U.S. Bancorp Q2 2009 Earnings Call Transcript

Jul.22.09 | About: U.S. Bancorp (USB)

U.S. Bancorp (NYSE:USB)

Q2 2009 Earnings Call

July 22, 2009; 9:00 am ET

Executives

Richard Davis - Chairman, President & Chief Executive Officer

Andy Cecere - Vice Chairman & Chief Financial Officer

Bill Parker - Executive Vice President & Chief Credit Officer

Judy Murphy - Director of Investor Relations

Analysts

Matthew O’Connor - Deutsche Bank

Ed Najarian - Isi Group

Betsy Graseck - Morgan Stanley

David Rochester - FBR Capital Markets

John McDonald - Sanford Bernstein

Nancy Bush - NAB Research

Mike Mayo - CLSA

Operator

Welcome to US Bancorp’s second quarter 2009 earnings conference call. Following a review of the results by Richard Davis, Chairman, President and Chief Executive Officer and Andy Cecere, US Bancorp’s Vice Chairman and Chief Financial Officer, there will be a formal question-and-answer session. (Operator instructions)

This call will be recorded and available for replay beginning today at approximately noon eastern time through Wednesday, July 29 at 12 midnight eastern time. I will now turn the conference call over to Judy Murphy, Director of Investor Relations for US Bancorp.

Judy Murphy

Thank you, Michael and good morning to everyone listening to the call today. Richard Davis, Andy Cecere, and Bill Parker are here with me to review US Bancorp’s second quarter 2009 results, and to answer your questions. If you have not received a copy of our earnings release and supplemental analyst’s schedule, they are available on our Web site at usbank.com.

I would like to remind you that any forward-looking statements made during today’s call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are detailed in our press release and in our Form 10-K and subsequent reports on file with the SEC.

I will now turn the call over to Richard.

Richard Davis

Thank you, Judy. And good morning, everyone. Thank you for joining us. Andy and I would begin the call today with a short review of US Bancorp’s second quarter results. After we have completed our brief formal remarks, we will open the line for questions from the audience.

Since our last earnings call, a number of significant events have occurred that have impacted our investors and our customers, as well as our company as a whole. I would like to take a moment to summarize those events before Andy and I review the details of our second quarter financial results.

On May 8, the results of the SCAP supervisory capital program or stress test were released. As we announced US Bancorp passed the stress test. I am also very proud to say that we ranked the best among our peers in the category of Resources to Absorb Losses to Risk-Weighted Assets and Total Loan Loss Rates. On May 11, w announced a $2.5 billion common stock offering and $1 billion non-guaranteed debt issuance.

The capital raised was not prompted by the results of the stress test, but rather by our company’s desire to redeem the $6.6 billion of preferred stock issued to the US treasury under the capital purchase programs and a move forward from a position of strategic flexibility and dependence.

The issuance of the non-guaranteed debt was also required to qualify to repay the TARP fund. We were very pleased with the outcome of this issuance, as it was completed at the best pricing of any other peer bank debt issuance up to that date, and was a testament to the credit quality of our institution. Both the common stock offering, which raised $2.7 billion of capital and the debt issuance were successfully completed in one day.

On June 17 we announced that we had redeemed the $6.6 billion of TARP funds and finally, on July 15th, announced that we completed our participation in the program by repurchasing the warrant issued in conjunction with the TARP funds for $139 million. A successful exit from the TARP program validates the strength of US Bancorp.

We are grateful for the support of the taxpayers and the regulators during our participation in the program and we are now looking forward to capitalizing on our position as one of the largest independent banks in the country.

While we were managing through these corporate events, the rest of the company continued to run business as usual, and produce strong core operating earnings in what can only be described as a very stressed economic environment. US Bancorp recorded net income of $471 million for the second quarter of 2009. Diluted earnings per common share were $0.12 cents.

Once again we achieved record total net revenue this quarter and it was driven by growth in both net interest income and fee revenue, the latter of which was led by mortgage banking activity. Although core operating earnings were strong, significantly higher credit costs, including the costs of building the allowance for credit losses to reflect existing economic conditions and higher FDIC insurance costs resulted in earnings that were lower than the second quarter of 2008 and the previous quarter.

Significant items impacting the company’s second quarter earnings per share included an FDIC special assessment of $123 million, accelerated amortization of the discount or deemed dividend of $154 million associated with the TARP preferred stock redemption, net securities losses of $19 million, and $466 million of provision expense in excess of net charge-offs. In total, significant items reduced diluted earnings per common share in the second quarter by approximately $0.34 cents.

Our performance metrics were impacted by these significant items with a return on average offset in the quarter of 0.71% and the return on average common equity of 4.2%. Excluding the significant items I just noted, return on average assets and return on average common equity would have been 1.41% and 15.9% respectively.

As I stated, our company continued to perform well this quarter on an operating basis, and I would like to review a few of the financial highlights that impacted these results. First, we recorded strong overall growth in total average loans year-every-year. Total average loans outstanding increased by $20.8 billion or 12.8% with growth in all major categories. Excluding the impact of recent acquisitions, total average loans on a core basis grew by over 5% year-over-year.

On a linked quarter basis, total average loans decreased by 1%. This linked decrease in average loans outstanding was principally due to the reduction in commitment utilization. Specifically, the average rate of commitment utilization by our corporate and commercial borrowers declined from an average of slightly over 37% in the first quarter of 2009 to slightly under 35% in the second quarter.

The decline also reflected an overall softening of demand for new loans by our customers, both commercial and consumer as they maintained a cautious outlook on the economy and their own growth opportunities. We are, however, continuing to originate and renew new lines and loans for our current and new customers.

In fact, during the second quarter of 2009, US banks originated over $16 million of residential mortgages, another record quarter for US bank home mortgage. We originated over $4 billion of consumer loans, including installment loans, student loans, lines of credit and home equity lines and loans. We originated new prime based credit card accounts with lines totaling $2.5 billion.

We issued almost $9 billion of new commitments and renewed over $16 billion of commitments to small businesses, commercial and commercial real estate customers. Overall, new originations plus new and renewed commitments were over 12% higher than in the previous quarter.

As I stated at the time we announced the redemption of our TARP preferred stock, we continued to look forward supporting the government’s efforts to maintain the flow of credit in these stressful economic times. We will continue to be responsive to the borrowing needs of our current and new creditworthy customers, and more importantly, we had the capacity to do so.

Another highlight of the second quarter results was our outstanding growth in total average deposits. Total average deposit increased by $27.4 billion or 20.2% over the same quarter last year and $2.7 billion 1.7% un-annualized on a linked quarter basis. Without acquisitions the year-over-year growth was a very strong 11.2%.

We continue to be one of the highest rated financial institutions in the country with our lead bank U.S. Bank National Association rated AA1 by Moody’s, AA minus by S&P, AA minus by Fitch and AA high by [BVR]. These ratings have given us a significant advantage as our customers make the decision as to where they should bank and where they should place their trust.

The excellent growth in the average deposits further illustrates that our company is benefiting from the uncertainty in the financial market and the flight to quality that consumers and businesses that are looking for a safe, stable and sound financial institution.

As I previously mentioned, the company reported record total revenue in the second quarter. A major contributor to this success was mortgage banking, which also produced record selling revenue with increases year-over-year and linked quarter of $227 million and $75 million respectively.

The growth in mortgage banking revenue reflected higher origination fees, servicing revenue and a favorable change in the fair value of mortgage servicing rights, and that of economic hedging activity, the latter which had a positive impact on revenue this quarter. Record mortgage production of $16.3 billion was significantly higher than both the same quarter of 2008 and of the prior quarter.

Finally, I would like to draw your attention to non-interest expense, which was impacted by the special FDIC assessment and overall increasing the rate of insurance coverage, partially offset by benefits from the implementation of the company’s cost containment plan in late January.

Year-over-year excluding impact of acquisitions and incremental cost of FDIC insurance, total non-interest expense increased by less than 1%. The $258 million increase in expense on a linked quarter basis was the result of the increase in FDIC expense, as well as seasonally adjusted higher operating expense, and a national marketing campaign, partially offset by the company’s cost saving efforts.

Our efficiency ratio as reported for the second quarter of 2009 was 51.0%. Excluding the FDIC special assessment the efficiency ratio was 48.0%. We continue to be one of the most efficient financial institutions in the industry. And I am pleased to report that we achieved positive core operating leverage this quarter on a year-over-year basis.

Now moving on to credit; as I pointed out earlier, an increase in credit costs including the cost of building the allowance for credit losses drove the year-over-year reduction in the company’s net income. Net charge-offs of $929 million were 17.9% higher than the first quarter of 2009. A lower percentage increase than we experienced in the previous quarters.

The increase in net charge-offs once again reflected the continued stress in residential home and mortgage-related industries, and the impact of the worsening economy on both our retail and commercial customers. Also, and as expected, nonperforming assets increased this quarter. The rate of increase at 17.8% was however; lower than the past number of quarters.

At June 30th, the total nonperforming assets were $4.016 billion compared with $3.410 billion at March 31. Included in total nonperforming assets were $682 million of loans and other real estate covered by a loss-share agreement with the FDIC in conjunction with our two California acquisitions. There is a minimal amount of potential loss in these loans, given the terms of the agreement with the FDIC.

Excluding these covered assets, the majority of increase in nonperforming loans within the core bank portfolio was related to residential mortgage and residential construction-related industries, as well as other commercial real estate lending.

Restructured loans that continued to accrue interest rose by 10.8% as the company continues to work with customers to renegotiate loan terms, enabling them to keep their homes. Since 2008, including loans serviced for others, we have modified over 15,800 residential mortgage loans totaling approximately $3.5 billion. These efforts are consistent with the government’s objective to restore the housing markets and are aimed to retain the value of these relationships for our shareholders.

As expected, given the upward trends of both net charge-offs and nonperforming assets, in addition to the continued weakness in the economy, we increased the allowance for our loan loss this quarter by recording an incremental provisions for loan losses in excess of net charge-offs of $466 million. This represents approximately 50% of the current quarter’s total net charge-offs of $929 million.

With this addition, the company’s allowance for credit losses to periods-end loans, excluding covered assets was 2.66% compared with 2.37% at March 31 and the ratio of allowance to nonperforming loans excluding covered assets was 152%.

As we look ahead 90 days, we anticipate continued growth in both net charge-off and nonperforming assets. However, we expect the rate of growth to trend lower. Going forward, we expect to continue to increase the allowance for loan losses until our credit quality has stabilized and we have consistent evidence that net charge-offs levels are leveling off or declining.

We will continue to assess the adequacy of our allowance for loan losses and provide for credit losses at a level that reflects changes in the credit risk of the portfolio and the current economic conditions.

Finally, and importantly, our capital positions remain strong. Our Tier 1 and total capital ratios were 9.4% and 13.0% respectively at June 30, both comfortably above the well capitalized bubble as defined by the regulators.

Additionally our Tier 1 common equity ratio increased to 6.7% from 5.4% at March 31, and our tangible common equity to tangible assets rose from 3.8% at March 31 to 5. 1% on June 30. All these ratios benefited from the recent $2.7 million capital issuance and positive earnings. Let me now turn the call over to Andy.

Andy Cecere

Thanks Richard. Overall the company’s second quarter results reflected the quality of our core franchise and its earnings power. And I would like to provide you with a few more details. I’ll begin with a quick summary of the significant items that impact the comparison of our second quarter results to prior periods.

First non-interest income included $19 million in securities losses. Included in this total were $88 million of impairment charges on securities including perpetual preferred securities, our SIV exposure and a few agency and non-agency mortgage-backed securities. These impairment charges were partially offset by gains and securities sold during the quarter of $69 million.

Second, other non-interest expense in the second quarter included a pre-tax $123 million charge for an FDIC special assessment that will be paid in the third quarter.

Third diluted earnings per share was reduced by the impact of $154 million deemed dividend, associated with the repayment of the TARP funds and finally, we recorded an incremental provision for credit losses in excess of net charge-offs of $466 million in the second quarter.

These significant items in the second quarter reduced diluted earnings per common share by approximately $0.34 cents. For comparison purposes during the second quarter of 2008, the company recorded $63 million in securities losses.

Additionally, results in the second quarter of 2008 included an incremental provision for credit losses of $200 million. The net impact of the second quarter 2008 significant items reduced diluted earnings per share by approximately $0.11 cents.

Finally non-interest income in the first quarter of 2009 included $198 million in security losses, a $92 million gain on a corporate real estate transaction. The prior quarter also included an incremental provision expense of $530 million. Together, these significant items reduced first quarter 2009 diluted earnings per common share by approximately $0.28.

As Richard mentioned at the beginning of the call, we repurchased the warrant issued as part of the TARP program for $139 million on July 15th. This payment will not have an impact in earnings the third quarter as the payment represents a direct reduction in equity. The payment will result in a nominal reduction in our Tier 1 and total capital ratios of approximately 6 basis points.

Now, a few comments about operating earnings. Net interest income in the second quarter was 10.3% higher than the second quarter of 2008, primarily due to a strong 10.5% increase in average earning assets. As projected, net interest margin for the quarter was 3.60%, one basis point higher than the previous quarter or in other words relatively stable.

Our outlook for the net interest margin hasn’t changed. Going forward, assuming the current rate environment and yield curve, we continue to expect net interest margin to remain relatively stable.

Total non-interest income in the current quarter was higher year-over-year, primarily due to strong mortgage banking revenue as well as favorable variances in net securities losses, commercial product revenue, ATM processing revenue and treasury management fees. The growth in both, commercial product revenue and treasury management fees reflected the company’s ongoing revenue initiatives.

Payment related revenue, trust and investment management fees, as well as deposit service charges and investment products fees and commissions declined year-over-year, adversely impacted by the slowing economy and unfavorable equity market conditions. These revenue categories, particularly payments in trust and investment management, however are positioned to rebound as the economy strengthens and the equity market stabilized.

Within non-interest income, other income was lower year-over-year, primarily due to an unfavorable variance in equity investment income, which was partially offset by lower end-of-term lease residual losses. Strong mortgage banking revenue and seasonally higher payments related revenue, trust and investment management fees, deposit services charges, treasury management fees, all contributed to the growth in non-interest income, excluding significant items of $180 million on a linked-quarter basis.

Additionally, the other income category benefited from the lower end-of-term losses on auto leases. As we indicated in our last call in January, the end-of-term losses on retail auto leases peaked in the third quarter of 2008 at $84 million, as a number of cars coming off-lease began to decline. End-of-term losses in the second quarter of 2009 were down to $14 million.

Finally, excluding the increase in FDIC insurance costs and acquisitions, non-interest expense was essentially flat year-over-year, again demonstrating the company’s ability to control expense at a level appropriate for the current operating environment.

I will now turn the call back to Richard.

Richard Davis

Thanks, Andy. The past few months have been anything but ordinary for our company. We have been operating in one of the most challenging economic environments in our country’s history. We completed and passed the regulatory stress test. We raised $2.7 billion of new common equity, redeemed $6.6 billion of preferred stock and subsequently completed the repurchase of the related warrant.

Working against this extraordinary event as a backdrop, our company posted record net revenue, maintained a control expense environment, continued to lend and gather deposits and preserved the strength of our credit ratings and capital base.

As we move forward, we will continue to build our franchise, enhance our products and services and engage and develop our employees. In other words, we will capitalize on our now unique position of strength and independence to further differentiate U.S. Banc from its competitors.

In fact, in early July we launched a nationwide ad campaign to reinforce those methods to our current and future customers as well as all of our financial partners. We felt this is the opportune time to further build brand awareness for our company in a distinctive position as one of the nation’s largest independent financial institution.

Our focus on revenue generation continues with an emphasis on building deeper relationship with our customers. For example, 39 weeks into our relationship review initiative, we’ve held over 6,700 meetings with clients and have identified almost 9000 opportunities to increase share of wallet, which translates into potential incremental annual revenue of almost $400 million.

On the revenue side, approximately 10% of our households have now signed up for a relationship deepening package or product that provide our customers the superior value and create more value for our shareholders. While focusing on these another new revenue-producing initiative, we remain poised to capture the many opportunities that will present themselves as the financial markets and the worldwide economy recovers.

We expect to continue to be among the best performers in the industry, as our diversified mix of businesses, longstanding prudent approach to risk, dedicated employees and the strength of our balance sheet enable us to manage and even prosper in this period of unsurpassed economic stress.

In conclusion, our second quarter results reaffirmed that our fundamental businesses remain strong, although credit cards remain and will remain elevated in the near-term; we are open for business and managing this company for the long-term.

As we continue to prudently lend to creditworthy borrowers, judiciously invest in and grow our franchise, support our communities, serve our customers, and importantly create value for our shareholders by sustaining our earnings power, high quality balance sheet and capital strength.

That concludes our formal remarks. Andy, Bill Parker and I will now be happy to answer any questions from the audience.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew O’Connor - Deutsche Bank.

Matthew O’Connor - Deutsche Bank

The past few quarters, I think you have been a little bit more explicit your charge-off guidance and this time you’re just saying will remain elevated. Any comments you want to give in terms of what elevated might mean? I mean up another 15%, 20% flattish?

Richard Davis

As I told you in the quarters before this we were always projecting that we would see pretty much flat results from the prior quarters and then last time we met 90 days ago, we said that we start to see that coming down. In other words the trajectory of the increase would come down. I’d expect that the trajectory you saw coming down in this quarter from prior quarters will continue in that same direction in the future quarter.

In other words we are starting to see this continued reduction in increase becoming now a more consistent outcome. So, if you like what you saw between quarters one and two, I think you’ll start to see the same trajectory follow in quarters two to three.

Matthew O’Connor - Deutsche Bank

So, charge-off closed to slow, and that would apply to NPAs as well or [it will be tough there]?

Richard Davis

We’d do both. So, that both moving in, not exact lock step, but both moving in the direction the same way. It’s a fairly positive outcome.

Matthew O’Connor - Deutsche Bank

Just in general like if we think they picture here you’ve managed the risk well on the market disruption in the first part of the cycle, consumer credit, the second part. I have some folks out there, very much out there, pretty concerned on the C&I and the commercial real estate.

Two questions one, what’s your outlook for those loan buckets in general? Two, has there been a meaningful difference in underwriting at USB versus others the last several years?

Richard Davis

Yes, I want Bill to answer the specifics, but I’ll tell you I think we are continuing to enjoy the benefits of the many years of not stretching to make loans to C&I and commercial real estate customers. I think you’d agree as what we told; we were the last large bank into the recession in terms of credit distress.

I predict that we’ll be the first out because that longevity of longstanding prudence is going to pay us dividends. You’ll see that we are stressing like everyone else. I think you’ll continue to see our peaks and valleys will be muted compared to others. Bill wants to bring some color on that.

Bill Parker

Sure. On the C&I portfolios the mid markets and corporate portfolios, the only areas that have been problematic there are the newspapers, media and gaming type industries, where you see higher leverage points.

We do not have a large leveraged portfolio. So, our core middle market and corporate is actually holding up pretty well. They have taken the correct actions to weather the storm. Small business, of course sees some stress in its environment, but overall C&I is holding up pretty well.

On commercial real estate, we talked about residential construction for a long time now, almost two years into this. What began in California and our outstanding there now $2.7 billion is down from over $4 billion before. So, that is an area that’s going to continue to be stressed and we are continuing to work through it.

I think I mentioned last time, it’s moved into the Pacific Northwest, where we also have bolder exposure, but the loss varied there, not as bad as we have seen in California.

Matthew O’Connor - Deutsche Bank

Okay and then just lastly, Richard if we look at commercial loan demand, it seems like it falling off the cliff both for you guys, which is the industry in general. I guess from a broader point of view it is the positive because customers are paying down debt or is it a negative because it implies for the cuts now put in staff.

Richard Davis

I think let’s see could it be both, because it feels like both. I think it’s a positive in terms of bank’s balance sheet not taking on customers that will fall into further stress with this kind of duration of this downturn. In our case the reason I highlighted the majority of our decrease in linked quarter outstandings was the derivative of our hoping to buy commitment was to show that the demand is still there for the right customers and as you know 12.8% in linked quarter origination.

Those who have the money have the availability to use their money, have really restructured the way they run their business and they’re simply not hoping to buy loans in line. So, I believe that the demand overall for the stronger customers is reflected what you’d expected a year, year-and-a-half into recession, where they permanently reset their capital expenditures some of their growth objectives and not using as much of the bank’s balance sheet or their own frankly to grow.

So, I think that it’s a normal outcome at this point in the cycle. I think it’s good for banks if we continue to be prudent as an industry and not reach to get loan growth by reducing our underwriting. Certainly won’t do that at this company. As I have told you before because of our strong operating earnings, we will compete on price for the AAA customers, in order to either keep our own or to go get someone else’s.

In fact our margin stability it probably reflects, that we probably could have a little margin increase, but we want to give it back in the form of high quality customer attraction. So, I think it’s probably both demand in terms of the economy is not very good news for the banks.

I think those who stay pure at their underwriting, you’ll see the demand is the biggest reflection of why a loan growth isn’t prominent across the industry. I think that’s probably a good sign, we are not reaching trying to do something we shouldn’t do.

Operator

Your next question comes from Ed Najarian - Isi Group.

Ed Najarian - Isi Group

Just couple of questions, first quickly, can you quantify the net gain in the evaluation of mortgage servicing rights net of any hedges?

Andy Cecere

Yes, let me give you the hedge number. The hedge gain, year-over-year, so in the second quarter of 2009, it was a positive $45 million, Ed. In the first quarter of 2009, it was a positive $2 million and in the second quarter of 2008 it was a negative $25 million. So, on a year-over-year basis the improvement in the hedge was $70 million.

Edward Najarian - ISI Group

Okay, but this quarter, the number that impacted revenue positively was $45 million?

Andy Cecere

That is correct. Then with regard to the remainder of the mortgage improvements, I would say two-thirds of it was rate-related and one-third of it was volume-related.

Edward Najarian - ISI Group

Okay. Thanks. And then secondarily, any comments on early-stage delinquencies? Looks like we are seeing a little bit less stability on early-stage consumer delinquencies from you guys and maybe we have seen it some other banks.

Bill Parker

Yeah, we did see some improvement. Our card portfolio was down 30 plus, I would say 30 plus, it was down 43 basis points in the last 90 days. So that is good for our outlook on the third quarter. On autos, our auto portfolios both are leasing and loan portfolios showed a little bit of decline one to five basis points decline on the 30 to 30 plus. At least that was stable.

Last year it was still trending up. And then finally, on our small ticket leasing portfolio, their delinquencies came down about 50 basis points. So that was positive as well. So we have seen a little bit of more normal, seasonal uptick, or improvement in delinquency patterns.

Edward Najarian - ISI Group

But in terms of mortgage and home equity, I guess that is a bigger portfolio?

Bill Parker

That is a little more mix on the late stage on both mortgage and home equity. We did see improvement but we did see an uptick some in some of early stage.

Edward Najarian - ISI Group

You are still looking at those numbers and feeling confident that at both NPAs and charge-offs can increase at a slower pace, it sounds like?

Bill Parker

Correct.

Richard Davis

And this is Richard. If there anything we’ve gotten good at is, it is modeling forecasting and stress testing again our own forecast. And if there is anything that I am comfortable with, it is our ability to predict 30 days for sure and now 90 days with a certain high level of certainty.

There is always a lumpiness where you can have a deal of large customer come out of nowhere with a surprise. We’re going to at least down the table there is a possibility, but in terms of the mechanics of the consumer, the home equity, the mortgage, those are very much annuities, you can get a pretty good line of sight of now 90 days.

Commercial and commercial real estate a little lumpier, but when you know your portfolio like we know ours, we have a high level of confidence in our ability to predict that and I said this to you guys two years ago.

We’ll always tell you the bad news clearly and honestly and transparently and when the news starts to get good, our hope with the responses if you’ll believe us then too. And we are not seeing [all green shoots] and we are not seeing the end of the road here but we are starting to see in our portfolio a new, repetitive improvement in overall performance of our credit.

We are starting to see that as first a decrease in the increase of negativity, and over the course of time, I think we will be one of the first to be at the top of the hill and get on the other side.

Edward Najarian - ISI Group

Okay thanks and then Richard, you have paid back the TARP and strengthened your capital ratios. Can you give us a sense of your M&A appetite at this point in the cycle?

Richard Davis

Sure. It is no difference firsts of all because of those other activities. Those are just nice variables to have behind us. The M&A activity interest remains the same, Ed. We are first and foremost interested in payment businesses and his corporate trust businesses that would add quickly to the scale and value of those businesses that right now are being impaired by the recession, but will come back with [gangbusters] when things get better.

In terms of acquisitions, we will always be available to the FDIC list of opportunities that come along weekly. But we also are going to keep our powder dry for an opportunity that may be above of more significant nature like the Downey PFF or something like that.

So I am not going to do a lot of the Bank of Idaho’s a lot of the small five and ten branch deals unless they are amazingly opportune. But otherwise we will stay on the sidelines. We will watch for a larger FDIC opportunity and in the old fashioned sense of acquisitions that continues to be a very slow, quiet process, given the new results of the SCAP and everything else.

So we are probably in the near-term going to remain on the sidelines, and watch and see the good things come along and be able to be opportunistic when and if it happens. But nothing transformational and nothing outside of the bounds that we have been talking about for the last couple of years.

Operator

Your next question comes from Betsy Graseck - Morgan Stanley.

Betsy Graseck - Morgan Stanley

Thanks, good morning. Couple of other questions on the early-stage delinquency. You indicated those have been improving in a couple of asset classes. And I guess I’m wondering where you fall out with regard to the debate on why they are coming down. Some folks are kind of suggesting it is still seasonality.

Others saying its just slow down and unemployment rate, growth rate or the jobless claims and then another angle is, is mismanagement, doing a better job managing or having an impact on managing these early-stage delinquencies. When you look at your portfolio, what are the drivers there?

Bill Parker

I would have to say after seeing fourth quarter and first quarter, going through very rapid deterioration in the number of portfolios, part of it is that we have completely upped our protocol on the collection areas and that does make a difference.

Also, I think it is more a return of just to some normal, seasonal patterns, which were not here before while the economy was deteriorating rapidly. So we expect, as the unemployment continues to rise, card losses will over time go up again but third quarter is normally a decent quarter for card losses.

Richard Davis

Betsy for your benefit, we have an unemployment expectation of slightly over 10% by year end with a continued increase in 2010. So w are not sitting here thinking, I don’t think outside of the bounds of what others are expecting. As you all know a few basis points increase in unemployment, it’s like the [retro scale]. It’s not linear.

So, it’s a big deal and we appreciate how to stretch out our portfolios, but for the most part, our unsecured portfolios are planned only and our collateral portfolios are well written to low loan to value. So whether it’s impairment in the beginning or an absolute loss, I think we are going to fare quite well.

On the housing side, we are also expecting an additional 5% to 10% drop in housing values, which at the end of that process will be peak to a drop of around 40% fall. Our expectations are so far aligned with that the mix of business we have across our primarily 24 states would reflect that that’s not going to be above the average for the national, but probably near or at about that same level. So, I think we are in the range of expectations that some of the economists would predict as well.

Betsy Graseck - Morgan Stanley

Okay. And then on deposits and deposit growth did a great job with core deposits this quarter. I’m sure that this is in part the reflection of the efforts that you’ve had with your branch strategies, but could you speak to where you think the jumbo CDs are, relative to last quarter? I mean obviously they are down a lot, but is that kind of an exiting of low risk strategy or did you price to get those folks out?

Andy Cecere

Our pricing strategy on the retail side is to focus on core checking and savings accounts. That’s where we are certainly a bit more aggressive. Not at the top of the peer group but in the middle of the peer group. So that’s been our focus in growing core accounts and we’ve been successful with regard to that.

On the wholesale side, we’ve had volatility up and down. That’s more of a function of liquidity on the wholesale customers, but I would say overall, both in terms of wholesale and retail, we’ve had strong deposit growth. I think it is a function of the flight-to-quality and the reputation of our company.

Richard Davis

I know you followed us for a long time. It is one of the advantages that this downturn created for y US Banks with a chance to get back into the competitive game for pricing on core deposits. As you know, we were probably at the bottom two years ago.

We are now very competitive, but just because we are competitive for core I want you to know we still don’t attract hot money. We don’t like it. We don’t know what to do with it. It is not consistent and repeatable and so you just won’t see us using our margin to attract on rates on any basis, where customers don’t bring the rest of the relationship.

So we stay true to that, but we’ve been fortunate enough to be able to keep this strong margin at the same time how we redefine ourselves as a competitive deposits, comprised of core deposits will not help as well as the flight to quality.

Operator

Your next question comes from David Rochester with FBR Capital Markets.

David Rochester - FBR Capital Markets

It sounds like your economic expectations may be a little bit weaker than they were in the last call, at least in terms of what you are looking for from the unemployment rate perspective, but you are still looking for a deceleration in the growth in NPAs and charge-offs.

Would you say that that’s largely predicated on what you are seeing in the early stage delinquency side because you are seeing the dip there you are thinking that the rate of growth should slow?

Richard Davis

I’ll let Bill answer technically. We don’t spend, it is not all modeling. We know our customers. We know them very well. NPAs are usually a proxy for future charge-offs.

There are lots of regulatory reviews and has a lot to do with capital allocation and those are all what we all know them to be, but we really want to know at the end of the day which of those NPAs would be a proxy for charge-off and which unsecured loans, primarily consumer lots should go to charge-off and that has a lot to do with delinquencies in first and late stage has a lot to do just knowing the quality of your portfolio.

We have a got a very high sensitivity to whom we lend our money to and how we’ve done it. I would say it is a blend between the statistics, David and what we know about our company. It would be very easy for me to take a very safe road and tell you that is going to be another many, many quarters of the same, 25% to 30% increase in both NPAs and charge-offs. We just don’t see that.

We could be surprised like anyone else, but our backset which has served us very well. I don’t think we’ve been wrong on any of our 90 day projections in this whole cycle are based on a lot of data, a lot more than just unemployment, housing and delinquencies.

Bill Parker

I think the other thing I would mention is that we are potentially prime-based lenders. And the early part of this economic downturn was really more market disruption, capital market disruption and unique events. Now, we are entering a phase that looks more like a normal recession that is not severe, but that has less of a dramatic impact than some of the things that occurred earlier on in this downturn.

David Rochester - FBR Capital Markets

Have you noticed any change at all, potentially improvement in the re-default rates that you are seeing in your restructured portfolio? Have you seen any meaningful contributions, or more notable I should say contributions growth in this bucket in the C&I or CRE products?

Andy Cecere

I’ll do the residential mortgages first because I’m guessing that is what you are asking about. Our re-default rates there we do modifications, of course, for all of our mortgage portfolios, first mortgage portfolios. We have a measure of 60-day default rate and right now, that is at about 22%. We also measure it based on who reenter or enters foreclosures and that is at about 12%.

We take steps to improve that all the time. We increased significantly the number of malls that we do, where the payment actually decreases. We have doubled the percentage there up to about two out of three of them now, where the payment increases. So, that should make the future performance even better. Additionally, we are entering into the [SCAP] program this quarter that’s the administration new program. That should help too.

On the commercial or commercial real estate side, we don’t have a lot of TDRs there. Generally, we’ll try to work with the borrowers. The credits will go into A, if it’s a real estate deal. We’ll get charges down to great value.

Operator

Your next question comes from John McDonald with Sanford Bernstein.

John McDonald - Sanford Bernstein

I was wondering if you have an outlook on the net interest income growth it seems that the margin flat and loan demand being rose a bit, it going to be hard to grow net interest income at least in the near-term. Do you have some views there?

Richard Davis

John, we do expect relatively stable margin. On the earning asset front, I want to separate wholesale from retail a little bit. On the retail side, we’d expect flattish to some moderate growth, which is what you say in this quarter.

On the wholesale side a lot depends upon the utilization that we talked about. We are booking new loans with gaining new customers. The offset is what the utilization would do. I would expect that to be flat to down. So, those two things may offset, that the bottom line from all that is maybe flattish net interest income.

John McDonald - Sanford Bernstein

How about on the securities portfolio, Andy I guess you assumed that will be pretty flattish?

Andy Cecere

I’d not expect major changes there. What you see in the last few quarters, what you should expect in the next few quarters.

John McDonald - Sanford Bernstein

You guys are pretty specific about the credit outlook. How about our reserve build for the last couple of quarters you building at 50% to 100% of charge-offs and it’s a little below that this quarter. What kind of outlook would you have there?

Richard Davis

Well, 50, is in our history. So, we’ve got 50, 67, 75 and 100. I just like round numbers very divisible by something. 50, is on the low end of that six quarter range, but its still in it. I think those suppose to be right at 50 today. So, we are trying to telegraph that we are the low end of the sixth quarter trailing circumstances.

I guess what I think, John, is if we start to see a continuation of the kind of trends we saw this quarter, and that continues to bear out, as I said in my comments, they need to be sustained and convincing. We’ll start to move that 50% down to 40% or 30% or 25%. Eventually we’ll get down to very close to where we only I think reserve build for the growth that we expect in the portfolio, which would be very nominal.

I’m going to be careful. I want us to have all the reserves built possible so when recovery is among us, we don’t have to take any of the earnings away from that recovery in order to continue to backfill on reserves and we started this cycle as one of the strongest balance sheets I promised you every quarter we ended.

You’ll see us be generous on provision that we will also telegraph our views of the future by the way we start to move that down, when it finally starts to happen.

John McDonald - Sanford Bernstein

So, the credit outlook plays out as you expect with the growth rate moderating in both NPAs and charge- offs. We should see that reserve build magnitude starts to at least stay at the 50 and maybe go down from 50?

Richard Davis

Yes, it has a positive vibe to getting smaller. We didn’t talk about it. That has a lot to do with if you like where you are at the moment in time. We do like our coverage ratios. I must say, we are adequately reserved. That’s the appropriate way to find it.

I like the way we are satisfactorily adequate and so I think we are at a place we like if it so, if that’s the only variable and that starts to become loan forecasting, loan loss forecasting, NPAs and those become favorably bias and I think so too will the reserve be.

John McDonald - Sanford Bernstein

Particularly if the loan book is not growing, all that much?

Richard Davis

Yes, although we want to grow. I mean I’m hoping those commitments just the recovery. The best thing to about open commitments and you noticed were 35%, that we will get better in our high quality customers decide to start drawing on our loans right away. That’s the easiest. That’s loan growth you’re going to get because I know the quality of our portfolio, we’ll take that all day long. I think you’ll see a growing balance sheet as well, but I think you’ll see at the prime level that we have had in the past.

John McDonald - Sanford Bernstein

Then the last thing is with TARP repaid, there is still some uncertainty I guess about maybe new regulatory regimes. What capital ratios will you guys manage to and which metric system will look for you to manage to?

Andy Cecere

We have two principal targets that we have talked about. John one is the Tier 1 cap one level. As you know historically we have been targeting 8.5%. We’ve raised capital actually to get above 9% given the current environment. I’d expect this to be continue to be above 9% and then about two-thirds at a just over two-thirds being Tier 1 common. So, the ratios that you see now would be consistent with what we manage to in the future.

John McDonald - Sanford Bernstein

You like that two-thirds of total Tier 1 being common? Is that a good perhaps, okay?

Andy Cecere

I do, at least two-thirds.

Operator

Your next question comes from Nancy Bush - NAB Research.

Nancy Bush - NAB Research

A question for the future, assuming there is going to be one. Could you clarify what the regulatory input is that you’re getting on reserves, when we come to the end of this credit cycle? In other words, are you going to be able to draw down reserves as we did in past cycles or are the regulators going to expect reserve levels to stay high?

Richard Davis

We have had no guidance on that. I have to report because we have had no reason to have conversation in any of the last two years on any quarter with our selection of both reserve bills and our adequate coverage. So, we don’t have the dialog even to reflect back on and what kind of guidance they are giving.

I will tell you from my perspective and what I know and what I’m affected by. I think that we all agree that the capital ratios will be higher in a pro-cyclical world than they were going into it and I think we are going to be required to keep both capital -- I’m sorry and loan loss reserves at a higher level.

I also think that in the future when I talk to you about loan growth being 10% forecasted growth that we are going to have to apply a 110% loan loss reserve built, all things being equal, so we are starting to build for our future book.

I have no conversations though to record with anybody here on any guidance whatsoever. I just think the prevailing wind is on a pro-cyclical basis. All of us at banks will have higher capital requirements, higher loan loss requirements and we will be paying insurance premiums for many years forward, all of which were at lower levels or nonexistent going into this cycle. So that is all I know.

Nancy Bush - NAB Research

So your view is that the emphasis on the regulatory basis will swing from this anti-cyclical to a pro-cyclical emphasis going forward?

Richard Davis

Yes pro-cyclical is a funny definition, but I think what you meant is that there will be, if I can, vis-à-vis the old SunTrust argument they had too much. I think there will still be a tight balance where we can have the appropriate level, but I don’t think anyone is going to argue that more is worse than less, but it is going to be important that we don’t build reserves to use for future earnings because that is just bad business and it doesn’t give you our shareholders a clear line of sight on real earnings.

So I think there will be a lot more guidance coming out as it becomes clear that the recovery is ending and the banks will no longer look on linked quarter that will say, are you at the right place and we’ll probably get that definition, I am going to guess, in a couple of quarters but we have not seen them yet.

Nancy Bush - NAB Research

Okay. And just on the capital front Richard, could you just give your philosophy about rebuilding the dividend?

Richard Davis

Sure. Wow it took six people to get to the dividend. The philosophy hasn’t changed here, first of all. And so I’m going to give you everything but the math. But we said for a long time that we will give a high percentage of our earnings back to the shareholders in the form of dividend and in stock buybacks. As much as we all forgot the stock buyback, it is still a reasonable approach to use. I think it will come back one day as one of the options.

So if US Banks gave a majority of its earnings to the shareholders in those two methods and I believe both odds will be used in the future by our company. And the dividend will be something; a percentage of a large amount of our earnings will go to the dividend. But it will be a line of sight that I have to have and the Board has to have as we look into the next year, as we begin to evaluate our first dividend increase.

And once we get into the latter part of this year we will have a good idea for 2010. It is my commitment for all the reasons you would expect to give the dividend an increase at a level that is both sustainable, one that we can grow from, one that is predicted on the basis of future earnings and that is meaningful.

But I will hold back some for potential stock buybacks to benefit the shareholders in that way and we will keep a little for ourselves to continue to invest in the future. But Nancy, you have known us for a long time. Our percentage of high value to shareholders through those two forms has not changed and it is just a matter now of getting my head around what those numbers will be and giving a high percentage of it back to the shareholders.

Operator

Your next question comes from Mike Mayo - CLSA.

Mike Mayo - CLSA

Good morning. And say, you are pursuing some national advertising. And I just, my first thought is that, you must be doing a big deal on a market. So maybe I’m too skeptical there. I mean you are gaining some share within your market, so why national advertising and how much might that cost?

Bill Parker

Sure the national advertising is intended to be certainly all end market too, but we are 24 state franchise and the other 26 we don’t usually get a lot of visibility for. This follows perfectly on our newfound growth of the corporate bank, moving it from a regional corporate bank to a high quality national corporate bank. As you know we have offices now in both New York and Charlotte and we have enhanced our team by more than 100 senior lenders and capital markets, people in these markets.

So number one Mike, you know the story from a couple of years ago, but our newest result on Fortune 500 companies is 467 of them do business with us, but only a mere 132 do corporate banking with us. The others do corporate trust and/or corporate payments. All very good. But we are a national bank and we should have the national corporate capability.

So, we are talking to the [litany] of high quality customers, both private and public that are starting to know us by our quality, knowing our brand a bit. They don’t know it is at least a neutral equity and now we want to build positive equity. The campaign is slightly more than $10 million. It will run the majority of quarter three and a little into quarter four.

It will be TV and it will be print and it will be equally end market and out of market, identifying primarily the attraction of key leaders outside of market and small businesses and consumer’s end market. So it’s got a nice bifurcated view. It is all about strength, stability and being honest partner with people who need a good partner at times like this.

Mike Mayo - CLSA

You touched on this before in terms of larger, out of market acquisitions. You are a little more open to that. Is that correct?

Richard Davis

No. I didn’t mean to say that. I’m glad you clarified. Out of market acquisitions are going to be first and foremost costing this company two basis. One is, we’ve got so much momentum going in our organic initiatives as many which you all just haven’t seen yet, that the cost of us doing a deal in or out of market is substantial.

Well again, stress against that momentum. I’m willing to take it if it is right, but I am not looking for it. Out of market additionally has a cultural risk, at least when you do an end market deal, you have the ability to introduce your culture and confirm that it remains.

We have a culture now that I really like. I don’t want it to get diluted. To do it out of market, which cause us to put a lot of people out of the current market to get into those new markets and create a culture. I wouldn’t be unwilling to do it, but it has to be remarkably a great deal to pursue and at this point in time, we don’t see anything like that.

I didn’t mean to indicate out of market is of higher interest than end market. There aren’t a lot of opportunities. I just want to let you all know if a great deal comes along, we’ll look at anything, but we won’t do anything outside of our very prudent approach we’ve used in the past, but if in a couple years nothing big would come along, and we haven’t done a big deal, I hope you are not disappointed because I like who we are.

We are very relevant and we’re very good at what we’re doing. Acquisition is not a course this company has to take unless the opportunity presents itself at which point we’ll evaluate it.

Mike Mayo - CLSA

In terms of delinquencies, as a good predictor for loan problems, maybe I’m haunted. I think it was 2001 Labor Day or the day after that when you had your investor conference. That is before your CEO, you had a different Chief Credit Officer, but it was six weeks or so after that conference when you had the big credit quality surprise.

So just through your experience, a couple of decades of doing this, how good of a predictor are delinquencies on future NPA? Are there times when it hasn’t worked so well?

Richard Davis

You mixed a couple of things there. First of all, in dog years, 2001 you are right. Its five generation ago. So, I’m going to tell you that this company and this team is much more able to forecast and we simply would not make that mistake. I guarantee you that.

In terms of predictability, I think delinquencies have always been the best predictor of most likely loss effects from consumers and from the small business portfolio because it is the annuity aspect of it, you just doesn’t change that fast. It is not at all a good predictor of course in non-NPAs, as a predictor of loss in the commercial and commercial real estate.

I would say it hasn’t changed seven years later. It is still the best predictor, but this company has changed. We know how to do that better, we do have a different team here.

Our focus as Bill mentioned it earlier has been to bring on as much competence on the defense of knowing what’s going on in our credit and quality as it was in offense before. I think it’s a good time for you to have trust in our ability to predict. That last by gone of 2001 is just that. Bill, you want to add to that?

Bill Parker

No, the second that I think the delinquencies plus bankruptcy trends are very good indicator at least for the next 90, 120 days on mostly consumer and small business. Again on the wholesale side, it’s not necessarily good predictor at all. You have to look at other factors.

Mike Mayo - CLSA

If there is one factor that makes you feel better on the wholesale side or maybe just the offset to the two because aren’t we kind of getting going on the commercial real estate side?

Bill Parker

Yes, there is still plenty of stress on our residential construction portfolio. Like I said, our stress there has moved into our portfolio in the Pacific Northwest that’s about a $700 million portfolio. So, yes, we still see stress.

Richard Davis

So, I think Mike, two things. One would be the mix of our business that unsecured versus secured. That which is secured was underwritten at fairly conservative level that we can even tell the stand for the majority of the downturn and predicted downtrend.

So, risk to loss continues to be less than perhaps likelihood of NPA in both mix of our portfolio and the quality of those that are underwritten. But we will definitely see the continued stress we were not immune to it at all, which is why we are not saying losses or NPAS will go down in linked quarter. They just continue to think will go up by now.

Operator

There are no further questions at this time.

Richard Davis

Michael, thank you very much. Judy?

Judy Murphy

The official close. Thank you for listening to our review of second quarter results. If you do have any questions, please feel free to give me a call at 612-303-0783.

Operator

Thank you, ladies and gentlemen. This will conclude today’s conference call. You may now disconnect.

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