Marshall & Ilsley Corp. Q2 2009 Earnings Call Transcript

Marshall & Ilsley Corp. (MI)

Q2 2009 Earnings Call

July 17, 2009 12:00 pm ET

Executives

Dave Urban – Director, Investor Relations

Mark F. Furlong – President and Chief Executive Officer

Gregory A. Smith - Chief Financial Officer

Mark R. Hogan - Chief Credit Officer

Analysts

Ken Zerbe - Morgan Stanley

Terry McEvoy – Oppenheimer

Kenneth Usdin – BAS-ML

Anthony Davis - Stifel Nicolaus & Co.

Brian Foran - Goldman Sachs

Scott Siefers - Sandler O'Neill

Steven Alexopoulos - J.P. Morgan

Presentation

Operator

Good morning. Welcome to M&I’s second quarter 2009 results conference call. (Operator Instructions). It is now my pleasure to introduce, Dave Urban, Director of Investor Relations for M&I.

Dave Urban

Welcome to M&I’s second quarter 2009 earnings conference call. The presenters for today’s call will be Mark Furlong, our Chief Executive Officer, and Greg Smith, our Chief Financial Officer, who will review the second quarter financial results. At the end of our prepared remarks, Mark, Greg, and Mark Hogan, our Chief Credit Officer, will be available for your questions.

Before we begin, let me make a few preliminary comments. If you have not read our earnings release, you may access it along with supplemental financial information from the Investor Relations section of our Web site at www.micorp.com.

Also, before we start, I would like to mention that comments made during this call contain forward-looking statements concerning M&I’s future operations and financial results. Such statements are subject to important factors which could cause M&I’s actual results to differ materially from those anticipated by the forward-looking statements. These factors are described in M&I’s most recent Form 10-K and M&I’s other SEC filings. Such factors are incorporated herein by reference.

For a reconciliation of any non-GAAP financial measures mentioned in this presentation to the most comparable financial measures calculated in accordance with GAAP, please refer to M&I’s Web site at www.micorp.com.

And now, I will turn the call over to Mark.

Mark F. Furlong

Before Greg reviews the details of the second quarter I have a few comments about where our organization is positioned today in this economic cycle and our strategy to reach the end of the cycle and emerge as a strong competitor.

First, clearly net charge-offs and non-performing loans remain elevated. We are now experiencing some charge-offs in Wisconsin but not at all to the extent of Arizona or some of the other markets under stress throughout the country. We expect to see this elevated level of charge-offs in Wisconsin for no more than the next couple of quarters.

Our strategy continues to be aggressively addressing credit issues, which have been concentrated mostly in the construction and development sector, and in particular, the housing segment.

Our concentration continues to be in Arizona, which is why last year two of our most senior executives relocated to Arizona to provide in-market leadership on the execution of our strategy. They have been very effective, along with the teams they lead, in attacking the housing issues, both in Arizona and elsewhere for M&I.

Although we have sold $1.3 billion of loans over six quarters, the strategy on each relationship differs based on the likelihood of a successful outcome. We have reduced the construction development portfolio in just seven quarters to $6.8 billion, or 14% of total loans, from a high of 23%, or $10.2 billion. We will shrink this portfolio to no more than 10% of total loans.

Fortunately, our C&I and commercial real estate portfolios continue to perform very well. Though they have shown some weakness in the midst of this recession, they continue to perform pretty well and we expect that will continue.

As this economic cycle continues, everyone is looking for any sign of a bottoming out, or even a slowing in the decline of economic activity or in the devaluation of homes. Over the next few quarters we at M&I may look back and regard the following trends as indicators that we were approaching the bottom of this challenging cycle.

Non-accrual construction development loans decreased by $75.0 million this quarter, although not to the extent we would have liked, with $62.0 million of the contraction coming from Arizona.

Early-stage construction development loan delinquencies, those loans delinquent 30 to 89 days, declined to their lowest levels in a year. For the overall loan portfolio, early-stage loan delinquencies throughout M&I declined to their lowest level since December of 2008.

In terms of preparing to emerge from this economic cycle, we have continued to improve our systems and procedures, rationalize headcount, and we continue to create efficiencies. We have further revamped our deposit strategies to shift our funding profile.

Our wealth management business continues to be an important source of growth and diversification. With $32.0 billion in assets under management and $110.0 billion in assets under administration, our platform remains one of the largest for regional banks.

Our asset management track record is strong. As an example, over the three-year period ending June 2009, we have five Marshall funds in the top quartile and eleven funds in the top half. In addition, many of our separate account strategies in equities and fixed income are also outperforming competitors.

We are proving to be an attractive partner for other firms looking for a wider distribution capability and feel fortunate to have been able to attract two very good partners this year: Taplin, Canida & Habacht in Miami; and Asset Management in Los Angeles.

Importantly, with almost two years into to this cycle, our primary issue has not changed. The issue is the housing component of construction of development. There are not other concerns of a similar nature on our balance sheet.

Our level of capital and liquidity remains strong and I mentioned, was are seeing some signs in early-stage delinquency that may prove to be an indicator that the early stages of an improvement in credit quality are becoming evident at M&I.

It is difficult to predict how quickly this improvement will drive the decline in credit costs, but we are seeing improvements in early-stage delinquency, and that bodes well for the future.

With that, let me turn the call over to Greg.

Gregory A. Smith

By now you've had an opportunity to see our press release and supplemental financial information. We have included detailed credit quality slides on our Web site, which you may want to have printed out and available for our credit quality discussion.

Our second quarter results continue to reflect the challenging operating environment that confronts banks. The important items to focus on to better understand our second quarter performance include the following:

We have continued our aggressive steps to address exposure to the construction and development businesses, particularly in Arizona, even though these steps continue to be the primary reason for our loss in the quarter.

As we have noted before, we continue to expect that the bulk of our Florida-related credit quality issues are behind us as non-performing loan totals and inflows have stabilized.

Although we do not believe our construction and development issues are completely behind us, we are encouraged that total non-accrual C&D loans contracted by $75.0 million, of which $62.0 million was due to the reduction in Arizona.

We continue to make progress toward our goal of reducing our concentration of construction and development loans, which now stand at 14% of our loan portfolio.

We have increased our reserve to 2.83% of total loans, or $1.37 billion.

Our net charge-offs for the quarter include the $47.0 million one-time impact of an acceleration in our charge-offs for consumer real estate loans. These losses were previously fully reserved.

Starting this quarter, we have changed the presentation of our non-performing loans to no longer include accruing restructured loans. This is more consistent with industry practice.

For the quarter, we have benefited from $50.0 million in after-tax securities gains as well as $18.0 million from the favorable resolution of a tax matter. These one-time benefits are partially offset by $18.0 million in one-time, after-tax expenses related to the FDIC special assessment, an after-tax loss of $7.0 million related to our available for-sale loans, and by $4.0 million in after-tax severance accruals.

With these one-time items, we estimate our core loss this quarter to be around $0.65 per share.

We continue to have a capital base well above any regulatory capital thresholds and have approximately $2.2 billion in excess tier-1 capital. At quarter end, our changeable common equity ratio was 7.3%, benefiting from our successful raise last month.

As noted in our press release, we reported a loss of $0.50 per share for the second quarter.

Now for some additional insights into the quarter:

First, the net interest margin—our net interest margin decreased by three basis points on a linked-quarter basis, to 2.79%. The cost of funding non-performing assets negatively impacted our net interest margin by 3 basis points. We estimate the negative impact of non-performing assets to be 12 basis points over the second quarter last year and 24 basis points over the second quarter of 2007. As always in the second quarter, our net interest margin was negatively impacted by day count by 1 basis point versus the first quarter.

We expect that the net interest margin will remain in this area going forward. Like the industry in general, we expect to be challenged by: competitive pricing; the impact of deposit pricing floors; the movement of new and existing deposits into lower spread, higher yielding products; wholesale funding spreads; and of course, the yield curve.

There continue to be many variables that impact margin. It is difficult to project this one data point, given the current interest rate volatility occurring in the market.

Moving on to our wealth management segment, our business benefited from improved equity markets this quarter. Our assets under management were $32.0 billion, or 25% above the same period a year ago, and 7% higher on a linked-quarter basis. Our assets under administration were approximately $110.0 billion, or 3% higher than the same period a year ago, and up 8% compared to the first quarter of this year.

In May we completed the acquisition of Delta Asset Management. Both Delta and Taplin, Canida & Habacht, acquired in December, continue to post excellent returns and have had strong client retention.

Trust revenues were stronger as asset management and outsourcing showed improvements. Total trust revenues were up approximately 4% on a linked-quarter basis.

Pipelines are beginning to expand as customers and prospects consider changes in their service providers, however sales cycles remain protracted.

Our private banking group experienced good deposit flows during the quarter and continued to aggressively manage credit situations. Overall, the private banking loan portfolio continues to perform well.

The brokerage and insurance arm of wealth management experienced increased transactional activity as affluent customers began making adjustments to their portfolios.

Revenues were up approximately 14% on a linked-quarter basis, although they lagged 2008 year-to-date revenues.

Moving on to other fee income components, mortgage loan closings for the second quarter exceeded $1.0 billion, which was 27% higher than the first quarter. With almost all of our production going into the secondary market, we have realized $17.0 million in mortgage sale gains this quarter.

As we noted earlier, we realized $50.0 million in after-tax securities gains this quarter. These gains represent $0.18 per share for the quarter and come from selling our Visa shares and a repositioning of the investment portfolio.

This quarter, our other income was reduced by the $12.0 million impact of a loss on our available for-sale loans.

From an expense standpoint, total non-interest expense amounted to $415.0 million in the second quarter. This is a $70.0 million increase from the first quarter as we incurred some one-time expenses and deposit insurance expenses were higher than they were in the prior quarter. These expenses include the following:

The FDIC special assessment cost us $29.0 million. In total, FDIC insurance expense increases for $34.0 million quarter-over-quarter were half of our expense increase. And salary and employ benefits expense increased $32.0 million in the second quarter compared to the first quarter.

The first quarter expenses were lowered by the reversal of previously accrued bonuses and retirement benefits. In the second quarter approximately $6.0 million of severance increased our salaries and benefits expense. In addition, we incurred $47.0 million in expenses related to non-performing assets.

Although our reported efficiency ratio is 71%, when adjusted for these items and other credit-related expenses, we view our core efficiency ratio to be 55.9%. Nonetheless, particularly in the current operating environment, M&I will continue to be very focused on maintaining our historical expense discipline.

M&I remains dedicated to deploying our capital prudently through lending and investment in our customers and communities. This is highlighted by our homeowners' assistance program and continued lending through the economic cycle.

Through the end of the second quarter we have approved over $3.8 billion in either new or increased credit to our customers since last November.

Now, moving on to our credit quality trends. M&I, like many other banks, has experienced continued credit deterioration during the second quarter. Our commercial, non-construction commercial real estate, and consumer portfolios continue to have non-performing characteristics materially better than the bank as a whole, while our construction and development and residential portfolios continue to show the stresses of the national housing markets.

This stress continues to be most apparent in the Arizona market where home prices have fallen over 50% from their peak in June of 2006.

For the quarter, we realized net charge-offs of $453.0 million and we provided $468.0 million for loan losses. Our quarter end allowance was 2.83% of period end total loans, which is an increase of $15.0 million from the prior quarter end.

As noted earlier, our charge-offs this quarter include the one-time impact of a somewhat technical but important change in our charge-off policy as it relates to consumer real estate loans. This quarter we accelerated the charge-off to reflect more recent experience with these previously fully-reserved losses. This led to a one-time increase in our net charge-offs of $47.0 million. Without this charge-off policy change, our provision would have exceeded charge-offs by $62.0 million.

In addition to building the allowance, we have identified the specific loss content in non-performing loans over $1.0 million and marked them to net realizable value with either a specific reserve or charge-off. As shown in Slide 5, M&I has conducted a specific impairment analysis on $1.7 billion, or approximately 66% of total non-performing loans, to quantify potential impairment. On average, 26% of the unpaid principal balance of these loans has been charged off.

Through building the allowance and aggressively writing down problem loans, M&I posted a solid adjusted reserve ratio of 135%.

Our underlying market assumption in taking these charges and provisions is that the prevailing economic and national residential conditions will last well into 2010 in many of our markets.

With regard to our loan loss provision, we continue to see deterioration in the estimated collateral values and repayment abilities of some customers, particularly commercial real estate developers, and generally, the consumer segment. These factors, combined with general economic trends, have led us to continue building our allowance.

As we look forward, we expect to continue taking aggressive steps to resolve our non-performing loans, the proceeds from which will be re-deployed in our business.

As in prior quarters, the largest proportion of the charge-offs, approximately 55%, were associated with the Arizona marketplace. As show on Slide 22, the net charge-offs by geographic location were: $251.0 million for Arizona; $59.0 million for Wisconsin; and $47.0 million for Florida.

Approximately 60% of our Wisconsin charge-offs are related to the construction portfolio and will be discussed in more detail shortly.

As we have noted before, we continue to expect that the bulk of our Florida credit quality issues are behind us.

Discussing our non-performing loan trends, during the quarter our non-performing loans increased $428.0 million. For the quarter, we sold $184.0 million in larger, stressed construction and development loans. As in the past, we have moved aggressively to identify potential non-performing loans and the associated loss content.

This is supported by the following: 17% of our non-performing loans are current or past due less than 30 days; 24%, or $586.0 million of our non-performing loans are past due less than 90 days. These stated percentages are lower than prior quarters, as we have removed restructured notes from our non-performing loan totals, as discussed earlier. Using the current methodologies, these percentages would have been comparable last quarter.

We have already realized partial charge-offs of $726.0 million against our non-performing loans, representing a 23% haircut. Another way to look at our partial charge-offs is that it represents a 44% write-down on specific non-performing loans where a direct write-down was deemed necessary.

Within our loan portfolios we continue to focus on our construction and development categories, particularly residential related. These loans are in both our commercial real estate and residential real estate portfolios, depending on the underlying collateral.

Please not on Slide 6 that we have segmented our commercial construction portfolio between C&I-related and housing-related. This slide highlights the continued strong credit quality profile of the non-housing component of the commercial construction portfolio. Less than half of our commercial construction portfolio is related to housing. As of quarter end we have $1.0 billion in construction and development loans on non-performing status, representing 40% of our total non-performing loans.

As shown in Slide 25, of these non-performing construction and development loans, 55% are in the Arizona and Florida markets. Clearly, our issues remain concentrated in these markets. As anticipated, we have seen some deterioration in our Wisconsin construction portfolio, which account for $151.0 million in non-performing loans and $36.0 million in charge-offs this quarter.

These charge-offs are predominantly related to two specific long-standing relationships. They are both working closely and cooperatively with us. We see no other Midwest-based C&D relationships with this level of stress. We do not expect this portfolio to be anything resembling our Arizona experience.

To provide a little more granularity on our portfolio of larger construction and development projects, the following may be helpful.

We have 39 loans greater than $5.0 million on non-performing status. Only 18 of these are in excess of $10.0 million and only 2 of these are in excess of $20.0 million.

We have seen further deterioration in the residential land portfolio during the second quarter. This portfolio is shown in Slides 29 and 30. We have $1.9 billion in residential land loans to individuals and developers. $1.1 billion, or 57%, are located in Arizona zip codes. The bulk of the Arizona loans, two-thirds, are in Maricopa County.

The loans to individuals in the Arizona portfolio are relatively modest in size, with an average balance of approximately $190,000. We continue to refresh both FICO scores and LTVs for the Arizona portfolio. Individual FICO scores averaged 734 at the time of origination and remain around 700 today.

Residential lot loans account for $378.0 million of non-performing loans. As in prior quarters, this level of non-performers, and the underlying LTVs, have factored into our allowance level. As we have noted before, our residential land portfolio is almost entirely zoned, entitled, and improved and largely to individuals.

With regard to conventional mortgages, we have noted deterioration as individuals are feeling increased economic stress. As we've noted before, we maintained our underwriting discipline through the cycle, have never originated subprime loans, and have avoided many of the more risky loan products. Nonetheless, during the quarter our non-performing residential loans have increased to $403.0 million, or 7.2%, of the residential mortgage portfolio.

Within the residential portfolio, we have seen some deterioration in many of our markets with the Arizona market being the most notable. We continue to aggressively monitor and manage this portfolio.

Just a couple of comments on our consumer loan trends, as the overall consumer portfolio has maintained its non-performing loan levels below those of the overall bank. As of quarter end only 1.4% of consumer loans were on non-performing status.

As we have noted in the past, our credit quality experience with this portfolio has benefited from our historical practice of selling much of production, as we did in 2005 and 2006.

Looking forward, consumer non-performers, including both residential and home equity, are likely to trend up, reflecting continued consumer stress, although we expect that our ultimate losses will remain better than industry averages.

With regard to the commercial loan portfolio, which is summarized on Slide 12, during the course of the second quarter we realized $65.0 million of net charge-offs in our C&I portfolio, of which the largest proportion was related to industries associated with the housing sector. Housing sector charge-offs amounted to approximately 35% of C&I net charge-offs.

In addition, we realized an increase of $111.0 million in non-performing C&I loans. This increase was largely driven by three bank holding company loans which were moved to non-performing status this quarter. Based on detailed analysis, we are approximately 50% reserved on these credits. We are monitoring this portfolio closely and one additional sizeable credit in particular. We continue to monitor our overall commercial portfolio closely.

With regard to the Franklin relationship, as of quarter end we have $49.0 million of remaining exposure of which $1.0 million is on non-performing status, with the remaining $48.0 million on restructured status. As you would expect, we will continue to monitor its performance and underlying portfolio closely. We expect no further charge-offs on this portfolio.

A few comments on our accruing renegotiated loans, over the past quarter we have seen a $387.0 million increase in accruing renegotiated loans, to a total of $833.0 million. Of these, $319.0 million are related to commercial credits and $514.0 million are related to individuals. In the commercial area, we work closely with a large relationship, covering $250.0 million in loan balances spread over a number of commercial estate projects to restructure their lending relationship with M&I. The restructuring enhanced M&I's position and these loans are performing as expected.

On the consumer side, the vast majority of these loans continue to be related to home, land, or construction loans to individuals. At quarter end the residential, residential land, residential construction to individuals, and home equity categories, accounted for approximately $510.0 million, or 61% of the total.

Within the consumer sector, our restructured loans continued to perform better than national delinquency trends with subsequent delinquencies running in the low 20% range.

Over the next few quarters we continue to expect non-performing loan and real-estate-owned balances to remain elevated, reflecting broader economic stress, though we anticipate inflows will subside.

We also anticipate that the inflows of larger construction credits are at or near their peak, while consumer-related inflows will continue to build.

As we have noted before, it is important to remember that most construction credits are complex and that it will take time for us, or any lender, to work through them. As I noted in discussing Slide 5, through building the allowance and aggressively writing down problem loans, M&I posted an adjusted reserve coverage ratio of 135%.

We will continue to evaluate the opportunity for further sales of non-performing assets and weigh that opportunity versus the cost of keeping those assets for a period of time. Sometimes the best resolution will be to take the underlying property to maximize our interests, which will cause increases to REO for a period of time.

As we anticipated, our REO increased this quarter to $357.0 million, which is up from $344.0 million in the prior quarter. The largest REO property remains a $12.0 million Minneapolis-based multi-family property. We have three additional commercial properties over $5.0 million. We continue to expect that REO balances will increase going forward and view this as a natural progression as we gain control of projects and move toward ultimate resolutions. We will continue to aggressively manage our REO balances.

A few final comments on credit quality, stresses in the national housing markets will continue to affect us and we will continue to address them proactively. We have, and will continue to take aggressive steps to resolve our non-performing situations. Nonetheless, should the economy continue to deteriorate beyond our current expectations, our losses could continue.

Our non-performing loans continue to be concentrated in the housing construction-related components of the commercial and residential real estate portfolios, particularly in our Arizona, Florida, and correspondent businesses. Again, we believe our largest challenges in the Florida market are behind us.

Although we are not immune from consumer deterioration, we believe our residential and consumer portfolios will continue to perform better than the industry as a whole. Recall that our credit card portfolio is relatively small with approximately $275.0 million of outstandings.

We will continue to maintain a strong reserve coverage ratio and will continue to aggressively write down problem loans. We remain committed to returning M&I to a level of solid credit quality.

Changing focus to the organic balance sheet trends compared to the same quarter in 2008, second quarter 2009 average loans were $48.9 billion, which is $1.1 billion, or 2%, lower than the second quarter of 2008 on average.

C&I loans decreased on average by $676.0 million, or 4.3%, as we are seeing lower seasonal borrowing than in prior years. For 2009 we expect C&I balances to be relatively flat. On a linked-quarter basis, C&I loans contracted slightly.

Across all of our construction and development categories, we have seen approximately $2.8 billion, or nearly 27% contraction, since the second quarter of last year. This is consistent with our broader goal of reducing our construction and development portfolio to 10% of total loans. At quarter end, construction and development loans accounted for 14% of total loans, down from a high of 22.6% in the third quarter of 2007.

Non-construction commercial real estate loans increased on average by $1.8 billion, or 16%, in comparison to the same quarter last year. This reflects the natural progression of projects to completion and lease up.

Commercial real estate volumes are soft in all categories, reflecting the economy. Business translated into significant declines in new construction in all of our markets, with our Arizona and Florida markets most impacted. Minimal investor activity in new construction projects with multi-family and medical office being least impacted. The lack of available financing is significantly impacting the commercial real estate market.

Retail continues to soften and is expected to do so throughout 2009 as many retailers have cut back expansion plans and are asking for rent concessions on existing leases.

Office continues to soften in all markets. Job losses are impacting this segment in 2009.

Hospitality softened with the economy in the second half of 2008 and is expected to continue to soften as the economy contracts.

Together, these factors lead to our expectation that non-construction commercial real estate growth for the remainder of 2009 will be relatively modest to flat.

On the deposit side, we have seen good underlying dynamics this quarter with the average deposit balances up $805.0 million versus the second quarter of 2008.

Non-interest bearing deposits increased $1.5 billion compared to the second quarter of 2008. This increase is attributable in part to the low interest rate environment and continued confidence in M&I. Reflecting recent deposit market dynamics, including current low interest rates, we have seen a shift in deposits from our money market and Euro deposit accounts to DDAs and CDs. We continue to maintain our pricing discipline.

A few final comments, as we move into the third quarter of 2009, and to reiterate comments made earlier, we expect our financial results to reflect the benefits of the aggressive credit steps we have taken, but also the challenges of the broader financial markets. Similarly, our strong capital position and high level of loan loss reserves have fortified our balance sheet in the current economic climate.

Although we do not believe we're at the bottom of the housing cycle, we remain confident that we have realized all the loss content that is currently identifiable in our portfolio. As you are aware, every economic cycle brings its own set of challenges. This economic cycle has been marked by continued deterioration in general economic conditions, a challenging and volatile interest rate environment, wider funding spreads driven by broader market liquidity challenges, competitive pricing pressure on many loan and deposit products, and a dramatic downturn in the national residential housing markets.

As we move forward in the challenging economic cycle, we will continue to benefit from the strength of our capital position, the dedication of our employees, and the diversification of our franchise.

This concludes our prepared remarks. Mark Furlong, Mark Hogan, and I are available to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ken Zerbe - Morgan Stanley.

Ken Zerbe - Morgan Stanley

Regarding your NIM outlook, could you try to reconcile your sort of lower than peer expectations for NIM improvement. We've heard a number of banks over the last couple of days talk about expectations for very strong NIM growth on the back of CDs repricing lower. Why do you think your NIM path is going to be different than theirs?

Gregory A. Smith

We've got a lot of different dynamics in the net interest margin at this point in time, as you can certainly appreciate. On the asset side we are finding there are opportunities to improve pricing and certainly from that perspective, we're benefiting.

And at the same time as I say that, it's also still very competitive, particularly for good relationships, on the pricing side.

We certainly have the impact of non-performing loans that impact our outlook on net interest margin and they've certainly impacted us to date. We have seen good trends on the deposit side and that is one of the positives, but at the same time deposits also remain competitive.

So when we bring those factors together, we think we see stability more than anything else at this point, on the net interest margin.

Ken Zerbe - Morgan Stanley

At the beginning of your comments you mentioned that we are seeing signs of credit improvement because of the reduction in early-stage delinquencies. Are there other signs that you're seeing, because if I remember correctly, I think second quarter of 2008 for the industry, saw an improvement in early-stage delinquencies and that unfortunately didn't turn out so well.

Gregory A. Smith

I think there's a couple of things we have to look at as we talk about that. And to be honest, as we looked at the second quarter of 2008 I don't know that we really saw much of a difference with what we had seen in prior quarters.

I think one of the things we look at today that would give us some early optimism would simply be the change in trends in the construction and development portfolio. The early-stage delinquencies, when you think about it in a dollar basis, were better than we were at any point going all the way back into 2007.

So, I think part of it comes back to the question of concentration in the C&D portfolio and the change that we're seeing in the early-stage delinquencies there, whether it's on percentage basis or a on a dollar basis.

Mark F. Furlong

The trends, also, they're not like a one-month blip. It's pretty consistent. I wouldn't say it's perfectly pro rata but it's pretty consistent month to month in the decline. So nobody wants to call an end when the end isn't yet here, but after you get several months consecutively where you see a pretty consistent decline then you start to think maybe this is going to be the trend. And that's what we see right now.

Will that trend continue, will it gain speed? It's probably harder to predict that but clearly it's been pretty consistent without any big aberration that would throw us off course or think that we had an event that occurred somewhere and therefore that's why we got the positive reaction. It's just a pretty consistent decline.

Operator

Your next question comes from Terry McEvoy – Oppenheimer.

Terry McEvoy – Oppenheimer

Could you talk a bit about within renegotiated loans, about half of the increase came in that other category, if I calculate the numbers correctly from the prior quarter. Could you provide a history, is that through the correspondent banking channel and specifically where was that increase coming from, again, in the other bucket?

Mark R. Hogan

I think Greg referred in his remarks to $250.0 million of loans that were covering several projects with a long-time investor sponsor here in Wisconsin. And those projects are throughout the United States. We have some recourse to them.

And I think also, as Greg said, we feel pretty good about the restructuring that took place and puts those properties in a very good position to perform over a long period of time.

Terry McEvoy – Oppenheimer

And Greg commented on the decline in early-stage delinquencies within the C&D portfolio. Any comment at all about the early-stage delinquencies in commercial real estate, which did, I think, scare some people in the first quarter when it popped up to over 4%.

Gregory A. Smith

At this point, when we look at commercial real estate, and this would be the non-construction component of commercial real estate, the percentages that I'm looking at are half of that today.

Terry McEvoy – Oppenheimer

I know it's hard for all of us who continue to see, unfortunately, some losing quarters to think about the investing in the future and growing the business, which you talked about future in terms of investing for tomorrow. Can you just, credit aside, talk about what else you're doing to make sure M&I's positioned for when the economy turns and how M&I is going to capture an above average amount of those opportunities.

Mark F. Furlong

It's probably just the basic blocking and tackling that's continue to make sure technology is at the state it's supposed to be at. You know, pretty significant investment in the retail platform has been ongoing now for about 18 months and has been rolled out to the branches.

And another step of that is taking place, you know, a lot of efficiencies in terms of paper flow through the organization has continued through this entire process. Some of the things are what's going on in industry in terms of remote capture, whether it's at the branch or the customer site. All that's underway.

Training is robust throughout the organization and it continues that way in terms of measuring customer performance as well as just to understand the product set. And a lot of work underway by the teams on the deposit side.

You know, the comment we heard earlier on some high-priced CDs that were rolling off and why our margin didn't expand. We didn't have a liquidity issue that caused M&I to have go out and price a bunch of CDs way up. So therefore, we focus more on how do you keep the technology as strong as you can on treasury management products and so we've done a fair amount of investing over the last two years of that and we're continuing to invest in that direction.

And then you focus on the teams in each one of the markets and that is where most of the major team spends time, outside of Milwaukee, in the market, and that's really where that is taking place.

So I really don't think—you know, you wonder in this kind of a cycle where you skipped a beat in terms of investing to position the company well for the future. And certainly there's prioritization that takes place because you can't do it all when you're going through this cycle. I think we've actually spent the money in the right places. It's probably given us even more discipline.

In fact, you know, some of the cases where we will do a little bit less on the de novo branch effort, that's probably not such a bad thing to give some of the de novo branches a chance to pop up. About 20% of our branches are de novos in the last three or four years, so that gives them a chance to really catch some traction without having the distraction of local management on the next set of branches to open up.

We will be back to doing that again. We're just going to give it a breather to let the growth in those branches take place, and by and large it is.

Operator

Your next question comes from Kenneth Usdin – BAS-ML.

Kenneth Usdin – BAS-ML

Could we talk a little bit about the Arizona land book and first of all, can you give us an indication of, I didn't see it in the slides this quarter, can you give us an indication of where those LTVs have moved to, if they've changed off from the last quarter in the Arizona land book.

Gregory A. Smith

Those LTVs have continued to deteriorate, if I remember correctly. Last quarter we were looking at something that was in the mid- to high-160s. Today it's running more like 180. So they have continued to deteriorate, as you would expect, given the overall performance of the Arizona real estate economy.

Kenneth Usdin – BAS-ML

And my bigger question is just we had talked recently about how you've been moving through that book and I'm wondering how much is there left to really just churn through as far as charge-offs in that Arizona land book. Where are you in the process of really getting through the problems there? I know delinquencies are down but there's obviously a lot of stuff that's already on the books in non-performing, so how much of this quarter's charge-off is really getting through that and then what is left as far as the Arizona land book charge-off rates and severities.

Mark R. Hogan

The debt portfolio has reduced by about $400.0 million in the last year and over the course of the last two quarters the total delinquency rate in that book has hovered around the 20%, give or take 1%. And that's what we're seeing, that's where we get some comfort in that, is that it just has not moved off of that mark. And yet we haven't seen any significant improvement, just as Mark and Greg mentioned before. Just a little bit of improvement in the last two to three months. So we would expect to still see some charge-offs go through that portfolio and until that delinquency number reduces significantly, we'll continue to have those.

Kenneth Usdin – BAS-ML

In that vein, when you are referring to elevated charge-offs and provisionings, should we be expecting to see this kind of last two quarter's rate continue to hold and how long do you think that will be the case if so?

Mark R. Hogan

First of all, there's about a $150.0 million swing between last quarter and this quarter. I think our hope here is that as the larger commercial construction inflows to non-performing come to an end here, that we'll see that side of the equation subside for us as we go forward.

It's likely that you would still see consumer step up in the interim versus where it is, but as commercial comes down there's a fair amount of leverage in that to what the overall total charge-off number is going to be.

Kenneth Usdin – BAS-ML

Are we at that point yet where you start to see a real decline here, after this quarter, as far as that absolute level of provisioning?

Mark F. Furlong

I don't know that we're at that point yet but I think we're getting very close to it. The thing that we talked about last quarter was really a subtle shift in our methodology and our provisioning and historically we had been about 60/40 commercial to community and consumer on our loss reserve, and last quarter it was very close to 50/50 when you look at our reserve and how it's allocated in this quarter.

Now for the first time that I can remember, the consumer segment of the loss reserve is higher than the commercial. And this comes back to what Greg was talking about. The impact of the charge-offs that we've taken and the steps that we've taken over the last 18 months to address the commercial construction and development portfolio and get those through the balance sheet.

So as we see the delinquencies stabilize and decline, then again, from a provisioning standpoint, then the methodology will drive the absolute dollar amount down. But I don't know that that will happen in the third quarter.

Operator

Your next question comes from Anthony Davis - Stifel Nicolaus & Co.

Anthony Davis - Stifel Nicolaus & Co.

Greg, what is due to reposition in the securities portfolio, particularly?

Gregory A. Smith

As we looked at the securities portfolio and we were carrying, to go back to last quarter, we were carrying about $7.7 billion of securities. We decided the right thing to do was liquidate part of that securities portfolio. Just $7.7 billion was probably too large for a bank of our size that was really looking at a trend of loan contraction.

So we used that repositioning as an opportunity to realize some gains as we went through this quarter.

And then the other issue was Visa, and as we looked at Visa, which is $0.08 of the $0.18, we liked the timing on that, to harvest the gain.

Anthony Davis - Stifel Nicolaus & Co.

Mark Hogan, I guess just to understand this reclassification, I wondered if the $250.0 million renegotiated credit, was that early feedback on shared national review or not and have you incorporated any early results of that at this point in your provisioning?

Mark R. Hogan

The answer to the first part of that question is no. The renegotiated debt was not shared national credits.

And we have received preliminary results on the shared national credits but nothing that would have significantly have impacted the provisioning but it would have been taken into consideration.

Anthony Davis - Stifel Nicolaus & Co.

This quarter?

Mark R. Hogan

The second quarter, correct.

Anthony Davis - Stifel Nicolaus & Co.

Just some color on risk classifications, that you are seeing in the commercial book. Today versus where you were back in the first quarter. The C&I book.

Mark R. Hogan

I don't think that we've seen any significant changes. I think over any period of time the problems that we have today are problems that we had identified, you could go back two to three quarters, and we continue to not have surprises in our migration. So I don't really see any big changes. I think that we are very cautious about the C&I portfolio and when we talked before about down the road provisioning, I think that's kind of a wild card. We feel we've got a good understanding of the construction and development portfolio and we can track the consumer portfolio but the C&I portfolio has always been more difficult to track.

Anthony Davis - Stifel Nicolaus & Co.

And similar observations on commercial mortgage I would imagine.

Mark R. Hogan

I think that's fair.

Operator

Your next question comes from Brian Foran - Goldman Sachs.

Brian Foran - Goldman Sachs

When I look at the reaction to today's earnings, I think credit is part of it but I think preprovision trends are the other part of it. And I appreciate the comments about some of the investments as well as obvious one-time items like FDIC. But when I try to back out core preprovision trends it seems like we're going from 310 to 315 type preprovision earnings per quarter, to like 270 this quarter. And then with the repositioning of the securities book as well as loans declining, maybe like 250 million next quarter. So is that kind of the right trend to think about and what can you do to kind of turn the tide in preprovision trends here?

Mark F. Furlong

We certainly have seen contraction to an extent in preprovision. There's certainly some preprovision pre-tax. There's certainly a couple of headwinds on the expense side that are tied to credit. Certainly as you look at the expenses we incur doing work out on credits, which of course goes through the expense line item, that's one challenge.

And also the cost of being a bank has gone up. Even the base rates for FDIC insurance have gone up, so there are those types of headwinds.

Nonetheless, we have positioned ourselves to be very liquid and to position ourselves to take advantage of an upturn in the market once it's there. So we would like to see the loan portfolio grow. Good credits, there are some out there but it's certainly hard to find many of those today. But that's really where our opportunity is. I think we're well positioned to grow, both from a liquidity perspective, a capital perspective, a general balance sheet perspective, as we work our way out of this environment.

Also, the investments we are making are investments designed largely to improve our operating efficiencies. The types of systems we have been upgrading are the types of systems that improve our efficiencies and our abilities to do things more quickly.

So I think we see opportunity. We need to get through a little bit more of the economic cycle to realize that.

Brian Foran - Goldman Sachs

And then if I can follow-up on Arizona land. I think the key question I ask and probably most people ask is this land in a market that's going to come back because the LTVs have gotten so high, you really need the market to come back pretty aggressively to get some of this back. And when I talk to people about Arizona, the thing that always strikes me is how, like Maricopa is like the size of New Jersey so there's still a tremendous of variability in there and there are just parts of that county that may never come back. So are there metrics you can give us around is the land in the inner belt of Phoenix or is it Tempe, Scottsdale, some of the markets where people are a little more bullish that we might be approaching a bottom. Anything you can provide to help to understand where this land is.

Mark R. Hogan

Slide 30 has it broken out and obviously you have talked about Maricopa being about two-thirds of that portfolio, but we have not broken that out for external reporting purposes. But we feel comfortable the fact that two-thirds of that portfolio is in Maricopa County.

Brian Foran - Goldman Sachs

Qualitatively is there anything you can say about what type of deals you looked for in Maricopa?

Mark R. Hogan

I couldn't speak to that right here. Just qualitative or anecdotally, I guess.

Operator

Your next question comes from Scott Siefers - Sandler O'Neill.

Scott Siefers - Sandler O'Neill

Greg, you had noted some of the loan sales that you did during the quarter. Were there any additional hair cuts on those loans when they were sold, relative to where they had been valued prior to the sale?

Gregory A. Smith

In many of the cases there were additional hair cuts. We find that your best buyer, of course, is the motivated buyer for some reason who wants that particular piece of property, whether it's the neighbor or whatever. When you do go down the route of more of a bulk sale type strategy or selling to somebody who's more likely to be a financial buyer, there's quite often an additional mark that you wind up taking on those.

That said, we find a lot of those properties are well marked ahead of [inaudible].

Scott Siefers - Sandler O'Neill

And do you find any other qualitative or quantitative points you can put. Is there a substantial difference between the before and after?

Gregory A. Smith

I don't think there is a substantial difference but the one comment that I would tell you is that over the course of the last three quarters now, although we don't talk about what the ultimate mark down is, that that mark down has been fairly consistent over each of the last three quarters. It hasn't moved.

Scott Siefers - Sandler O'Neill

Obviously you did a pretty substantial capital raise in the second quarter, and the TCE looks quite high. Obviously there will be presumably some continued losses and I guess I was just curious as to your thoughts on how you arrived at that being the appropriate number to do, just one item I've sort of noted, your tangible common level, the gap between that and the total non-performing base is a little more narrow than some of your peers. And I guess when you plop in the restructured loans as well, what were the factors that led you to believe the number you did was the appropriate one?

Gregory A. Smith

On your last point first, I think when you look at that type of a comparison you also have to factor in the strength of our allowance for loan losses as well, which at 2.83% we still expect it will be toward the high end of the peer group.

In terms of sizing on the capital raise, certainly, as we looked at the overall economy we thought the prudent thing to do was, given what market availability has been over the prior two years, we thought the prudent thing to do was fortify the balance sheet because at the time there was a fair amount of excitement about green shoots, which I think has taken a bit more of damper here lately.

We really wanted to position the company for a prolonged economic down turn above and beyond where we are today.

As we went through our own analyses, going through a variety of our own stress tests, as well as doing what we think was a pretty solid job of replicating the federal stress test process, we came up with an appropriate capital raise that was a little bit below that overall level of $575.0 million. And at the same time wanted to make sure we never had to go back again. So that was part of the goal of going ahead and raising the amount of money we did.

In all honesty, you would always prefer not to raise common equity but it was the prudent and risk-averse thing to do. And I think we're all happy we did it.

Operator

Your final question comes from Steven Alexopoulos - J.P. Morgan.

Steven Alexopoulos - J.P. Morgan

Regarding the $900.0 million sequential decline in the commercial construction outstanding, I wonder why it was so much this quarter. It seemed to be more than double what we saw last quarter. And is that paydown rate, seems to be $670.0 million or so, should we expect a similar rate here in Q3.

Gregory A. Smith

You have a few dynamics in that contraction of commercial construction. Certainly part of that is the normal progress on individual projects. Some of that is also individual projects that have gotten to their natural completion and have entered the lease up phase and that have migrated into the commercial real estate portfolio. Commercial construction will also be impacted by loan sales, as well as charge-offs.

But part of this is construction projects have a finite life and we are seeing construction projects come to the end and move on to the next phase.

Mark R. Hogan

Just as they move out of construction into the business real estate side, we see that obviously as a strengthening because they turn from construction to some form of income producing. The challenge that we've had is that, as everyone is aware, the secondary market to take some of those projects out is not in existence. And typically that's what's happened with some of our larger projects, is we've relied on the secondary market to take them out. But our initial underwriting was always based on making sure that that project would be in a position to be taken out into the secondary market when it came to fruition.

So now we are faced with the situation of looking at doing some mini-perm feature, maybe two or three years, and as we underwrite those we are capturing as much of the cash as we can. Because we certainly understand when the secondary market comes back, whenever that is, that the cap rates are probably going to be higher, the lease rates may be lower than what they had anticipated. And the leverage may be less than what had been in the market before.

So we want to drive our balance down as quickly as we can during that two to three year period. So that, again, when the secondary market is available that we are going to be able to take these out.

Steven Alexopoulos - J.P. Morgan

Can you break out how much of that migrated from construction to income producing commercial real estate?

Gregory A. Smith

Yes and I'm going to have to, if you don't mind, just look at in terms of total construction and what the total construction migration was to commercial real estate.

We saw migration from construction into commercial real estate of about $550.0 million last quarter. So some of that could be in business real estate, some of that could be in multi-family.

Steven Alexopoulos - J.P. Morgan

On your NIM outlook, are you looking for non-performers to just continue to increase for the rest of the year, keep pressure on the NIM? I'm not sure how we're balancing working through C&D outflows versus consumer inflows.

Gregory A. Smith

As you would have heard in the earlier comments, there's a possibility that we'll look back and we'll say that we are at the inflection point here in terms of what the overall provision, charge-off, and non-performing levels are. And that's why we look at these delinquency levels more than we have in the past.

Certainly as we look at our NIM, we have the drag of the existing non-performing that we have, as well as even as individual loans move into non-performing status, those individual loans will have an incremental impact on the NIM as well.

So there will be inflows but what we don't know at this point is if the net balances will come down. But we will still have inflows to NPLs. I can't tell you what the balance will be, though.

Mark F. Furlong

And I think it would be fair to say, and we talked about this during the equity raise, that we will see the inflows from the commercial and development portfolio start reducing pretty significantly over the next one to two quarters. And I think part of that is that we believe that within the portfolio right now, within that non-performing segment, we have addressed our largest exposures.

So we will continue and I'm sure that there will continue to be inflows but they will not be at that level. I'll come back to what I said before, though, about the C&I is that's more difficult to project where that might be in the fourth quarter or first quarter of next year, when you're looking at non-performing levels at that point.

Operator

There are no further questions in the queue.

Mark F. Furlong

Thank you for joining us today. We appreciate everybody taking their time and appreciate everybody listening to the information about our quarter.

Operator

This concludes today’s conference call.

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