Huntington Bancshares Incorporated (NASDAQ:HBAN)
Q4 2009 Earnings Call
January 22, 2010; 11:00 am ET
Steve Steinour - Chairman, President & Chief Executive Officer
Don Kimble - Senior Executive Vice President & Chief Financial Officer
Tim Barber - Senior Vice President & Credit Risk Management
Dan Neumeyer - Senior Executive Vice President & Chief Credit Officer
Randy Stickler - Senior Executive Vice President of Commercial Real Estate
Jay Gould - Director of Investor Relations
Dave Rochester - FBR Capital Markets
Bob Patten - Morgan Keegan
Matthew O’Connor - Deutsche Bank
Brian Foran - Goldman Sachs
Scott Siefers - Sandler O’Neill
Ken Zerbe - Morgan Stanley
Erika Penala - UBS
Ken Usdin - Banc of America
Jeff Davis - FTN Capital
Good morning. My name is Courtney. I will be your conference operator. At this time I would like to welcome everyone to the Huntington fourth quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions) Thank you. Mr. Jay Gould, you may begin your conference.
Thank you, Courtney and welcome everyone. I am Jay Gould, Director of Investor Relations for Huntington. Copies of the slides can be we will be reviewing to be found on our website, www.huntington.com and as is our custom this call is being recorded and will be available as a rebroadcast starting about one hour from the close to call.
Please call the investor relations department at 614-480-5676 for more information on how to access these recordings or playback, or should you have difficulty getting a copy of the slides. Slides two through four, notes several aspects of the basis of today’s presentation. I encourage you to read these, but let me point out one key disclosure.
This presentation contains both GAAP and non-GAAP financial measures, and where we believe it’s helpful to understanding Huntington’s results of operations or financial position. Where non-GAAP financial measures are used the comparable GAAP financial measures as well as the reconciliation to the comparable GAAP financial measure can be found in the slide presentation in its appendix in the press release and the quarterly financial review supplements to today’s earnings press release or in the related Form 8-K filed earlier today, all of these can be find on our website.
Turning to slide five, today’s discussion including the Q-and-A period, may contain forward-looking statements. Such statements are based on information and assumptions available at this time and are subject to changes and risks and uncertainties, which may cause actual results to differ materially. We assume no obligation to update such statements. For a complete discussion of the risks and uncertainties, please refer to this slide and materials filed with the SEC including our most recent Forms 10-K, 10-Q and 8-K filings.
Now, turning to today’s presentation, as noted on slide six, participating today are Steve Steinour, our Chairman, President and Chief Executive Officer; Don Kimble, Senior Executive Vice President and CFO; and Tim Barber, Senior Vice President of Credit Risk Management. Also present for the Q-and-A session is Dan Neumeyer, Senior Executive Vice President and Chief Credit Officer; and Randy Stickler, Senior Executive Vice President of Commercial Real Estate.
Let’s get started by turning to slide nine and Steve Steinour. Steve.
Thank you, Jay, and welcome everyone. First, a word introduction, I am pleased to introduce Randy stickler to you he joined us in March of last year it came to us from Charter One bank, State of Ohio President. He has over 25 years of commercial banking experience, most of it in commercial real estate businesses at various banks. He’s been very busy this past year. He’s been instrumental in the significant progress we’ve made in reviewing and addressing the issues in our commercial real estate portfolios.
So welcome Randy. 2009 will go down as one of the most challenging years facing the industry at Huntington in decades. A lot of difficult decisions needed to be made and as a result our performance was disappointing from a credit quality and earnings performance standpoint. However, I’m convinced that we’re entering a brand New Year in 2010 in many respects.
A much stronger company with underlying momentum that will result in significantly improved performance. There are recent signs that the economic environment is stabilizing, yet it remains uncertain and even fragile. Nevertheless, sometime during 2010 we expect to return to quarterly profitability. Our colleagues are working hard to make that happen with the objective of getting there as soon as possible.
Decisions in the fourth quarter were important to this end, and I hope that our remarks will give you the same confidence that we have in achieving this goal. I’ll begin with a review of our fourth quarter performance highlights. Don will follow with a detailed overview of our financial performance. Tim will provide an update on credit and review of our commercial real estate portfolio. I’ll then return with some 2010 outlook comments and what I hope our investors will take away from today’s presentation.
Let’s begin, turning to slide eight. Reported a net loss of $369.7 million, $0.56 a common share, the driver the loss was an $894 million provision for credit losses. This was $419 million higher than in the third quarter and more than double the fourth quarter’s net charge-offs. Contributing to this increase were certain credit actions that we’ll talk about in more detail in a moment.
Yet, we continued to make good progress in improving our pretax pre-provision income. This totaled $242 million, up just under $5 million or 2% from the third quarter, and represented the fourth consecutive quarterly improvement. It’s also important to note that this level was 24% higher than in the year ago quarter. This demonstrates the progress we’re making in positioning Huntington for a stronger financial performance once this credit cycle ends.
The linked quarter improved that was driven by a 3% increase in net interest income. Our largest revenue contributor, but the big story for the quarter was the large provision, so let me review what drove this. Now, as you will recall from earlier earnings calls and investor communication, since the first quarter, we’ve been deeply involved in understanding and addressing the risks in our credit and loan portfolio.
The first nine months were spent in a series of detailed portfolio reviews and the implementation of enhanced portfolio management processes. This permitted to us proactively identify and address the risks in our portfolio. Charge-offs remained elevate and we continued to build our loan loss reserves, again through the first nine months.
We reported last quarter that the growth rate in criticized loans has slowed but that our customers remained under pressure from the weak economy as a result, during the fourth quarter there was a continued increase in the absolute level of criticized loans, though at that time third quarter’s slower pace.
Given the uncertain economic picture in 2010 and a trend line of growing credit losses throughout 2009, during the fourth quarter we reviewed our loan loss reserve assumptions portfolio by portfolio. As a result we felt a significant increase in loan loss reserves was warranted.
We wanted to ensure that we had sufficient reserves to continue to address the resolution of problem credits, existing credits, inherent in our portfolios in what is like toll remain a fragile economy. Our period end allowance for credit losses represents 4.16% of total loans and leases and our non-accrual loan coverage improved 80% from 50% at the end of the third quarter. Yet we’re seeing signs that are very encouraging.
Total non-performing assets declined 12% from the end of the third quarter, and there was a 45% decline in new non-performing assets compared with the third quarter. As noted earlier, the rate of increase in criticized and classified loans is slowing. Early stage delinquencies also improved.
So as we’ve stated since January of last year, the area of most credit concern has been our commercial real estate portfolio and specifically our exposures to single family home builders and our retail segments. As we enter 2010, I think it’s important that our investors know that as a result of the actions taken this past year, we have substantially addressed the single family homebuilder segment. This is not a major concern going forward.
The portfolio management focused over the course of the year, combined with reserve actions and dividing our commercial real estate portfolio into core and non-core segments positions us better to deal with this exposure going forward, and Tim will provide details. Our C&I and consumer portfolios are experience higher than normal charge-offs given the weak economy, but we believe these will remain manageable with our consumer loan portfolio performing better relative to peers.
Turning to slide nine, despite a reduction due to the fourth quarter’s loss as expected our capital position remains a positive story. Our period end Tier 1 and total risk based capital ratios were 12.05% and 14.43% respectively. These are $2.6 billion and $1.9 billion above respective regulatory well capitalized 6% and 10% thresholds.
We continue to believe, we have sufficient capital to weather a stressed economic scenario. Say it again, we continue to believe we have sufficient capital to weather a stressed economic scenario. Our tangible common equity ratio was 5.92%. A year ago at the vend 2008, we were at 4.04%.
Liquidity, which has seen quarterly improvements for the first three quarters strengthened further. Again this past quarter a key driver was the strong 16% annualized growth rate in core deposits. Our loan to deposit ratio at the end of December was 91%. Improved from 94% at the end of September and significantly improved from 108% at the end 2008. Our deposit growth permitted to us reduce non-core funding by $1.8 billion during the quarter.
Turning to governance and management, we continue to build the strength of our Board of Directors with the employment of Rick Neu. Rick was the former CFO and treasurer of Charter One Financial, and prior to that was at First Federal of Michigan. He’s got extensive hands on experience in Detroit and Cleveland markets, and other markets, and he’s a CPA by way of training. He’s a tremendous addition to the Board.
Slide 10, a key element of growing Huntington is investing in resources and talent, especially in those areas that will grow revenue. The slide list selected new management team members hired over the last several months. If you can see some are in positions to take what we have and make it better, like those in retail business banking and commercial banking business segments.
Other new hires are leaders and teams aimed at developing critical mass in existing businesses, such as currency risk management or to expand existing businesses into new markets like brokerage sales and we’ve initiated a new business with the national settlement team. These investments reflect the early stages of implementing our strategic plan.
With that I’d like to turn this over to Don for a financial performance review. Don.
Thanks, Steve. Going on slide 11, our net loss for the fourth quarter was $369 7 million, or $0.56 a share. Two significant items impact with the quarters are low. First, we recognize $73.6 million or $0.07 per share gain or redemption of subordinated notes. We completed a tender offer early in the fourth quarter redeeming $371 million of then outstanding coordinated debt. The gain represents the discount paid on the tender and the impact of closing out the related interest rate swap. Second we had a $12 million or $0.02 per share benefit from recognition of certainly previously deferred tax valuation allowances.
Slide 12 provides a summary of quarterly earnings trends. Many of the performance metrics we discussed later in the presentation so let’s move on. On slide 13 we provide an overview of our pretax pre-provision income performance. We believe this metric is useful that being underlying operating performance. We calculate this metric by starting with the pretax earnings and excluding three items.
Provision for credit losses, security gains and losses, and amortization of intangibles we also adjusted for certain significant items including the gain resulting from this quarter’s subordinated debt tender offer. On this basis, our pretax pre-provision income for the third quarter was $242.1 million, up $4.9 million or 2% from prior quarter. This improvement clearly reflects to the management actions taken to the New Year and we continue to look for additional opportunities to improve our core operating performance.
Slide 14 provides a trend of our net interest income and our margin. During the fourth quarter our fully tax equivalent net interest income increased by $9.6 million reflecting a one basis point decrease in our net interest margin and a $1.3 billion increase in our average earning asset base.
The margin chain reflected and favorable impact of our improved deposit mix and loan pricing offset by the negative impacts of our stronger liquidity position, the deposit growth resulting in increases to our investment securities portfolio. Also impacting the margin was a swap in effectiveness occurring at the end of the third quarter producing the current quarter’s net interest income.
On slide 15 we show the change in the mix of our investment portfolio with the growth in our deposits we’ve invested the funds primarily in shorter duration and variable rate securities such as agency CMOs and certain asset backed securities. The short term into these investments provides the flexibility to reposition the portfolio if the yield curve starts to steep or if we decide to utilize the fund future loan growth.
Continuing on slide 16 we show the linked quarter loan lease trend. Total commercial loans were down $0.8 billion dollars or 4% reflecting the impact of lower line utilization for our commercial borrowers. The decline also reflects the plan lower commercial real estate balances from the pay downs and charge-offs occurring during the quarter. Total consumer loans were flat with prior quarter despite a 31% increase in origination volume for automobile loans. This increased origination volume was offset by the impact of our continued runoff of the auto lease portfolio and lower residential real estate balances.
Turning to slide 17, our strong core deposit growth continued in the fourth quarter. Total core deposits grew at an annualized 16% rate and the growth came from demand deposit and money market category. The Warren bank acquisition added $260 million of core deposits on average. Even after adjusting for this impact core deposits were up 13% on an annualized basis.
Slide 18 shows the trends in our non-interest income categories. Our non-interest income declined by $11.5 million from the prior quarter, other income declined by $7.5 million reflecting $16.4 million lower benefit from the change in the fair value of our derivatives that did not qualify for hedge accounting. This was offset by $7.5 million on losses of loans held for sale in the third quarter.
Our service charges on deposit account declined $4.1 million from the third quarter level from reducing lower NSF/OD related fees. Mortgage income was up $3 .2 million reflecting stronger origination volume and $2.2 million gain from the MSR hedging activity for the current quarter.
The next slide is a summary of our expense trends. Total expenses were down $78.5 million from the prior quarter. This reduction was primarily due to $73.6 million gain on the debt redemption. OREO and foreclosure expenses were down $20.4 million as the prior quarter reflects a $14 million loss on one commercial OREO property.
Personnel costs were up $8.5 million from previous quarter. This increase included $4.7 million from incentive related costs. Core salaries were up about 2% in the third quarter reflecting the crease of 81 FTE primarily for specific strategic initiatives. Slide 20 is a summary of our capital trends. We completed a series of capital actions over the last year.
The most recent action was a completion of a tender offer for subordinated debt resulting at $73.6 million in pretax gain. This transaction reflected to the utilization of proceeds from our earlier common stock issuance, our capital ratios throughout the year have improved and with our TCE ratio increasing for 4.04% a year ago to 5.92% at the end of this year.
Most importantly, we think these actions position us well to weather further economic challenges. We do not have any current plans to issue additional capital. Let me turn the presentation back over to Tim Barber for credit review.
Thanks, Don. Turning to slide 21, our total net charge-offs were $88.8 million or 25% higher in the fourth quarter, compared to the third quarter with substantial changes in the composition. Total commercial net charge-offs were $129.8 million higher in the quarter as both the C&I and commercial real estate portfolio showed increases. In the consumer portfolio, there were no portfolio actions this quarter contributing to the significant decrease from the prior quarter.
We saw elevated levels of losses as a result sister economic conditions. However, it is important to note that we continued to see a reduction in early stage delinquencies despite historically difficult fourth quarter timeframe. As we considered our asset quality trends and drivers, the commercial real estate portfolio remains the most stressed and our primary concern.
Within the commercial real estate portfolio, the single family home builders and the retail projects remain the two highest risk segments, generating the bulk of the credit losses. Of the $258 million of commercial real estate charge-offs in the quarter, 73% were associated with these two segments. The retail portfolio alone comprised nearly 50% of the commercial real estate charge-offs.
Both of these portfolio segments continued to show stress as we work with the borrowers in resolving the credit issues. While historically we have viewed the single family builder portfolio as the highest risk segment, we believe that we have substantially addressed that exposure at this point. Based on the sum total of our activity over the last two and a half years, we do not expect any material future credit impact from this portfolio segment.
The $41 million increase in C&I net charge-offs was primarily associated with losses on four large C&I relationships. The four borrowers represent different industries, but all were significantly impacted by the difficult economic environment over at the past year. Aside from the impact of these loans, the quarter looked much the same as prior quarter.
Given the difficult economic environment, we expect that there will be some continuing challenges in the C&I portfolio as we obtain an analyzed updated financial information throughout the next year, but we feel comfortable regarding the overall performance of the C&I book.
Of particular note is the continued strengthening of our business banking portfolio performance over the past couple of quarters. We continued to feel very good about C&I loans in our auto finance and dealer services portfolio. We do not anticipate any material dealer related losses in the portfolio even in the face of the market disruption over the past year it has clearly been a positive for our portfolio.
Our dealer selection criteria with a focus on multidealership groups have proven itself in this environment. While the outstandings have declined in this portfolio as the utilization on floor plan lines has decreased, we continue to pursue and win new relationships that meet our credit profile.
In a seasonally difficult quarter, the consumer portfolio performed consistent with our expectations. The auto loans and leases continued their strong performance, while the increase net charge-offs in home equity loans continued to be driven by our loss mitigation activities.
There is fewer account in our loss mitigation cues today as we continue to proactively work away through the portfolio. Residential mortgages and the other consumer loan category were consistent with the prior quarter on an adjusted basis. In the residential portfolio, our loss mitigation cues are down 50% from midyear 2009.
We were generally pleased with the results across our consumer portfolio during the quarter. There has been some industry discussion recommend regarding the loss recognition on bankrupt accounts. We take an appropriately conservative stance on recognizing losses on customers, who have filed for bankruptcy protection across the consumer portfolio.
Slide 22 represents the net charge-off ratios associated with the portfolios. Turning to slide 23, we were very pleased with the reduction in non-performing assets in the quarter. A $286 million, 12% reduction was centered in a substantially reduced inflow with significant payment and sales activity.
The reduction was evident across all of the individual portfolios, but was particularly strong in the commercial real estate portfolio. The accruing restructured loans shown at the bottom of the page reflects the impact of our continued efforts, particularly in the residential secured portfolio segment. On a portfolio continues to be affected by the fragile economic environment across our footprint, our commitment to the enhanced portfolio management processes and problem loan resolution activity over the course of 2009 became more evident in this quarter.
Slide 24 provides a reconciliation of the quarterly changes in the non-performing asset balances. You can see the dramatic decrease in the additions line from $900 million last quarter to under $500 million this quarter. Please note that we continue to be focused on the early recognition of non-accruals.
As with the prior quarter, 35% of the total C&I and commercial real estate non-accrual loans were current from a payment standpoint. While the loan losses represent the next largest reduction in the quarter, it is important to focus on the impact of each of the other line items. As you have heard us say over the last year, we have made significant commitment to the size and expertise of our commercial workout group. Payments, return to accrual status, and sales activities are all a function of this group’s impact. Each of these line items represents a high watermark to-date.
As we through slide it is important to include some comments regarding the underlying migration we are seeing in the portfolio. While the non-accruing loans decreased by a net 12% in the quarter, we did see a continued increase in the level of criticized loans, although at less than a 4% rate. This rate of increase is slightly lower than the third quarter results, one indication of some stabilization evident in the portfolio.
As you may recall, and using slide 68 in the appendix as a reference, there was a substantial migrate of out standings into the criticized category, a combination of the classified segments in the second quarter as a result of exporters broad based review activity. The third and fourth quarter increases were manageable given the economic environment.
The commercial real estate portfolio continues to be the primary source of the increases in criticized loan out standings. We were encouraged by the low level of net change in criticized loan levels for both the C&I and business banking segment. This is consistent with our view that the commercial real estate portfolio is the primary driver of the asset quality performance.
Slide 25 provides an overview of the asset quality trend, particularly in relation to our reserve levels. We have discussed the reduction in non-accruing loans and the basis for the increase in the charge-off ratio in the fourth quarter. The 90 plus days past due on accruing line represents a continued focus on active portfolio management and non-accrual treatment decisions.
Steve has provided an overview for the quarter and the bottom half of this slide provides with you some historical context for the resulting ratios. Since we view the entire allowance for credit losses as available to cover loan losses, I will focus on the ACL ratios in my discussion.
The 4.16% of out standings and 80% coverage of non-accruing loans are inline with where we believe the industry will be as of the fourth quarter. The 96% coverage of adjusted non-accruing loans excludes the Franklin exposure. We have established a set of allowance for credit loss benchmarks to provide a basis for assessing the adequacy of the reserve and it was within this framework that we determined the level of increase appropriate for the portfolio.
In conjunction with our asset quality trends the general economic conditions and a forward-looking view of the commercial real estate market we used these benchmarks in determining the $450 million increase to the reserve. There was a $200 million increase in judgmental component including enhancement to the reserve portion. There was also an incremental $200 million allocated primarily to the commercial real estate portfolio addressing the severity of commercial real estate loss given default percentages and a longer term view of the loss emergent time period.
Lastly, approximately $50 million was a function of our normal annual process of adjusting the reserve factors on our consumer portfolios allocated specifically to the residential and home equity portfolio segments. We continue to be pleased with the steady reduction in the 30 day accruing delinquency ratio for the total commercial loan portfolio as shown on slide 26.
This is a result of the focus and intention of our relationship managers and the enhanced portfolio management process we put into place over the course of the past 12 months. As expected, we no accruing loans over 90 days past due.
On slide 27, our early stage consumer delinquency trends are also positive. Led by the significant reduction in the residential portfolio, this decrease represents a core decline as the portfolio sale and timing of loss recognition adjustments in the third quarter did not impact this segment. The 90 plus days past dues were up slightly for the residential portfolio. Should be noted that the residential presentation excludes the government guaranteed and Franklin related loans.
The auto and home equity portfolios performed much as expected. The next four slides provide additional disclosure around our commercial real estate portfolio specifically the reconciliation of the balance reduction and the introduction of the core versus non-core concept. You won’t be able to find the product type and maturity schedules from the prior quarter on slides 82 through 84 in the appendix.
Slide 28 shows the material decrease in the level of commercial real estate outstanding since the year ago quarter. While the net reduction of $2.4 billion is significant and analysis of the specific components is important we originated only $255 million of new commercial real estate credit, but did have over $1 billion of take downs on existing projects. The remaining unfunded commitments associated with commercial real estate projects.
The remaining unfunded commitment associated with commercial real estate projects is not material. The $1.7 billion of payments is a very significant number and is a function of our commitment to reduce the commercial real estate concentration via portfolio management activities such as right sizing loans with our borrowers. The increased expertise in our commercial workout area and the ramp up in payments over the course of the past two quarters reflects this commitment.
As we have previously indicated, this past year we embarked on an exercise to properly classify our loans. In the first quarter we made it initial series of changes primarily centered on moving owner occupied loans from commercial real estate to C&I based on the cash flow underwriting of the credits. We made similar adjustments in the fourth quarter primarily associated with loans to healthcare entities and colleges and universities.
We believe that loans underwritten based on cash flow from operations should be considered as commercial loans secured by real estate and not housed in the commercial real estate portfolio, which is a real estate project oriented portfolio. The final portion of the reduction was associated with the charge-off activity.
Slide 29 provides a summary of the credit quality metric for commercial real estate portfolio including a breakout of the single family homebuilder and retail project portfolio segments. Including the impact of the fourth quarter reserve build, we have taken a 31% grossed up credit mark on the remaining $857 million single family homebuilder portfolio.
As I indicated earlier, we do not expect any material credit issues from the homebuilder segment going forward. The retail portfolio has a 20% credit mark, which we also believe is an appropriate mark given our current assessment of the projects within the portfolio. The overall increase in the reserve level to 9.94% of loans represents a proactive assessment of the portfolio and the market dynamics likely to exist in the coming quarters.
Slide 30 provides the basis for distinguishing between the core and non-core portions of our commercial real estate portfolio. The key to the core designation is a meaningful relationship Midwest footprint projects and adequate returns on capital. This segregation gives our investors increased transparency as it allows us to provide ongoing performance metrics.
Slide 31 provides the breakdown of the commercial real as at the end of the quarter with the September balances and credit metrics provided to facilitate comparisons. You can see the breakdown between the designations with core comprising 53% of the total. These borrowers we intend to support, grow, and develop.
While the core portfolio as of December is very clean, we have maintained a 4% reserve given the economic environment and commercial real-estate market conditions. For the non-core portfolio, we have established very substantial reserves and calculated a credit mark. This 27% ratio indicates the aggregate credit mark incorporating both prior charge-offs and existing reserves associated with the loans in the portfolio.
Does not include any full balance charge-offs, the charge-offs picking on well and that has been paid off. The 27% mark includes a 40% factor on loans managed within the special assets division. We believe that this level of credit actions puts us in a strong position of flexibility to continue to deal proactively with future credit issues.
Let me turn the presentation back to Steve for wrap up.
Thank you, Tim. Turning to slide 32, let me share with you my expectations about 2010’s performance. First, we still do not believe there’ll be any significant economic turnaround this year. We do see signs of stabilization, and a key assumption for our current outlook comments is that the economy stabilizes at or near the current level throughout the year. With that in mind, we expect net charge-offs and provision expense will be meaningfully below 2009 levels.
For us, 2009 is the peak year. Our allowance for credit losses is expected the decline on an absolute basis from its year-end level, reflecting the utilization of existing reserves for elevated inherent losses. We expect our net interest margin will improve from its 3.19% level in the fourth quarter.
We anticipate strong growth in core deposits as we grow our retail and business customer bases as well as increase cross sell performance to existing customers. Loan growth is expected to be flat up to slightly. On one hand, we expect increases in C&I and certain consumer segments as customer confidence improves. However, commercial real estate loans are expected to continue to decline. Fee income will continue to be flat to slightly down.
However, we expect growth in asset management as well as brokerage and insurance revenues offset in part by declines in NSF overdraft fees. Expenses are expected to increase reflecting the investment in growth and implementation of key strategic initiatives. We believe this set of expectations will return to us quarterly profitable performance sometime during the year.
Let me use the next slide to provide some perspective on slide 33, we show the quarterly improvement in pre-tax, pre-provision performance. It also shows that we’re targeting the continued improvement, $275 million in the third quarter. This is an aggressive target for sure, but one we feel is achievable. It will be dependent primarily on our ability to increase net interest income, control our expense growth by offsetting the cost of investments with improved efficiencies.
The growth in net interest income is expected to reflect the combination of factors, including loan and investment securities growth, continued growth in lower cost core deposits, and the resulting improved funding mix and a higher net interest margin reflecting improved loan and deposit spreads.
Let me use the next two slides to review key messages that I hope that come to our comments today. Throughout 2009, we reviewed all assets on balance sheet. We specifically commented frequently about the in-depth review of our loan portfolios, as well as the strengthening of our credit management and review processes begun last January. These reviews are completed.
Second, our loan loss reserves are strong and we’re better positioned to continue to address the resolution of problem credits. The rate of increase in criticized and classified loans as well as tin flow into NPAs is slowing. Net charge-offs and provision expense reached their high watermark in 2009.
The core and non-core segmentation of our commercial real estate portfolio provides greater transparency and facilitates its further reduction. This will result in improved loan mix overtime. We’ve made significant progress in addressing key commercial loan portfolio concerns especially Franklin and the single family homebuilder segment of the commercial real estate portfolio.
Our C&I and consumer loan portfolios continue to perform within expectations given the state of the economy. We continue to believe our consumer loan portfolio performance will outperform many of our peers on a relative basis. I think it’s also important to remember that we’re not yet out of this economic cycle. Negative credit migration is expected to continue, though at a slower rate than we saw in 2009.
Slide 35 and continuing our liquidity position has been built to a very strong level, the strongest in many years. Our funding mix is much stronger and balanced given the increase in core deposits. We’re growing households and business relationships. Our capital sufficient to weather a stressed economic scenario, we have no current plan to raise new capital.
We’re better positioned to eventually repay the $1.4 billion TARP capital. We’re continuing to make progress in growing pre-tax pre-provision earnings and our goal is $275 million by the third quarter is aggressive, but we believe it’s achievable. We’re continuing to strengthen our manage team and the depth of expertise at all levels.
We’ve shifted the offense as reflected in our new hiring and the implementation of our strategic plan and we’ll continue to make investments targeted to growth key fee businesses. We enjoy one of the better fee incomes to revenue ratios amongst our regional peer banks.
Lastly, when we put it all together, we believe we’ll return to quarterly profitability sometime during 2010. As I said at that time beginning 2009 was a very difficult year. We’re all excited about the possibilities for 2010. We still have credit challenges, but we’re much better prepared to deal with them today than a year ago, and I think those challenges going forward will be much more manage afternoon. We’re getting stronger every day at Huntington.
So thank you for your interest. Operator, we’ll now take questions, Courtney, back to you.
(Operator Instructions) Your first question comes from Dave Rochester - FBR Capital Markets.
Dave Rochester - FBR Capital Markets
My first question is on the CRE portfolio. It sounds like you’re very comfortable now with the write-downs on the single family homebuilder portfolio. You’re talking about continued stress in the CRE portion for 2010. Can you talk about the degree of flexibility or cushion you factored into your reserve on this portfolio that’s giving you comfort that the reserve builds are behind you? Is that 20% mark on the retail basically factor in further declines in values and increased frequency if we kind of bump along the bottom in stabilization?
Dave, this is Tim. I think the credit mark is designed to convey exactly that. We have looked at the retail portfolio very, very closely. We take a forward looking view of things such as an example factor that into the values we use. At the end of the day, we believe we’re comfortable or we have sufficiently addressed tissues at that 20% credit mark.
Dave Rochester - FBR Capital Markets
Then just a quick follow-up on the reserve level itself. You talked about on an absolute basis declining. Should we see something like that occurring as early as the first quarter, or is that more like a second half type of event?
No, I think second half. To give you a little more guidance that decline is modest. We’re not going to get to profitability off some significant reserve recapture Dave, but we spent a lot of time throughout the year going through these portfolios. We spent a lot of time, particularly in the fourth quarter, looking at the trend and other information and projecting, I think as most people do a continue soft commercial real-estate market intent. We think we’ve gotten ourselves in a reasonable and prudent level with the reserve build.
Your next question comes from Bob Patten - Morgan Keegan.
Bob Patten - Morgan Keegan
So along the same lines, on the non-core CRE portfolio, we have a 27% mark. Now, obviously we’re going to slowly try to exit this portfolio. You may have to induce, bigger marks are do you get sales done or do get deals done. How did you come to the 27% number?
The 27% is an aggregation of the entire portfolio. So, there’s a portion of that 40 plus percent credit mark. There’s a portion of that’s below 27. I think it’s important to talk a little bit about what’s in there. Within the non-core is a significant amount of what we call investment real estate loans that tend to be smaller commercial loans doesn’t mean that they’re core performers.
It just means that’s not businesses that were going engage in going forward. So there’s a real mix in that portfolio, and from an aggregate level, the 27% makes a lot of sense to us, incorporate what we see today as well as what we think is going to happen in the coming months.
There was a tremendous effort in scrubbing this book-to-break it core/non-core and a lot of sensitivity analysis. So we’ve got a lot of confidence around the core. These are identified customers. Randy, why don’t you just comment briefly about that if you would, so will you get a sense of how we’re viewing this.
Should, Steve. I’d be happy to. As you can imagine, I’ve got a passion about this the core and non-core development, was an ongoing process that not only engage the business segment but included credit administration, risk, and policy. We looked at the core portfolio, just to give you some metrics of that. On average they’ve been customers of this bank for well over a decade. I have nearly 30 years in the business.
Whenever we address some of the sensitivity issues that Steve mentioned, if you look at this portfolio on a performing basis, and use a 7%, 25 year amortization, on average this portfolio has over a 130 debt service cover. We have on each and every borrower global cash flows on their business. We actually have verified the cash of the guarantor 95 plus percent of this book does have guarantors.
We have operating level cash flows, and even with this, what we believe to be good portfolio of commercial real estate, we have an ongoing review process that we look at a portion if not all of these loans on a rolling monthly basis. So, we have an ongoing prudent process to be sure that we are identifying in the early stages any risk that maybe portfolio. So that was a rigorous process that brought to us these conclusions, and we’re very comfortable with where we sit today.
Thank you. I would say, last year we were almost in the firehouse stage for much of the year, absorbing, and I think many of you use the catch a falling knife analogy. We’ve caught it we’ve got a tight grip on it, a consequence that is calendar year shifting into a value maximization out of what might be thought of as a triage and maybe even a bit of a dumping approach.
Your next question comes from Matthew O’Connor - Deutsche Bank.
Matthew O’Connor - Deutsche Bank
If I could follow up on the positive net interest margin outlook, looking at the liability side of things it seems like there’s a lot of room to reprice your core CDs. I think they’re costing you north of 3% and there are still some higher cost broke up CDs that I seem to be running off. So, I’m just wondering, given flexibility overtime on the liability side, can you give us a sense of the magnitude of the margin expansion that you’re expecting here?
Thanks, Matt. As for as the margin expansion, I think that we will see the benefit of that deposit book repricing that our average going on rate for time deposits is right around 1%. That clearly is a lift coming from that. I think our greater opportunity, as for as the deposit base, is continuing to see the positive mix change that we’re generating here.
As you’ve noted, our time deposit balances are going down. We’re seeing very strong growth in the core transaction type accounts and we’ve been underweighted in that historically compared to what we think the industry is performing at. So that clearly will add additional margin benefit for us and historically we’ve talked about that being upwards of 20 to 25 basis points just for the lift from the deposit mix change. I think that kind of gives you a ballpark range.
Matthew O’Connor - Deutsche Bank
Just separately, the inflows into non-performer were down sharply quarter-to-quarter. Is there, do you think this level is sustainable, or could it tick up a little? I guess is there anything unusual that made the number so low?
In the third quarter, we tried to really proactively identify what we saw possibly emerging. We think we did that. That contributed in part, maybe large part, to the fourth quarter slowdown, but we don’t see that as a one quarter phenomenon. Our early on view of the first quarter is encouraging in that and in other respects.
Matt, I would add that we didn’t change the focus on early identification, 35% of them are still current. 50% of them are less than 90 days past due. So the decrease was not a function of a change in treatment in any way.
The bulk of the reduction, again, was cash payment. So is fundamentally it reflects our efforts to direct activity and resolution of credit.
Your next question comes from Brian Foran - Goldman Sachs.
Brian Foran - Goldman Sachs
I’m sorry, if I missed this at the beginning, but a lot of banks were putting excess liquidity to work over the past three or five months. Did you kind of walk through why you were carrying the excess liquidity?
We’ve continued to carry the excess liquidity just because of deposit growth we’ve experienced throughout the last quarter. Our core deposits are up $1.3 billion from third quarter to fourth quarter, and that’s resulted in a net increase to our earning asset base. So we think that’s a distinguishing factor compared to some of our competitors is that with their shrinking balance sheet, they probably showed a wider expansion of their margin.
If we would have just kept our balance sheet flat and not had that deposit growth, our margins, in instead of 319, would have been a 326. We think it’s prudent for us to continue to focus on growing core deposit relationships and we’ll continue to focus on that going forward.
We shared earlier strategically that we believe we can take the balance sheet and do a deposit funded balance sheet, and we’re making progress in that regard with core deposits.
Brian Foran - Goldman Sachs
If I could follow up you kind of touched on it, but if I translate just on the excess liquidity point, the margin point you’re making to net interest income dollars. Are you going to be rolling off kind of limited spread securities, and therefore margin goes up, but all else equal, net interest income isn’t really affected, or is this a case where you’re going to be take excess liquidity and remixing it into higher yield loans or securities?
One, we think the net interest income will continue to improve over the next several quarters and we think that could be a key driver for us to get to the $275 million pre-tax, pre-provision levels. I think that they were trying to position the balance sheet in such a way right now so that we’re investing the proceeds from our deposit growth in fairly short dated or variable rate securities, so that as rates do start to tick up we’re better position he’d to be able to leverage that increase in rate.
The other thing that we do have available at some point in time, this is that we are going to start to see the loan side of the balance sheet start to pick up again. We saw a little built of that with the indirect although our pipeline is very strong on the commercial, the C&I book and so we think that will also provide incremental lift compared to what we’re seeing now as far as 230 type of investment yield on new asset purchases there. The asset mix, as question is one of the bigger opportunities for us. We’re very, very liquid.
Your next question comes from Scott Siefers - Sandler O’Neill.
Scott Siefers - Sandler O’Neill
Just on the guidance, you gave a lot of good detail on the expense expectations, for example. I guess I was a bit surprised that almost all of the guidance for the higher pre-provision earnings comes from the revenue side, and there’s no real expectation for lower expenses. I guess I’m just curious what type of flexibility or contingency plans you guys would have on the cost side to help you meet the pre provision earnings goal if the revenue side doesn’t pan out?
Your question would reflect the answer. If we’re not getting the revenue, we’ll dial back the expenses, but the expense build reflect an intent to invest on a multiyear basis to deliver a strategic plan that has a number of different growth dimensions, and has a ramp up that doesn’t entirely come through in our outlook for 2010, but if we need to adjust it, we will, Scott.
Your next question comes from Ken Zerbe - Morgan Stanley.
Ken Zerbe - Morgan Stanley
My first question is I was hoping could you just explain specifically again what exactly changed with the reserving methodology. Really, I’m just trying to understand, what was it about fourth quarter that you were not doing in third quarter? Did you see any incremental deterioration? Really, I’m just trying to get at, if you go through this sort of annual reviews, are we going to see another big reserve build at some point in the future?
We went through, what I would call our annual review of the process. I think that was clearly colored this quarter by the market, and in particular, the commercial real estate market, how we’re thinking about it. We also were faced with thinking about changes in our asset quality conditions. Our non-performers were down $500 million of inflow is a significant number.
Our criticized loan levels continue to increase, albeit at a slower rate. So as we thought about all of those factors combined, we felt it was prudent to increase the reserve. I provided the breakdown in the comments, and I’m happy to go back through that if would you like a fair amount of it had to do with commercial real estate, both in terms of the severity side of the equation as well as the timeframe over which we’re seeing losses.
We also incorporated a more substantial judgmental portion to the reserve, specifically enhanced our economic reserve modeling portion of that and then the last piece was what I would call a normal or very regular change in our consumer reserve factors. That’s something that we have been doing for well over five years now, and there have been both a positive and negative moves over the course of that five year period.
Ken Zerbe - Morgan Stanley
Is there any explicit assumptions about you would need to see, basically you’d have to hit your guidance of lower NPLs or reduction in classifieds in order to make sure that the reserve is adequate or if you see sort of ongoing NPL inflows at reduced levels, but still elevated levels, that that would require additional reserve build?
We’ve got a series of benchmarks that we’ve put together that provide an overall view of the adequacy going forward. Certainly, changes in non-accruing loans are one of those, but it is not the only one. As you mentioned the quality, if I can use that term in conjunction with non-accruing loans, would have a significant impact on how we think about the reserve level going forward.
Ken, as rather the consequence of the review activity monthly, there’s a shared conclusion that we have turned the corner, we have expectations of improvement, and to be prudent about potential or ongoing degradation. We’re suggesting that reserve recapture would be modest in the course of ‘10, even though our expectation is that we’ll be able to demonstrate meaningful improvement throughout the year.
Your next question comes from Erika Penala - UBS.
Erika Penala - UBS
I apologize if I missed this, but when you comb through your commercial real estate portfolio and stress tested it, did you stress test debt service coverage ratio for higher interest rate?
Yes, we used a 7% fixed.
Erika Penala - UBS
Could you explain that?
What we looked at was from a permanent market, if it did exist today, we felt that the normalized rate would be at a 7% constant, so we did that with a 25 year end, which would take your constant into the low 8 and with that it would have a 130 debt service covered.
Whenever we would look at the contractual rate, which if we reflect back to 12 months to 24 months, whenever it was a very aggressive pricing markets, and these loans were based upon LIBOR, maybe a spread as low as 200 over LIBOR that contractual rate, the actual debt service coverage goes up into the 140’s.
So the note rate that they’re paying us has a better coverage than what we would have used with the 7%, so we raised it to the 7% to give some cushion to know if we’ve had the ability to take the loan out. So, that was kind of the margin and even with 27%, we still feel that we have adequate debt service covered with that 1.3.
Erika Penala - UBS
I know it’s hard to generalize, given the different asset classes within the portfolio, but the 1 to 3 debt service coverage, what does that assume in terms of forward rent?
What we would do, we always are constantly reappraising as required, and we will use those appraises and look at the rents and as we looking going forward the rents that we’re seeing are downward there is no doubt about that. So as we model those and we go forward and we put together the pro forma cash flow, we generally take those rents down.
Erika Penala - UBS
Just a quick question, following up with Matt’s question. On the margin guidance, what are you assuming in terms of the underlying interest rate environment?
Our base underlying assumption includes the forward curve and so it assumes basically the short earned of the curve stays fairly flat until the end of the year. I think there’s a 25 basis point increase in the third or fourth quarter, but we’re not assuming essential any significant lift coming from. That we tend to manage our interest rate risk position essentially we possibly can.
Your next question comes from Ken Usdin - Banc of America.
Ken Usdin - Banc of America
One question on capital, Steve, hearing your comments that if you really good about where your capital levels are to with stand any type of adverse scenario, I’m just wondering, can you give us some understanding kind of where you expect capital to live what you’re going to be managing to over the longer term?
First of all, we’re comfortable work with where we are. We’re expecting at some point there’s going to be some regulatory guidance that emerges in 10. We think we’re prudent with where we are and we expect to turning to profitability, be generating capital. So that is the basis for the current position.
Ken Usdin - Banc of America
So we just to have wait and see on what the real ratios are before you can actually set us?
We can, but we don’t think we’re not convinced we’d be outside of any ranges to begin with and we certainly that wouldn’t expect to be meaningfully outside.
Ken Usdin - Banc of America
With regards to the DTA as you get to that point where you do expect profitability, what needs to occur to be able to recapture the rest of the portion of the DTA that’s currently excluded from your regulatory ratios?
The regulatory calculations get a little complex, but essentially will take about a four quarter process before you start to see some of that benefit return, but it’s really utilization of the reserves that are established that’s could create some of the reduction in that DTA disallowance.
Ken Usdin - Banc of America
So that would still be a ways away.
Your final question comes from Jeff Davis - FTN Capital.
Jeff Davis - FTN Capital
Steve, the FDIC presumably is going to ramp up closures in Michigan. I know you’ve done one deal up there. What’s your interest in expanding your footprint and depository base up the FDIC?
Jeff, as we’ve said before, we would opportunistically look at acquiring with assisted transactions and possibly a variety of flavors, but it’s really important to us. Our primary focus is getting to profitability, executing our strategic plan, driving the core. We’re not feeling any pressure to do another little deal in Michigan or for that matter anywhere else and there’s a distraction factor doing these little things. I don’t mean to be demeaning in terms of any acquisition.
Everybody, this is Jay Gould. I apologize for the couple of people that were still in the queue. If you have those questions, please bring them to my attention, and I’ll sit down with you, or Don, or whomever we need to get together, but we have another time commitment coming right upon us. So, thanks for your participating. We’ll appreciate your interest Huntington. We’ll talk to you later. Good bye.
This concludes today’s conference call. You may now disconnect.
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