(Operator Instructions) I would like to welcome everyone to the Comerica Third Quarter 2009 Earnings Results Conference Call. I would now like to turn the call over to Ms. Darlene Persons, Director of Investor Relations; you may begin the conference.
Welcome to Comerica’s Third Quarter 2009 Earnings Conference Call. This is Darlene Persons, Director of Investor Relations. I am here with Chairman, Ralph Babb, our Chief Financial Officer, Beth Acton, and Dale Greene, Chief Credit Officer.
A copy of our earnings release, financial statements and supplemental information is available on SEC’s website as well as on our website. Before we get started, I would like to remind you that this conference call contains forward looking statements and in that regard you should be mindful of the risks and uncertainties that can cause future results to vary from expectations. I refer you to the safe harbor statement contained in the earnings release issued today, which I incorporate into this call as well as our filings with the SEC.
Also, this conference call will reference non-GAAP financial measures. In that regard I would direct you to the calculation of such measures within the earnings release and presentation.
Now I’ll turn the call over to Ralph.
Our third quarter results were consistent with our prior outlook and reflect the many actions we have taken to position our company for the slow economic recovery now underway. These actions include the strengthening of our already strong liquidity and capital levels, the quick identification of problem loans, the building of our reserves credit by credit, and the careful management of expenses. Coupled with our strong focus on customers we believe we are well positioned for the future with confidence in our strategy and a dedicated workforce to deliver the results.
Net income in the third quarter was $19 million up from $18 million in the second quarter and from $9 million in the first quarter. After preferred stock dividends to the US Treasury Department of $34 million or $0.22 per share we had a net loss applicable to common stock of $15 million or $0.10 per share.
Loan demand continued to be weak and average core deposits continued to increase as businesses and consumers remained cautious in this economic environment. New and renewed loan commitments totaled $11.8 billion in the third quarter an increase of $1.6 billion from the second quarter. Our lending efforts continue to be focused on new and existing relationship customers with the appropriate credit standards and return hurdles in place.
We are working hard to ensure we effectively manage credit, particularly in this economic environment. Early recognition of issues continues to be key. We have moved credits to our work out area at the first signs of significant stress. The provision for loan losses was stable in the third quarter with charge-offs similar to the second quarter as expected. Over the past 15 months we have reduced by 46% our exposure to residential real estate development, the main focus of our credit issues.
Non-accrual loans were charged down 41% as of September 30, versus 39% at June 30. Loans past due 90 days or more and still accruing decreased $49 million or 23% from June 30. The allowance to total loans ratio increased 30 basis points to 2.19% from June 30. All of these metrics are reflected in our outlook in which we expect to see a modest reduction in net charge offs in the fourth quarter, assuming there is no significant deterioration of the economic environment.
As expected, the net interest margin of 2.68% was relatively stable reflecting improved loan spreads and the maturing of higher cost time deposits more than offset by a higher level of excess liquidity. Excluding excess liquidity represented by average balances deposited with the Federal Reserve Bank the net interest margin would have been 2.84%. Our capital ratios once again increased from already strong levels as evidenced by a tangible common equity ratio of 7.96% an increase of 41 basis points from June 30 of this year.
With regard to the $2.25 billion in preferred stock we still plan to redeem it at such time as feasible with careful consideration given to the economic environment. It remains a top corporate priority. We continue to focus on expense controls with year to date expenses down 9% from a year ago.
Looking at our footprint I’ll provide some comments on what we see in each of our primary markets. Generally things seem to have bottomed. Customers are speaking in more positive tones then they were just three months ago. However, they remain anxious and continue to hold the line on expenses, inventory levels and capital expansion plans.
In our Western market the California economy is showing signs of strengthening particularly in the middle market and among small businesses. The key and still missing ingredient, to a sustained and healthy rebound there continues to be job growth. However, the housing situation appears to be stabilizing as evidenced by home sales which so far this year are running about 25% above last year’s pace.
Also encouraging, the median existing home price in California has increased 18% since bottoming in February. We are hopeful that this leads to further stabilization of our residential real estate development portfolio in California.
While the economy has slowed in Texas it has consistently outperformed the national economy and will likely outperform again in 2009. The state is less burdened then most by an overhang of unsold houses and with the unemployment rate in Texas running almost two percentage points below the national average the state continues to attract businesses and people. One of the reasons for Texas success is the fact that the economy is well diversified. In fact, there are more Fortune 500 companies headquartered in Texas then in any other state. We have a relationship with well over half of them today and that number continues to grow.
We recently announced the opening of our first lead certified banking center in Ft. Worth, Texas and a new banking center in the southern sector of Dallas as a further demonstration of our commitment to the community. We believe we are well positioned in our Texas market to develop new relationships and expand existing ones as the economy improves.
Michigan has been battling fierce economic headwinds for many years in large part due to the restructuring of the automotive industry for which we were prepared. This is evidenced by our relatively low auto related non-performing assets and charge-offs throughout the cycle and the fact we no longer have any direct exposure to Chrysler or General Motors. Our experience in dealing with Michigan’s challenges over many cycles has helped us weather the economic downturn in that state. It remains an important market for us. The annual FDIC summary of deposits report that came out last week shows us ranked number one in deposit market share in Michigan.
In Florida our customers have been able to manage through challenging market conditions in the state where we have limited land and single family housing exposure. However, the prolonged recession took its toll with respect to large condominium projects which have been delivered with substantial presales but where there has been limited access to mortgage financing. Our Florida condominium exposure is limited to about $127 million. It is encouraging to see the Case-Shiller house price index show increasing prices in both Miami and Tampa in June and July.
Turning to our 2009 corporate outlook we believe loan demand will still be subdued as historically it has taken a couple of quarters after a recession ends for loan demand to return. We expect to see continued net interest margin expansion. We also expect to continue to diligently manage our credit issues. Finally, we plan to maintain our strong focus on expense controls as we successfully manage through this phase of the economic cycle.
Now I’ll turn the call over to Beth and Dale who will discuss our third quarter results in more detail.
As I review our third quarter results I will be referring to slides we have prepared that provide additional details on our earnings. Turning to slide three, we outlined the major components of our third quarter results compared to prior periods. Today we reported third quarter 2009 earnings of $19 million after preferred dividends of $34 million the net loss applicable to common stock was $15 million or $0.10 per diluted share.
Slide four provides an overview of the financial results for the third quarter compared to the second quarter. Average earning assets decreased $2 billion including a $2.9 billion decline in loan outstandings. The continued slow economic environment has resulted in lower loan demand in all of our markets. We have had very strong deposit generation again in the third quarter with core deposits, excluding financial services division, increasing $1.1 billion including an $835 million increase in non-interest bearing deposits.
The net interest margin in the third quarter was relatively stable as expected. Increased loan spreads, reduced deposit rates, and the maturing of higher cost time deposits were more then offset by a low return on excess liquidity which I’ll discuss in more detail in a minute. Credit quality metrics were stable, consistent with our outlook. Net credit related charge-offs decreased to $239 million and the provision of $311 million was consistent with the second quarter. The allowance for loan losses to total loans increased in the third quarter to 2.19% compared to 1.89% in the second quarter as we continued to reserve for loan losses substantially in excess of charge-offs.
Non-interest income included securities gains. As indicated last quarter we further reduced our investment securities portfolio as we no long need downside interest rate protection and took advantage of favorable market conditions to sell mortgage backed government agency securities at $102 million gain. We continued to successfully control expenses. The third quarter results reflected a decrease in salaries, incentives, and share based compensation over year ago levels. Our workforce has been reduced by approximately 1,000 positions or 9% since September 2008. Year to date non-interest expenses decreased 9% from the same period last year.
Our capital position is strong and was further enhanced in the third quarter. The Tier 1 capital ratio increased to an estimated 12.18% at September 30. In addition, the quality of our capital is solid as evidenced by our tangible common equity ratio of 7.96%
Turning to slide five, average loan outstandings declined in the third quarter compared to the second quarter as a result of low demand in all of our markets. We had $11.8 billion in new and renewed lending commitments in the third quarter up from $10.2 billion in the second quarter. Markets outside the Midwest comprised 63% of average loans.
Overall, customers experienced lower sales volumes which resulted in lower accounts receivable financing requirements. Also they continued decreased inventory levels as they cautiously managed their businesses in the weak environment. The successful “Cash for Clunkers” program reduced dealer inventories and contributed to national dealer services average decline in outstandings of $514 million or 14% from the second quarter. Decreases in the third quarter were also noted in Middle Market, Global Corporate Banking, Commercial Real Estate, and Energy. Line utilization was 47% in the third quarter down almost four percentage points from the second quarter.
On slide six we provide details of our Investment Securities Portfolio. We proactively sold $2.8 billion of mortgaged backed government agency securities in the third quarter. Over the last two years we had significantly increased the size of the portfolio to dampen the effect of the decline in interest rates. It has served its purpose well. We purchased the securities at very attractive prices and wide spreads relative to US Treasuries. Further interest rate reductions are unlikely so the need to hedge declining interest rate risk has diminished. For these reasons it has been prudent to reduce the size of the portfolio.
Our guideline is to maintain the investment securities portfolio excluding auction rate securities at about 10% of average assets. As we reposition the portfolio we temporarily increased holdings of short term US Treasury securities resulting in a lower overall yield on the available for sale portfolio in the third quarter.
As shown on slide seven we had very strong deposit growth again in the third quarter in all of our major markets and all commercial lines of business. Average core deposits excluding the financial services division increased $1.1 billion including an $835 million increase in non-interest bearing deposits. I’m pleased to say that to date we’ve retained the majority of the balances of maturing customers CDs many of which were put on a year ago at rates over 3%. Deposit pricing conditions remain competitive in the third quarter and we believe we have hit rate floors on a number of our products. However, we were able to selectively decrease rates in certain deposit categories.
As outlined on slide eight, the net interest margin in the third quarter was relatively stable at 2.68% compared to 2.73% in the second quarter. Excluding the impact of excess liquidity the net interest margin would have been 2.84% in the third quarter, an increase of three basis points from 2.81% in the second quarter. The increase was the result of our continued success in expanding loan spreads and selectively reducing deposit pricing combined with maturities of higher cost time deposits.
In the third quarter excess liquidity had an approximately 16 basis point negative effect on the margin compared to an eight basis point impact in the first and second quarters. The excess liquidity resulted from strong core deposit growth and the sale of mortgage backed government agency securities. Excess liquidity was represented by an average of $3.5 billion deposited with the Federal Reserve Bank in the third quarter up from an average $1.8 billion in the second quarter.
At the end of the third quarter this position has decreased to $2.2 billion with the expectation that it will dissipate further in the fourth quarter. This excess liquidity is above and beyond the investment securities portfolio which will continue to provide a large reservoir of liquidity.
On slide nine you can see that we have consistently reduced personnel over the past several years even while we were building new banking centers. We focus on expense management on a daily basis. Our largest expense item is salaries and therefore management of staff levels is key. Full time equivalent staff decreased by approximately 100 employees from June 30 and 1,000 employees or 9% from year ago levels. We have been working hard to leverage technology and maximize productivity to support growth.
Now Dale Greene, our Chief Credit Officer, will discuss credit quality starting on slide 10.
As expected, third quarter net credit related charge-offs and the provision for loan losses were similar to the second quarter. Provision for credit related losses of $313 million exceeded net charge-offs by $74 million. Economic conditions continued to be challenging particularly in residential real estate development in the Western market and Middle Market in the Midwest.
Net credit related charge-offs were $239 million in the third quarter a reduction from the second quarter. Net charge-offs included $91 million in the commercial real estate line of business primarily related to residential real estate development down from $108 million in the second quarter. The decline in commercial real estate charge-offs reflects the fact that we have been working hard to reduce the portfolio and have been taking the necessary charges to reflect declining values over the past 18 to 24 months. We have also seen values stabilize in select markets.
The commercial real estate exposure we have through commercial mortgages for owner occupied properties of our Middle Market and Small Business customers continues to perform in line with our C&I loans. These mortgages are typically made in conjunction with a full relationship and our cross collateralized with the working capital lines of credit.
Turning to slide 11 total non-performing assets were $1.3 billion or 2.99% of total loans and foreclosed property. The growth in non-performing assets decelerated in the third quarter. Excluding the commercial real estate line of business, non-performing assets declined by $10 million to $531 million. Our watch list loans total $8.2 billion at the end of the third quarter and reflect that we continue to proactively recognize issues and quickly move credits to our work out areas at the first sign of significant stress.
In line with the economic environment the commercial real estate line of business and middle market, particularly in Michigan, continued to drive negative migration. Compared to residential real estate development we believe that the loss severity will be substantial for the remainder of the portfolio.
Loans past due 90 days or more and still accruing declined to $161 million from $210 million in the second quarter. The allowance for loan losses was 2.19% of total loans an increase of 30 basis points from the second quarter. The allowance for loan losses was 80% of non-performing loans. We have written down our non-accrual loans by 41% which reflects current appraised values.
In addition, it is important to note that Comerica’s portfolio is heavily comprised of commercial loans which, in the event of default, are typically carried on the books as non-performing assets for a longer period of time then our consumer loans which are typically charged off as soon as they become non-performing. Therefore, banks with a heavier commercial loan mix in their portfolios tend to have lower NPA cover ratios than do retail focused banks.
On slide 12 we provide information on the makeup of the non-accrual loans. The largest portion of the non-accrual loans continues to be commercial real estate which consists primarily of residential real estate development loans. Commercial real estate non-accrual loans increased $75 million in the quarter and will take longer to resolve then C&I problem loans due to the nature of the underlying collateral. Non-accruals decreased in global corporate banking by $26 million, small business $14 million, and energy which falls within other business lines, declined by $14 million.
By geography 42% of the non-accruals are in the Western market and 31% are in the Midwest market. During the third quarter 2009 $361 million of loan relationships greater then $2 million were transferred to non-accrual status a reduction of $58 million from the second quarter. Of these inflows commercial real estate line of business contributed $211 million and middle market had $89 million both slight increases from the second quarter. Leasing with $29 million in inflows and global corporate banking with $26 million in inflows both decreased.
Slide 13 provides further detail on our non-accrual loans. Collateral value on non-accrual loans are reviewed every quarter as part of our credit quality review process. We have written down non-performing loans by 41% compared to 32% a year ago. A carrying value plus the reserve reflect the current market conditions. Foreclosed property totaled $109 million and reflected our efforts to work through the issues in the residential real estate development portfolio.
We had only $2 million in reduced rate loans and $10 million in troubled debt restructurings included in non-performing assets. We also had $8 million in troubled debt restructurings included in performing assets. The total amount of TDRs was unchanged from the prior quarter. When negotiating troubled credits we avoid situations that would results in granting below market terms unless the loan is going to be non-accrual regardless of the outcome. Therefore a few credits are reported as performing TDRs.
We had no held for sale loans. In the third quarter we sold $65 million in loans, pen loans totaling $41 million were non-performing. The average price was close to carrying values plus reserves. These loans were distributed across several industries and geographies. We have seen an increase in secondary market activity the last several months.
On slide 14 we provide a breakdown of net credit related charge-offs by office of loan origination. Net charge-offs for the Midwest which made up 42% of the total were relatively stable compared to the second quarter. About half of these charge-offs or $50 million were from the middle market where we continue to see softness in a very challenging environment. We saw a slight decline in commercial real estate line of business which accounted for $17 million and relative stability in small business with net charge-offs of $14 million.
Western market charge-offs made up 40% of the total. The increase in the second quarter was driven by commercial real estate line of business which totaled $58 million. Virtually all residential development related which I’ll discuss further in a moment. Global corporate banking totaled $18 million which was a small increase from the second quarter. All other lines of business were stable.
Texas had an increase in net charge-offs from very low levels and we believe the issues remain manageable with no particular area of concentration. As far as Florida, while net charge-offs declined in the third quarter we expect some lumpiness as issues continue to be concentrated in condo developments, which totaled $127 million, with continued difficulty closing unit sales. Other markets net charge-offs were down significantly and continue to be focused on real estate developments which are more diversified by geography and project type.
Slide 15 provides detail on net loan charge-offs by line of business. The commercial real estate line of business continues to drive the charge-off levels. Charge-offs in Midwest, Middle Market increased as expected in the current economic environment. Charge-offs for wealth and institutional management, small business and personal banking were relatively stable.
On slide 16 we provide a detailed breakdown by geography and project type of our commercial real estate line of business which declined $222 million from the prior quarter. There is further detail provided in the Appendix to these slides. At September 30, 25% of this portfolio consisted of loans made to residential real estate developers, secured by the underlying real estate. Michigan outstandings of $656 million represented 13% of the portfolio and were down $136 million or 17% from a year ago. Florida outstandings of $589 million represented 12% of the portfolio.
As shown on slide 17, as of the end of the third quarter, we reduced residential real estate development exposure by $1.1 billion or 46% since June 2008. Total single family construction outstandings were down about $700 million or over 50% from June 2008.
Turning to slide 18, we displayed project type and geographic breakdown of net charge-offs for the commercial real estate line of business. Residential real estate development loans continued to account for the bulk of these charge-offs in the third quarter. Charge-offs decreased in Florida and other markets. Midwest was stable and the Western and Texas markets saw small increases in charge-offs. In the Western market we have seen prices for single family homes stabilize and even increase in select areas. However, land prices remain soft and in some locations continued to decline. The increase in Western charge-offs in the third quarter largely reflects a single residential project which has a large land component.
As far as Florida, we have limited land exposure and single family exposure has been managed down for some time. The decline in charge-offs in Florida can be attributed to the condos that were delivered to the market in the second quarter and the resulting charge-offs we took at that time. We expect some lumpiness in charge-offs for this segment as condo closings are occurring but at a very low level.
Many pre-sales have been unable to close as buyers have had difficulty obtaining mortgages. We continue to work to help resolve the issues. While we continue to see softness in the non-residential real estate construction segment, as you can see on the slide, charge-offs have been small and reflect that we have had far fewer defaults and much lower loss content then the residential construction segment.
Slide 19 provides an overview of our consumer loan portfolio which includes the consumer and residential mortgage loan categories on the balance sheet. This portfolio is relatively small, representing just 9.5% of our total loans. These loans are self originated and are part of a full service relationship. The residential mortgages we hold on our balance sheet are primarily associated with our private banking customers.
Net charge-offs for residential mortgages increased in the third quarter as customers felt the stress of the prolonged weak economy. The home equity loan portfolio has held up relatively well with a decrease in charge-offs in the third quarter and 30 and 90 day delinquency rates were relatively stable.
On slide 20 we provide detail on our shared national credit relationships. Shared national credit outstandings were $9.9 billion at the end of the third quarter an $830 million decline from the second quarter and $2 billion decrease from year end. This category is very granular consisting of approximately 1,000 borrowers. Outside of global corporate banking where you would find large syndicated facilities the majority of our shared national credits have bank groups consisting of seven or fewer banks. We work with small groups of banks to mitigate concentration risk.
We did not compromise our credit standards, return expectations, or exposure guidelines in order to participate in a syndicated facility. The credit issues we are seeing with shared national credit are similar to those we’ve seen in the bank as a whole which are primarily driven by residential real estate development. Based on the recently published results the annual shared national credit review our credit metrics are significantly better then the national average as measured by classified, criticized, and non-accruals as a percentage of total commitments.
Slide 21 outlines the recent performance of the non-dealer automotive supplier portfolio. We have reduced our loans outstandings by $1.5 billion or 57% since the end of 2005. This portfolio now represents less than 3% of our total loans and we plan to continue to reduce our loans to this sector. The industry continues to be under stress but we believe the issues in our portfolio remain manageable. Non-accrual loans were steady at $2.8 million at the end of the third quarter. Third quarter net charge-offs were $22 million down from $27 million and were primarily related to one customer.
In our auto dealer exposure average outstandings have declined $1.5 billion or 33% over the past year in line with falling sales volumes of new cars. We continue to have excellent credit quality in this portfolio with no non-accruals or charge-offs in the third quarter. In fact, we have not had a significant loss in the dealer portfolio in many years. A slide with further detail can be found in the Appendix of this presentation.
To conclude on credit, we conduct in depth reviews of all of our watch list credits at least quarterly to ensure that we have an appropriate work out strategy as well as reserves and carrying values that reflect our collateral assessment. We continue to obtain current appraisals on residential and commercial properties and take charge-offs and provide reserves to reflect those values. The proactive action has resulted in a current carrying value of non-performing loans of 59%.
While the US economy has bottomed we expect to continue to see the impact of the weak economy on our customers, particularly within residential real estate developer and Michigan middle market. We are pleased that the inflow of non-performing loans slowed in the third quarter. Also, non-commercial real estate non-performing loans declined in the quarter. Past due loans also decreased. These metrics support our outlook for net credit related charge-offs to improve modestly in the fourth quarter. We expect the provision for credit losses will continue to exceed net charge-offs.
Now I’ll turn the call back to Beth.
Turning to slide 22, our Tier 1 capital ratio is well in excess of the well capitalized threshold as defined by the regulators and it has increased in each of the past four quarters.
Turning to slide 23, the tangible common equity ratio, we have maintained a solid capital structure with a large component of common equity in many years. Our tangible common equity ratio which was 7.96% at the end of the third quarter increased from the second quarter and historically has been well above the average ratio of our peer group.
Slide 24 updates our expectations for 2009. While the economic recovery appears to be underway, management expect subdued loan demand as loan growth typically lags other economic indicators. We believe that the fourth quarter net interest margin will increase as a result of maturities of higher cost CDs and wholesale funding and a reduction in excess liquidity. In addition, we expect the margin will continue to benefit from improved loan pricing.
With the economy beginning a recovery our outlook is for net credit related charge-offs to improve modestly in the fourth quarter. Provision is expected to continue to exceed net charge-offs. A current topic of interest in the industry is deferred tax assets. We paid significant taxes for 2008 and are paying taxes for 2009 so we do not believe there is risk of a deferred tax write-off in the foreseeable future. We believe that our strong capital position, vigilance in managing credit and building reserves, as well as focus on controlling expenses will assist us in managing through the current economic environment and position us well as the economy improves.
Now we’d be happy to answer any questions that you may have.
(Operator Instructions) Your first question comes from Steven Alexopoulos – JP Morgan
Steven Alexopoulos – JP Morgan
Could we start with your outlook for calling for a modest improvement in charge-off levels in the fourth quarter? If we break that into two areas; one being real estate construction loans, and two being C&I loans, is this outlook solely driven by expected improvement in the construction side and what is the outlook for the C&I book?
Part of it clearly is related to the fact that the construction loan portfolio continues to perform fairly well as you could see by some of our slides. We’ve worked the resi way down as you can also see. If you look at the composition of the non-resi construction portfolio again the non-accruals and charge-offs there really its all resi. The income producing side continues to look fairly good. If you turn to C&I while as we said we think we’re going to continue to be challenged on the C&I front, particularly in Michigan and middle market, I think the stability we’ve seen there is likely to continue. Frankly, unless there are some significant economic issues I would expect that that would continue to be the case.
Steven Alexopoulos – JP Morgan
Is the bulk of the decline in the balance sheet now done? What’s your best guess in terms of the timeline it’ll take to realize the 284 Nim without the excess liquidity?
Our expectation is that margin will improve in the fourth quarter because of a dissipation of a lot of the excess liquidity. I think I mentioned in the slides that we had $2.2 billion at September 30 on deposit with the Fed that was down from the average level of $3.5 billion during the quarter. We do have $1.8 billion of retail brokered CDs that mature in the fourth quarter that carry a 3.45% yield on them. We will soak up some of the excess liquidity with maturities in the quarter.
Part of it will be a function of how deposits go through the quarter as well as loans. Loan demand I think will continue to be weak. Our expectation is a lot of the excess liquidity will dissipate in the fourth quarter and you’ll see a nice bounce back in the margin.
Steven Alexopoulos – JP Morgan
That would take the balance sheet down by another $2 billion or so?
It depends on what happens with loans and deposits. In terms of liquidity yes. In terms of the deposits that our expectation is substantial amount of that will be dissipated in the fourth quarter.
Your next question comes from Craig Siegenthaler – Credit Suisse
Craig Siegenthaler – Credit Suisse
Asking the charge-off question a different way, I’m wondering what gives you confidence not by let’s say loan mix but more is it a function of the improvement we’ve been seeing in the net inflows of NPLs and delinquencies, is that really a driver? Or is it more of a driver of a low valuation of your book? I’m wondering what kind of drives the confidence behind the lower net charge-off level that you guys expect in the fourth quarter?
Its several things. One is I think that while we’re not out of the woods on the residential construction side, if you segment residential from again the old portfolio we were talking about for a long time, the starter home piece, that’s way down below $300 million. Really I think we’ve managed that very effectively, marked that book down fairly aggressively over time with the appraisals we’ve gotten. That piece, while still challenging, we feel pretty good about in terms of where we got it marked.
If you look at the rest of the residential pieces, while again it’s still challenged, again if you look at the number of projects we have there which are not an enormous number, we have great detail on every single project and we feel pretty good about where those marks are and what’s going on with those residential projects.
If you look at the rest of the non-resi construction book, which is income producing, and you look at what’s happening there, the vast majority of those projects the construction risk is behind us, a large majority of those has stabilized lease up and cash flows. Those look to be performing fairly well so far. There’ll be some issues there of course but I don’t view them to be overwhelmingly negative.
If you turn back to the C&I book where clearly we, in Michigan, continue to fight the battle. I think the battle has been fought fairly successfully with charge-offs there fairly stable. Even if the economy doesn’t improve materially, even if it continues to bounce along where it is, given the fact that we’ve marked the book down so aggressively, frankly given the evidence of some of the recent loan sales and what that suggests to us, we feel pretty good about where we’ve got it all positioned today. Those are the pieces and my judgment of the answer.
Craig Siegenthaler – Credit Suisse
Does that mean you also feel pretty good that we’ve already passed the peak in that charge-off or do you think we could visit higher levels again in 2010?
I hope not. That’s a tough one to answer. As we said at the second quarter call that we thought the third quarter would be consistent with the second quarter, its actually a little better certainly on the charge-off side. We said that the fourth quarter we think will be a modestly better then that assuming no bad economic news. I believe that based on what I’ve just said. If the trend continues we may have in fact peaked but I would not be so bold as to say, things can happen, individual projects that you’re working on something can go awry, something unanticipated. It’s difficult to make a blanket statement. I would hope that generally we would see a declining trend.
Your next question comes from Gary Townsend – Hill Townsend Capital
Gary Townsend – Hill Townsend Capital
Could you discuss your position vis-à-vis the government and willingness ability to repay the TARP at present?
As we said earlier, we’re looking at that, we review it based on where we think the economics are, where we think credit is, and the outlook is. We would like to pay it back as soon as feasible. We’ll continue to review that and take the necessary steps accordingly.
Gary Townsend – Hill Townsend Capital
If I could press you on that, are we looking at six months, three quarters, a full year?
We’ve not set a timeframe but as I said, it’s a top corporate priority and we would like to do it as soon as feasible.
Gary Townsend – Hill Townsend Capital
Would it be fair to say that you have ongoing discussions with the regulators on the same subject?
We have ongoing discussions, as we’ve said in the past, with the regulators on all of the things that are important based on where we are and those will continue.
Gary Townsend – Hill Townsend Capital
This was the second consecutive quarter where the level of securities gains was high. Could you discuss the strategy there and perhaps the opportunities that the market is giving you?
As we said in our outlook we aren’t expecting significant gains in the fourth quarter so we’re largely through the repositioning of the portfolio on its way to a smaller level then certainly it was a year ago. I don’t see that we’ll have significant securities gains in the fourth quarter.
Your next question comes from Jeff Davis – FTN Equity Capital
Jeff Davis – FTN Equity Capital
In terms of the margin headed up in the next couple quarters or 4Q does net interest income turn up rather then the margin regardless of what the margin is? Secondly, I missed the very beginning of the call and you touched on it some, if you could talk just a little bit more about, is there any real pickup out there with the backdrop of your loans continue to decline and liquidity continues to build is the inventory story build for the economy is that real, are you really seeing early signs? Maybe within the dealer book, are dealers moving to rebuild inventories or is it all just we’re in a holding pattern to wait and see?
Also in relation to the reduction in loans if I’m correct, would $1.3 billion between $830 million on the SNIK book and $500 plus million on the dealer book did corporate bond issuance materially impact the reduction in loans for you this quarter or even last quarter?
The first question I think was on net interest income what it would look like in the fourth quarter. We certainly see the margin expanding in the fourth quarter; obviously net interest income will be a function of what happens with loans. I think loan demand remains weak, this will get covered a little but I think we will see an up tick in dealer loans outstanding in the fourth quarter but whether it will offset other potential further declines is not clear obviously at this juncture. It’s hard to answer without the loan question the net interest income. Clearly we’re very positive about the expansion in the margin that will come in the fourth quarter. Again assuming liquidity dissipates at the level that we anticipate.
If you think about your question regarding loan growth, loan opportunities, and so forth I have a few responses. One is that we are clearly seeing opportunities. We are clearly looking for those and yes the credit underwriting is more strict no question and certainly the pricing is important as well as the full relationship so that’s part of it. The dealer book will grow simply because inventories have fallen so far that they need to be replenished which helps not only dealers but our suppliers who have working capital needs.
My big issue is really around capacity utilization. One is that there’s a fair amount of capacity in the system that has to be utilized and that’s happening gradually. I think business people just generally while there may be a more positive feel there’s still a fair amount of caution out there right now. I think it’ll be while till we see that change and I think that will also a be a while till we see some employment growth which will be important to a recovery. While we see opportunities I think it will be muted for a while.
That’s not unusual in a recovery of a recession it usually lags a couple of quarters.
I would say of our market that we’re seeing a little pickup of interest in California. It obviously went into the recession first and we’re seeing a little more activity there then perhaps in some of our other markets. You asked a question on corporate bond issuance. I don’t think it had a big an impact on either quarter frankly in terms of the loan decline. Most of these customers are privately held, are not accessing the capital markets.
Your next question comes from Matt O’Conner – Deutsche Bank
Matt O’Conner – Deutsche Bank
Liquidity is quite strong, the capital is strong and building, and you’re managing credit I think better then many and frankly better then I had thought. I just step back and I think about what are the opportunities to go in the offensive in terms of FDIC deals or other things that you can do to help longer term earnings power besides what the environment will give you?
We are certainly looking at all of the opportunities and as I mentioned earlier in response and in my remarks in response to Gary, certainly a top corporate priority is paying back the TARP. We are always looking at opportunities that avail themselves as you mentioned in institutions that come through the FDIC but again we’re being very diligent, those need to fit our model in our market and fit in culturally as well as otherwise. We are certainly looking at the opportunities.
Matt O’Conner – Deutsche Bank
From a mix point of view obviously you’re heavily concentrated on the commercial side. Would you be more open to trying to balance it out from a retail banking point of view?
In the markets, as I mentioned, if we found an opportunity that fit that was more retail oriented then business oriented we certainly would. The deposit and our products would fit together very well.
Matt O’Conner – Deutsche Bank
I know it’s impossible to know but I’ll ask anyway. Any thought on when loans will start to flatten out, at what level, obviously down quite a bit quarter to quarter because of the weak demand and the stuff that you mentioned? Any guess on when that bottoms and at what level?
As I think we mentioned, as Dale and Beth were going through the previous question, typically in a recession and coming out of a recession you find a lag of a couple of quarters before you see that begin to build. Many have talked about this may be a little slower because of the fact, Dale mentioned, overcapacity that’s out there that needs to fill and then that will start to generate jobs which will then begin to, in my opinion, ramp up the acceleration in the economy.
Your next question comes from Chris Mutascio – Stifel Nicolaus
Chris Mutascio – Stifel Nicolaus
If I look at page eight and I look at the margin excluding liquidity impact it looks like it’s called the core margin was up about three basis points. I understand the margin guidance going forward is, the stated margin will go up as liquidity declines. If I look at the core margin being up three basis points that’s nice to see it’s up. What is holding that back from expanding even more in the quarter given the fact you’ve had pretty good non-interest bearing deposits growing, loan spreads are widening, what’s preventing that core margin from going up more then it did?
We had an impact certainly non-accruals have a very minor impact as well as just some of the repositioning of the investment portfolio during the quarter had an impact. I guess what I would focus you on is if you look at our loan yields, our loan yields were up 17 basis points in the quarter. I think that’s pretty significant given one month Libor was down 10 basis points and three month Libor was down 44 basis points. To be up 17 is a very positive thing. At the same time our core interest bearing deposits were down 19 basis points in terms of cost.
What held us back fundamentally was this excess liquidity and the mix of having some temporary holdings of treasury securities in the investment portfolio as we repositioned the investment portfolio. Fundamentally in the business loan yields are improving in spreads, deposit costs decline, and in fact will decline further give I mentioned we had $1.8 billion in retail brokered CD maturing in the fourth quarter that yield 3.45%. The key drivers there are well positioned to improve the margin as we go forward.
Chris Mutascio – Stifel Nicolaus
Can you provide on the guidance on your provision expense exceeding net charge-offs will they exceed net charge-offs at the same pace we’ve seen the last couple quarters?
That’s very hard to predict. That’s a bottom’s up process we go through. It is our expectation that it will exceed it by how much is very difficult to predict at the moment.
Chris Mutascio – Stifel Nicolaus
I’ve always enjoyed your macro view on credit. When you look at the credit environment coming out of this recession and everyone is trying to look at what is normalized earnings going to be and when are we going to get there for all these banks. Once we peak in credit losses do we substantially fall from that peak like we’ve had seen after the 1991 recession and after the 2001 recession or is this a little bit different then that?
I don’t know. All of this is different so it’s hard to predict. I guess if it was my view I don’t think it’s going to look quite like that. My view is its sort of a gradual improvement. I think its going to take some time for this recovery to really take hold. I think it’ll be a more modest recovery then perhaps past recoveries. The unemployment question weighs heavily on me in terms of when that begins to reverse which will be part of the answer. My own view is I don’t necessarily think it falls off a cliff and suddenly gets materially better right away I think it takes some time, that’s what I would expect would happen.
A lot of that will depend on the economy and the way, as Dale prefaced, I think we’re all looking at a slow recovery. Historically there have been the V recoveries in a lot of cases and I think that’s what’s driven the rapid increases in credit so it’ll really be tight.
Unemployment is going to be a key ingredient.
Unemployment and the economy will dictate that.
Your next question comes from Heather Wolfe – UBS
Heather Wolfe – UBS
A follow up to that last question, it sort of seems that questions regarding the commercial real estate cycle will give us the answer. Some of your peers this morning posted some pretty sharp deterioration in just plain vanilla commercial mortgages. You guys look like you’re holding in pretty well. Can you talk just about some of the underlying trends that you might be seeing?
I think if you look at the composition, if you look at the construction portfolios that we have and the various pieces of it, since we haven’t really made a new construction loan, whether it be resi or non-resi in some time, what you’re really seeing is a lot of projects nearing completion or being completed so the construction risk becomes less of an issue. You’re seeing the resi component still being the key issue and we continue to deal with that and continue to take the marks and so forth. I think that’ll continue to be a bit of a strain, a bit of a headwind.
I think on the income producing side when you look at what we’ve got there again it’s a fairly limited number of projects frankly. These are projects that are largely completed, these are projects that are generating stabilized cash flow for the most part, these projects have guarantees behind them of strong individuals who can and have stepped up to support the projects and so forth.
It has a lot to do with I think the type of underwriting we did back a few years ago and so when we put these on the books and the fact that we haven’t added a lot to them I’m not saying that there will be issues clearly there are issues but I think its within the realm of our expectations.
If I could add on that on the C&I side both owner occupied as well as non-owner occupied C&I our metrics are very good except for middle market Michigan which is seeing more stress. If you look across the rest of our footprint, middle market is good, stable, small business, wealth management, all relatively stable. Not seeing any particular concerns there and certainly not on the owner occupied side.
Heather Wolfe – UBS
On capital, I know you guys are materially above the well capitalized threshold but are you having any conversations with your regulators about changes to that well capitalized threshold on Tier 1?
There have been no specific pronouncements or dialogue related to changing the minimums or any particular changes in those. There’s a lot of rhetoric in terms of the US Treasury made some comments, international [Bosil] regulators have made comments about capital but there have been no specific discussions or pronouncements that would shed any light on that.
Your next question comes from Justin Maurer – Lord Abbett
Justin Maurer – Lord Abbett
Relative to Steve’s earlier question about what you envision as you guys talk about the fourth quarter credit being modestly better. Do you have any stats, you talk about the entire portfolio has got the 41% mark, what is it in resi construction and is that relevant in terms of the number?
I don’t know what it is off the top of my head but if you think about the fact that the bulk of the issues are in non-performing almost 60% I think its 58% or in residential construction. Clearly you can tell from that it’s much more heavily weighted in that direction so you can tell by extrapolating that a big piece of the marks would be certainly related to residential construction.
Justin Maurer – Lord Abbett
Is it the idea that stuff should start to tail off pretty meaningfully as that portfolio has aged so much given the fact that you guys have exited that and weren’t there in a meaningful way in the first place. Is it just simply the thought that it’s going to be replaced by the later cycle credits that everybody is fearful of?
You’re right, we haven’t added to the pile over the last few years. Clearly you can see the slide that shows how much we’ve worked the residential construction loan book down over the last 15 months which has been substantial. The non-resi piece is a lot of that construction is completed and so we’re just dealing with that most of which has stabilized cash flow. For us since we don’t have a heavy consumer presence the whole issue around late cycle for us is not really a significant issue per se. If you look at what we have in the consumer loan book particularly home equity that’s performing very well. In fact the delinquency statistics are somewhat better in the quarter versus last.
For us it’s just working through the general malaise in the economy primarily with our middle market and small business customers and I think so far we’ve done a pretty good job of managing through that. If we truly are at the bottom and maybe even starting to see some improvement that gives me some hope that the kinds of numbers we’re looking at will in fact materialize.
Justin Maurer – Lord Abbett
On Jeff’s question about the NII versus Nim, I know like you said it’s all a function of where the loan portfolio stands at the end of the year or during the quarter. Would you guys be hopeful that one could offset the other potentially given the pressure that we saw last couple quarters in earning assets?
It’s very hard to know on the loan side. I think as I described earlier related to margin expansion we’re pretty comfortable that we will see a pretty nice expansion in the fourth quarter. I just can’t say at this juncture whether that could offset, I just don’t know where loans are going to be. Loans are a very difficult thing to predict.
If we had things to make projections about that’s one of the hard ones right now because while we’re seeing some indications of interest put together as I mentioned earlier in California and I think we’ll see some dealer V higher its just not clear whether that will offset some of the other conservatism that businesses are using to manage their businesses. It’s a hard question to answer but I am confident we’ll see a nice expansion in the margin.
A lot will depend on confidence and where the economy is going.
Your last question comes from Brian Klock – KBW
Brian Klock – KBW
With the tax rate there was a third quarter adjustment of tax credit in there mostly all the other noise with the return to provision adjustments they usually take place in the third quarter. If we could for modeling purposes look out do we go back to the normal guidance you gave us last quarter that effectively 35% effective tax rate but you still have the $15 million low income housing tax credits in there quarterly?
Brian Klock – KBW
Did you give us the watch list balances for the third quarter?
Yes, we had them reported in here at $8.2 billion I believe was the number in the quarter.
Brian Klock – KBW
Within that watch list obviously it didn’t look like there was much migration into lower grading because your provision levels didn’t really change much. Obviously the impact of the SNIK exams and with your regulatory outlook it looks like your credit is actually pretty stable.
Yes and I think that from the perspective of what we’re seeing for us its really identification, early action, moving stuff to the work out areas all of our systems are geared, particularly in this environment, exactly tot hat point and that’s exactly what we’re doing and that’s one of the reasons at least to date we’ve seen somewhat better improvement in terms of the default characteristics.
I would like to thank everyone for joining us today. We appreciate your continued interest.
This does conclude today’s conference call. Thank you for your participation. You may now disconnect.
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