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Executives

James Abbott - Director of Investor Relations

Harris Henry Simmons - Chairman of the Board, President, Chief Executive Officer

Doyle L. Arnold - Vice Chairman, Chief Financial Officer

Gerald J. Dent - Executive Vice President

Analysts

Ken Zerbe - Morgan Stanley

David Rochester - FBR Capital Markets and Co.

Craig Siegenthaler - Credit Suisse

John Pancari - Fox-Pitt Kelton Cochran LLC

Todd Hagerman - Collins Stewart

Jason Goldberg - Barclays Capital

Robert S. Patten - Morgan Keegan & Co

Brian Klock - Keefe Bruyette & Woods Inc.

Larry Zatal (ph) - More Capital (ph)

Ken Hoexter - Bank of America

Steven Alexopoulos - JP Morgan Securities Inc

Presentation

Zions Bancorporation (ZION) Q3 2009 Earnings Call October 19, 2009 5:30 AM ET

Operator

Good day, everyone, and welcome to the Zions Bancorporation third quarter earnings call. Today's call is being recorded. At this time I would like to turn the conference over to Mr. James Abbott, Director of Investor Relations. Please go ahead, sir.

James Abbott

Thank you and good evening. We welcome to this conference call to discuss our third quarter 2009 earnings. I would like to remind you that during this call we will be making forward looking statements. Actual results may differ materially. We encourage you to review the disclaimer in the press release dealing with forward looking information which applies equally to statements made in this call. We will be referring to several schedules in the press release during this call. If you do not yet have a copy of the press release, it is available as an Adobe Acrobat file at ZionsBancorporation.com and can be easily downloaded and printed.

We will limit the length of this call to one hour which will include time for you to ask questions. During the Q&A session we will ask you to limit your questions to one primary and one followup question to enable other participants to ask questions. I will now turn the time over to Harris Simmons, Chairman and Chief Executive Officer.

Harris Henry Simmons

Thanks very much, James, and welcome to all of you. The environment remains reasonably challenging as you are seeing around the industry, especially as it pertains to some fundamental credit issues. But we are encouraged by some positive signs that we are seeing and that we will be addressing here in the call. One of those is that we are encouraged by the resiliency in our core pretax pre provision earnings. Our net interest margin has remained strong and the core pretax pre provision earnings number continues to amount to a little more than $1 billion annually, which is consistent with what we have been experiencing in prior quarters.

It would be maybe interesting for some of you to know that we have put into place incentive plans for about the 400 or so most senior officers in the company that are very focused on maintaining a strong pretax pre provision core earnings number, as well as reducing problem asset levels. And we hope that that will have real motivational impact over the next seven or eight quarters as that incentive plan will run.

I think it's notable that during the quarter we actually have seen some improvement in special mentioned loans, criticized loans that are sort of the first stage of deterioration before they move into more severe categories of substandard or doubtful. We saw a 4% reduction in those special mentioned loans during the third quarter. That was the third quarterly reduction since the second quarter of 2007.

Additionally, while we saw some increase, about a 6.9% increase in classified loans during the third quarter, the increase is coming at a much reduced rate from prior quarters. Going back to say the fourth quarter of last year, we had a 30% increase in that number, we had a 47% increase in classified loans, and the first quarter of this year was down to 16.3% in the second quarter and 6.9% in the third quarter. So we do think we have a trend running here in terms of a diminishing volume of loans coming into these more severe classifications and that is certainly underscored by the improving level of special mention assets.

It is also, I think, notable, that during the quarter we had about a 26% reduction in the beginning balance of classified assets. You go back to those that were in place on June 30th, and before accounting for new assets, being identified as substandard or doubtful. We actually had through charge offs, pay downs, and other forms of resolution, about a 26-percent decrease in that beginning balance so we are very proactively working through the problem pile even as we continue to identify some new problems that come along.

It might be useful or of interest to you to know that as we look at the internal grating of our portfolio, we think that we are very much on top of that. Regulators and our internal credit review staff are continually examining the portfolio and in recent reviews there have been relatively few downgrades from what our officers are actually recognizing in their portfolios, and we actually saw some loans upgraded as a part of this process by both regulators and our internal exam staff during this past quarter. So we think that we are at a place now where we are very much recognizing the problems as they are occurring and I think we are very much on board with where those who independently look at those grades are finding the grading to be.

We were very pleased during the quarter to see a significant growth in non interest bearing deposit balances. This is one of the factors that contributed to a strong net interest margin during the quarter. I think many of you are aware that during the quarter we continued to access the capital markets both through common equity and senior debt and we will continue to do so as the need arises.

Our tangible common equity ratio declined 23 basis points to 5.43% during the quarter primarily because the balance sheet remains somewhat larger than desired due to excess liquidity which we are now working at actually running off or running down in the banks. But I would note that all of our regulatory ratios strengthened during the quarter.

We expect to continue to issue common equity through our ongoing distribution program as well as to manage the ratio through sales of loans or balance sheet attrition. We certainly are mindful of, as we have stated in the past, of the need to be very watchful about diluting existing shareholders, but also keeping our capital at levels that are safe and sound.

With that overview I will ask our Vice Chairman and Chief Financial Officer Doyle Arnold, to review the quarterly performance.

Doyle L. Arnold

Thank you, Harris. Good afternoon and good evening, everyone. First a quick overview to echo Harris's. As noted in the press release, we posted a net loss applicable to (inaudible) on a GAAP basis of $179.5 million or $1.41 per diluted common share for the third quarter. Our pretax pre credit cost earnings however did hold quite steady at around $1 billion annualized, which excludes several items that are unusual and lumpy that I will talk about when we go to the income statement.

The reported GAAP net interest margin did decline from 4.09% last quarter to 3.91% this quarter, but as we discussed at length on last quarter's call, the NIM was going to be affected by several impacts related to the sub debt exchange that we initiative in June. And if you pro forma'd the second quarter NIM, the 4.09% for those effects, you would have gotten to, and I think most of you did, to a third quarter NIM or an adjusted NIM of 3.82%.

So the fact that we posted a 3.91% margin meant that the core net interest margin showed improvement of about nine basis points.

This was primarily driven by a reduction in the cost on interest bearing deposit accounts. The cost declined by about 25 basis points compared to the second quarter, and yet another strong increase in average non interest bearing deposits. All this was partly offset by a decline in loan yields as nonaccrual loans did increase and weighed on the portfolio.

The allowance for total credit losses was $221 million. Some of that was the A Triple L and some was the expense related to unfunded commitments or about $1.07 per share, and I think we had guided you to expect that the provisions for credit cost this quarter would again exceed net charge offs, but by a smaller amount than last quarter by a couple of hundred million. So I think that is about where we ended up we thought we would.

We are now heavily influenced in determining our credit provisions by the most recent more severe loss experience, typically just in the last 6-12 months and the provision is being totally driven by that experience, not the previous lower charge off levels earlier in the cycle.

During the past two quarters we have increased the allowance for credit losses by nearly $650 million and we think we now have one of the strongest reserve levels among regional banks.

During the quarter we did update the way we forecast future defaults for banks within our CDO pools. These are the bank trust preferred CDOs that are the focus of a lot of attention. As time passes we have an increasingly significant dataset of failed banks in this cycle which improves our ability to backtest various statistical regression to see which financial ratios are the best predictor of future failures for the private banks names in these pools.

As you recall, we use a third party publicly available default model for the performing banks whose stocks are publicly traded, but our updated private bank model now has a very strong correlation with actual bank failures and in most third quarter defaults, had probabilities of default in the high 90-pecent range based on the second quarter ratio analysis, and that is a significantly more highly correlate than actual failures in our previous reliance on LACE ratings, and we are no longer using LACE ratings to estimate PDs for private bank names.

Using this updated analysis, the impairment for the entire securities portfolio was $198 million, split between $142 million of OCI which may be recaptured if discount rates fall and/or cash flows improve, and $57 million of credit related OTTI.

The OCI mark primarily reflects the fact that we are using higher discount rates for the liquidity impairment on original single A rated and original triple B rated securities in prior quarters. And we will come to, in a minute, the actual carrying values that we are now carrying those securities at.

Okay. Turning briefly to some of the schedules attached to the press release, page 13. At the end of last quarter we said that we would be trying to shrink the balance sheet. We were unable to do that this quarter and it actually grew by over half a billion dollars. Partly that was due to the Vineyard acquisition that occurred in July, partly because the overall size of the balance sheet is being driven by the liabilities, not the assets. It was increased by the senior debt that we issued during the third quarter, and in general, just a continued strong liquidity of the banks and the parent in the aggregate.

And you can see that, for example, money market investments, interest bearing deposits, and commercial paper were $2.2 billion up from $1.0 billion last quarter. And just in general, liquidity was up by many hundreds of millions of dollars.

Just to kind of scale this for you, for every billion dollars of asset size we have given a same amount of tangible common equity, that has an 11 basis point impact on the TCE ratio. So greater by a billion means TCE down by 11 basis points.

Turning to page 14, consolidated statements of income, as Harris mentioned, the poor pretax pre credit cost to earnings remains steady at about $1 billion. We excluded several major items that appear on this page from that calculation.

In particular, the fair value and non-hedged derivative income of $59 million which largely rose from again, terminating ineffective interest rate swaps. We excluded that. We excluded the securities impairments, and then you can see the $146 million acquisition related gain. That is all due to Vineyard. We told you at the time of the acquisition that we expected that gain to be comfortably in excess of $100 million and it was $146.2 million. And we also excluded from getting to that $1 billion number, the (inaudible) expense of $30 million since that is, in effect, a credit cost and bounces around a bit from quarter to quarter.

Page 17 and 18 the investments securities portfolio, we are again providing you here with a great deal of information about the securities portfolio. But I think in future press releases we are going to relegate these particular tables to the 10-Q. They are very difficult to put together and tie out in a timely fashion for public disclosure purposes, and also I am not sure that people are finding them that useful. What we did try to do, if you will turn back to page six of the press release, we tried to collapse this all down into three lines of what we think are highly relevant and important numbers. We took the bank trust preferred CDO portfolio and organized it by the original grades of the securities that we have, not the current grades, but the original grades.

We know we have gotten criticized by some for not marking our CDOs to the level of some of our peers, but we do want to highlight and think this table highlights the fact that 58% of the par amount that we have was originally Triple A rated which we think is rather higher on the quality scale than that of —

James Abbott

Fifty-two.

Doyle L. Arnold

I'm sorry, what did I say, 58? I am sorry, 52%. And because there is such a very strong level of overcollateralization on the Triple As, it is highly probably that there will be very little credit lost on these securities, and therefore it is reasonable that we could realize maturity or realize full value — par at maturity.

But they are held at $0.69 on the dollar and that is primarily because when we purchased them out of Lockhart funding. That was our off balance sheet QSPE. They had to be purchased at a discount, an interest rate mark, at fair value, at the time. So the rest of the portfolio there is a sizable amount of original single As that are now marked to $0.37 and the original triple B rated CDOs are now marked at 25% of par.

If you're in the camp that believes the original triple As are likely to have very little credit impairment and you apply the $355 million discount that we are currently carrying the original triple As at. If you applied that discount to the single As and the triple Bs, those trenches would be carried net in the low single digits. So basically we think the whole portfolio is now marked pretty fairly.

We turn to page 20. I think you can go through the usual numbers. We do want to point out that near the middle of the page just above the reconciliation of the allowance and reserve for credit losses, if you look just above that, we have added four new lines. We have added accruing loans 30 to 89 days past due, excluding those from FDIC support assets, and then the 30 to 89 day passed dues in the FDIC supported assets. And then just below that, the last two lines, we have given you restructured loans that are included in the nonaccrual loans above and then also, restructured loan that are on accrual at quarter end.

So, some information that a lot of you ask about and we have now just included in the table — you are going to hear a few — did not look — we did not do the math for you here, but non performing asset formation has been fairly steady over the last few quarters. It actually drifted down a little bit this quarter, probably too soon to call that a definitive trend, but basically it is at least holding now steady.

As Harris mentioned, special mention loans declined during the quarter and the classified asset growth was in a mid-single digits kind of growth rate.

Again I will point out the A Triple L increased to $1.433 billion, up $185 million, and is now 3.61% of net loans and leases and 79% of nonperforming loans . And the total reserve bill, including the unfunded commitment allowance was $221 million, up to $1.53 billion.

Next page, page 21, another new schedule. Many of you asked for hat so here it is. This is nonaccrual loans for the last five quarters by loan type. You will note that the rapid increase in construction and land development loans that we've experienced in former quarter has somewhat flattened out. Also the CNI loans somewhat flattened. The two increases that are ongoing appear to be coming from the owner occupied commercial and from the commercial term, both of which have, we believe, had lower loss content than the construction loans which have been driving most of our losses.

In fact, once again just under 60% of total losses, I believe it is just over half of total losses this quarter, again came out of the construction and land development category.

Page 22, the average balance sheet, we already talked about this. Margin 3.9%, you can see the total interest bearing deposit cost declined by 25 basis points. I will point out one number that will jump out at the page at you when you get to it, long-term debt average rate 9.9% up from 3.3% in the prior quarter. That is the effect of the subordinated debt that converted to preferred stock during the quarter, i.e. that exercised the conversion option. And we immediately accrete back all of the discount that was taken on the debt back through interest expense, and that is where it shows up, most glaringly is on that particular line item.

On page 24 we give you capital ratios with ate cautionary note that the risk-based capital ratios are still estimates. The capital is not an estimate, but the risk-based assets or the dominator is what is an estimate.

The tangible common equity ratio declined primarily because the balance sheet grew and also because of the greater than expected OCI marks on the securities in part reflecting the change in the way we got to the assumptions on defaults and deferrals.

The risk-based capitals ratios all were up slightly however, because the balance sheet growth was in very low risk, therefore low-risk rated assets. We were satisfied that our efforts during the quarter to issue equity helped maintain overall very stable ratios.

Okay. Some guidance for the next couple of quarters; we expect loan balances organically to continue to decline and we would expect modest overall shrinkage in the balance sheet. We do expect continued solid NIM performance in the fourth quarter and as we do think there is still room to reprice funding costs down and improve the funding mix as well as were able to hold loan pricing up fairly solidly. And as a general statement, the balance sheet does remain fairly asset sensitive.

Credit quality based on the moderate increase in classified assets, we do expect NPAs to continue to increase in the fourth quarter, although the rate of change is likely to continue its decelerating trend. Fourth quarter net charge offs may likely be similar to the third quarter. Factors that could cause an increase would an overall higher level of NPAs as well as possible trend towards higher severity levels in some loan categories, but the mitigating factors may be that the composition of NPAs, as I mentioned, has begun to shift away from the high severity loans like construction and development and tort loans that typically have lower severity such as our owner occupied CRE and investor-owned term CRE.

We expected provision to again exceed net charge offs in the fourth quarter, but based on the data available today we would expect the overt provision to be less in the fourth quarter than the third quarter amount. So credit cost should continue to decline, but probably still in excess of actual charge offs.

Also, the charge to noninterest expense for unfunded commitments is likely to be significantly lower in the fourth quarter because the third quarter's expense was largely due to the completion of the one-time updating of several of the major loss factors in the model.

In the securities impairment area we expect a more moderate adverse impact to TCE in the fourth quarter which is the combination of the after-tax impact of OTTI and any adverse change in OCI. As the change in assumptions within the model were relatively major in the third quarter, but we expect only small refinements in the future.

So in summary, while conditions continue to be challenging for us in the industry, we are encouraged by the steady pretax pre credit cost earnings, a loan loss reserve that is quite strong, and a noticeable slowing of the growth in classified assets.

With that, I think we will open it up for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator's Instructions) And we'll take our first question from Ken Zerbe with Morgan Stanley.

Ken Zerbe - Morgan Stanley

Thanks. Can you just talk about the environment right now or the market for potential loan sales and I guess also address the agreement that you have with the OCC in terms of keeping your classified assets over your Tier 1 plus reserves to 100% and where do you stand on that currently?

Doyle L. Arnold

Well, to answer the second one first, there is no agreement with the OCC that requires us to get that ratio. What I have said is that it is a ratio that is of keen interest to the regulators, but there is no formal requirement that we hit that or any other particular ratio. I think on the whole we are probably right around that ratio around the 100% level. It varies a bit by bank, but that would be the other to that question.

In terms of loan sales, I think the best way to address that would be first of all to say that we work through about 26% of total classified assets. If you take the classified asset balances at the end of the second quarter, before any new inflows, we resolve 26% of those balances in the third quarter. Some of that was pay down, some of that was sales, some of it was charge offs, et cetera. Now, actual loan sales in the third quarter were a bit over $100 million that the two biggest components of that would be coming from California and from Nevada. And again, primarily those reflect basically selling one note at a time, not bulk loan sales. Did you want to have a followup on that, Ken, if I missed the mark?

Ken Zerbe - Morgan Stanley

No. I think you got it. I would have a followup, but sort of off the subject a little bit. The one thing I was just curious about was given your expectation for further reserve build, would you consider revising the pace at which you are raising the additional equity to accelerate that in coming quarters?

Doyle L. Arnold

Well, we raised about $188 million I believe it is in net common in the third quarter. And if I gross that is up $250-$275 million of loss and charge off.

Ken Zerbe - Morgan Stanley

I guess I was thinking specifically about the most recent $250 million ATM offering.

Doyle L. Arnold

Well, I think we will probably use that over one or two more quarters, but we will meter it out as we think appropriate. There is not a particular number or ratio that we are trying to hit, but I think you would probably look for another significant issuance this quarter of over $100 million and maybe $150 million, but I am not sure we will use all of it this quarter.

Ken Zerbe - Morgan Stanley

Okay, great. Thank you very much.

Operator

We will take our next question from David Rochester with FBR Capital Markets.

David Rochester - FBR Capital Markets and Co.

Hey, guys. How are you? You mentioned completing the implantation of loss factors this quarter. Can you talk about what portion of the total provision for your on balance sheet exposure as well as for the unfunded commitment that was, and can you go into how many of your sub banks were impacted by that?

Doyle L. Arnold

Probably cannot answer the specific question. I will just say that on a net basis, substantially all of the reserve build was in California and Nevada which were the two biggest banks that we did not fully apply that methodology to last time.

David Rochester - FBR Capital Markets and Co.

Okay. And di you ultimately end up pushing any capital down to any of those banks this quarter?

Doyle L. Arnold

Yes. We did a number of capital actions at the bank level. We converted a little over a half a billion dollars of subordinated debt at various other banks and to Tier 1 capital as a sub debt that as been issued to the parent. In addition we pushed a couple hundred million of capital to Nevada and a smaller amount to Texas to the amount of about $80 million into Amery Bank in Texas. That will all come out in the call reports, I just do not happen to have the full schedule here.

David Rochester - FBR Capital Markets and Co.

Sure. So that I guess was the entire balance of the $510 million or so of sub debt outstanding at the holding company level?

Doyle L. Arnold

That the holding company owned yes, that is substantially all of it.

David Rochester - FBR Capital Markets and Co.

Okay. All right, thanks, guys.

Operator

And we will take our next question from Craig Siegenthaler with Credit Suisse.

Craig Siegenthaler - Credit Suisse

Thanks and good evening. Just first on M&A, I am just wondering if you can comment on your desire to do additional FDIC assisted deals here, especially in light for your desire to shrink the balance sheet.

Doyle L. Arnold

The two are not explicitly linked because the last deal that we did was self capitalizing and at the bargain purchase gain essentially capitalized the increase in the balance sheet. But what is limiting our capacity — I mean we are still, as we said last quarter, we are taking a pause. We have got over $2 billion of assets to work out and frankly we have not seen another one that was even remotely tempting to us in the last few months. The quality of the franchise that are going under now is not very good.

Craig Siegenthaler - Credit Suisse

Got it. And if I could just ask one additional question. The delinquency level was up a little bit sequentially, but it looks like your classified loans that you say on the call has improved. What does that mean in the past from P&L growth a few quarters out?

Doyle L. Arnold

Well, this cycle is so without precedent really, that it is hard to extrapolate from the past. I guess we would expect that if we are doing our job right, the classifications downgrade should precede movement into non performing status which should precede the losses. So the fact that criticize and classify appear to be peaking, it probably means that those other things are not that far behind one or two quarters maybe in terms of peaking.

Craig Siegenthaler - Credit Suisse

Great. Thanks for taking my questions.

Operator

And we will go next to John Pancari with Fox-Pitt Kelton.

John Pancari - Fox-Pitt Kelton Cochran LLC

Good evening. Could you give us some color on the increase in owner occupied in term CRE non performers? Specifically what market did you see the increase and what are some of the trends you are seeing, and particular on the owner occupied set.

Harris Henry Simmons

Well, the owner occupied I think comes out of our — I think it is mostly here in our Utah bank. This again is the kind of low loan to value SBA 504 or 504-like small business owner occupied loans. It is a national program that is run out of the bank here in Utah. So the specific geographies around the country I am not sure about. The largest component of that portfolio is actually in California, followed by various other western states, and then nationally. And the last content remains — I mean, the actual loss realization remains way below 1% on an annualized basis right now. It has been creeping upward and it looks like it might get to 1% or a bit more than that before we're done but currently it's well under that.

So does that give you the answer on owner occupied?

John Pancari - Fox-Pitt Kelton Cochran LLC

Yes. It does. And then on CNI?

Harris Henry Simmons

You mean on the term?

John Pancari - Fox-Pitt Kelton Cochran LLC

I guess I would ask about both term CRE and CNI.

Harris Henry Simmons

Okay. The geography for the — I am not sure we know. I think — let us see. Why do we not take another question? We will fumble around here and look and see if we can come up with a geography specific answer on that. Sorry.

John Pancari - Fox-Pitt Kelton Cochran LLC

Okay. Good, that is not a problem. I will ask a related question then. It looks like you just indicated that you follow an additional amount of capital back to the Texas sub, to Amery. It looks like the second quarter that you did that. Can you talk about that a little bit? Are you seeing mounting pressure there on the credit side that is giving you the rationale hereby you are going to find more capital down there?

Harris Henry Simmons

Yeah. We have seen an increase and criticized and classified in nonperforming assets in Texas — fairly substantial over the last few quarters. Their general sentiment in Texas is not that things are about to start improving but that the rate of that deterioration is beginning to slow meaningfully. We saw that kind of ramp up in other markets, but earlier, and Texas later to the party. But yes, that is primarily that has been driving those capital ratios.

If we have a coherent answer to your question, we will come back and interject it later in the call or you can followup with James later.

John Pancari - Fox-Pitt Kelton Cochran LLC

Will do. Thank you.

Operator

And we will take our next question from Todd Hagerman of Collins Stewart.

Todd Hagerman - Collins Stewart

Good afternoon, everybody. Hey, Doyle, just wondering go back to your comments on the reserve. If I understand it right, you have added in excess of $600 million to the reserves the last couple of quarters. There has been some shift in recent quarters in terms of the waiting and recent loss migration, but how should we think about it in terms of with the acceleration on the commercial side that we are saying, particularly in CNI, and presuming that the loss factors would have gone up across the board, what does that mean for the reserve build going forward? Particularly since your reserve coverage is still kind of around that high 70 kind of coverage of nonperforming loans with commercials continuing to increase.

Doyle L. Arnold

Well, I tried to indicate that we do expect another over provision this quarter, but we think that we are nearing the end of that sometime in maybe the next couple of quarters. The increase in non performers was still heavily skewed toward that owner occupied commercial and again, the loss content in that even applying just the most recent loss experience is still extraordinarily low and we have no indication that it is going to spike up dramatically from there.

So the rest of the CNI is pretty stable. It has been between $200-$250 million for the three quarters in a row now. So all of the increase in CNI is coming from there, and most of the increase in commercial is coming out of commercial term where we have seen some increases in losses. We had a couple of casino real estate secured loans in the most recent quarter go bad, but as a general matter, we do think the loss content in that is lower than in the construction and land development component of CRE.

Todd Hagerman - Collins Stewart

Okay. And if I may just a followup to that then. I mean, what about that there is a lot of discussion obviously currently in terms of the differences between the GAAP accounting and the formula approach to some of the reserves and perhaps increasing regulatory pressure on the reserves particularly given the absolute level of problem assets. What can you say just in terms of those discussions that you are having now with the regulators and just kind of how to think about reserves in the coming quarters or year in terms of absolute levels.

Doyle L. Arnold

I am not sure what you are alluding to even there. I would say I have no ideation that the regulators are dissatisfied wither with our level of reserves or the methodologies that we are using to derive that reserve.

Harris Henry Simmons

I do not think there is a gap between their view and GAAP accounting. I mean that is basically — we are applying loss factors from graded credits and over the last several quarters and —

Doyle L. Arnold

If what you are trying to ask, Todd, is two years out after the peak of the cycle, how is the SEC and the Fed and the FASBI going to resolve the pro cyclicly, or if the Fed has its way or if the regulators had their way, the lack of pro cyclicly in the reserving process. I do not know. I will stay tuned like you will.

Todd Hagerman - Collins Stewart

No. I mean that is part of it. I guess I am just more focused just in terms of the absolute mathematics between again, kind of the concentration on the commercial real estate side and is as that starts to trend lower, but the bucket in part continues to fill in terms of inflow of problem assets. Does the absolute level still come down byte pure mathematics as opposed to even though the NPAs continue to go up?

Doyle L. Arnold

Well, I think what we are really looking at is the actual loss migration using the most recent and therefore most relevant time periods, particularly in this unprecedented cycle. I mean we are not looking back farther than 12 months now and much of this is being driven by the most recent six months loss history and that is likely to remain the case until we clearly have very clear and compelling evidence that we are over the crest of this hill and then we will decide how do you start to normalize this over a whole cycle as opposed to making sure that the reserve is adequate for these peak losses.

Todd Hagerman - Collins Stewart

Okay. Fair enough, thanks.

Operator

And we will take our next question from Jason Goldberg with Barclays Capital

Jason Goldberg - Barclays Capital

Thank you. Good afternoon. I want to be careful not to put words in your mouth, but I think you made the comment that we do not want any agreements with the regulators with respect to specific ratios. Was that meant to say there is agreements in place that do not have specific ratios involved in them (laughter)?

Doyle L. Arnold

Yes. And I stopped beating my wife last Tuesday. How do I answer that question? I mean look, we have lots of discussions with the regulators. I am not going to comment on agreements with regulators or lack thereof. I am just saying, I got to ask the specific question alluding to the fact that I had said there were agreements that had that ratio in it, and that is not the case, and that is as far as I am going to go.

Jason Goldberg - Barclays Capital

That is helpful. And then secondly, with respect to the slowdown in increase of criticized assets, could you maybe talk some color on the composition of that? Is it kind of similar to what you are seeing in terms of MPAs where construction-line development may be declining and you are starting to see an increase in unoccupied (inaudible) CRE or just maybe flush out the kind of endowment for that?

Doyle L. Arnold

Yeah. I think the clearest turn is in Arizona by geography, where we are clearly criticized and classifieds are both trending solidly downward. The criticized and classifieds have flattened in Nevada. We still have a very high rate of charge off coming out of what is there and as a general statement, residential construction and development in California, Arizona, and Nevada, are the source of most of that flattening or decline in criticized and classified. Those are the most clear cases where those trends have turned for the better.

Harris Henry Simmons

And I would say the clearest increase remains in various geographies in commercial construction and development CRE where they are still increasing.

Operator

And we will take our next question from Bob Patten with Morgan Keegan.

Robert S. Patten - Morgan Keegan & Co.

Hey, guys. Just about all my questions have been asked. Just I guess coming back to the margin, Doyle, when you said it was going to be solid. Are you looking at on a core bounce from what we saw from second and third quarter this quarter and going into the third and fourth quarter?

Doyle L. Arnold

I think the bias in the core margin would still be slightly upward in the fourth quarter, yes.

Robert S. Patten - Morgan Keegan & Co.

Is it the same delta?

Doyle L. Arnold

Who knows? I do not know. I just think there is still room — all right, I get there this way. I think there will be a moderating increase in NPLs and so there will still be a drag there, it just will not be the headwind getting a little weaker each quarter in terms of the rate of increase, and there is still room to reprice the funding costs, and potentially to shrink the balance sheet from the liability side, all of which would tend to improve the margin.

Now once again, we still have some sources of noise. From the sub debt modification we have, I believe it is next month, another election date for conversion into a sub debt in a preferred stock. You saw the impact on one little line of funding and therefore on the margin from $27 million this quarter. I have no idea what that number will be next quarter.

Robert S. Patten - Morgan Keegan & Co.

Okay. You do not now the amount that is up?

Doyle L. Arnold

No. I know how much — I mean, the amount that can convert is in the many hundreds of millions. I have no idea how much we will elect to convert.

Robert S. Patten - Morgan Keegan & Co.

Okay. Gotcha. And then just on the deferred tax asset, it's a good percentage of your tangible common, any thoughts around having to take a valuation of the allowance or are you just continuing to look at it?

Doyle L. Arnold

I think it was $688 million up this quarter from about $640 million in the second quarter. As we get deeper into the cycle we'll have to continue to look at it and test the justification for not taking a valuation allowance as it may become more formalized over the next few quarters and it has been until now, but I don't think I will — I remain pretty confident that I won't have to take one.

I will just note that for those who want, there is an estimate of how much, for regulatory purposes, was disallowed this quarter. And that is $122 million of regulatory capital purposes up from $59 million last quarter. It's in the same three banks, but these numbers are probably not finalized yet, but they will be by the time of the call report; $67 million in Nevada, $26 million in Arizona, and $29 million in California Bank and Trust. That is the disallowed regulatory DTA.

Robert S. Patten - Morgan Keegan & Co.

Thanks, Doyle.

Operator

And we'll take our next question from Brian Klock with KBW.

Brian Klock - Keefe Bruyette & Woods Inc.

Good afternoon, gentlemen. Thanks for taking my call. I did have a few of my questions answered already, bu I guess sort of onto the DTA question and we think about when the timing differences will reverse. What is your outlook that ties into when you think of return of profitability?

Doyle L. Arnold

You are asking me when I think I will return to profitability?

Brian Klock - Keefe Bruyette & Woods Inc.

Yes.

Doyle L. Arnold

Sometime next year, roughly speaking in the middle.

Brian Klock - Keefe Bruyette & Woods Inc.

Okay. And I guess with that, obviously the regulatory accounting is a little more bright lined than the accounting testing of your look backs and when it becomes (inaudible) et cetera. But as of this point you are saying you don't think even before year end you would have to more formally test the DTA?

Doyle L. Arnold

No. We have talked about, I believe, at a conference recently, all these hedging strategies related to asset liability management and securities that would have an ancillary benefit of realizing operating tax losses that would help mitigate any DTA disallowance issues. And we are continuing to pursue those and think that we will execute some of those hedging strategies this quarter.

Brian Klock - Keefe Bruyette & Woods Inc.

Okay. And wouldn't you still need to generate taxable income in that quarter though, in order to realize that tax benefit?

Doyle L. Arnold

No. Because we can carry it back against operating losses (inaudible) gains operating income, so (inaudible) operating and loss carryback to 2007 and 2008 taxes paid.

Brian Klock - Keefe Bruyette & Woods Inc.

Okay. All this talk about DTA is getting you choked up so I will just ask one other question.

Doyle L. Arnold

It is. It's my favorite topic.

Brian Klock - Keefe Bruyette & Woods Inc.

All right. I appreciate all the extra disclosure this quarter on the NPLs by category, the TDRs, et cetera, do you actually have the gross inflows into NPL in the quarter? We have got the net change, we have got net charge offs?

Doyle L. Arnold

It is between $650-$700 million. What we should do is give you the number and tell you exactly how we calculated it. All we did was add and subtract numbers from page 20. So essentially — wait a minute. This is not accruals. New loans that went to nonaccrual were $873 million. Is that the number you are looking for?

Brian Klock - Keefe Bruyette & Woods Inc.

Yes. And your call reports last quarter, I think it was 863.

Doyle L. Arnold

Yes. So it is down a little bit.

Brian Klock - Keefe Bruyette & Woods Inc.

Okay. And then one last question and I will try to get out of here. Harris, you mentioned earlier the level of classified loans and the rate has decreased over the last few quarters. Can you give us the balance of those classified loans at the end of the third quarter?

Harris Henry Simmons

No.

Doyle L. Arnold

No.

Harris Henry Simmons

Yes we can, but no we won't.

Brian Klock - Keefe Bruyette & Woods Inc.

Okay. I thought I would try. Thanks for taking my call (laughter).

Operator

We will take our next question from Larry Zatal (ph) with More Capital (ph).

Larry Zatal - More Capital

Hi, thanks. Doyle, you've spoken in the past about trends in the intermountain west. I guess Colorado, Oho, Utah, and how those markets were starting to show signs of weakness. Can you bring us up to date on that?

Doyle L. Arnold

I do not know. Harris, do you want to take a crack at that one or do you want me to?

Harris Henry Simmons

You start and I will chime in.

Doyle L. Arnold

Let's see. I think they are still deteriorating, they are still in general in better shape than the national average. For example, the Utah unemployment rate I think is 6.2% compared to national average of very close to 10 now. You are starting to see some actual pickup in residential construction activity again in Utah. Corresponding with that, there is still a lot of foreclosures. I think Utah has one of the 10 highest foreclosure rates in the country still, and it is generally the case that consumer credit weakens more in Utah than in other states in a downturn.

At the same time, our home equity portfolio which is largely Utah and most of our mortgage portfolio, continue to perform very, very well,. In Colorado we have had a sharp increase in criticized and classified there in the last couple of quarters and I think it is going to moderate, but clearly the recession is coming to Colorado as well.

Harris Henry Simmons

But not large.

Doyle L. Arnold

Yeah. It is a sharp increase, but relatively small ballers in the total sense. What else would you want to add? Do you have a specific question or —

Larry Zatal - More Capital

No. I mean you have given us color on that in the past. I just was hoping for an update and you have done that.

Doyle L. Arnold

Well, I think the Utah economy is maybe the strongest of all the economies we are operating in. Texas still remains, I think, in reasonable shape. The rig count is actually back up from its bottom and that is encouraging. But there is still weakness all around. I think small businesses are feeling this and certainly consumers have a ways to go and commercial real estate is going go take another two or three quarters, I think, to play out.

Larry Zatal - More Capital

Okay. And I just simply forget, have you had to put capital down to Zion's First National Bank?

Doyle L. Arnold

We converted some subordinated debt during the quarter into preferred.

Harris Henry Simmons

Yeah. A couple hundred million and probably we'll have to put a little bit more than there before this is all over.

Larry Zatal - More Capital

Okay great. Thank you.

Operator

And we'll go next to Ken Hoexter with Bank of America.

Ken Hoexter - Bank of America

Thanks. Two quick one, guys, I know we're at the end here. First question, Doyle, on the bank CDO portfolio, with the revised methodology, do you have an updated look on what you expect future OTTI to be? I know you said you'd be able to model it better, but has that altered your expectation of the potential future loss?

Doyle L. Arnold

I think what you are seeing this quarter is a bit of a one-time change in approach reflecting the modeling and I would not expect a repeat of this level of OTPI and OCI in the next couple of quarters, but I would expect some more of each, but maybe back to more moderate levels again, but it is hard to know.

Harris Henry Simmons

The model is really sensitive to deferrals more so than really defaults and so it is really subject to how many new banks the regulators require of them to stop paying their interest on their trust preferred. And in fact, in the third quarter that number is down from the second quarter and so we are actually encouraged that there seems to be fewer new deferrals so we think we need another quarter here to make sure it is a trend, but it is actually encouraging.

Ken Hoexter - Bank of America

Okay. And then secondly, you mentioned this $250 million kind of core pre tax pre provision run rate, are you expecting that to just kind of be the new run rate? I mean is there anything that would get it to — what would you need to see to see it actually start increasing? And there was a lot of one-time items you have to tease out to even get to 250, but do you expect it to kind of stay there or what are the risks and positive potentials to grow it over time?

Doyle L. Arnold

Loan growth or loan shrinkage is probably the biggest near-term swing factor once we get through with the repricing opportunities in the funding side of the balance sheet. There is nothing in the nature of our non interest income that, other than these unusual items like the swap, which we have excluded from this, is susceptible to dramatic increases or it's not like we have big capital markets or investment banking markets — it goes from no profits to a lot of profits on a quarterly basis.

So the bigger driver is going to be when the loan demand begins to stabilize and pick up again leading to loan balance stabilization and growth again.

Harris Henry Simmons

Well, bringing down nonaccrual loans is part of it. I mean that is probably a $100 million drag right now.

Ken Hoexter - Bank of America

On the margin, right. Okay. Thanks a lot.

James Abbott

We have got time. Let's take one more question and then there looks like there is a few people still waiting in the queue so this is James, just give me a call and I'll get back in touch with you.

Operator

Thank you, sir. And we'll take our final question from Steven Alexopoulos with JP Morgan.

Steven Alexopoulos - JP Morgan Securities Inc.

Hey, everyone . I actually just had one question for Doyle. We have had a couple of quarters now of one-time gains which have come at a pretty good time, given the way provision and where OTTI impairments have come in. Doyle, I am just wondering, when you look out into your crystal ball, do you see any one time gains out there on the horizon?

Doyle L. Arnold

Nothing of the magnitude of the Vineyard acquisition. And we tried to be pretty up front about that one by telling you we thought it would be well north of $100 million. The one that we may see some more of is the swap. I think the line item is non hedge derivative income and that was $58 million this quarter. That's coming out of the termination of swaps which have become ineffective for FAS 131 purposes because each of the pools that we had has to be homogenous in terms of the pricing characteristics. So it has to be a pool of LIBOR plus 200 loans or prime plus 50. Everything in there has to be like that. And those loans pay down in a pool and then are replaced — the new loans we are making are at wide spreads generally, than the loans that we hedged. The hedges on those pools become ineffective and they're torn up.

We have, today, I think it is $100 million roughly of unrealized gains on FAS 133 hedges, sitting out there, yet one portion of which could be realized in this quarter or next as long as interest rates stay low and spreads on new loans stay higher. So that is the one source of potentially ongoing gains. And $100 million today is about the amount. I wouldn't think all of that would be realized in one quarter, but some of it could.

Steven Alexopoulos - JP Morgan Securities Inc.

Okay. Thank you.

Doyle L. Arnold

Before we sign off here, I am going to let you do this, Geri, but there was a question earlier that we were unable to answer that we will — why don't you try to restate the question, Geri, and give the answer.

Gerald J. Dent

It related to where the concentrations were in the real estate non accruals, and Doyle pretty well answers the question as it relates to owner occupied. So the remaining question is with respect to term theory loans and what the source of that is. Primarily the bulk of it is coming out of our Nevada banks. The other banks are really a pretty small amount in that grant total. So the answer would really be out of Nevada.

James Abbott

I was just going to add a little bit of color on that is it could be related to the gaming industry where we have seen some of the bigger problems out of term commercial real estate.

Gerald J. Dent

That is accurate.

Doyle L. Arnold

Could be, would be, is be — all right, I think we are going to wrap it up today and James will sig us off here I guess.

James Abbott

All right. Thanks, everyone for joining the call, and for those of you that were on the call that still had questions, we are going to try to keep it to an hour because we receive heavy complaints when we go over the hour so I will call you back in the hour that you had dialed in. Thank you.

Doyle L. Arnold

Thanks, James.

Operator

Thank you. That does conclude today's conference. We appreciate your participation.

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