see gosh. They’ve got $2 billion in CDs at this cost and as they roll down to the cost. We’re after going to say then that interest margin should really increase dramatically for the bank, but the truth of the matter is, we’re not able to extend as long as we wanted to on the securities portfolio.

So, some of that gain that we’re going to see on the reprice of the CD is going to go to a lower yield in the securities and it is just simply because we’re trying to stay shorter on the securities market than we have in the past, because we really do feel, maybe wrong, may be right, I don’t know.

We really feel that as you buy today interest rates will go up and depending on what period and how long it take to go up, you could have a loss in them. So, we’re being a lot more defensive. We’re trying to shorten, what we buy pretty good right now. We’ve been buying up until recently a lot of 10 year mortgage-backed security product with about a 3.5, 3.7 year average life.

Some of the stuff we’re looking at today is really some structured stuff, still agency, Fannie Mae, Freddie Mac stuff, where they’re moving together maybe a CMO or where they’re having some 6.5% coupons that you’re going to get some rapid payback. The average life today is probably only 1.7 years, 100 basis points of 2.7 years and so, but again the yield is a lot less. It’s like about 3.2, but we feel like we really have to stay shorter right now based on what we think might happen later.

Operator

Your next question comes from Joe Stieven - Stieven Capital.

Joe Stieven - Stieven Capital

David, my question was pretty much on the deposit in the CD side, because if you look at what your rates did in the June quarter versus the March quarter, rates came down pretty sharply. You sort of answered the question already. My point was how much more in the next six months? Do you guys have that will be repricing and what’s your guesstimate as far as how far you’ll be able to move those rates down on that book?

David Hollaway

Again, when you’re looking at our numbers roughly 60% of our CDs mature within six months and so you’re absolutely spot-on, you can see on our marks. When you look at our net interest margin page on the press release, you can see the average cost of those CDs is about 260, somewhere in there 270 and current market rates and what we’re paying is more in the 1.5 range.

So, you can see there should be opportunity there. This is not hot money and I think that David had alluded to this. One of the questions is, in the past, especially in this Franklin book of business there’s rate shoppers, there is always a lot of players out there. You can certainly find somebody paying well above market rate.

A lot of those seem to have fallen off the face of the earth and so they are not chasing that money right now. So, if they stick with us they having to re-price at these much lower rates, and so there is huge potential for us. Of course I think again, David, this just hit the nail on the head.

How much of a pickup will there be? It depends on what we’re doing. If we don’t lend that money out, what are we doing with it? Are we putting it in a security bond portfolio or do we try to stay liquid because we do have to be cognizant that rates could be turning up and they will turn up fast.

We don’t want to get stuck that way either and you see part of that thinking when you are looking at our balance sheet. Note that our cash position and our Fed Fund overnight position is much higher today than it was because that is a dilemma. We are trying to be very careful here right now.

David Zalman

Yes, Joe. David Zalman I would say that Hollaway as we mentioned earlier it could probably turn out either way. If we increase our loans, there’s no question we could dramatically increase from that interest margin and so a lot of it depends on that.

If we don’t increase the loans and we just say where we’re at today and reinvest in the shorter securities two year average life, on the two year average life, the yield comes down, but having said that the net interest margin, I think, looks pretty stable really. I wouldn’t count on it going up a great deal. It could, but I wouldn’t count on it.

David Hollaway

It will trend up, but it just depends.

David Zalman

Yes, but not astronomical.

Operator

Your next question comes from Brett Rabatin - Sterne, Agee.

Brett Rabatin - Sterne, Agee

I wanted to ask on the other real estate owned, what was were there any expenses related to dispositions this quarter and then just wanted to get some color on kind of what you’re saying with, as you try and get rid of those loans you have on other real estate, kind of what the market trends were and if you were able to let’s say you have a borrower who is willing to buy the properties, do you guys end up doing the funding for those or how that works?

Dan Rollins

Yes. Let’s break that up into multiple pieces.

David Hollaway

The first question is, were there expenses involved with this and the answer is absolutely yes. It’s not broken out at this point because the numbers haven’t been big up to this point, but for this past quarter those ORE expenses related with all this and this is of the top of my head, but it will be close. It’s somewhere to the tune of $400,000, $500,000 for the quarter.

Previous quarter was probably I want to say $300,000, somewhere in that $350,000. Somewhere in that so it is running in about that range. So hopefully that helps you out on that part of the question.

Dan Rollins

On the trend piece, Tim can jump in here. Really that depends on it is kind of like I talked about our portfolio a minute ago. We have a very granular portfolio that the larger ticket items as we have said now for multiple quarters, larger ticket items, you have a smaller pool of buyers. It takes a little more time to move those things through. The smaller residential credits, we are able to move very quickly.

So, that piece of the puzzle is working well are we funding the sale of ORE? That would be an exception to our normal policy. We are not going to say we haven’t done it, but that would be a big exception for us.

David Zalman

I think we have because we have against one of the properties we have, we have made one loan against it.

Dan Rollins

That is an exception.

David Hollaway

There have been one or two instances where we have financed the acquisition of the ORE but…

Dan Rollins

With cash equity in the transaction.

David Hollaway

Have gotten real solid down payments, and there...

.

David Zalman

In terms and conditions that match our other loans.

David Hollaway

Exactly there haven’t been any out of market terms or conditions and in terms of the trend, Dan is correct. I would say that it has slowed a bit across the board. You don’t have to go back too far and we were very fortunate that we could move most assets out really within 30, at the most, 60 days and that has been extended a little bit especially the larger pieces as Dan says.

Dan Rollins

Investors have fishhooks in their pockets. They can’t get their money out.

David Hollaway

That’s right, but a lot of the average priced residential properties we still turn very quickly, but we haven’t seen buyers disappear. They are out there; there is activity on all the pieces. It just seems like the length of time to solve the issues has increased a little bit and I don’t have the hard numbers on the average time, but it probably wouldn’t be unreasonable to say that it is gone from 45 days to 60 days to maybe 90 days on some of these properties.

Brett Rabatin - Sterne, Agee

Okay, that’s great color. As a follow up, I wanted to ask, you have a fairly small piece of land development but it seems like that’s one of the pieces that a lot of lenders in Texas are saying, look there’s just no liquidity so they’re not able to sell lots and so it’s hard for some of those borrowers to have any kind of cash flow. I’m just curious what the trends are in that individual loan segment at this point?

David Zalman

I would say in the land development area, again we don’t want to be cavalier about this, because nobody is that great, but the kind of loans that we’ve made in loan development, land development are usually to well seasoned customers that we’ve had since the ‘80s. Some that have more money on deposit than what they have in loans to us and I would say that we are not afraid of land development that we know where we’re at.

In fact, we made an offer to a customer recently a week ago, a $30 million loan, that’s probably financed one of the hottest subdivisions in the nation right now in Texas, here in Houston and it’s secured by possibly $150 million of collateral and there is a lot of loss and at selling. So we are not necessarily afraid to that and I don’t think that we have a great deal of fear in that area for the loans that we have.

Tim, you may want to jump in on that.

Tim Timanus

I think that’s right. There is clearly a softness in some areas in that regard and when I say some areas, I’m talking about areas within Texas. Obviously, the areas and places other than Texas.

Dan Rollins

The softness that we are seeing is nothing compared to what…

Tim Timanus

Absolutely, nothing compared to what...

Dan Rollins

What we’re hearing…

Tim Timanus

What is taking place elsewhere, that’s right. I guess the best way to describe it is it’s spotty. Some lots seem to be selling fine. Some developments seem to be moving along well. Others are sluggish and not doing so well and it all probably really comes down to quality. The ones that were quality to begin with are still quality and the ones that weren’t in that category are the ones that are struggling the most and we don’t have very many that fall into that category.

So as David says, we’re cautious about it and we’re trying to move forward with our eyes open, but we don’t see any immense problems in that area on the immediate horizon.

David Zalman

Yes, it doesn’t need that we don’t have any, but I’d say the ones that were in the major metropolitan areas, the subdivisions that we may be in are still very good and have a lot of turnover and we’re seeing a lot of transactions. If there is a concern, it may be from some of the banks that we might have purchased previously that might have had $1 million or $2 million development loan primarily to a smaller developer primarily.

It doesn’t mean that we don’t have any because, we do. I don’t know just how many, it’s not that much, but I still think we feel pretty comfortable with where we are at.

Dan Rollins

We have some in there, but again I think we all feel like we’re managing that process fairly tightly.

Operator

Your next question comes from Jennifer Demba - SunTrust Robinson Humphrey.

Jennifer Demba - SunTrust Robinson Humphrey

Acquisitions and opportunities there David, could you talk about what you are seeing?

David Zalman

There’s no question there are opportunities out there today. There is opportunity where banks from out of state banks that have some operations are trying to see if they can get some money for what they have to try to shore up. Maybe their capital positions are some of the problems they have in other states so you got that there is other opportunities that we are looking at. I think there’s going to be a lot of opportunities maybe not all in Texas, but there will be some in Texas and I think that we’re ready for that.

This is really a time that we’ve been waiting for. It’s a time that if you go back to the ‘80s when we started, that we really made more money for shareholders than we ever did just on the day-to-day plain-vanilla banking. So we are finished with the Franklin transaction. The operational integration turned out very well. We’re surprised ourselves how well it turned out and how smooth it went. Thanks to everybody.

I mean, again, don’t want to be cavalier about it because it took a lot of work by everybody, but we really feel and we talked about it as senior management, we really feel that we have the ability and the opportunity to really do maybe some good transactions going forward and we are ready for it.

Dan Rollins

There’s a good opportunities out there and I think the hard part for us is to make sure that we don’t take. We’ve got to pick the right one of the opportunities, since there’s going to be several of them. So, I think we’re kind of just watching and paying attention and we want to be prepared when the time comes.

David Zalman

I would comment that we’re not going to twist off on an opportunity. We primarily like to look at an FDIC deal more than anything else and we’re going to try to cover ourselves completely on the downside, which for many loan exposure really.

Jennifer Demba - SunTrust Robinson Humphrey

So, are you still inclined to wait for a potential opportunity before perhaps raising capital to make yourself ready for those opportunities?

David Zalman

I know people don’t want to hear this, but that’s still the case. We still want to make sure that we have a deal before we raise any additional equity even if we have to. We have a lot of good earnings and a lot of the deals that are out there right now, especially on assisted transactions, there may even be support and help from the FDIC really.

Operator

Your next question comes from Bain Slack - KBW.

Bain Slack - KBW

Two quick questions, one I think there’s a lot to ask about the net interest margin. I guess just focus on the asset side of that. I guess, David Hollaway, you said there was about $1 billion in cash flow running off annually. I’m assuming that’s pretty evenly spread across the quarters or is that…?

David Hollaway

Yes, that’s a good assumption.

Bain Slack - KBW

Then on the loans, I guess where we stand right now. Didn’t look like much repricing in the quarter. We feel pretty good assuming rates kind of stay where they are and that they’re going to stay in this range? There is no resets maybe resets coming, I would assume or do you have floors then? What kind of color can you give me there?

Dan Rollins

You’re asking a couple of questions. We are building floors into many of the loans that are out there. We do have floors in some loans. The loan yield for the quarter was 638. I think that we continue to have opportunities to deploy capital. I think that when you look at the risk returned we’re getting on the money. I think we’re able to get a better spread than we were getting in the past. Now obviously primes, I don’t even know what it is three or something. We’re not making any loans that low.

David Zalman

No, I think our floors that we have on anything right now are usually 5.5 is our floor.

Tim Timanus

We have put floors in virtually almost 100% of the variable rate loans.

David Zalman

If we’re locking into something for three years or five years, our rate is going to be anywhere depending on what type of product it is, it could be anywhere from 6.5 to 7.5.

Dan Rollins

Yes. Tim gave the numbers on variable rate, floating rate and fixed rate and the fixed rate number actually went up 1% or something, but again that the loan portfolio remember is also turning to the tune of $1 billion a year and cash flow coming off of the bond portfolio. We’ve been able to deploy most of that loan portfolio. The loan portfolio has got $1 billion plus a year in cash flow coming off that we’re deploying back into the loan portfolio and the goal is to continue to grow that.

Bain Slack - KBW

Okay and I guess when I look at your construction portfolio and clearly it’s coming down overall, but it seems like within the segments, obviously the residence real estate seems to be coming down a little faster. There actually seems to be some growth on the commercial side. I guess could you just give color as to what kind of opportunity you’re seeing there? I assume part of that is what you were saying earlier, Dan about the better risk reward and is this market share take away or new demand? What is going on in that…?

Dan Rollins

I don’t know that I have got a new demand at all.

David Zalman

I would say Bain, we are seeing more opportunities today than we ever have on credits, commercial credits and all around were credits that might have been at some of the larger banks are now coming to us and we are getting an opportunity to look at them, price them, commercial credits even on the commercial real estate side.

There might have been in the past where you had some bigger projects and people would actually come in and we couldn’t compete because of the rate, because of the guarantees. They would do a take it and securitize it and sell it off. So, we’re getting a whole lot more opportunities than we have ever had and it’s really back to traditional banking.

Again I don’t know how long this will last. I hope it last a couple of years, but we’re getting terms and conditions that are what they should be in banking and where we’ve had a lot. We’re trying to, I wouldn’t say run off some of these other loans and construction and that as some of that stuff is going and we’re foreclosing on some of these other pieces of property. It is hard to see, but I really feel good about the loan, our loan piece out there. I think that we’re getting more opportunities than we ever had.

Dan Rollins

You were asking specifically on the construction pieces of it and I think we may be swimming against the stream. I don’t know. I hear folks talk about competitors that have basically just said they’re not doing any more of X type loans or they are not doing any more of Y type loans.

We’ve been very resistant to say, just put an X on a certain type of credit. We’re looking at every credit as an opportunity just like we talked about acquisitions. We want to look at the borrower, we want to look at the customer, we want to look at the relationship, we want to look at the opportunity, and so we’ve not said no to a construction credit.

You heard David talk about a big one. Are we out actively soliciting them? No, but there are some very good long term developers and old folks customers that have deep pockets in the markets that we serve that are not being treated properly by their banks and we’re taking advantage of moving that business over, even in the construction category.

David Zalman

Yes, I think a lot of banks, not because they want to, but they’re just in that situation where they’ve had to say okay, no more commercial real estate or no more of this and no matter how good the customer is, they’re trying to outsource those people. It’s because it helps them and gives them liquidity. In our most banks are loaned up 100% loan to deposit and we’re not. So this is just a great opportunity right now.

Bain Slack - KBW

That does help give me the color I was looking for. I guess we’re also seeing that in the loan production numbers that may give us a sign of what’s going on with the production numbers that Tim had given. I’m assuming so.

Operator

Your next question comes from Terry McEvoy - Oppenheimer.

Terry McEvoy - Oppenheimer

Everything on my list has been discussed except for one small question and I believe in the first quarter, there was a good slug of loan servicing income that was paid by the FDIC, and I believe that contract ended this quarter. Was that the case and was there a significant amount at all of revenue or loan servicing fees paid in Q2 that would not be there in Q3?

Dan Rollins

That contract ended in Q1, so all that revenue, there is virtually no revenue for that in Q2 is the answer.

Operator

Your next question comes from Andy Stapp - B. Riley & Company.

Andy Stapp - B. Riley & Company

You touched on the fact that 30 day to 89 day delinquencies went down. Do you have the actual number of 30 to 89 delinquencies?

Dan Rollins

I don’t have an actual number because they are still putting that together in the call report, but it is off over $7 million from the March number.

Andy Stapp - B. Riley & Company

Okay and regarding your increase in 90 day plus delinquencies, just if you could provide some color why they fell into the 90 day bucket as opposed to the non accrual bucket?

Dan Rollins

Yes, the accounting rules for that are what I was talking about what I gave the color on the three pieces of CRT. If it’s over 90 days and still accruing, then we believe there is not loss in the credit. So when you heard me talk about that, the hotel credit that’s out there that’s $1.5 million it is clearly over 90 days. That property is under contract for over $3 million, so our risk of loss is not there. So we don’t take that to non accrual. If we believe there is risk of loss in the credit then it moves into the non accrual category.

Andy Stapp - B. Riley & Company

Great. That’s all I had. All my other questions have been asked.

Operator

Your next question comes from Carl Dorf – Dorf Asset Management

Carl Dorf - Dorf Asset Management

Mine is more of a comment than a question and it’s relating to the securities portfolio. My belief is that that Fannie Mae and Freddie Mac are bankrupt and have been for a long time without the government behind them. There is guarantees on that paper through the end of this year. I don’t know what is going to happen subsequent to that, but you guys have a lot of investments. I know you have a lot in Fannie and Freddie and I would hope that you would take this comment into consideration in what you’re doing with your investment portfolio?

Dan Rollins

I think that’s something that we all think about all the time. On the other hand, I still believe if Fannie and Freddie ever go under or they let it go under then you and I won’t even have to be talking today. We’ll all be eating beans under the bridge probably because that’s probably every bank in the United States would go under, I would think.

Carl Dorf - Dorf Asset Management

If they don’t have to let them go under, there could be changes that were made that would certainly change the ratings on the obligations. Yes, I don’t know how this is going to come out. Your comment is true and that’s the way everybody is looking at it. In my opinion anyway it’s an awfully big bet that the government is going to continue to stand by a very difficult situation rather than try to make them go private and perhaps result in some changes that people are not cognizant of or looking at this point in time.

David Hollaway

Well I hear you and again. I’m not underestimating anything that you say and it’s always been something in the back of our mind at the same time. So, I really appreciate your saying it. I thought about it myself really.

Operator

Your final question comes from Dave Bishop - Stifel Nicolaus.

Dave Bishop - Stifel Nicolaus

Question for you, I don’t know if you touched on this since I might have missed it, but the increase in some of the short term, that’s unsold in the other temporary investment. Is that sort of reflective of trying to fund some of the anticipated runoff from the Franklin deposit that you guys are baking in over the coming quarters?

Dan Rollins

Probably the other side of that is probably no place to put the money to get any yields. The question is how come your Fed funds are up $150 million as short term investments.

David Zalman

It goes back to in our earlier comment what are we, what is our strategy, what are we going forward and what are we thinking rates are going to be and we’ve been dragging our feet on a lot of things. We have kept anywhere from $100 million, $200 million liquid at any given time and again we’re trying to find shorter securities a year to two year average life out there. So, that is some of the issues.

Tim Timanus

You can look at it the other way. Obviously, if those CDs were to run off quicker we wouldn’t even have that dilemma, right.

David Zalman

In the back of our minds we really thought we’d have a bigger runoff than we had. We thought that the liquidity coming in would just go to the run off and we just haven’t had the run off actually.

Dave Bishop - Stifel Nicolaus

Another follow-up in terms of the branch closures there, where are you in that process and what’s the count at this standpoint?

Dan Rollins

What do you mean by branch closures?

Dave Bishop - Stifel Nicolaus

The Franklin branches.

Dan Rollins

We consolidated everything right off the bat. Franklin had 46 locations in November, a year ago and many of them were consolidated early in the first quarter and the final three or four of them were done on March 1. So, the remaining 33 locations that were the 33 pickup from the Franklin transaction has been in place since March 1. We’ve not had any change in that this quarter at all.

Dave Bishop - Stifel Nicolaus

Finally, just in terms of the state economy there just in terms of the energy sector, any sort of change? Any sort of noticeable change there you’ve seen over the past couple of months or so?

David Zalman

I’ll jump in on that. Obviously, oil is not at $140 of barrel, but even at the $60 and $70 a barrel the oil companies can make a whole lot of money, but have they reduced their work over rigs and some of their drilling rigs? The answer to that is yes. They’re all still very healthy and again probably the good part is that we don’t see them laying off a bunch of people like they’ve done in prior years, simply because they found out last time that happened in the 80s.

I guess they trying to recruit people when it does gear backup is almost a virtual impossibility. They didn’t have enough people in the industry. So, I think they’re still making a lot of money. They may not be as busy, they may not be drilling as much, but it is still okay.

David Hollaway

Also I think a lot of that, I guess what we could call is sluggishness in what they are doing, I don’t think is so much driven by the economic marketplace as it is the political marketplace. The political things that are going on I think they’re all suspicious to say the least of the cap and trade issues and they don’t know really where that is going to end up and what it means for them economically. So I think the political face of it has really frozen a lot of them in place.

Dan Rollins

There are a lot of cross winds blowing, what I was going to add into that, Dave, I think the energy business is very similar right now to the CRE business in that the prices out there are actually pretty good, but you’ve got a lot of people just literally sitting on their hands. They are not willing to do anything.

Whether it is commercial real estate based; whether it is business based; whether it’s energy-based everybody is kind of sitting on the sidelines waiting to see when the right time to take action is. When the right time to put money in is and I think until something changes that people decide they want to get in the game, I think we are going to see just kind of slow.

Operator

It appears that we have no further questions at this time.

Dan Rollins

Ladies and gentlemen, thank you so much for participating in our call today. As usual we appreciate the support that we get from the investment community and we look forward to seeing you all again over the next few months. Thank you very much.

Operator

Thank you. This concludes today’s teleconference. You may now disconnect your lines and have a wonderful day.

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Source: Prosperity Bancshares Inc. Q2 2009 Earnings Call Transcript
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