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Marshall & Ilsley Corporation (NYSE:MI)

Q2 2010 Earnings Call Transcript

July 20, 2010 12:00 pm ET

Executives

Dave Urban – Director, IR

Greg Smith – SVP and CFO

Mark Furlong – President and CEO

Analysts

Tony Davis – Stiefel Nicolaus

Bob Patten – Morgan, Keegan

Terry McEvoy – Oppenheimer

Jon Arfstrom – RBC Capital Markets

Ken Zerbe – Morgan Stanley

Matt O'Connor – Deutsche Bank

Craig Siegenthaler – Credit Suisse

Steven Alexopoulos – JP Morgan

Jason Goldberg – Barclays Capital

Kenny Houston – Bank of America/Merrill Lynch

David Konrad – KBW

Brian Foran – Goldman Sachs

Erika Penala – UBS

Operator

Welcome to M&I's second quarter 2010 results conference call. My name is Stephanie, and I will be your conference operator today. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded for replay purposes. It is now my pleasure to introduce Dave Urban, Director of Investor Relations for M&I. You may begin your conference.

Dave Urban

Thank you. And welcome to M&I's second quarter 2010 financial results conference call. The presenter for today's call will be Greg Smith, our Chief Financial Officer, who will review the second quarter financial results. At the end of our prepared remarks, Greg will be joined by Mark Furlong, our Chief Executive Officer; and, Mark Hogan, our Chief Credit Officer, who will be available for your questions.

Before we begin, let me make a few preliminary comments, if you (inaudible) our release, you may access it along with supplemental financial information from the Investor Relations section of our Web site at www.micorp.com.

Also, before we start, I would like to mention that comments made during this call contain forward-looking statements concerning M&I's future operations and financial results. Such statements are subject to important factors, which could cause M&I's actual results to differ materially from those anticipated by the forward-looking statements. These factors are described in M&I's most recent Form 10-K and M&I's other SEC filings. Such factors are incorporated herein by reference.

For reconciliation of any non-GAAP financial measures mentioned in this presentation to the most comparable financial measures calculated in accordance with GAAP, please refer to M&I's Web site at www.micorp.com.

And now, I will turn the call over to Greg.

Greg Smith

Thank you, Dave. And thank you everyone for joining us today. By now, you had an opportunity to see our press release and supplemental financial information. We have included the detailed slides on our Web site, which you might want to have available for later in our discussion.

Our second quarter results provided us with continued confidence that a recovery underway at M&I. Our credit quality trends continued to benefit from our aggressive approach to non-performing loan identification and resolution as is shown by continued improvement in loans going into non-performing status, which reached our lowest levels since the first quarter of 2008; continued improvement in early stage delinquencies, which decreased for the fifth consecutive quarter; continued improvement in total non-performing loans, which decreased for the fourth consecutive quarter.

The important items to focus on to better understand our second quarter performance include the following, our core loss this quarter is in line with the prior quarter and substantially less than the second quarter last year. Recall that our reported results last quarter included a $48 million pretax gain from our merchant [ph] processing sale.

Our loan loss provision and net charge offs this quarter are consistent with the first quarter. They continue to reflect the progress we've made in addressing asset quality challenges to our early identification of problem credits. Our second quarter loan loss provision is 25% [ph] lower than our 2009 quarterly average, and is at its lowest level in nearly two years. We expect our provision to continue declining over time.

Non-performing loans were down $153 million this quarter. From our high in June 2009, non-performing loans are down 25%. For the quarter, early stage loan delinquencies, those performing loans past due 30 to 89 days declined again to the lowest level since 2007.

Our non-performing construction and development loans were down $120 million or 18% from March 31st. Approximately half of this decrease is attributable to the Arizona market where our non-performing construction and development loans now total only $113 million. We continue to make progress, reducing our concentration of construction development loans to be less than 10% of the total portfolio.

Today, our construction and development exposure is less than 10.7% of total loans, compared to nearly 23% at its high in the third quarter of 2007. For the quarter, our provision essentially matched charge offs. Our reserve now stands of 3.67% of total loans or more than $1.5 billion.

We continue to make progress in improving our funding profile. Our loan to deposit ratio stands at 104% highlighting the substantial progress we've made since our high of 132% in 2007. We continue to maintain a strong capital base with a tangible common equity ratio of 8.3% and an estimated Tier 1 risk-based capital ratio at 10.9%.

Now, for some additional insights into the quarter, first, the net interest margin, our net interest margin increased by four basis points on a linked-quarter basis to 3.17%. During the second quarter, our net interest margin benefited from changes in our deposit mix and deployment of our excess liquidity.

Despite recent asset quality improvements, our marking continues to be negatively impacted by non-performing assets. The negative impact is 26 basis points in total. We expect net interest margin will stabilize for the near term. Many variables continue to impact margin, including competitive pricing and the influence of deposit loan force. It is difficult to project this one data point with a high degree of accuracy given the current yield curve and competitive environment.

Now, moving on to the wealth management segment, total revenue, driven by strong trustees and private banking net interest income, grew 3% on the linked-quarter basis and 8%, compared to the second quarter of 2009.

Despite market volatility and economic headwinds, assets under management of $32 billion remain relatively constant, compared to the second quarter of 2009 due to continued expansion of our client base. Assets under administration fueled by institutional and outsourcing customer growth grows 11% to $121 billion, compared to the same period last year. Our private banking group continues to experience stable loan demand and strong deposit flows, lifting net interest income 3% on a linked-quarter basis and 24%, compared to the same quarter last year.

Credit quality within private banking continues to improve and is approaching historic normalized levels. Against the challenging market backdrop, client retention and wealth management remains at record levels reflecting our aggressive business strategies and customer focus.

From an expense standpoint, total non-interest expense amounted to $388 million in the second quarter in line with the prior year and an increase of $22 million from the first quarter. Salaries and employee benefits expense increased in the second quarter, compared to the linked-quarter reflecting normal incentive and employee benefit activity that largely occurred in the prior quarter.

Net expenses for non-performing assets and other credit related items were $38 million this quarter. Nonetheless, particularly in the current operating environment, M&I will continue to be very focused on maintaining our historical expense discipline.

Now, moving on to our credit quality trends. Non-performing loans decreased for the fourth consecutive quarter, resulting in our lowest level of non-performing loans since the end of 2008. We anticipate continued improvement in our non-performing loan trends, reflecting sustained improvement in early state delinquencies, reduced inflows, and continued aggressive strategies to work out or sell non-performing credits. We expect our early stage delinquents, but accruing loans to stabilize around the current level of 1.1% of total loans.

Our commercial and consumer portfolio continue to have non-performing characteristics better than the portfolio as a whole while our construction and development related loans continued to show distresses in national housing markets.

Our core Midwest portfolios continue to perform well through the cycle as is highlighted by our 2% non-performing loan ratio in Wisconsin, 3% in Minnesota, and 2.8% in Indiana. We have identified the specific loss content in non-accrual loans over $1 million and marked into net realizable value with either a specific reserve or charge off.

As is shown in slide 8, M&I has conducted a specific impairment analysis on $1.2 billion or 69% of total non-performing loans – by potential improvement. On average, 31% of the unpaid principal balance in these loans has been charged off.

Regarding net charge offs, for the quarter, we charged off $438 million, which is approximately 15% below last year's quarterly average. Provisions essentially managed charge offs. Although the Arizona and Florida market places continued to be the largest proportion of charge offs approximately 52%, they are decreasing as expected. As shown on slide 33, the largest concentrations of net charge offs by geographic location were $137 million for Arizona and $92 million for Florida. Otherwise, charge offs were diversified from a geographic perspective.

Discussing our non-performing loan trends, during the quarter, our non-performing loans decreased $153 million, which is 8% below last quarter and 25% the below the second quarter of 2009. For the quarter, we sold $102 million in larger (inaudible) construction and development loans.

As in the past, we had moved aggressively to identify problem loans and the associated loss content. Of our $1.8 billion in non-performing loans, $660 million or 37% are past due less than 90 days. $510 million or 28% of total non-performing loans are current.

Our new non-performing loan formation continued to improve this quarter, with $612 million moving to non-accrual status or a 9% improvement from the prior quarter and the lowest since the first quarter of 2008. We have already realized partial charge offs of $738 million against our non-performing loans, representing a 29% haircut. Another way to look at our partial charge offs is that represents a 54% write down on specific non-performing loans or a direct write down, which is deemed necessary.

We continue to see notable contraction in our residential vacant land portfolio, which has contracted 50% since its September 2007 high watermark. Residential lot loans to individuals and developers account for $183 million of non-performing loans, which is down 23% from the prior quarter. Other non-performing loans in this category, 40% are based in the Arizona market.

Shifting to the commercial loan portfolio, this portfolio continues to perform relatively well during this cycle, while still showing the effect to the economy. For the quarter, net charge offs was $309 million [ph], down substantially from the prior quarter and non-performing C&I loans were down 3%.

With regard to our non-construction commercial real estate portfolio, we have $13.3 billion outstanding, with $3.5 billion in multi-family and $9.1 billion in business real estate. As shown on slide 16, two-thirds of the business real estate portfolio is concentration on our core Midwest markets, with only 17% in our combined Florida and Arizona markets, and another 4% in other higher risk areas. Thirty-six percent of this portfolio is owner occupied.

In the second quarter, we saw our non-performing loans in the non-construction commercial real estate category remain steady at 4.9%. Like others, we continue to be watchful of this portfolio and continue to stay close to our borrowers. As part of our proactive strategy with this portfolio, we continue to identify to adapt our problem loans early as is shown by the fact that approximately half of our non-performing commercial real estate loans are still current. Delinquencies in this portfolio are down 34% from the prior quarter and continue to be manageable with approximately $75 million of accruing notes past due 30 to 89 days.

A few final comments on credit audit. We have, and will continue, to take aggressive steps to resolve our non-performing situations. We remain committed to returning M&I to a solid level of credit quality, and expect that our declines in non-performing loan inflows and early stage delinquencies are continuing indicators of achieving that goal.

Changing focus to the organic balance sheet trends, compared to the same quarter in 2009. C&I loans decreased as we continue to see stabilizing, but low-lying utilization from existing customers consistent with the slower economy. Across all of our construction and development categories, we have seen approximately $2.8 billion or 36% in average balanced contraction due to second quarter of last year.

This is consistent with our broader goal of reducing our total construction in the development portfolio to less than 10% of total loans. At quarter-end, construction and development loans accounted for less than 10.7% of total loans, down from a high approximately 23% in the third quarter of 2007.

Non-construction commercial real estate loans decreased slightly in comparison to the same quarter last year as well as on a linked-quarter basis. We expect this trend will continue.

On the deposit side, we continue to benefit from positive mix shift with average deposit balances up $1.3 billion versus the second quarter of 2009. Non-interest bearing deposits increased $570 million, compared to the second quarter of 2009.

As we have discussed before, we reconfigured many of our deposit product offerings. The benefits of these changes are shown by the $1.3 billion growth in savings deposits since the second quarter of last year. In addition, we have benefited from an improved deposit mix as our time balances have declined by over $4 billion.

A few final comments, as we move into the third quarter of 2010 and to reiterate comments made earlier, we expect our financial results to reflect the benefits of the aggressive credits steps we have taken, but also the challenges of the broader financial markets. As our credit quality trends continue to improve, our retention will increasingly shift towards rebuilding our profitability profile; nonetheless, we will not waver in our credit quality focus.

This concludes our prepared remarks. Joining me now are Mark Furlong, our CEO; and, Mark Hogan, our Chief Credit Officer.

Operator, you may open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Tony Davis with Stiefel Nicolaus.

Tony Davis – Stiefel Nicolaus

Right. Good morning.

Greg Smith

Hi, Tony.

Tony Davis – Stiefel Nicolaus

I wondered with the macroeconomic and housing data more recently weakening, what is the very, very latest on Arizona C&D and the residential portfolio? We talked about it in the quarter, but how do things look here in July?

Mark Furlong

Well in terms of July, it will be way too early for us to have any observations at this point for the month. I mean I think we keep going – we go back and look at just the fundamental trends that we've seen over the past quarter in that portfolio. And as much because of some of the steps that the team has taken we’re really been able to identify some of those areas that have been the most stressed and been able to bring that portfolio down. Again, I will point to construction and development loans in aggregate in that market being about $130 million on nonperforming. And we certainly see that much more skewed toward the housing sector than we do any other sector.

In terms of residential mortgages in that market, you certainly continue to see stresses but we actually saw our nonperforming loan ratio for residential markets in Arizona come down about 80 basis points for the quarter itself. I think it's as much a fact we've been – we've transferred over the last two years some real important resources from this company into the Arizona market to focus on exactly this part of the portfolio.

Tony Davis – Stiefel Nicolaus

Great. Following up on that, what is that redefault rate on your negotiated – renegotiated residential one to four aggregately and is Arizona materially different from that?

Greg Smith

You know it’s awfully hard to distinguish that on a market-by-market basis, Tony, so much of the single-family restructured loans we have are indeed in the Arizona market. We are still seeing redefault rates run in the 20% to 25 % area with single-family mortgages. Certainly because those are – that’s going to be a cumulative statistic over time. We would expect that to trend a little bit higher. Nonetheless, we’re still running well below any of the Federal government numbers that might come out with redefault rates, many of which are moving into that 60% range.

Tony Davis – Stiefel Nicolaus

Right. One question Greg, really back on loan growth. Your credit line utilization rates right now, could you give us an update that, and if what you’re seeing in terms of backlog, thoughts about what the third quarter might look like, the back half of the year versus the run-off you saw in the first half?

Greg Smith

Sure. I’ll start and Mark Furlong certainly, you’re welcome to add a comment or two. In terms of utilization rates, utilization rates were flat for the C&I portfolio from the first quarter to the second quarter. And that’s running at about 53.2%. We still see some contraction in commitments. Companies of course don't want to keep excess levels of commitments in place if they know they're not going to be using them given the growth profile in the overall economy. We’re still seeing companies cut back on what they want to have for commitments.

That said, we've also had some really nice high quality customer wins in the C&I area, and that really is across a number of our regions. So in that sense we've actually been very happy with some of the types of customer wins we've been seeing. As we look forward, I think we expect C&I balances for the rest of the year, Tony, to remain relatively stable with more of a bias to down a bit than up. And if you guys, we go – as we look past that, it’s really going to depend on how the economic recovery holds in there and hopefully expands at some point. But I think this is not the type of economic environment where you’re going to see a marked change, marked growth in C&I balances until there’s better growth profile out there.

Tony Davis – Stiefel Nicolaus

Thank you. Thank you, sir.

Greg Smith

Thanks.

Operator

Your next question comes from the line of Bob Patten with Morgan, Keegan.

Bob Patten – Morgan, Keegan

Good morning guys.

Greg Smith

Hi, good morning, Bob.

Bob Patten – Morgan, Keegan

Actually good afternoon. Greg or Mark or Mark, I guess provisioning charge-offs. Charge-offs came in a little higher, directionally they are going in terms of trends in the right direction but when do we kind of get caught up on credit? Obviously everything you talked about in terms of inflows was good, in terms of the most severe portfolio starting to shrink down, but we're still seeing pretty high numbers in terms of quarter to quarter charge-offs and loan loss provisions, so I'm trying to get a feel for when do we see you guys finally get caught up with this?

Mark Hogan

Yes, Bob. This is Mark Hogan. I think we're at that point now where we've been talking for the last two to three quarters, that the third quarter of this year would be when – given the improving delinquency and the improving inflow, the new non-accruals, where we’d start seeing some pressure – downward pressure on the reserve. And we've already started – we started to see that in this – at the end of the first quarter on the consumer side and that’s continued in this quarter as well. And when you look at our reserve right now, a year ago our reserve was split 50-50 between the consumer and then the business related portions of our portfolio.

Today, that has shifted to 60% of the commercial portfolio, or business related and 40% of the consumer. So we've already seen the downward pressure on the reserve coming from the consumer side. And we would expect that with the continued reduction in the new non-accruals and the delinquency trends that we would start seeing at the – that our methodology would start showing some reduction in the loss rates that are attributed to the commercial side. And then also, but more importantly, the level specific reserves that were taken against new non-accruals.

We've been talking about this now for almost the last year relative to the third quarter being a pivotal quarter and we believe we're at that point. But as Greg said earlier, and we've tried to reiterate this as much as possible, now is not the time to stop being aggressive. We've been at this for two and a half years and we think we're very close to getting to the end of the credit issues. And we're just going to continue to work through the third quarter to do that. But we are starting to see some very positive results from the – from a reduction in the delinquencies and the inflows.

Bob Patten – Morgan, Keegan

Okay. And I appreciate that, Mark. And just in terms of OREO, everybody knows it's a bumpy number and based on – and so forth but what are the issues that are in your $37 million or $38 million that are marks that had to be taken to get deals done. How is the pricing occurring on the loans that you sell? Are you above, below, give us a little feel there.

Greg Smith

On other real estate?

Bob Patten – Morgan, Keegan

Yes.

Greg Smith

On other real estate we just continue to look at the portfolio. We've had – we've actually had some fairly good velocity with that, taking properties back but also moving properties up. And if we look at every property and the larger side and we make the determination that if we think it’s going to be a longer term hold because we think the recovery is better by holding it for a longer period of time, we’ll take the appropriate marks. And some of what you’re seeing is just that – an additional adjustment to the valuations.

But again, our goal is the same on the other real estate as it is through the loan sales, which is, we're going to be aggressive with it and when we receive it, we'll consider them seriously.

Bob Patten – Morgan, Keegan

All right, thank you.

Mark Hogan

Bob, let me just add after that for one second. In terms of the net credit expenses, consistent with what we saw last quarter, with some level of stabilization in property values, our marks as we move properties into ORE are just holding up much better than they did a year ago. And as an example, this quarter net marks on property were about $14 million, which is well below the $38 million we saw on the fourth quarter of last year. So we got much better predictability on that front.

Bob Patten – Morgan, Keegan

Good. Thanks, Greg.

Operator

Your next question comes from the line of Terry McEvoy with Oppenheimer.

Terry McEvoy – Oppenheimer

Thanks, good morning.

Greg Smith

Hi! Good morning, Terry.

Terry McEvoy – Oppenheimer

I guess the question it sounds like well charge-offs were probably above what many of us were looking for, it was pretty consistent with your internal models and also Mark's comments about the third quarter showing some improvement. Could you just talk about getting back to profitability and is that still something you potentially see in the fourth quarter or the early part of next year?

Greg Smith

Yes. And Terry, although we still see the chance to cross over to profitability in the fourth quarter, again going back to my earlier comments, this weak economic recovery is certainly not helping – helping the cause there. So in terms of profitability, we still see ourselves moving into profitability and although there might be a shot of crossover in the fourth quarter, I'd say the odds of that are lower than they were at the start of the year. But with each successive quarter, particularly as we continue to work through credit quality and see the types of improvements we've seen with early stage delinquencies and inflows, with each successive quarter we see an improving shot to cross over into profitability. But it really – ultimately it’s going to depend on the speed of credit quality but, most importantly, the economic recovery.

Terry McEvoy – Oppenheimer

And just another question. Any comments on third quarter salaries and benefits lines expectations again for next quarter where you see that trending?

Greg Smith

Yes, salaries and benefits, although on the linked quarter basis it’s up about $22 million. A lot of that just ties into the annual reversals that we had in the first quarter as it relates to incentives and other annual accruals. If you go and look at the second quarter of last year you could see where our salaries and benefits this quarter are a little bit lower.

I think if you were going to think about our salaries and benefits somewhere in the range of what we saw at this quarter versus the third quarter of last year, you’re probably getting a sense for the right ballpark.

Terry McEvoy – Oppenheimer

Thanks, Greg.

Operator

Your next question comes from the line of Jon Arfstrom with RBC Capital Markets.

Jon Arfstrom – RBC Capital Markets

Thanks, guys. Good morning.

Greg Smith

Good morning, Jon.

Jon Arfstrom – RBC Capital Markets

Yes. Just a quick follow up on that. So, Greg you’re saying you think is that salaries and benefits line can continue to come down over the next few quarters like it did last year?

Greg Smith

Yes. Anywhere from where we are at this point to drifting down like it’s done in prior years.

Jon Arfstrom – RBC Capital Markets

Okay.

Greg Smith

But again in this ballpark, I think it’s probably a decent assumption. In this ballpark, maybe down a little.

Jon Arfstrom – RBC Capital Markets

Okay, good. Mark Hogan, just a quick question for you on home equity. It looks like the non-performers have come down but the delinquencies jumped up on the 30 to 89 day bucket. Can you talk a little bit about that trend and maybe any color on the outlook for that portfolio?

Mark Hogan

Yes. I don't think there’s really a trend there, Jon. I think what you’re looking at –and from a percentage standpoint it’s just a reduction in the loan balances where the actual non-accrual dollars or the delinquent dollars rather has stayed relativity the same. So, nothing that we would – that is the only area in the residential real estate side where we did see increases in delinquencies across that portfolio. I don't think it’s anything that‘s significant.

Jon Arfstrom – RBC Capital Markets

Okay, good. And then, just one question for you, Greg, just the percentage of loans that are at floors.

Greg Smith

The percentage of loans that are at floors, let me answer that in a couple of minutes. We'll go ahead and take the next question. And then, I'll have it for you.

Jon Arfstrom – RBC Capital Markets

Okay. Thanks.

Operator

Your next question comes from the line of Ken Zerbe with Morgan Stanley.

Ken Zerbe – Morgan Stanley

Okay. Thanks. Just going back to your expectations for reserve in the recent third quarter, how – when you think about the impact of the weak recovery on your reserving models, how much of what the model speaks out saying, "Okay, you should relieve X amount of reserves or release that amount is going to be offset by your suggested adjustments to keep reserves higher than what the model would suggest." And then (inaudible) has explained, the competitors last night seemed to – indicate that not release terms because of that subjectivity.

Mark Furlong

Let me just come back and say, I don't think I said that we were going to release reserves in this quarter. What I said – I was starting – as we've talked to the last couple of quarters, now is when we're starting to see some of the trends that we see in order to put us in a position to make that happen.

But (inaudible) fact that there's a second part of that, we think we've been very aggressive relative to the specific reserves that we've taken and the charge offs that we've taken on the non-accrual, both as they sit in the non-accrual over any period of time, but also as it goes into non-accrual. So we're comfortable with that. And I'll go back to what I said before just earlier that we continue to be aggressive with loan sales and working through the problems of the existing non-accrual pool to the extent that new non-accruals are refused. And the impact on the reserve will be reduced because we won't have the level of impairment because we don't have the level of new non-accruals.

Ken Zerbe – Morgan Stanley

Okay. The other question I had just in terms of balance sheet, I think I heard you guys say that C&I balances are back to slightly down for the rest of the year. Do you have any comments on the rest of the portfolio? I mean obviously, you're getting close to that 10% mark for construction, but I doubt against probably 10%. What's your thought through all the balance shrinkage?

Greg Smith

Yes. I think we continue to see shrinkage across a number of loan categories, Ken. I mean, commercial real estate, just very little new commercial real estate going on the books and natural – just natural amortization activity in that portfolio that should have a bias toward down.

And construction development, I mean the reality subtle – that basically, no construction and development has come on the books here in the last – probably close to two years. So you really just don't – there's – all you have is (inaudible) proven in the portfolio here for a sustained period of time. And we will always overshoot that 10% just because there is so little that has been added.

When there is real estate also continues to contract a bit here, we'll see what the impact of changes in the yield curve will be on the residential portfolio. But ultimately, we're selling 85% plus of our residential real estate originations. So we are biased down more than that portfolio as well. So across the major categories, although C&I have maybe flat, the others, we'll still see a bias down.

Ken Zerbe – Morgan Stanley

Do you have any internal expectations for where the total balance sheet onset?

Greg Smith

It depends on the strength of the economic recovery. Clearly, we're now at $41.3 billion of loans and there is a decent chance that we will touch the low forty before we start turning around.

Ken Zerbe – Morgan Stanley

Okay. Thank you.

Operator

Your next–

Greg Smith

Look, I'm sorry, on the question as it relates to floors, 25% to 30% of the loan portfolio is floored. And that's actually was to be a large component of the C&I portfolio.

Go ahead, operator.

Operator

Your next question comes from the line of Matt O'Connor with Deutsche Bank.

Matt O'Connor – Deutsche Bank

Hi, guys.

Greg Smith

Hi, Matt.

Matt O'Connor – Deutsche Bank

Just a follow-up on an earlier question regarding the loan sales, were there any charge offs related to loan sales this quarter and how does that compare to last quarter's?

Greg Smith

There were. I would say that the loan sales were sluggish. You can see it form the presentation of loan sales were slightly higher this quarter than they were last quarter, and relative to the marks that we're taking on them, really not into change. We don't talk about that probably the mark down has not changed over the last three to four quarters now.

Matt O'Connor – Deutsche Bank

Okay. If I get them to try to dig into a little more why the charge offs were up a little bit in this last quarter given I think last quarter has construction loss than C&I. So I was just trying to see is it because you are selling more loans, and naturally this is going to increase? Or is it marks on stuff that's still on the books.

Greg Smith

It's a combination. But again, we continue to be – to look aggressively at the portfolio. And where we – when we're looking at the portfolio, we're looking at loans that have the same tendencies of losses that maybe on accrual, that maybe current. And we've brought those forward. And we took charge on some loans. So that's somebody's impact of it. But I think you have that every quarter. It's not that this is new to this quarter. It's just following the same process that we've gone on along. Sooner or later when we get to the next cycle, we won't have that and that would be the reduction in the charges.

Matt O'Connor – Deutsche Bank

Okay. And then, just a better picture question, do you think you're making good progress on both credit as well as de-risking the loan book. And obviously, the market's starting to shift towards revenue and growth opportunities the next couple of years. I was just wondering if you could highlight maybe two or three key areas that focus that can move the needle over time in terms of generating revenue and underlying franchise growth.

Greg Smith

Sure, Matt. And again, this was not an economic spike over. It's going to lead through a dramatic revenue growth. Certainly, you need to see the economy get some better underpinnings. That said, near term opportunities for us are really where we continue to focus on improving our funding profile. We'll make great headway there. But as we move forward, the opportunity to continue focusing on the interest expense component of net interest income is something where we still see some opportunity. And also, well of course, we see opportunity for growth there, particularly as we've seen growth this quarter over the prior quarter and the prior years.

And finally on the banking side, really just the opportunity for the revenue growth as we rarely focus on blocking – basic banking blocking and tackling, whether it's continue to improve our process, or it's continuing to improve how we package our product opportunities. Those are the type of things we are looking at in improving every single day so that we're better positioned as we come out of the out this economic malaise we're in, to show revenue, and ultimately, profitability growth. We also see opportunity in a number of our core markets to win more of our fair share.

Matt O'Connor – Deutsche Bank

Okay. That's helpful. And then, I just wanted to, if I may, I don't think you guys have promised in as much as some other folks on the debit card or the overdraft. I think it's smaller numbers for you, but if you had some figures in terms of the size and what you can get in terms of regulatory changes out there that would be very helpful.

Greg Smith

Sure, in terms of, maybe specifically on the debit card, and then I may a couple of comments on regulatory reforms as well. First of all, in terms of debit card, there's not a lot specific at this point to point to what the impact's going to be. Our debit card revenue probably runs close to $32 million a year. So that's the point, which the regulatory – that reform will – will be impacted, but we don't know what the impact would be.

More generally, on the front of regulatory reform, I think we're fortunate that our business model isn't the most diversely impacted, just given that our business model is client-focused – not focused I think like proprietary trading. Generally, as we look at that legislation, there are some benefits from it, whether it's a resolution authority or more systematic risk oversight. But we're also very cognizant, that their legislation is going to drive many new rules. And the impact of these hundreds of new rules that still has to be written, the impact's really not known yet.

And so, those are certainly beyond known consequences for the economy and customers. Debit cards, as I a mentioned, you don't know enough yet in terms of actually quantifying what the risk is. What we know is the revenue pool that's impacted is about $30 million. As we go forward, we'll certainly provide more information as the impacts of regulatory reform are more personalized for us.

Matt O'Connor – Deutsche Bank

That's a pretty small page for you. But just from overdrafts, I think it's also less for you than others. But just to have than number handy would be helpful.

Greg Smith

Yes, in terms of the overdraft component of – I don't have the actual overdraft number. What we do have though, Matt, is if we have the – is if we see about a 20% up (inaudible), we expect the impact could be as much as $3 million a quarter on our revenues. If we see an uptick related to customers that goes to the 80% that I see some other banks have used, that impact is going to be more like $150,000 a quarter.

Matt O'Connor – Deutsche Bank

Okay, either way not too much. Okay, very helpful. Thank you.

Greg Smith

Sure. Thanks, Matt.

Operator

Your next question comes from the line of Craig Siegenthaler with Credit Suisse.

Craig Siegenthaler – Credit Suisse

Thanks and good morning. It's Craig Siegenthaler from Credit Suisse.

Greg Smith

Hey, Craig.

Craig Siegenthaler – Credit Suisse

Just first on the – I was looking your slide five, and just a follow-up to Matt's last question on charge offs. You disclosed $343 million with charge offs in slide five in the second quarter, that's roughly $100 million below what you actually reported. What's the delta there? Is it on the loan sales? Doe is it come from restructured loans? I'm just wondering where that extra $100 million of rough charge offs are.

Mark Furlong

It would be in the other categories.

Craig Siegenthaler – Credit Suisse

The rate is bigger than others or–?

Mark Furlong

Other real estate, loan sales, so the others that are in the decrease as it would be – it would come out in the next.

Craig Siegenthaler – Credit Suisse

Are any of them coming from restructured bucket, a little more (inaudible) perhaps?

Greg Smith

It's not going to be a material part of it, Craig.

Craig Siegenthaler – Credit Suisse

Okay.

Greg Smith

They're just really wasn't much movement there in this quarter.

Craig Siegenthaler – Credit Suisse

And wouldn't be the OREO flow to the income statement, not the charge off there.

Mark Furlong

The real estate would flow through the – would flow through the income statement. That's about–

Craig Siegenthaler – Credit Suisse

Okay. Got it.

Mark Furlong

Craig, it depends on the timing as to when a property moves into the other real estate. If there's a charge off that occurs on that within the first 90 days that it loosened the other real estate, it actually would run through other charge offs. If you did much of a trough up of that charge off when you moved in the to the real estate. After 90 days, it runs through expenses.

Craig Siegenthaler – Credit Suisse

Okay, got it.

Mark Furlong

And in the loans, the non-accrual loans sole bucket is – it's outside of what's going on here in terms of the non-accrual for it.

Greg Smith

Can you rephrase your question, Craig? We want to hear it for certain.

Craig Siegenthaler – Credit Suisse

Arguably, the $100 million that isn't on this charge off page on slide five, it's $343 million. I was wondering, it sounds like they're coming from two spots, it looks like. One is initial OREO charge offs. And the second is the non-accrual loan sole bucket. Is that right?

Mark Furlong

That's correct.

Craig Siegenthaler – Credit Suisse

Perfect. And then, the – my second question is just on other income, a little weaker this quarter than the prior run rate. I'm wondering if anything's unusual in there. And how should we think about that run rate going forward?

Greg Smith

Actually, Craig, I'd look at other income this quarter as being – once adjusted for one time things in prior book, I actually look at it as being pretty consistent. If you're going through – let's start with the $221 million we had last quarter. You had $ 48 million of merchant gain in there. And you had about $10 million gain on debt termination, which did not repeat this quarter. So at that point, you get to about a $6 million improvement over at this quarter over last quarter. I'll leave you with the impression that we're building strike there. I'd like to leave you with the impression that it's actually very stable on a quarter basis.

Craig Siegenthaler – Credit Suisse

All right, very helpful. Thanks for taking my questions.

Mark Furlong

Yes, sure.

Operator

Your next question comes from the line of Steven Alexopoulos with JP Morgan.

Steven Alexopoulos – JP Morgan

Good afternoon, everyone. Hi. Without the $100 million or so of the problem assets in Florida and Arizona, it looks like the ending in NPAs would have been roughly flattish or that about 3%. I'm just curious, given the comment on slide seven that there's now a limited inventory of problem assets for sale on those two markets. Is the read through from this that the rate of decline in NPA should slow over the next quarter or two? Or are you expecting sales to pick up somewhere else.

Mark Furlong

We'll continue to look at the portfolio, Steven, and just from a portfolio standpoint, and make the determination at that time. I think it's more likely that we'll see some additional sales in Florida than it is at Arizona at this point. But again, the focus will continue to be on the existing non-performing loans and trying to knock those down in going through the loan sale regardless of which region they're in.

So Steve, you also have to think about that where (inaudible) in the context of decreasing inflows to non-performing status and continue improvement with early stage delinquencies. Of course, non-performing loans, in total, are in balance. And what we’ve seen in the last few quarters has been an improvement in inflows to that capital. And certainly, the early stage delinquency improvements we saw again this quarter would lead us to expect inflows in the third quarter should be continue to be trending down.

One other thing, we’re at the point in a cycle where a lot of our borrowers have been – they really hung on the cycle, anywhere from two to three years depending on what industry, depending on what market you’re in. And now is not the time for them to give up. And that’s one of the things we’re seeing. We’re seeing in the improvement of the delinquencies, but also the decline in new non-accruals. We continue to see that core base of borrowers that have toughed it out through the cycle and they want to be the survivors. And we’re seeing – that’s part of what we’re seeing.

Steven Alexopoulos – JP Morgan

Thanks. Maybe just a follow-up. a lot of questions on the reserve. I just want to make sure I understand your comments. Are you guys looking for the reserves to be stable over the next couple of quarters? Is that the best way to describe it?

Mark Furlong

I think the best way to describe it is that when we’re confident that the trends that we’re seeing in the new non-accruals and the delinquencies have stayed, that’s when we’ll start seeing the reduction in the reserve. And I think as we've said the last couple of quarters, they're seeing that right now. So whether it’s the third quarter or the fourth quarter, the first quarter, I think we will start seeing that as long as these trends continue to – we will see a reduction in the reserve.

Steven Alexopoulos – JP Morgan

Perfect. Thanks.

Operator

Your next question comes from the line of Jason Goldberg with Barclays Capital.

Jason Goldberg – Barclays Capital

Thank you. I guess I'd like to – what’s going on a deposit side. There’s no loan growth. But I guess even if you excluded time deposits, overall deposit's down about 5% linked-quarter. I guess given that you guys have a tendency to be more customer-focused. Are these customer relationships going out for – I just want to understand on your (inaudible) strategy?

Greg Smith

Well, really, what we've been doing, Jason, is as much focusing on core customers and contracting some of those non-core customers. As example, we had lead quarter basis about $1.4 billion of contraction in the now account categories. Those balances were largely tagged related balances, and we didn’t like the economic proposition of having those balances. Given that you had to maintain a higher level of cash expecting those balances to leave, you're earning 25 basis points. But then, you are paying in press as well as FD IC insurance premiums. So really, it’s much been a focus on maintaining and building the core customer deposit balances. That goes back to your comments about improving deposit mix.

Jason Goldberg – Barclays Capital

Okay. And then, again, given your timeline for profitability, it appears to be pushed out and in a fairly disciplined month loss position because maybe updated from the status from the DTA [ph] – the prospects for evaluation allowance requirement.

Greg Smith

Yes, there's really nothing new to report on the DTA this quarter. Certainly, we continue making progress, both in terms of our credit quality trends as well as back toward profitability, but early nothing new to say about the DTA at this point in time.

Jason Goldberg – Barclays Capital

Because at what point does profitability get pushed out until debt comes impaired?

Greg Smith

Yes, I don’t think there’s just a threshold answer, where ex-quarter makes a different. I think it’s going to be one of these things where as long we continue to mark on the road back to profitability, and as we get to a point where we have better clarity about future profitability. All that will continue to be positive support for maintaining the deferred tax allowance. But there’s not a special trigger date or anything like that.

Jason Goldberg – Barclays Capital

And then lastly, I got a lot of questions on you guys continue to roll these foreclosures (inaudible). I think now we’re at (inaudible). I say this in terms of – are these credits that are actually built or goes on the charge offs and just a loss definition process around that?

Greg Smith

A lot of what the foreclosure moratorium does is formalize programs that we would have had in place anyways. The moratorium in and of itself, I don't think has much of an impact, if any, on any of our financial results. If there's a charge off that needs to be taken on a property. But then we would go ahead and realize it. If it is a non-accrual loan, it's a non-accrual loan. So it's just a – it's a very effective way for customers to ask of them and make sure that they have some alternatives to it.

Jason Goldberg – Barclays Capital

So when mortgage is under water and you're not proposing, you don't necessary book the charge off?

Greg Smith

If we didn't have a charge off, we'd have a reserve.

Jason Goldberg – Barclays Capital

So where's our position, right?

Greg Smith

Correct. We will set up a specific reserve.

Jason Goldberg – Barclays Capital

That, thank you.

Operator

Your next question comes from the line of Kenny Houston with Bank of America/Merrill Lynch

Kenny Houston – Bank of America/Merrill Lynch

Hi, guys. Two quick questions, Mark can you just walk us through the changing dynamic of the inflows? So obviously that's meet [ph] now, but can you give us a little bit more color on the types of loans and the types of – kind of severity that you're expecting from the new loans that are coming in?

Mark Hogan

Well, I take this from an inflow standpoint. There are some (inaudible). Stick to the presentation. There are some discussions there. There's kind of a place number. Ken, it's $240 million to $250 million that's coming in from the community side. And then the balance is coming in from commercial or commercial real estate. I wouldn't say when we looked at, whether it's from a reasonable standpoint or from a line of business standpoint that they really haven't done any changes as to where it's coming from. But, Ken I would make – regarding the loss exposure on the new non-accruals, we continue to see a reduced level of loss associated with both new non-accruals.

And it's primarily because as we've discussed before the exposure level on individual borrower significantly different today than it was a year ago and certainly two years ago. And to the extent that the new non-accruals are at $5 million to $10 million rather than $40 million to $50 million, it's not about the dollar amount per se, but it's about the percentage of loss. And that percentage of loss is significantly less today and smaller new non-accruals than it was on the larger new non-accruals a year ago. So we are seeing some improvement in the impairment required against those new non-accruals specifically on the construction and developmental zone on the commercial side.

Kenny Houston – Bank of America/Merrill Lynch

Okay. And my second question, it relates to the (inaudible) business. Can you talk a little bit about pricing across the market and where – if you are starting to see new relay shifts [ph] come in? Are they coming along the lines of bigger credits, smaller credits?

Mark Furlong

This is Furlong, our new relationship that has come in, they're probably – when the medium-sized creditors opposed to a $35 million to $40 million individual fees on a credit. And I say pricing is – the margins are still on and stronger than pre-recession margins. And I think they'll hold as well. You get in the relationships – is that service, their expectation is service and certainly based on failure of service and that side of where we get the business.

So there are still some pretty good opportunities out there. When you go to this like – offer a fair amount of changes that are occurring in other organizations, we kind of have a little more stability here and that's probably benefited and that certainly in the last probably three quarters. When you look at this period of time a year ago, very few new relationships are coming in. I mean a lot of customers hanker down whether with us or elsewhere.

But these are full relationships do sought [ph]. All the treasure mentioned and deposits as well as whatever portfolio they're lending needs require.

Kenny Houston – Bank of America/Merrill Lynch

Okay, I've got it. You're not really seeing that detrimental pricing even – I know versus the free-cycle it's – there have been a substantive kind of wiggle its way into the market incrementally?

Mark Furlong

On that by us yet [ph]. So we'll have to see where it's got. I think if we see it, it won't be from the smaller community banks. Many of those have put in the challenges, given what's thrown in the market and just lack of access to the market.

If we see it, it would be mostly from the very largest banks who have a significant (inaudible) liquidity. And then of course, there are challenges that are – due to security. And I would rather have a loan and courses [ph] (inaudible) depending on the security versus the loan. But that's where I would guess you would see it over time. But frankly, it's the source of where we're getting some of the new business. So that probably answers itself, right?

Kenny Houston – Bank of America/Merrill Lynch

Yes, thanks a lot, guys.

Operator

Your next question comes from the line of David Konrad with KBW.

David Konrad – KBW

Good afternoon.

Greg Smith

Hi, Dave.

David Konrad – KBW

Most of my questions have been already asked, but I guess indirectly a follow-up on the DTA, where is it through on common ratio come up this quarter?

Greg Smith

Tier 1 common looks like it's coming in at 7% for the quarter. And then the (inaudible) Tier 1 capital is coming in at 10.9%, total risk base still over 14%.

David Konrad – KBW

Okay. Thank you. And then, maybe seeking out longer term with the earnings part of the company of the company in terms of NIM, if you balance it out, M&I has always been a little bit pressured on NIM because asset growth is so strong yet, as you mentioned, the high loan deposit ratio. But in an environment we can see where we have a below 100% loan and deposit ratio, how does that help your NIM longer term, but also realizing a lot of construction loans might be off the balance sheet? How do you see what your NIM would be historical?

Greg Smith

Let me start with on the last comments there. All you have to do is look at the yield table that we have in the supplemental financial. And then it will highlight that construction development is not necessarily the highest spread lending asset that we have.

Okay. Generally, we are guiding for stabilization on net interest margin. There are probably more factors by it to the positive NIM than negatives at this point in time where there is improvement in funding profile. On the asset side, certainly, spreads are – have been relatively attractive in comparison to what were. And going back to the impact of non-performing loans, they're non-performing assets on our NIM. That's still about a 26 basis-point headwind for our existing net interest margin. So although stabilization is what we're playing to, to follow more factors biased to improvement in the NIM as opposed to duration in it.

David Konrad – KBW

Okay. Great.

Mark Furlong

Another way this, shedding the construction development portfolio will be a positive impact on the net interest margin percentage. We were not targeting high risk customer base, whether on the consumer side and individual construction or on the business side. We are targeting certain performing local developers. And as a result, those – there's probably a little more competition on yield there, but full relationships, counter-relationships, (inaudible) we're thinking.

And then where two markets were (inaudible) hit in Arizona and Florida. And so, as a result, that's the – the challenge is on those markets as well. And then we also have spotty challenges here and there. It's not been broad-based at all.

David Konrad – KBW

Great. Thank you.

Operator

Your next question comes from the line of Brian Foran with Goldman Sachs.

Brian Foran – Goldman Sachs

Hi, guys.

Greg Smith

Hi.

Brian Foran – Goldman Sachs

Good. I guess coming back to the expenses or the salaries, in particular, and maybe things in a different way. I guess where I got caught off guard was the salary relative to loans and relative to net interest income. So should we think about this level of slightly lowered as a fairly fixed cost? And thus, if loans shrank negative operating leverage, if loans grow off a (inaudible) operating leverage? Or is that not the right way to think about it?

Greg Smith

Well certainly, I supposed it said salaries and benefits. We are, as we do every year, curling towards target payouts, et cetera, that we would be expecting at the end of the year. So at this point, we would certainly think that this is – that relatively stable number. We'll have to see how economic growth and some of those factors that you mentioned fall through the financial statements as to how that will play out as the year goes forward.

Brian Foran – Goldman Sachs

And you can ask the follow-up – and I apologize if you've (inaudible) somewhere in the release than this did, but it did more dollars per headcount or is it more headcount that is driving the increase?

Greg Smith

Again, I don't really look at it as an increase versus where we were last year. I think headcount is generally stable at this point in time, although, certainly down from where we were a couple of years ago. Yes, as a matter of fact, headcount's just up a small touch this quarter in comparison to the prior quarter and in line with the fourth quarter.

Brian Foran – Goldman Sachs

Okay. So ultimately, the fourth quarter and the first quarter are artificially low because of reversals of incentives, and focused more on the second quarter versus 3Q '09 and prior.

Greg Smith

Yes, I mean I'd look at Q2 '10 versus 2Q '09 and 3Q '09.

Brian Foran – Goldman Sachs

Great. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Erika Penala with UBS.

Erika Penala – UBS

Good afternoon.

Greg Smith

Hey, Erika.

Erika Penala – UBS

Could you give us the dollar reserve that you have associated via single family TDRs and what your underpinning assumptions are for redefault rates and severity?

Greg Smith

We haven't gone into that type of detail, Erika. That's a pretty specific number and there're lots of pieces that go into that reserve. As I mentioned earlier, the redefault rates that we've seen in the single family residential mortgage are running between 20% and 25%. And we would expect those to trend up.

It is important just in terms of the reserve to keep in mind that once a loan goes on to TDR status, regardless of whether it gets cleared for calendar year or not, it is still treated as a TDR non-reserved process. So it does not just go back into normal accruing pool for reserving purposes.

Mark Furlong

So what that means is every report that we have to do, a full analysis on that credit to ensure that the carrying value is supported. And when it's not, then we have to provide for additional reserve (inaudible) for the life of that loan – for the life of that loan until we leave them or not.

Erika Penala – UBS

And as a follow-up to Tony's question earlier, you mentioned that a good deal of their single family TDRs are in (inaudible). But can you give us some more specific geographic place town of single family TDRs?

Greg Smith

In terms of single family TDRs, we would be looking at – without going into all the different buckets, I probably have $167 million of single family TDR in the Arizona market.

Erika Penala – UBS

Okay. And I'll actually follow-up a little bit. My last question is on the increase in losses in terms of commercial real estate. Was there any specific asset class or geography that drove the dollar increase quarter-over-quarter?

Greg Smith

No, nothing in particular. It was all pretty diversified on that front. And in terms of the increase, I'll also go back to Mark Hogan's earlier comment that we were pretty aggressive in trying to identify what looks like to be future problems and moving those into this quarter. So that drives it – piece of that increase as well.

Erika Penala – UBS

And in terms of selling the notes or in terms of taking ordered impairment on non-performing loans?

Greg Smith

Actually, taking loans that are technically performing and still part of – because there are certain aspects of those loans that we don't like moving those current loans onto non-performing status. And they're very well maybe a haircut on any of those loans when we move them into non-performing status.

Erika Penala – UBS

Thanks for taking my call.

Greg Smith

Okay. Thank you, Erika.

Operator

At this time, there are no further questions. I would like to turn the conference back over to Greg Smith for closing remarks.

Greg Smith

Okay. Well, thank you everybody for your time today. I appreciate everybody's questions, and certainly feel free to give us a call if you have any follow-up. Thanks. Thanks for your interest today.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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Source: Marshall & Ilsley Corporation Q2 2010 Earnings Call Transcript
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