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Bank of Ozarks Inc

Q4 2013 Earnings Conference Call

Jan 17, 2014 / 11:00 a.m. E.T.

Executives

Susan Blair – EVP

George Gleason – Chairman and CEO

Analysts

Jennifer Demba – SunTrust

Brian Zabora – KBW Research

Michael Rose – Raymond James

Peyton Green – Sterne, Agee & Leach

Andy Stapp – Merrion Capital Group

Matt Olney – Stephens, Inc.

Blair Brantley – BB&T Capital Markets

Brian Martin – FIG Partners

Operator

Good day, everyone, and welcome to the Bank of the Ozarks Incorporated fourth quarter earnings release conference. Today's call is being recorded.

At this time, I would like to turn the conference call over to Susan Blair. Please go ahead.

Susan Blair

Good morning. I'm Susan Blair, Executive Vice President in charge of investor relations for Bank of the Ozarks. The purpose of this call is to discuss the Company's results for the quarter just ended and our outlook for upcoming quarters. Our goal is to make this call as useful as possible in understanding our recent operating results and outlook for the future.

To that end, we may make certain forward-looking statements about our plans, goals, expectations, thoughts, beliefs, estimates, and outlook including statements about economic, real estate market, competitive, credit market, and interest rate conditions, revenue growth, net income and earnings per share, net interest margin, net interest income, noninterest income including service charge income, mortgage lending income, trust income, net FDIC loss share accretion income, other income from loss share and purchased non-covered loans, and gains on sales of foreclosed assets including foreclosed assets covered by FDIC loss share agreements, noninterest expense, our efficiency ratio, including our goals for achieving a sub-40% and eventually a sub-30% efficiency ratio, asset quality and our various asset quality ratios, our expectations for net charge-offs and our net charge-off ratios, our allowance for loan and lease losses; loan, lease, and deposit growth, including growth in our legacy loan and lease portfolio through 2014; growth from unfunded closed loans; and growth in earning assets in 2014, 2015 and beyond; changes in expected cash flows of our covered loan portfolio; changes in the value and volume of our securities portfolio; the opening and relocating of banking offices; our goals for traditional mergers and acquisitions; changes in growth in our staff, including our plans to build our corporate loan specialties group team and add new lease originators; other opportunities to properly deploy capital; and our goal of improving on our 2013 earnings in 2014.

You should understand that our actual results may differ materially from those projected in the forward-looking statements, due to a number of risks and uncertainties, some of which we will point out during the course of this call. For a list of certain risks associated with our business, you should also refer to the forward-looking information caption of the Management's Discussion and Analysis section of our periodic public reports, the forward-looking statements caption of our most recent earnings release, and the description of certain risk factors contained in our most recent Annual Report on Form 10-K, all as filed with the SEC. Forward-looking statements made by the Company and its management are based on estimates, projections, beliefs, and assumptions of management at the time of such statements and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statement based on the occurance of future events, the receipt of new information or otherwise. Any references to non-GAAP financial measures are meant to provide meaningful insight and are reconciled with GAAP in our earnings press release.

Now, let me turn the call over to our Chairman and Chief Executive Officer, George Gleason.

George Gleason

Good morning and thank you for joining today's call. We are pleased to report our fourth-quarter results, which provided an excellent finish to another excellent year. In today's call, in addition to discussing our recent results, we're going to make a number of comments regarding strategic plans for the future. Let's get to some details.

Net interest income is traditionally our largest source of revenue and as a function of both the volume of average earnings assets and net interest margin. Of course, loans and leases comprise the majority of our earning assets. In the quarter just ended, our loans and leases, excluding covered loans and purchased non-covered loans, grew $110 million, bringing our total growth in such loans and leases for 2013 to $517 million.

Since 2012, we had predicted a minimum 2013 growth in loans and leases of $360 million. And in our January 2013 conference, call we introduced the possibility that such loans and leases could grow as much as $480 million during 2013. We are pleased to report that our actual results exceeded both that minimum goal and the stretch goal.

Our unfunded balance of closed loans increased another $78 million during the quarter just ended, and now stands at $1.21 billion, up substantially from $769 million at December 31, 2012. While some portion of this unfunded balance will not ultimately be advanced, we expect that the vast majority will be advanced. This has favorable implications for future growth in loans and leases outstanding.

We are very pleased with the growth in both funded and unfunded balances of loans and leases in 2013. But we are even more pleased with the credit and interest rate risk profile of the loans and leases we booked.

Throughout last year, we operated in an intensely competitive environment, in which some competitors were, in our judgment, taking on excessive credit risk and excessive interest rate risk to generate volume. In contrast, we believe our lending teams were maintaining very sound pricing and credit discipline.

We obtained large amounts of cash equity in most new loans. We continued to require appropriate risk-adjusted pricing, and we actually increased our percentage of variable-rate loans from 58.2% of loans and leases, excluding covered loans and purchased non-covered loans, at year-end 2012 to 62.7% of loans at year-end 2013.

It took a lot of hard work to achieve our 2013 loan and lease growth while adhering to stringent credit and stringent interest rate risk standards, but we believe that discipline will distinguish us in a very positive way in the future from banks that may have disregarded conservative credit and interest rate risk standards in order to achieve growth.

In regard to net interest margin, our fourth-quarter net interest margin on a fully taxable equivalent basis was 5.63%, which is an 8-basis-point increase from the third quarter of 2013 but a 21-basis-point decrease from the from fourth quarter of 2012.

In our January 2013 conference call, we provided guidance that if we achieved $480 million in net growth in loans and leases, excluding covered loans and other purchased loans, we expected our quarterly net interest margin for 2013 to range somewhere between 5.80% and 5.55%. That guidance was almost spot on, as our net interest margin for the four quarters of 2013 ranged from 5.83%, just 3 basis points above the top of that guidance range, to 5.55%, which was exactly equal to the lower end of that guidance range. All this resulted in favorable net interest income in 2013.

Let's provide some updated guidance regarding loan and lease growth, and investment portfolio growth.

First, we expect excellent growth in loans and leases in 2014. Our quarterly results for loan and lease growth in 2014 will likely vary substantially from quarter to quarter, just as they did in 2013.

In our last conference call in October, we increased our 2014 loan and lease growth guidance, excluding covered loans and purchased non-covered loans, upward from a minimum of $480 million to a minimum of $540 million. We are now further increasing that guidance to a minimum of $600 million.

In recent years, we have demonstrated an ability to grow loans in a slow growth economy. While doing this, we have also been constantly striving to enhance our future capabilities to produce increasing volumes of good quality, good yielding, earning assets. As a result, we believe we are strategically positioned for even stronger growth in earnings assets in the years to come.

To explain that we want to discuss briefly our five engines for growth and earning assets, apart from acquisitions. Currently the strongest of our five organic growth engines is Real Estate Specialties Group, which has contributed the majority of our organic growth in recent years and is well known from our numerous discussions of this unit in previous conference calls and public presentations.

The growth capabilities of Real Estate Specialties Group have expanded in recent years with the continued growth and development of our team in Dallas, and the opening of additional Real Estate Specialties Group offices in Austin, Texas in January 2012; and Atlanta, Georgia in July 2012; and in New York City in July 2013.

This expansion is continuing with the long-planned opening of a Houston Real Estate Specialties Group office on January 2 of this year and the planned opening of a Los Angeles Real Estate Specialties Group office in February of this year. You can probably see while why we think Real Estate Specialties Group will continue to be our strongest engine for organic growth in earning assets for some years to come.

With that said, we believe that our organic growth engines – our other organic growth engines will continue to contribute to our growth, and will in fact contribute more to our growth in earning assets in 2014 and future years than they have in recent years.

Our second most important engine for organic growth and earning assets is our vast network of community banking offices in seven states.

Frankly, our community and banking offices have delivered only modest growth in earning assets in recent years. In many of our markets we have faced intense competition from competitors offering long-term, fixed, low rate loans often on very aggressive credit terms. With the recent uptick in rates and the beginning of Fed tapering, some of these competitors seem to be rethinking their long-term fixed low rate strategies.

Similarly, a number of our community banking offices are from our seven FDIC-assisted acquisitions, and only recently have we begun to see a meaningful increase in new loan opportunities in those markets. Accordingly, we believe that our community banking offices will be a much more meaningful growth engine in 2014 and beyond.

To capitalize on this perceived growing opportunity, early this month we promoted Matt Reddin to Director of Community Bank Lending and John Carter to Deputy Director of Community Bank Lending. These individuals will be our offensive coordinators to provide additional leadership to our community banking offices and lenders in those offices in order to maximize good quality loan growth opportunities throughout our community banking offices.

Our third organic growth engine for earning assets is our leasing division. Our leasing division has operated as a small but consistently high-performing and important part of our Company since 2003.

Scott Hastings founded that division for us and continues to lead it. Prior to joining our Company, Scott ran an $800 million lease portfolio for a major national company.

We believe the timing is right to make leasing a more important part of our balance sheet. We think that we can grow leasing from its current $86 million in outstanding balances to several times is current size over the next five years. The magnitude of that growth in leasing will depend on a variety of factors, including economic and competitive conditions, and our ability to higher quality originators. – hire quality originators.

A 25% compounded annual growth rate in leases would triple our lease portfolio size in five years, and a 35% compounded annual growth rate would increase the portfolio to about 4.5 times its current size in five years.

As evidenced by our very low loss rates on leases during the recent downturn, we have been very conservative with our credit underwriting for this portfolio and we expect to continue to be very conservative. Our growth is expected to come by adding originators and expanding our customer base, and not as a result of changes in our credit or pricing standards.

Our fourth and newest engine for organic growth is a new part of our Company. For some time now we have been searching for a leader around who to build a non-real estate lending team equivalent to our Real Estate Specialties Group team. As a result of the search, Manish Raj [ph] joined our Company recently as president of our newly created corporate loans specialties group to be based in Frisco, Texas.

While this unit will focus on non-real estate lending, its business strategy is going to be very similar to the business strategy we have utilized with great success at Real Estate Specialties Group for the past 11 years. Corporate Loan Specialties Group will pursue complex transactions in which our modeling, structuring, and execution capabilities, combined with the deep expertise of the team we expect to build, should allow us to achieve very favorable returns while adhering to conservative credit standards.

Much like Real Estate Specialties Group, we expect Corporate Loan Specialties Group to start slowly and be built over time in a very careful and methodical way. Our fifth engine for organic growth and earning assets is our investment portfolio. As we have said many times in recent years, we have been very defensive in managing our investment portfolio and we have maintained its size at near the minimum level needed to manage our balance sheet.

We've said repeatedly that we expect to significantly increase the size of our investment portfolio at a time when interest rate conditions and market conditions make it advantageous to do so. We continue to think that we may be one to three years away from such an advantageous opportunity to significantly grow that portfolio, but we continue to believe that higher interest rates will come, providing an excellent entry point for portfolio growth.

A great deal of work has gone into building the talent and the infrastructure needed to make all five of our organic growth engines effective. Hopefully, from this discussion you can see why we are very optimistic about our ability to achieve increasing levels of growth in earnings assets in 2014, 2015, and beyond.

With our new Houston Real Estate Specialties Group office and our Corporate Loan Specialties Group both opening in January, followed by the expected opening of the Los Angeles Real Estate Specialties Group office in February, accompanied by the expected steady stream of lease originators we hope to hire over the course of 2014, and considering the infrastructure that we have already put in place throughout our Company to support these various growth efforts, we will see resulting increases in overhead from the outset of 2014.

This will put some pressure on first quarter 2014 earnings, which is always a challenging quarter due to normal seasonal factors. But we believe that as 2014 progresses, these initiatives will result in meaningful increases in both earning assets and net income.

Let's provide some updated guidance on net interest margin.

For the full year of 2013 our net interest margin declined 28 basis points, from 5.91% in 2012 to 5.63% in 2013. We expect some further decline in our net interest margin in 2014.

Considering our growth expectations, the dynamic interest rate environment that we expect, and the continued pay down of our covered loan portfolio, frankly it is difficult to precisely predict our net interest margin for each quarter or the full year of 2014.

But our expectation is that our 2014 net interest margin will decline, but that the year-over-year decline from 2013 to 2014 will be less than the 28 basis points decline in net interest margin from 2012 to 2013. Included in this guidance is the expectation that our cost of interest-bearing deposits will increase slightly in coming quarters as we continue to accelerate deposit-gathering activities to fund expected future loan and lease growth.

Of course, all this guidance for both the volume of earning assets and our net interest margin ignores the impact of additional acquisitions, including our pending acquisition in Texas, which is expected to close in early March. While that acquisition is small in size, we believe the expanded presence it will provide us in Austin, Houston, and San Antonio will be an important addition to our franchise.

Let's shift now to noninterest income.

Income from deposit account service charges is traditionally our largest source of noninterest income. Service charge income for both the quarter and the year just ended were records and increased 25.7% and 11.6% respectively, compared to the fourth quarter and full-year of 2012. Our fourth-quarter results reflect both the significant organic growth in core deposit customers that we've achieved throughout 2013 and a full quarter's service charge income from the former FNB Shelby offices.

Mortgage lending income for the quarter just ended decreased 34.8% compared to the fourth quarter of 2012. As we all know, mortgage interest rates have increased significantly over the course of the last three quarters, and this has been evident in our declining mortgage lending income in each of the last three quarters.

Trust income for the quarter just ended increased 38.9% compared to the fourth quarter of 2012 and was at a new record level. Our fourth-quarter trust income included a full quarter's trust income from the former FNB Shelby offices.

Gains on sales of other assets – and let me clarify, that's net gains – were $1.80 million in the quarter just ended compared to $2.43 million in the fourth quarter of 2012, and $2.50 million in this year's third quarter.

In recent years such gains have been a meaningful contributor in every quarter. In most quarters these gains have been primarily attributable to gains on sales of foreclosed assets covered by loss share agreements. We expect that net gains will continue to be a significant income item for many quarters to come.

As part of our FDIC-assisted acquisitions, we record a receivable from the FDIC based on expected future loss share payments. And we record a callback payable to the FDIC based on sums expected to be owed to the FDIC at the end of the applicable loss share periods. The FDIC loss share receivable and the related claw back payable are discounted to net present values, and such discounts are accreted into income over the relevant time periods.

In the quarter just ended the resulting net accretion income was $0.90 million, a decrease from $1.34 million in the fourth quarter of 2012 and $1.40 million in this year's third quarter. Of course, this income category is expected to go down as we continue to collect and reduce our FDIC loss share receivable.

The decrease in this net accretion income in recent quarters, particularly the last two quarters, has reflected another phenomenon. As we have more experience with our portfolios of covered loans, and as these portfolios become more seasoned, we are increasingly revising up the projected cash flows of certain loans where we originally expected an elevated risk of loss, but no longer believe that such loans have an elevated risk of loss.

There are many loans where principal reductions through amortization, unscheduled principal payments, provision of additional collateral, improvement in the borrower's financial condition or other factors have in our view largely eliminated the elevated risk of loss. The effect of these upward revisions on these loans is to accrete into interest income over the remaining life of the loan the previous non-accretable difference.

Correspondingly, to amortized against accretion income over the remaining life of the loan or the remaining loss share term – whichever is shorter – the related FDIC loss share receivable. This is one of the reasons for the decline in income from accretion of our FDIC loss share receivable in the quarter just ended. This was also the primary factor in the increase in the yield on covered loans from 8.93% in the second quarter of 2013 to 9.49% in the third quarter and to 10.66% in the final quarter of 2013.

Based on the improving risk profile and greater seasoning in many of our covered loans, we expect to identify additional loans in future quarters for which it will be appropriate to upwardly revise our estimated future cash flows. These, again, are loans in which any perceived elevated credit risk will have been resolved, and therefore, it will be appropriate to accrete the previous non-accretable difference in income over the remaining life of the loan and amortize any related FDIC loss share receivable over the shorter of the remaining life of the loan or the remaining loss share term.

The net effect of this will be positive for net income, since we will have an additional $1.25 of interest income for every $1.00 of reduced non-interest income related to amortization of the FDIC loss share receivable. Of course, if this plays out as expected and as we discussed in last quarter's conference call, income from accretion of our FDIC loss share receivable will tend to decline in future quarters with corresponding increases in yields on covered loans. We saw that phenomenon play out in the quarter just ended.

In addition, non-interest income in the quarter just ended included other income from loss share and purchased non-covered loans of $4.83 million compared to $3.19 million in the fourth quarter of 2012 and $2.48 million in this year's third quarter. This line item includes certain miscellaneous debits and credits related to the accounting for loss share assets and purchased non-covered loans, but it consists primarily of income recognized when we collect more money from covered loans and purchased non-covered loans than we expected we would collect.

We refer to these additional sums as recovery income. It is likely that this will continue to be a meaningful income item for many quarters to come. Because it can be significantly impacted by loan prepayments, other income from loss share and purchased non-covered loans will tend to vary quite a bit from quarter to quarter.

You will note from our press release that we had $0.7 million for provision expense in the quarter just ended for covered loans. Obviously, that number reflects covered loans where we were not conservative enough in our initial estimates of cash flows. However, if you consider that number in the context of our gains on sales of other assets, including assets covered by loss share and our other income from covered loans and purchased non-covered loans, you will see that our acquisitions continue to have a very positive impact on income.

Let's turn to non-interest expense.

In recent conference calls we have stated that one of our key goals is to get back to a sub-40% efficiency ratio over the next two to three years and to ultimately achieve a sub-30% efficiency ratio. Although we acknowledge that the timing and likelihood for achieving that latter goal are much less certain, we believe there are four key steps we must take to achieve these efficiency goals.

First, we must continue to make sure that all overhead is encouraging highly productive activities. For example, we must eliminate redundant overhead as well as unneeded overhead, and reallocate those overhead dollars to highly productive new activities.

Second, we have to capitalize on the tremendous deposit growth, capacity, and fee generation potential inherent within our existing branch network.

Third, we must utilize our highly effective Real Estate Specialties Group and leasing divisions to efficiently generate loan and lease growth beyond what we can generate through our community bank branch network.

Finally, we must reload our investment portfolio when market conditions allow us to do so in a safe and profitable manner. While a sub-40% and ultimately a sub-30% efficiency ratio are ambitious goals, we continue to think that we can achieve these goals through carefully implementing a combination of these four strategies over time.

Our efficiency ratio for the full year of 2013 improved slightly to 46.0% from 46.6% in 2012. Our efficiency ratio in each of the final two quarters of 2013 was approximately 45.5%, reflecting modest progress toward achievement of our long-term goals.

While our efficiency ratio will vary from quarter to quarter we expect to see improvement for the full year of 2014 as compared to 2013. But our first quarter 2014 efficiency ratio might actually increase somewhat as a result of the initiatives previously discussed.

This guidance regarding our efficiency ratio ignores the potential impact of any acquisitions.

One of our long-standing and key goals is to maintain good asset quality. Economic conditions in recent years have made our traditional strong focus on credit quality even more important. The strength of our credit culture and the depth of our commitment to asset quality are both evident in our key asset quality ratios in the quarter just ended.

At December 31, excluding covered bones and purchased non-covered loans, our nonperforming loans and leases as a percent of total loans and leases has improved to 33 basis points, which is our best ratio since the third quarter of 2011. Similarly, excluding current covered loans and purchased non-covered loans in foreclosed assets covered by loss share, nonperforming assets as a percentage of total assets improved to 43 basis points, which is our best ratio since the fourth quarter of 2007.

Finally, excluding covered loans and purchased non-covered loans our ratio of loans and leases past due 30 days or more, which includes past due nonaccrual loans and leases, as a percentage of total loans and leases improved to 45 basis points; which is our best ratio since the third quarter of 2007. Our net charge-off ratio for non-covered loans and leases for the full year of 2013 was 13 basis points, compared to 30 basis points for the full year of 2012. In recent years we have accumulated a sizable war chest of capital through retained earnings.

We believe that we will have numerous opportunities over the next several years to profitably deploy our accumulated capital and that the most immediate and important capital deployment opportunity we foresee is growth in our legacy loan and lease portfolio.

The second opportunity relates to traditional M&A activity, an area, which continues to be a significant focus. We continue to be active in identifying and analyzing M&A opportunities and we expect this to be an important part of our business going forward. We are also optimistic about our prospects for additional live bank acquisitions in 2014.

The third opportunity will likely come whenever interest rates increase significantly and we consider it strategically timely to reload our investment securities portfolio.

In closing, let me say that we are very optimistic about our balance sheet growth and earnings growth prospects for 2014. As always, we expect the first quarter to be a seasonally challenging quarter, and that challenge will be amplified somewhat this year due to the number of staff additions associated with the expansion of our origination teams in Real Estate Specialties Group, community banking and leasing, as well as the addition of Corporate Loan Specialties Group.

As I have previously stated, we believe these initiatives will greatly enhance our prospect for net income growth over the course of 2014 and for years to come. That concludes our prepared remarks. At this time we will entertain questions.

Let me ask our operator, Kim, to once again remind our listeners how to queue in for questions. Kim?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Jennifer Demba from SunTrust.

Jennifer Demba – SunTrust

Hey. Good morning, George.

George Gleason

Good morning, Jennifer

Jennifer Demba – SunTrust

Just a follow-up question on your comments on this corporate lending initiative. Just curious if you could give us some more details on what size range of loans you will be targeting. Any industries you might be staying away from or not? It's become quite a competitive landscape for that segment of the market over the last few years.

George Gleason

Yes. And it has become very competitive in a barbell sort of way. The competition for C&I lending that is done at the community bank level is very straightforward C&I lending that's done by regional banks. It's just – the pricing on that has gone to almost nothing. On the other end, in the large national syndicated deals, which are the bailiwick of really, you know, the top 25 or 30 banks in the country that do those deals, and I guess really even more the top 10 or 15, primarily, that pricing has gotten back probably within 100 basis points of, you know, the low levels of pricing that you would have seen in 2007, 2008.

Just like Real Estate Specialties Group, what we’re looking to do is work in that market between the highly aggressive local competition and the highly aggressive big national syndicated deals, where transactions have size and scale and complexity but where you can get a lot of very high level of equity – 50% type equity in transactions with quality management team and quality companies, but you are underneath the universe of the big banks and you are above the universe of your more localized competitors. And you can get really good credit terms and you can still get really good pricing because there are not a lot of competitors in that sector. That sector right now is really dominated by a handful of debt funds that really do a lot of that business. Because of the combination and size and sophistication it takes to do that business, we think there is a real window of opportunity there.

Jennifer Demba – SunTrust

And with the leader you hired, where did he come from?

George Gleason

He was – Manish is a Wharton graduate. He had background at Credit Suisse and he was a member of one of the seven credit teams at Deutsche Bank that was doing their large syndicated deals. So he has been in Wall Street doing the larger transactions, and he and I have had numerous discussions over many months about how we can transfer the skills, ability, and knowledge that he brings from that big syndicated loan area and downsize that to much smaller transactions where we could find competitive advantage in the market.

I am very excited about the Manish's joining our team. I am very excited about the prospects for that division. But as I said, we are going to grow that in a very methodical and careful sort of way, much like we did Real Estate Specialties Group. I think in the first 12 months of Real Estate Specialties Group we actually closed one loan and we may start this off very slowly. We are going to be very careful about what we do there and make sure that as we originate loans, they really are high-quality transactions with a lot of equity and we get paid appropriately for it.

Jennifer Demba – SunTrust

Well, great. Thanks for the color.

George Gleason

Okay. Thank you.

Operator

Our next question comes from Brian Zabora from KBW.

Brian Zabora – KBW

Yes. Good morning.

George Gleason

Hey. Good morning, Brian.

Brian Zabora – KBW

I have a question on loan yields. They were – say, the core loan yields – originated loan yields were a little bit up in the quarter. Could you give us some background on maybe what happened there? Are you seeing better pricing than maybe the larger loans? Was there any kind of one-time item that maybe boosted the loan yield this quarter?

George Gleason

There was a couple of items that probably gave the legacy loan yields a little bit of a boost. And one of those items is – we had one loan that paid off that had a pretty good yield maintenance provision in it, so we booked I think about $150,000, $160,000 of extra interest income on that because of the yield maintenance covenants that were in that. And then, we had a high level of prepayments in Q4. We had about $200 million in loans pay off. You know we deferred loan origination costs over the life of the loan. We defer loan fees over the life of the loan. We have more fees deferred than origination costs in the aggregate on the portfolio.

So when loans prepay, it tends to drop a little of those FAS-114. Now, that's the old term. I don't know what the new ASC codification is for the…

Unidentified Speaker

FAS-91.

George Gleason

I'm sorry. I'm even wrong on that. FAS-91. I'm glad I've got accountants here. Our FAS-91 deferred fees of, you know, net deferred fees fall into income. So we did have probably another couple of hundred thousand dollars of income that fell into interest income as a result of a little bit higher than normal level of prepayments in the portfolio in Q4.

You’ll also note, for the reasons I discussed in the prepared remarks, that our yield uncovered loans escalated substantially from Q3 to Q4, as it did from Q2 to Q3, as we just seem to be identifying more loans each quarter in the last couple of quarters of the year where we felt like it was appropriate to amortize those previously non-accretable differences in the income. So that trend is likely to continue to be an upward trend in the covered loan portfolio. If you took $300,000 or $400,000 off the legacy loan portfolio that would probably get you to a more normalized yield for the legacy portfolio; which is probably back pretty consistent with where we were in Q3.

Brian Zabora – KBW

Great. That is very helpful. And then on expenses in the fourth quarter, other operating expenses were up a bit. Is that related to the build that you are talking about, these strategies? Or is there anything kind of one-time in the fourth quarter that results in a bit elevated number again in the fourth quarter?

George Gleason

Yes, there was. We started really about midyear making a gigantic all-out push to resolve a lot of our more complex collection and problem asset resolution issues in the loss share portfolios. Really tried to negotiate a lot of settlements and get a lot of those lingering complex collection litigation issues resolved. You really saw that hit our Q4 numbers into places.

One, if you look at other income from loss share loans that was a very robust number – $4 million plus; $4.8 million, I think. Is that right? $4.825 million. Then you saw a big increase in non-interest expense as we spent a lot of money, incurred a lot of legal fees and other collection costs, and just miscellaneous cost related to that effort.

You know, I would guess that our real effort to put a lot of those issues to bed and wrap them up and clean them up so we can get a much cleaner start in those portfolios going into 2014 probably resulted in – and I am guessing at this number – but I would say there's about $1 million of extra cost related to that. And it probably – the unusual effort to resolve about bunch of these things probably resulted in about $1 million of extra income in that recovery item.

We probably had more non-interest income than would be a normalized run rate by roughly $1 million; and that's a real rough number. We probably had about $1 million more expense related to those initiatives than would be a normal number.

Brian Zabora – KBW

Thank you for taking my questions.

George Gleason

Okay.

Operator

Moving on. We’ll hear from Michael Rose from Raymond James.

Michael Rose – Raymond James

Hey. Good morning, George. How are you?

George Gleason

Doing great, Michael. How are you?

Michael Rose – Raymond James

Good. Hey, I just wanted to circle back. I know you increased the monthly loan growth guidance. How much of that increase – I guess $5 million a month is coming from some of the new initiatives that you mentioned: your community bank initiative, the leasing initiative, et cetera? And then beyond that how should we think about your previous statements around what you would expect for 2015? Any color you can provide there would be helpful. Thanks.

George Gleason

Yes. We’re not ready to give specific guidance on 2015. But I think the comment that I made in my prepared remarks that we are expecting increasing levels of growth in earnings assets in 2014, 2015 and beyond reflects our general mindset that we believe we are putting in place the talent, the infrastructure, the units, the teams, the offices that are needed to accelerate growth from the $600 million minimum level we are providing guidance for 2014 to a higher level in 2015.

Perhaps we will be in a position in next quarter's conference call to quantify that. But at this point, we’re just – the only guidance I will give you at this point is we’re expecting more in 2015 than in 2014. And it's a result of this infrastructure that we are building in, designed to generate earning assets.

In regard to how much of the $60 million annual increase in guidance as a result of community banking, it's actually just a result of sort of re-summing our guidance for Real Estate Specialties Group, community banking, the leasing – some of that increase is a slight upgrade in our growth expectations for leasing next year, as we have made the decision to hire more originators than we would have expected to hire night 90 days ago because we think the opportunity is ripe there. Part of that reflects the fact that are really putting a greater emphasis on community banking and Matt Reddin and John Carter's promotion to those offensive coordinator sort of roles.

Obviously, we had Houston Real Estate Specialties Group in our earlier projection because we had been planning that for a long period of time. We tweaked, I think, the overall guidance up slightly because of the plan to add L.A. Real Estate Specialties Group office in February.

We’ve been in dialogue with the gentleman who is going to run that office for probably six, seven, eight months now, but we really didn't have a deal worked out for him to do that until after our October conference call. So, none of that office was built into our guidance. We have assumed some fairly conservative startup numbers for that office and that slide addition is also factored into the $600 million number.

Michael Rose – Raymond James

Okay. And just one follow-up, if I could. What are you looking for in an M&A transaction at this point? Size parameters matter. I know they haven't, historically. I know we've moved away from FDIC-assisted deals. Can you kind of discuss any change in parameters? And then also, kind of what the pipeline looks like? How many deals? More deals, less deals versus a couple of months ago? Thanks.

George Gleason

About the same number of deals we’re looking at now as what we were looking at a quarter ago. As I said, and is said repeatedly for the last year and a half or two years, we’re seeing as many opportunities as we can take a look at. In fact, we are seeing more opportunities than we can take a look at more constantly prioritizing what we look at.

You know the transaction in Houston is probably on the small side of what we would generally want to do. We did that transaction at that size and are very excited about that transaction, because, you know, I can't imagine any acquisition having three better markets in which to provide you a foothold entry than Houston, Austin, and San Antonio. And so, you know, we would do acquisitions that size again, if they provided that sort of strategic and compelling factors to us.

We might do an acquisition that is smaller than that, but we would probably only do an acquisition smaller than that, if it was sitting right on top of an existing franchise or footprint or had some really super compelling attribute to it, where we could, you know, get disproportionate cost saves, or pick up a line of business we would really like to be in that we’re not in, or something like that.

So, I – bottom line is I think the odds are that future acquisitions will tend to be larger than the Omnibank transaction. That could be something in the size of the FNB Shelby transaction or we would certainly be comfortable doing transactions as large as a couple of billion dollars. So we’re looking to cross across a broad size range of smaller deals like the Geneva Alabama deal that we did 13, 14 months ago. That would be too small to interest us again, unless it was just right on top of something we already had and we were going to get huge synergies as a result of it.

One comment I do want to make about acquisitions, you know, the three live bank acquisitions that we have announced over the last 18 months have all been at institutions that had a few scratch and dent issues. And as a result, the pricing on them tended to be on the – very close to adjusted value when you fair value marked all the assets.

That is a coincidence and a common element of the three acquisitions we've announced so far. But we are certainly not married to that, going forward. We will do acquisitions. We will consider acquisitions that both fit that profile and also acquisitions that have premium pricing to the adjusted book values, so the transactions and would result in goodwill, as a result of the transaction; if the transaction makes economic sense when all those factors are considered. And as we have said before, our bogey is a 20% plus or minus a bit ROE on an 8% capital allocation. And we’re looking at a wide range of transactions size-wise, pricewise, and geography-wise that would fit that profile.

I had in investment banker tell me about a month ago that he just did not see us doing a premium transaction based on our history. And that’s a misread of our intentions and philosophy in that regard. We will do a transaction, if it makes sense and if it will hit our earnings bogeys, even if it's got goodwill and a premium associated with it.

Michael Rose – Raymond James

Great. Thanks for taking my questions.

George Gleason

Thank you.

Operator

And we’ll take another question that comes from Peyton Green from Sterne Agee.

Peyton Green – Sterne Agee

Yes. Good morning, George. Congratulations on a great year and a great quarter. I was wondering if you could talk a little bit about the commercial lending effort and maybe what do you think a reasonable ramp period is. I know you qualified it by saying that the commercial Real Estate Specialties Group maybe did one loan in their first year. Is there anything that you think would take longer in this approach, or might be a little quicker?

George Gleason

You know it probably – I think it will probably be faster than that, because the skill sets of our Company and our sophistication in structuring and handling transactions that we have developed over the last decade through our Real Estate Specialties Group provide us a lot of reference points and tools that are transferable to a non-real estate setting.

Certainly you've got other issues and complexities in non-real estate loans, but a lot of the skill sets that we have developed and mastered and really spent a lot of money building over the last decade – last 11 years with Real Estate Specialties Group will transfer over. So I think that does give us a considerably faster ramp-up profile of this.

But, again, we’ve been – in the guidance we’ve given – we’ve been very conservative on this unit and assumed it ramps up fairly slowly, just because you know we don't know. And we’re not going to – I don't want to go out and give guidance that assumes a high growth rate for that unit or a medium growth rate for that unit and then we decide we want to be more deliberate and cautious about it. And we need to go slower. And I am doing that in the face of having higher guidance out there. So we’ve given guidance on the assumption that it is a very slow ramp.

Peyton Green – Sterne Agee

Okay. And then with regard to the community banking effort, you mentioned that deposit costs were likely to go up. Is that the result of spinning 10 or 15 branches that might not have an effect on other markets, but trying to drive growth in those markets where you think you can get more deposits than maybe you have had historically?

George Gleason

Yes.

Peyton Green – Sterne Agee

Or is this a broader growth?

George Gleason

No. It would be a selected, targeted typical market segmentation strategy where we would pick the markets where we can, you know, get the most growth at the lowest overall impact on our cost of funds.

We probably won't need to do that. You know we’re setting on 100-something million dollars of – $130 million of surplus cash right now. So it will be, you know, late and we’re generating net cash.

It seems like, from our deposit base as we go without doing anything to spin up offices. So, it's probably a second quarter phenomenon where we spin those up. And you know that could even be pushed out, if our Omnibank transaction closes. We made other acquisitions and they happen to have net cash, then that could adjust the timing of that. So we’ll just manage that as we go.

But we’re not thinking significant increases in cost. I’m thinking, one or two basis points a quarter increase in our cost of interest-bearing deposits over the course of the year.

Peyton Green – Sterne Agee

Okay. And then, last question, if you could remind me when the conversion is on the North Carolina acquisition and to what degree have you mined the expected cost savings out of that?

George Gleason

We still got quite a bit of cost saves to get there and no date has been set on the conversion for FNB Shelby for core systems.

We’ve converted a number of their ancillary systems, but not the core system. We’re probably about two weeks away from completing a – what’s basically been about a four or five-month comprehensive request for proposal process from FIS, Bankway, Jack Henry, and FiServ. Looking at the core systems that each of them runs, it would be appropriate for us – it's a $30 billion, $40 billion, $50 billion bank – and really analyzing where we want to – what core platform we want to be operating on.

Our new Chief Information Officer, Sean O'Connell, has been with us now several months leading that process along with Tyler Vance who, as you know, last year was promoted about three or four months ago to Chief Operating Officer. They’re doing a great job running that process. They've already identified some very nice cost saves and economies in our operating systems, as well as making a number of improvements in our operational capabilities even in the short run before we consider core conversions.

So, we think we are making great progress on both capabilities and cost so far and we will narrow in on what core system we are going to convert to. If we are going to convert it. It may be that we stay on our existing core system longer-term. We've gotten a lot of help from our existing provider, who has been working with us on capabilities and other elements of that system, just making us feel better about the system we’re on, although we are still very seriously looking at all options.

So, we’ll have that narrowed down. And once we have determined what core system we're going to be operating on the longer-term, we will then line up the order of conversions. You know the – we've got the Shelby branches to convert; we've got the Omnibank deal we expect to close in the first week of March. And it will just depend on what system we're going to as to what order we convert, whoever we are converting to.

Peyton Green – Sterne Agee

Okay. So you would expect the conversion on your – if you change, the conversion on your end to a new system would be done sometime this year, and then just stack the others on top of it.

George Gleason

Yes. We expect to have all of it done by year-end 2014 and probably would do the first conversion in the third quarter.

Peyton Green – Sterne Agee

Okay. Great. Thank you very much George.

George Gleason

Thank you.

Operator

Moving on. We’ll take a question from Andy Stapp from Merrion Capital Group.

Andy Stapp – Merrion Capital Group

All my questions have been answered. Thank you.

George Gleason

Thank you, Andy.

Andy Stapp – Merrion Capital Group

Certainly.

Operator

And up next, we have Matt Olney from Stephens.

Matt Olney – Stephens, Inc.

Hey. Good morning, George.

George Gleason

Hey, Matt.

Matt Olney – Stephens, Inc.

Hey. Increasing the production of your leasing division was one of your priorities you discussed today. Can you talk more about why now is the right time to expand this group? Also remind us what the average yields are within that division.

George Gleason

Our yields in that division are probably about 8.5%. New origination yields are running really from about probably a 7.5% to 9%. On those – it’s a small ticket leasing operation. And we’ve pretty consistently had 8%, 9% type yields in that portfolio, mid-7%'s to mid-9% yields over the life of the business, which we‘ve run for a decade. I think our highest loss year at the depth of the downturn, we were less than 200 basis points in losses. And we typically are running 50 to 100 basis points in annual losses on that portfolio. So – and it’s certainly has been stress-tested through a couple of cycles now, so we really have gotten comfortable with the business model and Scott's leadership in that portfolio.

So, you know, part of our comfort level is we just had a couple of economic cycles of experience with the portfolio. And the way we run it, the credit selection – which we are very selective on credit the way we do it, has proven to be very successful. It’s left us with really nice spreads after losses in every year. So we‘re very pleased with that level of business.

We think the timing is right to do it because, you know, a lot of the economic downturn flushed a lot of potential customers out of the market. And, you know, a lot of customers who would have been potential customers failed, so the quality of application we are seeing now and the quality of the customer are generally folks that, you know, withstood the recession and managed to maintain profitability and financial viability throughout the downturn. And they’re coming out here on the other side and they ‘re seeing new growth opportunities and they need to add new pieces of equipment and so forth.

So, we like this part of the cycle because a lot of the guys, you know, that would not have withstood a cycle are gone. And the quality of customer you are seeing, if it ‘s something that weathered that cycle, shows a pretty good management and financial ability on their part. So, we think it’s a good time to expand it.

Matt Olney – Stephens, Inc.

Okay. That's helpful. And then secondly, you mentioned in the prepared remarks about the percent of variable rate loans has increased over the last 12 months. How should we be thinking about that relative to your initiatives on the Community Bank side, corporate lending team and the leasing division?

George Gleason

Our goal is to continue to increase that percentage. So, I would hope that when we have this call 12 months from now, that we can report that our percent of variable rate loans is up another, you know, 2%, 3%, 4%, as a percent of the portfolio compared to where it is today. So, the lenders in all the units of the Company understand that focus is generating variable-rate loans, not fixed rate loans.

Now, we generate a lot of fixed rate loans in our community banking model just because they’re fully amortizing two-, three-, five-year loans and it's just not efficient or appropriate to balloon those or to variable-rate those. So, we do a lot of that in community banking.

But our Real Estate Specialties Group, which of course some is half of our non-loss share, non-purchased loan portfolio now has zero fixed rate loans. Everything we do there is variable-rate. We expect that to continue to be the case. And as that part of the portfolio continues to grow as a percent of the total portfolio, then that accentuates the bias toward a higher level of variable-rate loans going forward. I think our Corporate Loan Specialties Group – whatever they originate – I would expect to also be variable-rate. So I think they will also contribute to that bias.

Matt Olney – Stephens, Inc.

Okay. That's helpful. Thank you George.

Operator

And we have a question from Blair Brantley from BB&T Capital Markets. Excuse me.

Blair Brantley – BB&T Capital Markets

Hey, George. How are you?

George Gleason

Sure. I’m fine, Blair. How are you?

Blair Brantley – BB&T Capital Markets

Good. Probably a couple of follow-ups on that. Regarding the leasing book, from a geographic perspective is that going to be within your branch, subprime primarily? Or are you seeing potential growth outside?

George Gleason

It never has been. We’ve originated leases in 40 states.

Blair Brantley – BB&T Capital Markets

Okay.

George Gleason

And it’s been a pretty much all across the country sort of business from the get-go.

Blair Brantley – BB&T Capital Markets

Okay. So no change there, then.

Okay. And then also speaking to the variable rates, how much of that is still having floors put on them for the new pre-production?

George Gleason

The – I can give you some really good data on that. 94% of our variable-rate loans have floors in them. Now, if you – 70 per – let’s you – if you – rates go up 0.25%, the 94% that are at a floor rate today – if rates go up a quarter, only 70% of the variable rate loans are at their floor. And if rates go up 100 basis points, only 43% of the variable-rate loans are at their floor. And if rates go up 200 basis points, only 7.76% of our variable-rate loans are at their floor. So, the floors will tend to mute the adjustment somewhat through the first hundred basis points and less significantly through the second hundred basis points.

But by the time rates are moving 200 basis points, almost everything is off their floor. Less than 5% of the portfolio in total would still be at a floor rate. So if – that's a much less significant factor than it would have been in our discussion of this a year ago or two years ago. A year ago or two years ago, the percent of loans that didn't adjust in an up 100 and didn't adjust in an up 200 because of the floors was much, much higher than it is today. And that’s one of the reasons if you look at our interest rate risk disclosures – and, of course we don't have 12/31 interest rate risk disclosure. But that movement and evolution of where these floor rates are and is one of the reasons that for the last four, five, six, seven, eight quarters our interest rate risk model has shown us going from very slightly liability sensitive to vary slightly asset sensitive.

And that’s largely a result of two things: the increasing percentage of variable-rate loans and the diminished muting of our ability to raise rates, caused by the fact that, as rates rise, they're caused by the fact that loans are at a floor that is well above the formula rate. That number is greatly diminishing.

Blair Brantley – BB&T Capital Markets

Okay. And then our one – a one small housekeeping item. Is there anything different in your tax rate for this quarter? How should we think about that going forward? Looks like it kind of went up a little bit this quarter.

George Gleason

I am not aware of anything in that.

Blair Brantley – BB&T Capital Markets

Okay.

George Gleason

And Greg is nodding to the negative, as well. It’s what it is.

Blair Brantley – BB&T Capital Markets

Okay. Thank you.

George Gleason

Thank you.

Operator

And we have a question from Brian Martin from FIG Partners.

George Gleason

Good morning, Brian.

Brian Martin – FIG Partners

I'll keep it short here. I know you're probably getting tired. The community, the growth you talked about for 2014, Just let me break out kind of how much you expected that to come from the community bank group that you alluded to, that it's kind of expanding a bit here, or growing. Can you just kind of put a fence around maybe how much growth you expect to come from that group, just in general? And maybe what areas are performing the best or giving you the most optimism there?

George Gleason

Well, the best markets probably continue to be the Central Arkansas division and the Charlotte unit. Although, we are seeing some nice upsurge in opportunities from our loss share markets.

In one period a few weeks ago, I guess it was about two weeks before Christmas, I approved four different loans in five days that ranged from $1 million to $2.5 million in size. Each out of a different one of our loss share markets. And you know we just haven't seen those sorts of opportunities, and my guys are telling me that they've got a good pipelines of opportunities working in those markets. And you know those markets are finally beginning to heal up enough that we are seeing a little more new volume opportunities each quarter there.

So, you know, it’s spread broadly across the Company. Community banking is going to be a bigger part of our growth expectation in 2014 and 2015 than it was in 2013; which it was very little in 2013. But Real Estate Specialties Group, certainly with the expanded staff we have put in place there and the expanded number of offices there, will continue to be the dominant growth engine for the next several years.

Brian Martin – FIG Partners

Okay. And in Real Estate Specialties Group the offices you put in and all the people you – the markets you have talked about, does that kind of – is that what you are limited to for 2014? Or would you expect new offices beyond what you have talked about, or are they possible later in 2014?

George Gleason

Well, I – we don't have any expectations or plans right now for new offices beyond Houston, which we opened the first week of January, and L.A. which opens mid-February. Beyond that we do not have any plans for additional Real Estate Specialties Group offices in 2014.

With that said, if the right individual with the right skill set and profile came along, I wouldn't shut the door on another office. But we have no plans and we are not out looking for anybody else right now. We are focusing on what we've got lined up and what we've already got in place.

Operator

There are no further questions at this time. Speakers, I will turn the conference back to you for any additional or closing remarks.

George Gleason

Thank you all for joining the call today. There being no further questions, that concludes our call. Have a great day. We look forward to talking with you in about three months. Thank you so much.

Operator

And that does conclude our conference today. Thank you all for your participation.

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