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PNC Financial Services Group (NYSE:PNC)

Q3 2009 Earnings Call

October 22, 2009; 8:30 am ET

Executives

Jim Rohr - Chairman & Chief Executive Officer

Rick Johnson - Executive Vice President & Chief Financial Officer

Bill Callahan - Director of Investor Relations

Analysts

Paul Miller - FBR Capital Markets

Mike Mayo - CLSA

Betsy Graseck - Morgan Stanley

Ed Najarian - ISI Group

Moshe Orenbuch - Credit Suisse

Heather Wolf - UBS

Gerard Cassidy - RBC Capital Markets

Keith Horowitz - Citigroup

Heather Wolf - UBS

Rick Weiss - Jane

Operator

Good morning. My name is Shawn, and I will be your conference operator today. At this time, I would like to welcome everyone to PNC Financial Services Group earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions) Mr. Callahan, you may begin your conference.

Bill Callahan

Thank you. Good morning, everyone and welcome to today’s conference call for the PNC Financial Services Group. Participating on our call this morning will be PNC’s Chairman and Chief Executive Officer, James Rohr; and Rick Johnson, Executive Vice President and Chief Financial Officer.

The following statements contain forward-looking information. Actual results and future events could differ possibly materially from those that we anticipate in our statements and from our historical performance due to a variety of factors. Those factors include items described in today’s conference call, press release and related materials and our most recent 10-K and 10-Q filings and other various SEC filings available on our corporate website.

These statements speak only as of October 22, 2009 and PNC undertakes no obligation to you update them. We also provide details of reconciliations to GAAP and non-GAAP financial measures we may discuss. These details maybe found in today’s conference call, press release, and our financial supplement in our presentation slides and appendix and various SEC reports and other documents. These are all available on our corporate website, www.pnc.com in the Investor Relations section.

I’d now like to turn the call over to Jim Rohr.

Jim Rohr

Thank you, Bill. Good morning and thank you for joining us today. In these challenging times, I’m very pleased with the performance of our business model. In the third quarter we had strong revenue performance, reduced costs, and we continued most importantly to grow clients. We also began to see signs the rate of credit deterioration has eased.

Thinking about the economy, certainly appears that the economy is stabilized. While we expect unemployment to continue to increase through year end, we are seeing some signs of tangible recovery. When we look at our balance sheet, we believe it is well positioned. In the third quarter, we further increased our capital and we strengthened our loan loss reserves. We’re very pleased with our deposit franchise.

We remain core funded with a loan to deposit ratio of 87% as of September 30. Our bank liquidity is excellent, and we’ve been able to access markets in order to fund our holding company obligations. Our revenue and expense performance for the quarter resulted in pretax pre-provision earnings of $1.7 billion well in excess of our credit costs of approximately $900 million. These are encouraging signs, but also encouraging is that the pace of our credit quality deterioration may have eased.

As a result, PNC reported third quarter earnings of $559 million or $1 per common diluted share. In the quarter, the impact of the TARP preferred dividends was $95 million or $0.21 per share. Year-to-date earnings were $1.3 billion or $2.17 per common diluted share. This is a very solid performance we believe, and I’m very pleased with our results. It’s important to note that we’ve been profitable in every quarter since the economic downturn began in the middle of 2007, other than the fourth quarter of 2008 and only then because of the conforming provision we took for National City that quarter.

Turning to our customers, we continue to see strong product sales activity in the third quarter. Our client retention trends are strong in all markets as reflected in our solid revenue performance. We see meaningful product sales opportunities and legacy National City markets and results should continue to improve as we complete the customer conversions.

In retail banking, our focus is to win in the payment space and in the third quarter checking account relationships grew by 4% on annualized basis. Active online banking increased by 12% annualized, and online bill payment customers rose by 16% annualized. This growth was driven in part by investments in our brand and innovative products such as Virtual Wallet. Those gains excluded the impact of the required divesture of 61 branches with $4 billion in deposits that we completed by early September.

Corporate and institutional banking had a strong third quarter as lower credit costs benefited the results. We saw good results as we are increasing cross selling of our products and services to legacy National City customers. We continue to be a leader in serving our business clients through the first nine months PNC again ranked first nationally in the number of traditional middle market loans indications arranged.

Our Asset Management Group, which includes wealth management saw its assets under management increase to $104 billion at September 30 as a result of higher equity market values and improved net flows. Client retention and satisfaction rights continue to be strong in the business pipeline for the fourth quarter is accelerating.

Residential Mortgage Banking performed well in the third quarter, primarily driven by lower expenses. In November, we will rebrand our mortgage business as PNC Mortgage. This is more than a name change. Instead, it reflects the strategy of a new leadership we put in place at the beginning of the year. PNC Mortgage will be at top ten retail mortgage lender offering mortgage products as it means to deepen customer relationships consistent with our moderate risk profile. This line of business also provides high quality assets for investment.

Turning to global investment services, asset based fees increased in line with the improvements in the equity markets and client growth. We are seeing the benefits from expense reduction efforts that were initiated in previous quarters and a global investment service continues to have a strong sales pipeline and I am pleased with the relative performance of this business.

BlackRock you saw reported a quarterly profit of more than $300 million in the third quarter, rallies of equity and fixed income markets along with improved investor settlements drove the improved results. BlackRock also announced with its pending acquisition of Barclays Global Investors is on target to close on December 1. This will provide PNC with additional capital upon closing assuming BlackRock’s current stock price.

A distressed asset portfolio is focused on maximizing the value of our distressed loans. We made good progress in disposing of for closed assets through the sale of more than 1,200 properties in the third quarter, bringing the total number of properties disposed to almost 4,200 for the first nine months of the year.

Turning to credit availability, PNC remains committed to meeting the credit needs of qualified customers. Through the end of the third quarter, refinances under the home affordable refinance program totaled $242 million. Our servicing unit sent out more than 60,000 workout packages to troubled borrowers under the home affordable modification program.

On the commercial side, we continue to reach out to small businesses and corporations. Despite slow demand, we originated more than $900 million in small business loans in just the third quarter and continue to be a leader in loan syndications arranging more than $9 billion in business loans for the first nine months of the year.

Now, let me turn to the integration of National City. I am very pleased with our efforts here, particularly the teamwork we’re seeing from our legacy National City and PNC colleagues. Together our employees are working very hard on this integration, and I appreciate their ongoing efforts and their enthusiasm. Just a few weeks away from our first wave of customer conversions, which is will involve National City business and consumer customers in Western Pennsylvania, Eastern Ohio, and Florida.

Customers in those areas have been contacted, and provided with the details on how their accounts will be converted to PNC products and services, and we conducted a successful mock conversion in September and October. The remaining customer conversion waves will run through June 2010, six months faster than our original estimate, and our goal is a seamless transition for customers and I believe, we will reach that mark given the investments we are making and our solid preparation.

The tremendous leverage we expected from this transaction is having a positive effect on our results. One of the reasons is that we’re well on our way to achieving our cost savings goal. On annualized basis, we have already captured more than $800 million in cost savings against our two year goal of $1.2 billion and we’re confident that we will exceed that $1.2 billion at this point. The acquisition of National City was accretive to our year-to-date earnings, and we expect it to be accretive for the full year.

Let me turn to the balance sheet critical to our success is transitioning to a higher quality balance sheet and we made significant progress towards that in the first nine months of the year. We believe our balance sheet is shown on slide four as well positioned and continues to differentiate us. The size of our balance sheet has declined since the end of the second quarter.

We reduced high cost deposits, completed required brands divestitures and have seen loans decline due to reduced originations as well as lower utilization levels, paydowns and charge-offs. However, our balance sheet reflects improved funding, which Rick will discuss in a couple of minutes.

On the deposit side total deposits are down $9 billion since year end. However, the mix is important we continue to grow our core deposit relationships in the first three quarters of the year our transaction deposits increased by $11 billion. Those gains were more than offset by the reduction of our higher rate brokered and retail CDs.

The greatest challenge we see is on the asset side, loan to bank continues to be soft across the country although the opportunities we do see are providing much better returns for the risks we are taking. As a result, loans decreased by almost $15 billion, since year end despite originating more than $82 billion of loans and commitments through the first nine months of 2009.

With the combination of PNC and National City, we have a large client base and more than $16 billion in annualized revenues. In the third quarter our ability to grow revenue and effectively manage expenses continued to generate pretax pre-provision earnings that more than covered our credit costs. On a year-to-date basis revenue was nearly $12 billion.

Our pretax pre-provision earnings of $4.5 billion were more than $1.6 billion above our credit costs providing a solid contribution to the increase in our capital ratios. In the third quarter we delivered $4 billion in revenue and we continued to focus on expense control. For the quarter our noninterest expenses of nearly $2.4 billion were down 10% on a linked quarter basis.

By continuing to manage the revenue expense relationship effectively our pretax pre-provision earnings for the quarter were $1.7 billion or $750 million more than the cost of credit. Now, Rick will provide you with more detail around our third quarter results beginning with our revenue performance. Rick.

Rick Johnson

Thank you, Jim. Good morning everyone. I am going to focus on the key drivers of revenue and expense, our loan book and reserve levels. The repositioning of our securities portfolio and our capital growth I will also provide you with some additional guidance around the sustainability of our strong third quarter performance.

Let me begin with net interest income, which was 55% of total revenue. Our balance sheet produced net interest income of more than $2.2 billion, which was up slightly from the second quarter. The ongoing transitioning of the balance sheet resulted in a net interest margin of 3.76%, 16 basis points higher than last quarter.

The largest benefit to our net interest income was on the funding side where the deposit rate declined from 1.25% in the second quarter to 1.04% in the third quarter as we continue to re-price our deposit funding base and the rate on borrowed funds declined 40 basis points due to debt maturities.

We expect the funding rate to continue to improve in the fourth quarter given that we have about 7 billion of higher rate CDs maturing that we believe we can re-price at much lower rates while retaining a large part of the core relationship based accounts. In addition, the balance sheet as of the end of the third quarter was highly asset sensitive with duration of equity of negative two years, giving at substantial opportunities to invest in the future.

Noninterest income of $1.8 billion represented 45% of total revenue and was also up slightly from the second quarter. These sources of revenue are primarily customer related and remain high quality and diversified. As expected, residential mortgage fees were down link quarter driven by less refinancing activity as mortgage rates increased.

Looking ahead to the fourth quarter, we would expect net interest income to be relatively flat and our net interest margin to improve as we capture the remaining benefit from re-pricing our high cost deposits and redeploying some of the balance sheet liquidity into securities portfolio. We would also expect client related noninterest income to continue to improve as equity markets have improved and we integrate our product offerings. Now let me take a moment to talk about our focus on expense management.

As Jim said, our third quarter noninterest expenses of nearly $2.4 billion were down 10% linked quarter. Excluding the FDIC special assessment in the second quarter, the reversal of a portion of the charge for the Visa indemnification and ongoing integration costs expenses were down $44 million on a linked quarter basis, reflecting additional integration savings of $60 million, bringing the total savings for the quarter to $200 million, and year-to-date savings related to the acquisition to more than $460 million.

The right side of the chart highlights some of the actions we’ve taken to achieve our integration cost savings and reflects our focus on continuous improvement that is an integral part of our corporate culture. As we look ahead to the fourth quarter, we would expect savings to exceed $660 million, well in excess of our 2009 goal of $600 million. We remain confident that we will exceed our $1.2 billion annualized cost savings target by mid 2011.

We’re in the process of finalizing the 2010 budget now and given our progress to date I expect to raise our cost savings target in January of 2010. In the current economy clearly the focus is on credit quality, so let’s take a look at our loan portfolio on slide eight. Our loan portfolio represents only 59% of our total assets, which is at the lower end of the peer group.

Let me begin with our core portfolio, which excludes our distressed assets. Overall the core portfolio of $141 billion is diverse, relatively balanced with 41% from consumer lending and 59% from commercial lending. It is primarily in our geographic markets and the majority is collateralized. More than $62 billion is primarily comprised of diversified middle market relationships in our region.

It is well balanced with no concentrations in any one sector. The two largest sectors are manufacturing and retail with a combined total of $20 billion, both are holding up relatively well in the current economy. The greatest pressure we saw in the third quarter was in the financial services sector where MPLs increased by $140 million driven by two large non--bank credits. We have already sold 50% of one of these exposures at $0.90 on the dollar.

Our exposure to commercial real estate sector of 9% of total assets is among the lowest concentration in our peer group. When you exclude the $3.2 billion of residential construction loans and our distressed portfolio our core real estate outstandings of $21 billion is only 13% of our total loan portfolio. This core portfolio includes $8 billion of commercial mortgages, which are performing well.

The re remaining core commercial real estate book of $13 billion is primarily real estate projects with average outstandings of less than $10 million per loan that are well diversified in term of assets classes and geography. While the environment remains challenging and we expect further losses in this book, we believe they will be manageable for the following reasons.

First, we don’t see the over building as we did in previous cycles. Second, we believe the underwriting for legacy PNC was more rigorous than many of our peers and third, our acquired loans have been marked and are well reserved. Now let’s take a look at the consumer side. Core home equity loans and residential real estate make up more than 71% of our core consumer lending portfolio.

The remainder of $16.5 billion is primarily comprised of education loans, credit card and auto loans and all are performing as expected in this environment, both our core home equity and core residential mortgage portfolios are relatively high quality and overall are performing well especially in comparison to many of our peers. Net charge-offs for core home equity loans were 52 basis points in the quarter and in the same period they were 50 basis points for core residential mortgage loans.

Now turning to our distressed assets, this portfolio had $19.7 billion of loans at the end of the third quarter and page 19 of our financial supplement describes the makeup of this portfolio. The distressed portfolio includes $7.8 billion of impaired loans that were marked down by 37% at September 30.

In other words, when the allowance for loan losses of more than $900 million associated with these loans this segment is included; the entire distressed portfolio is being carried at about 75% of the outstanding balance. The goal of our distressed loans is straight forward. We to want optimized the economic value of these assets and I am confident with the tools and the talented to meet this objective and so far the loans assigned to this segment are performing as we expected.

Now let me summarize our total credit book and its performance. First, overall past due loans appear to be stabilizing and while nonperforming loans were up in the third quarter, the growth rate is lower than the previous quarters. Second, as expected, we continued to see stress in commercial real estate and the mortgage sectors, but the pace of the deterioration has been manageable. Third, net charge-offs in the third quarter are down 18% to $650 million compared to the linked quarter charge-offs of $795 million.

Our allowance for loan losses is $4.8 billion, or nearly 3% of total loans versus a current annualized charge-off rate of 1.59%. Even still we expect to continue to add to reserves in the fourth quarter as we project our fourth quarter provisions to look similar to the third quarter. Fourth, the fair value marks in our impaired loans, stand at $6.6 billion at the end of the quarter. This is 37% of impaired loans outstanding. This means, we have a total of $11.4 billion, or nearly 7% of our loans outstandings in reserves and fair value marks. We believe this loss coverage is substantial and appropriate.

Slide nine; looks at our investment securities portfolio, this $54 billion portfolio represent a 20% of our balance sheet at the end of the third quarter. Our goal is to have the securities portfolio that consists of high quality well diversified assets. Since the end of 2008, we have made considerable progress in reducing the risk of this portfolio. We have enhanced our investments and lower risk asset classes by increasing our purchases of Treasuries and government agency securities. Where opportunities existed to sell non-agency securities at a gain to cover the cost of our OTTI charges we did.

We also saw improvements in credit related OTTI charges from $55 million in the second quarter to $129 million in the third quarter and we expect this trend of improvement to continue. We have stated before that the underlying assets and the portfolio are high quality. The unrealized pretax losses on this portfolio improved by $1.6 billion in the third quarter and have improved by $3.2 billion from year end primarily due to better market conditions in both agency and non-agency securities.

As you can see, we are recapturing a substantial portion of the market valuations and this has a positive impact on tangible common equity. We continue to see capital as a key differentiator and effective capital management as an integral part of our business model. Since year end 2008, we have increased common equity by $3.5 billion to $21 billion due to retained earnings and the reduction of the marks on a securities portfolio.

As shown on slide 10, we’ve strengthened our capital ratios throughout the year. As of September 30, Tier 1 common ratio was an estimated 5.5% and our Tier 1 risk based capital ratio was 10.8% estimated. These increases have been driven primarily by growing retained earnings and reductions in risk weighted assets. Now, keep in mind that these ratios already reflect the impaired loan marks of approximately $6.6 billion as of the end of the third quarter. The losses related to these marks are behind us.

We see further enhancements to these ratios on the horizon. First, we expect fourth quarter results will again be accretive to capital. Second, unless loan demand strengthens, I think we will have modest balance sheet contractions reducing risk weighted assets and third, in addition to executing our business model if the BlackRock BGI transition closes this year, we would expect a significant after tax gain of over $700 million based on the current BlackRock share price, which would add an additional 30 basis points to our Tier 1 ratios.

Our position on TARP repayment has not changed. Our plan is to repay TARP as soon as appropriate and in a shareholder friendly manner subject to approval by our banking regulators. As you can see, we are building capital that should allow us to achieve this objective. As I said before, our goal is simply to execute on our business model. As you can see, we’re making strong progress on each step in our plan.

With that, I’ll hand it back to Jim.

Jim Rohr

Thank you, Rick. Slide 11, is a scorecard, we use to measure our progress as we integrate National City and apply PNC’s business model to our new franchise. You saw this at the Barclays presentation. These goals are not new instead, these goals represent where we were prior to the recession and prior to our acquisition of National City. They reflect our efforts as we work to transition our balance sheets and position the company for future growth, which we were prior to either one of those items.

As evidenced by our third quarter performance, I believe we’re making good progress against these targets. We now have a large client base and more than $16 billion in annualized revenues, and we believe there are three reasons, why we can build on these opportunities.

First, as Rick discussed with the marks we’ve taken on the impaired loans we believe our credit costs will decline faster than others as the economy begins to recover. Our third quarter results indicate the rate of credit deterioration has eased. Second, we expect to exceed the $1.2 billion in annualized integration expense savings. We made significant progress in the third quarter, and we’re confident that we can achieve that objective.

Finally, the acquisition of National City provides us with a larger distribution platform for cross selling our products and services and we’ve just begun to see increased revenue across the franchise in the third quarter.

Looking ahead, improving markets should further enhance income from our fee based businesses and our assets sensitive balance sheet provides us with a great deal of flexibility. Our return on assets in the third quarter was 0.81% making our year-to-date ROA 0.62%. We obviously have higher aspirations on that and as the economy recovers and once we’re able to repay TARP, I believe we should be able to deliver returns consistent with our historical performance in excess of 1.3% on assets.

Now, as I reflect on the first nine months of this year, I’m very pleased with how we performed during this difficult economy. Our proven business model continues to demonstrate its effectiveness. Clearly, we have an established framework for success. The economy is beginning to show signs of stabilization, and we’re seeing signs that the pace of credit quality deterioration maybe easing.

The acquisition of National City continues to exceed our expectations, and we’re ready to begin the first wave of the client conversions early next month. We’ve a very strong team, and we’re focused on execution. Clearly, we believe our enterprise will create tremendous opportunities for shareholder value as we continue to build a great company.

With that, we’re pleased to take your questions. Operator, could you give our participants the instructions, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Paul Miller - FBR Capital Markets.

Paul Miller - FBR Capital Markets

Can we go into a little bit more detail about your NIM? I mean it was a very strong NIM and strong growth and I believe you guide it to relatively slight in growth, but we what exactly are the benefits coming through on the Nat City purchase accounting marks? I think the street has been very confused about what exactly the accretion is and do we have to back anything out going into next year? I know you said it should be strong going into next quarter, but what about 2010? Do you expect this same type of performance on the NIM or with some of it maybe backed out because of accretion impact will be lower?

Rick Johnson

I think we’re getting more benefit and the purchase accounting attributes to us, because when we did the marks on the deposits, it was about a 2% mark. We’re actually repricing all of those below 1.8%. So we’re actually doing better than those marks, but we’re also repricing a lot of PNC retail CDs as well, probably coming down in the fourth quarter from an average of 3% down to again less than 1.8%.

So we’re not giving guidance going forward, but I will say we do have the substantial number of deposits, which will also reprice in 2010, so yes, I do expect the benefit to continue.

Paul Miller - FBR Capital Markets

Can you real quick address to me the marks? What is your average marks, I don’t know if you disclose or not in your nonperforming asset portfolio? When you moved that stuff in? What is the overall portfolio and the marks, and what was the new stuff you brought in? What type of marks did you put on it?

Rick Johnson

We’ve approximately $6.6 billion of marks on the impaired loans that we have. That brings at overall balance down to about $11 billion in total. So it would about $17 million pre the marks and on the rest of the portfolio we’ve got $4.8 billion of allowance if you add the two together, you get close to 7% of loss coverage on our total credit exposure.

Paul Miller - FBR Capital Markets

I meant more in the sense of nonperforming assets like, when it goes from delinquent into NPA, that’s where the bulk of the charge-offs are coming from, am I correct and most companies are telling us they’re marking them somewhere between $0.65 and $0.75, and I was just wondering what is the overall marks inside that nonperforming assets portfolio and what was the new stuff that came in this quarter?

Rick Johnson

When a loan goes to nonperforming, you don’t take a mark on it. You would set aside a reserve for it, but you wouldn’t take a mark out. So, there is a whole range of different types of nonperforming assets whether they’re collateralized or uncollateralized. When it goes into OREO or the impaired portfolio that we took when we bought National City, those are the marks that Rick is talking about in the impaired portfolio.

Paul Miller - FBR Capital Markets

I’m just saying most banks have told us like our MPAs are marked down like to $0.65 in the dollar it be it debt reserves set aside for it or not. I am just wondering if I guess you have those similar types of numbers. If not, I can take it off line.

Rick Johnson

I think if I understand what you’re trying to get on our nonperforming loans we have specific reserves of approximately 25%.

Operator

Your next question comes from Mike Mayo - CLSA.

Mike Mayo - CLSA

Just first as far as TARP, you’re still a TARP bank. What do you thinking about there and what would be the financial impact if you were to pay back TARP? How do you think about that?

Jim Rohr

We’re not in a rush to payback TARP simply because although the recession is technically over, it doesn’t feel like the recession is over and we expect the housing prices and unemployment to continue and increase and housing prices to continue to decline somewhat, so we’re still relatively conservative in terms of the economy although we have seen some stabilization for sure.

I think the issue for us is to pay it back over a reasonable period of time. I would expect we will be beginning conversations with the regulators to pay it back perhaps over the next 15 months and I think we’ll do it in a shareholder friendly manner we built these capital ratios up and we will continue to do so as Rick mentioned.

If you look at the tier 1 ratio that many peers were able to reduce their capital ratio to when they paid it back, that was around 9% we’re at 10.8% right now. When we get the BlackRock gain that will be worth 30 basis points taking us over 11 on presuming it closes on December 1 as scheduled. We expect to be continuing to build our capital ratios in the quarter.

The balance sheet continues to reduce. We get a $20 billion distressed book that we have approximately $2 billion with of capital supporting that we wouldn’t expect that to be around forever, so I think we’ll be able to pay it back in a shareholder friendly manner without having to do a some huge capital raise like other people have had to do. So, I think we’ll be really conservative in that.

Mike Mayo - CLSA

Is it a matter of you deciding when you want to pay it back or you need the approval?

Jim Rohr

Of course you need the approval. I am sorry I left that out profession.

Mike Mayo - CLSA

Then separately the HAMP program, how like what percentage of your mortgage loans have modified and how is that impacting some of the delinquency or charge-off data?

Jim Rohr

It is a small percentage I would guess it is a small percentage of our charge-off data.

Operator

Your next question comes from Betsy Graseck - Morgan Stanley.

Betsy Graseck - Morgan Stanley

Just on that question regarding HAMP, I think the concern that some folks in the industry have is that the recidivism is not very good and that shadow inventory in housing is building and this is going to hit banks and your institution as you move into 2010 and I am just wondering if you can give us some color as to the modifications that you have done so far to date, how those have been going?

I am sure you are watching them very closely could you give us some color as to how you expect to deal with borrowers who might not be able to make the payments long term and give us some sense as to what you can potentially do to manage through that process.

Rick Johnson

We have done about 9,000 modifications so far and about 4,000 have been under HAMP, and the others non-HAMP type programs. It is an impact on about $1.7 billion overall of loans that we have, but you’re right. I think there is a question around how successful are those going to be overtime. Our rate is in terms of success is pretty consistent with the industry. I think the industry is about 54% or rate around that same level.

You’re absolutely right, I think over time as we work through here, there will be more assets, certainly moving into the OREO portfolio, and that’s why we’ve been very active in terms of selling them out and have sold out over 4, 200 properties year-to-date. So we’ve been building up pretty sources there to be prepared for exactly what you’re anticipating.

Betsy Graseck - Morgan Stanley

Does your reserve reflect expectations with regard to people who can make it or not make it through these kind of programs?

Rick Johnson

Yes.

Operator

Your next question comes from Ed Najarian - ISI Group.

Ed Najarian - ISI Group

I have two questions, first, Rick, in prior quarters you were laying out the dollar amount of the accretable yield from the purchase accounting marks back through net interest income. Could you give us that number for the third quarter and remind us again what it was in the second quarter?

Rick Johnson

In the second quarter I gave you a number related to deposits in particular, of about $253 million. That number is down about $60 million, Ed. Again, all of that value is coming to us through the repricing of the deposits.

Ed Najarian - ISI Group

So that accretable yield number is down about $60 million from $253 million in 2Q?

Rick Johnson

As a deposit piece, that’s correct, yes. Again all of that comes back to us because, we’ve repriced those CDs at rates below the 2% mark that created that purchase accounting accretion. So as the loan numbers haven’t changed dramatically at all.

Ed Najarian - ISI Group

Weren’t you previously given us a bigger number that I guess included the asset side and the deposit side?

Rick Johnson

We were, but we got too much confusion I think in our discussions about how people should treat those, and the bottom line is, we’re able to grow the margin because, we’re able to actually achieve those values, and the detail wasn’t adding any help to the story.

Ed Najarian - ISI Group

I guess the message you’re giving us is to sort of forget about that old line of thinking and just sort of go with your new view in terms of sort of a stable or up margin?

Rick Johnson

Yes, I think you saw the margin go up 16 basis points from the second to the third quarter. I think you can expect a similar improvement going from the third to the fourth.

Jim Rohr

I know it’s a busy morning, but on page five of the supplement, it describes really how the funding costs have come down on the deposit side, and that’s very consistent with Rick’s comments. We took the purchase accounting mark to 2%, and now we’re rewriting them at 180 and 170. So we’re actually getting more than the accretion. We’re realizing more than the accretion.

Ed Najarian - ISI Group

Then my second question just has to do with this $314 million that you have classified as other noninterest income. I think there was a line in there I can’t find it right now, but talk something about net asset valuation improvements include in that number. I guess if you could maybe give us some context on that number and if there was anything that you would regard as nonrecurring gains within that number?

Rick Johnson

It’s very well diversified. I think you see some modest private equity gains I’m talking less than $20 million, some modest trading gains, number like 30, so you just asset values BOLI income, which we have every quarter improving in value, modest amounts of gains on sales distributed across five air six or six books, so nothing there substantial, Ed.

I think which you’re seeing, we did have one item which is the BlackRock gain and the fact that they did raise capital in anticipation of the BGI deal, so we had $29 million on that, but these are relatively small, very diversified. I think what you saw in the second and third quarters, is a pretty stable performance that you can continue to expect.

Ed Najarian - ISI Group

So it’s not unrealistic, Rick, in your mind to think about that line item being in the $300 million range in future quarters.

Rick Johnson

That’s correct.

Operator

Your next question comes from Moshe Orenbuch - Credit Suisse.

Moshe Orenbuch - Credit Suisse

Could you talk a little bit about the kinds of securities that you’re adding? What the tenure of that is? You did mention that the balance sheet was still asset sensitive. Could you talk about the degree of asset sensitivity?

Rick Johnson

We’re buying primarily agencies and treasuries, and we’re buying very short dated. I think we feel at the moment, it’s important to keep liquidity and stay asset sensitive at the time. We think as we get into the New Year, I think as unemployment might be peeks, the economy starts to comeback a little bit, the government stops buying assets off the market in terms of both residential mortgages as well as treasuries, and they finish up their programs, then they think maybe rates will go a bit higher.

We’ll have an opportunity to invest a little longer term, and also just keeping a lot of liquidity. I think we just important at this moment, we think the economy has started to improve, but we want to be cautious not to be overly confident about where the economy goes at this stage. So we’re investing in very short dated assets.

Operator

Your next question comes from Heather Wolf - UBS.

Heather Wolf - UBS

I’m sorry if I missed this. Can you guys tell us of the $1.7 billion in loan marks? What dollar value is carried under non-accruing and what’s carried under accruing?

Rick Johnson

Heather, let me call you back. I think we have to take that off line. I’m not sure we have that level of detail here this morning.

Heather Wolf - UBS

Then just a quick follow-up on Ed’s question, can you explain to us why some of us may have been sort of thinking about the purchase accounting accretion wrong? I think you had told us as of the second quarter that you had accrued $1.1 billion. Should we think about that as sort of staying in your lending revenues going forward or are we thinking about it wrong?

Rick Johnson

Actually, we accrued $1.1 billion over the first two quarters, but the second quarter was much lower than the first. It was actually down by 130, and again I would say that the third quarter will be down again, but it’s all driven by deposit accretion, and all that deposit accretion is being captured through the repricing of the CD portfolios at National City.

Jim Rohr

I think if I could, one of the things that’s important, is that when we talk about accretion, people perceive that it’s accounting. I think what we’re saying is that the cash being received and paid out is now in the benefit of it because of the declining rates and the way we’ve been able to manage our funding costs is in excess of the accounting assumption that we made at the beginning of the year.

So the realization is very real in terms of cash, lower cash expense for our deposits. So that’s why I think Rick has point out that it’s just in the system now, because we have recognizing in a very real way in the marketplace.

Operator

Your next question comes from Gerard Cassidy - RBC Capital Markets.

Gerard Cassidy - RBC Capital Markets

Can you give us some color on the National City business that used to be called the rest of Nat City, meaning it wasn’t the first Franklin or real estate lending, but a core basic business in the Midwestern part of the United States. How is that doing in view of the recession and are you seeing any early signs of it starting to stabilize and improve assuming that it got hit by the recession?

Jim Rohr

I think there’s a number of ways to look at National City. As you know, we tried to acquire National City a number of times because of the core business that they had. The deposit business of National City has done extraordinarily well this year. They’ve raised the transaction accounts dramatically over the course of the first nine months. I think they increased demand deposits by $3.5 billion in the first four or five months. So the deposit business is very good.

I would say that generally speaking, if you look at their home equity book it’s been very good, commercial loans have worked out well given the economic environment. When you look at what National City did in its various silos that caused significant problems. You had one part of the company, which for example, in the core business was cutting back its exposure to the big three.

So that on a combined basis today, we’re less than $50 million to the big three, but on the other hand they originated and bought $9 billion of brokered home equity from around the country. That obviously has done poorly and that’s a big part of our impaired booked and then they acquired two banks in Florida and clearly the assets, the timing on that was very, very difficult. That became a big part of our impaired books.

So I think when you look at the core business of National City, it’s doing very well and the issue for us is to eliminate the subprime as you brought up. The subprime, the brokered home equity and some of the ancillary activities they got into and I think that’s what we’re doing.

We were able to take charges and reserves, $12.5 billion I believe it was at close of the transaction and move those issues or the losses on those issues upfront and I think that’s coming home now. The other thing is that because they were so silent, they really didn’t cross sell products at all.

For example, at PNC we cross sell eight times as many dollars per customer of capital markets customers and capital markets revenue as they did, three times in the Treasury Management space. The Treasury Management has already taken off, and the capital markets will come along. We’re starting to see signs of it so working as a team is something that National City didn’t do as well as they might have and they are now. So, there is a lot of opportunity there.

Gerard Cassidy - RBC Capital Markets

Have you guys put incentive plans in place to encourage the National City folks to cross sell these products?

Jim Rohr

You’re exactly right I mean that was the big issue. The lenders were paid to be lenders and were paid only on a lending basis and not paid or rewarded in anyway to cross sell other products and so whether its workplace banking, they didn’t really refer anybody to the private bank. We have basically changed that, and they have really come on board operating as a team extraordinarily well.

Gerard Cassidy - RBC Capital Markets

Your loan portfolio obviously similar to the industry is shrinking because of the economic conditions of the country. Historically it takes awhile though we know Washington is complaining that the banks aren’t lending, they don’t I guess realize that banks are in the business to lend and you guys would like to lend more if the demand was there. When do you see loan demand coming back? Is it something that you could assuming the U.S. economy is expanding in 2010 and we’re back into a growth mode?

Jim Rohr

You won’t see a lot of expansion in the economy unless you do see expansion in the credit space, so I think there is a few things that as to happen I think the consumer has to be more confident in their position. I think stable environment, whether it be governmental or economic I think is very important before the consumer starts buying and you seen this savings rates go from 1% where they were for 20 years to last time I saw was 6.7% in a month.

So they’re paying down their credit cards, they’re paying down their home equity loans and saving money, so we have to get back to a stable position there and I think you have just started to see corporations start to spend money on capital expenditures. Now whether that’s a blip or whether that’s sustained and of course the stimulus money hopefully will come in next year, which causes people to spend money, capital money, so those kinds of things would incant borrowing as well.

So we love to see borrowing come back. I don’t see it turning around in the immediate future, but hopefully the economy turns around next year you will see it on demand next year. Utilization rates are from what I can tell an all time low for utilization of credit facilities, so if the economy starts to come back, I think that could change in a hurry.

Gerard Cassidy - RBC Capital Markets

You mentioned that on the credit deterioration some of the credits in the finance space were drivers of credit deterioration in quarter. You also I think said that you sold one of those credits at $0.90 on the dollar. On page 10 the credit that was sold, was it the number one or number two credit that was listed there as your largest nonperforming asset?

Rick Johnson

Yes, the number one credit. We note that exposure in half.

Gerard Cassidy - RBC Capital Markets

Finally, just trying to take a stab at the accretion from the purchase accounting, is it safe to look at it that because you guys were assuming the 2%, now cost of funds is less, that the initial estimate was too low and you’re getting additional benefit now from the purchase accounting because the cost of funds are lower than the 2%?

Rick Johnson

The initial estimate was done as of 12/31/08, so as of the end of last year and rates have come down obviously since then, so we have been able to do better. Deposit rates come down a lot less competition today than it was at the end of the year, so deposit rates were down. The thing I think people also might not be picking up on, we’re repricing all the PNC CDs, and we didn’t have marks on those, and we’re dropping those from 3% down to under 2%. So there is that additional value coming in there as well.

Gerard Cassidy - RBC Capital Markets

So if you would and again I know rates were a lot different in the market was different when you guys made these assumptions. If you would have assumed 1.8% on the deposit side, for example, then the initial assumption on accretion would have been greater back in ‘08. Is that correct?

Rick Johnson

If that were the market environment then, then that’s correct, yes.

Jim Rohr

We still would not have estimated the total benefit from the lower rates because; we wouldn’t have marked the PNC book.

Rick Johnson

Yes.

Operator

Your next question comes from Keith Horowitz - Citigroup.

Keith Horowitz - Citigroup

Sorry for another internationals revenue question, but if you look just on the cash, if you look at 3Q over 3Q and kind do a pro forma margin, pro forma internationals revenue, your international revenues growth is up 10% year-over-year, your balance sheet is down 7% year-over-year in terms of earning assets and implies your margin is up 55 basis points from like 322 to 376.

So maybe you should forget about talking from the perspective of accretion just talk about why would the combined margin of two companies be up about 50 basis points year-over-year? That’s clearly something that I was missing in terms of trying to model the earnings power, international revenues in line a lot lower.

Rick Johnson

I think if you take a look at page five, it’s easy. Look at the cost of funds. It has come down dramatically, even since the beginning of the year, the cost of funds has come down. The borrowed funds and the deposit rates, deposits overall down to 1%, and we haven’t done a lot of comparisons actually to the prior year, because we’re kind of a much bigger and very different company, but you can see even if you did that comparison, you can see the overall cost of funds coming down from 2.29% down 90 basis points.

It’s about as simple as that increase and while the cost of assets is coming down, it’s not as great. I don’t know how else to explain the margin increase other than the fact that we’re getting funds a lot cheaper than we were a year ago.

Jim Rohr

A lot cheaper than we have assumed at the end of the year.

Keith Horowitz - Citigroup

So you think this kind of level of margin of that 375 is consistent with how your balance sheet is constructed?

Rick Johnson

I think it is. I think we gave in guidance before we do expect this to continue to go up because we do expect another $7 billion of retail CDs and brokered CDs to roll off in the fourth quarter, and we’ll be able to reprice those at below the rates of which we have them marked, getting better cash on that side as well as a portion of that is PNC CDs, which retire accruing a 3% and we’ll reprice them below the 1.8 level.

Operator

Your next question comes from Heather Wolf - UBS.

Heather Wolf - UBS

Just a quick question on the non-accretable difference. One of your peers started giving what the remainder is left in that. Do you guys have that number?

Rick Johnson

The non-accretable difference, I mean you’re talking about the credit markets.

Heather Wolf - UBS

Right, how much of the credit market have you used so far?

Rick Johnson

In the quarter, we basically used about $1 billion of that market. I think last quarter, this quarter it’s at $6.6 billion, last quarter is about $7.5 billion, something like that, yes.

Heather Wolf - UBS

Also can you just talk about your guidance for lower provision in the context of the increase in nonperformers that you saw?

Rick Johnson

We actually said the provision would be consistent with the third quarter, so fourth quarter; yes we didn’t lower the estimate there. What we did say is that we believe the growth in nonperformers should continue to come down.

Operator

Your final question comes from Rick Weiss - Jane.

Rick Weiss - Jane

I think following up a little bit with Heather’s last question, can you talk a little bit about the relationship between net loan charge-off and nonperforming assets? I was little surprised that when the nonperforming assets did go up this quarter, but the charge-offs came down. Why would that be?

Rick Johnson

The charge-offs are very asset specific and they can be very volatile they’ll bounce around a bit. I think the trend you’re really want to stare at there is the nonperforming, and watch to see that come down. Keep in mind also that at National City we took about, what $2.8 billion worth of reserves at the end of the year related to the portfolio. At some point, we’re going to charge those off. So the charge-off number can be very misleading as to where our overall credit quality is headed.

Jim Rohr

Operator, are there any more questions?

Operator

There are no further questions at this time.

Jim Rohr

Okay. Thank you very much, everyone. We appreciate it. We think it was a very good quarter given the environment we’re in and I think it shows we’re making a lot of progress on our plan. So thank you very much for joining us this morning, and talk to you later if you have any questions. Thank you.

Operator

Thank you all for participating in today’s conference call. You may now disconnect.

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Source: PNC Financial Service Group Q3 2009 Earnings Call Transcript
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