Fifth Third Bancorp (NASDAQ:FITB)
Q2 2010 Earnings Call
July 22, 2010 9:00 a.m. ET
Jeff Richardson - IR
Kevin Kabat - President & CEO
Dan Poston - EVP & CFO
Mary Tuuk - EVP & CRO
Kenn Usdin - BofA Merrill Lynch
Todd Hagerman - Collins Stewart
Paul Miller - FBR Capital
Nancy Bush - NAB Research LLC
Brian Foran - Goldman Sachs
Betsy Graseck - Morgan Stanley
Good morning. My name is Ginger, and I'll be you conference operator today. At this time, I would like to welcome everyone to the Fifth Third Bancorp Second Quarter 2010 Earnings Call. (Operator Instructions) Mr. Jeff Richardson, Director of Investor Relations, you may begin your conference.
Thanks Ginger, and thanks everyone for joining us this morning. We'll be talking with you today about our second quarter 2010 results. This call may contain certain forward-looking statements about Fifth Third Bancorp pertaining to our financial condition, results of operations, plans and objectives. These statements involve certain risks and uncertainties. There are certain number of factors; sorry there are a number of factors that could cause results to differ materially from historical performance in these statements.
We've identified a number of these factors in our forward-looking cautionary statement at the end of our earnings release and other materials, and we encourage you to review those factors. Fifth Third undertakes no obligation, and would not expect to update any such forward-looking statements after the date of this call.
I'm joined on the call by several people. Kevin Kabat, our President and CEO; Chief Financial Officer, Dan Poston, Chief Risk Officer, Mary Tuuk, Treasurer, Mahesh Sankaran, and Jim Eglseder of Investor Relations.
During the question-and-answer period, please provide your name and that of your firm to the operator. With that, I'll turn the call over to Kevin Kabat. Kevin?
Thanks, Jeff. Good morning and thanks for joining us. I'll make some opening comments, and then hand the call over to Dan and Mary for more detailed discussion of our financial and credit performance.
We've also developed a presentation this quarter to facilitate that discussion, which we hope you find helpful. Obviously, this quarter marks an important turning point for us. Although the first quarter's loss was very small, it's still a loss. For the second quarter, we reported significantly stronger results particularly from the credit standpoint that resulted in a profit of 192 million. It was 130 million or $0.16 per common shareholder.
Environment remains challenging, but I'm pleased with the progress we've demonstrated in both credit trends and continued strong operating metrics. We've seen fairly sharp improvements in credit results, which I believe is the result of our aggressive actions earlier in the cycle, and while the phase of that improvement is obviously not sustainable, we do believe that credit should trend favorably as we move forward.
Taking a look at the few trends in credit, we saw a very significantly move in charge offs this quarter down 25% or 148 million from last quarter to 434 million. It was better than expected and it is the lowest level of charge offs we have seen since the second quarter of 2008.
Charge offs peaked in the third quarter of last year at 756 million, we have seen a reduction of over 40% just three quarters. NPAs were down a 160 million or 5% sequentially and NPLs were down 7%.
Delinquent loans 90 days past due were down another 39 million or 9%, so problem loan levels and loss content as both grew solidly in the right direction and this contributed to a reduction in loan loss reserves.
Still our reserve position remains very strong at 4.85% of loans, and with coverage actually improving to a 146% of NPLs in over two times annualized charge offs. Looking forward to the third quarter given the size of the decline in charge offs we just saw and have seen in the past several quarters, it probably will be difficult to beat the second quarter charge off level. Right now our expectation would be for charge offs to be stable to a bit higher in the third quarter.
We are probably looking a net charge off of something like 450 million plus or minus 10 or 15 million. Commercial probably be up modestly and consumer losses should be flat or down a little.
We continue to expect net charge offs to be significantly lower in the second half of the year than the first half of 2010 and for them generally follow a stable to declining trend line.
NPAs and delinquencies have declined recently and we expect those to slowly improve over time. We don't currently expect a significant move one way or the other in the third quarter and finally we would expect the reserve to continue to come down based up on our current views for credit trends and the economic environment.
Let me give some high level operating results, pre-provision net revenue of 567 million was consistent with that reported last quarter and was in line with expectations reflecting better than expected fee income results and lower expenses.
That was partially offset by lower net interest income resulting from weaker than expected loan demand and a decline in market interest rates. Fee income results were strong partially offset by lower mortgage banking revenue as expected. Total non-interest income was down 1% sequentially. Corporate banking revenue and card and processing revenue both showed mid-teens growth.
Average core deposits were up 1% sequentially and 12% over 2009 levels that include 1.8 billion in runoff of public funds deposits without significant other relationship aspects as expected.
We will continue to focus on gathering households and long term core funding and we will continue to manage our balance sheet and funding by minimizing our high cost non-relationship deposits.
Average loans were down 2% from last quarter, we came into the quarter expecting better results from that but commercial borrowers became more cautious as the European crisis developed and the U.S. equity markets declined in the middle part of the quarter.
Loan production was up from last quarter and we continue to gain market share. However, it was more than offset by higher than expected prepayment levels as companies continue to deleverage and defer investments. Line utilization hasn't increased but it did remain stable. The economy seemed to take a pause during the quarter still growing perhaps less the expected a quarter ago and borrowers have reacted to that.
Expenses were down 21 million from last quarter as expected driven by lower credit related cost and lower FICA. We continue to invest in the business for the long term which you can see in our FTE growth. Our strategic plan is focused on approving our core franchise and strengthening our financial performance as we look to the end of the cycle. Our strategic initiatives are focused on continuing to improve the customer experience at Fifth Third which will result in deeper customer relationships and improved retention.
This includes the role out of new products like the relationship savings product and other new product bundles such as our secure checking package but also includes additional investments in our sales force. Since September of last year we've added almost 200 personal bankers to our high traffic branches. We have expanded our branch hours on weeknights and weekends at most locations which is continuing to improve customer service levels.
We hired 125 new business banking officers and five affiliate market pilots with an expanded small business banking sales focused on customers in the 1 to 3 million revenue channel. We plan to open a number of new branches in the second half of 2010 as we selectively refresh and add to our network to improve our presence and delivery in those markets. We've brought in several commercial loan teams from competitors in recent months which we expect to better position us long term in key markets.
We've seen early positive impact from these initiatives, specifically in better deposit account production, deposit balance growth for both new and existing customers and solid loan production which is helping to offset weak loan demand otherwise. We think they are the right step to take for our future although it will take some time and a better environment to see the payoff. We'll keep a close eye on the performance of these initiatives in the economy and we'll dial them up or back as appropriate.
We still see a lot of opportunity in our markets today and our sales force continues to do a good job winning new business and clients throughout our footprint. My expectation is that this should continue, particularly as we add value to services and products.
Dan and Mary will talk about our outlook in more detail but we expect bottom line results to remain favorable in the third quarter and to see continued organic growth in capital. Our return to profitability is a major step in the progress of the company as per the events of the past couple of years. I'd like to thank Fifth Third's employees for their focus and dedication in helping us turn the corner on our credit issues and for staying focused on our customer relationships. The quality of work they've done has been fantastic and has enabled us to produce these solid results.
Our fee income businesses are performing well and expenses remain well controlled. Despite that, market developments during the quarter, particularly in Europe and U.S. equity markets resulted in some moderation of economic expectations as higher levels of caution among potential borrowers. We hope that greater certainty around legislative and regulatory developments and a general direction of the economy will begin to more fully translate and the customer comfort with borrowing and investing in their businesses again.
Dan will walk through some of the key features of financial reform legislation, the way we believe some of its elements may affect us and some of the things we expected due in response. We're good business people and while this will certainly present some challenges as we adapt, we believe it will be manageable.
I really do think that the net result of these developments, more of which are supposed to be addressed towards reducing systemic risks will play to Fifth Third's strengths. I've noted that we saw no key business in Fifth Third impaired or eliminated by the crisis. By the same token there are no key businesses that were eliminated for us through financial reform.
Business activity is fairly sluggish right now and our balance sheet and expense base and underleveraged relative to what they can support as things improve, as they will. We'll have to adapt to new costs and ways of doing business but they're consistent with the ways we've always tried to do business and I expect us to be a winner as we move ahead.
With that, let me turn it over to Dan to discuss operating results. Dan?
Thanks Kevin. As Kevin discussed we've seen positive trends on both the credit and the operational fronts and I'd like to spend some time discussing our performance in a little more detail.
Overall, we're very pleased with the results for the quarter. These results were significantly better than anticipated, offset somewhat by lower than expected net interest income due to weak loan growth and higher than expected cash balances.
Turning to the presentation, page 3 just summarizes the quarter for you. So, if you'll turn to slide 4, I will start there. In the second quarter we reported net income of 192 million and paid preferred dividends of 62 million which resulted in 130 million net income on an available per common share basis, which is $0.16 per share.
PPNR was 567 million, consistent with strong first quarter levels. The reduction in our net charge-offs and the overall stabilization and improvement of credit trends contributed to a reduction in our loan-loss allowance of 109 million.
Let me start with NII which is shown of slide 5. Net interest income on a fully taxable equivalent basis decreased 14 million sequentially to 887 million. Our net interest margin decreased 6 basis points to 3.57%. The decrease in NII was primarily balance sheet driven. Loans during the quarter were lower than we expected, particularly from mid-quarter on.
Commercial customers are also holding record levels of cash as the euro-zone crisis and domestic policy uncertainty have led them to adopt or maintain a cautious posture. Long-term investment securities were also lower than expected.
We didn't reinvest portfolio cash flows which were elevated by the pickup in prepayments during the quarter, driven by GSE buyouts of delinquent loans out of mortgage backed securities which also resulted in higher premium amortization.
These factors led to an increase in excess liquidity, where obviously we're not earning much right now. This was partially offset by the benefit of deposit mix shift in CD re-pricing as well as wider LIBOR spreads during the quarter and the impacted day counts. Net interest margin benefitted from lower deposit rates as our mix continued to shift to lower cost deposits. But that was largely offset by the drag created by low yielding excess liquidity.
Outside of those factors, the 6 basis point decline was largely attributable to increased premium amortization, resulting mainly from the impact of GSE repurchases as well as day count and a reduction in purchase accounting accretion.
With that context, I am turning to slide 6. Let's go through the balance sheet in a little more detail. Average earning assets were down about 1 billion sequentially or 1%. Taxable investment securities balances declined about 800 million on a sequential basis. We deferred reinvestment of cash flows as we were concerned about the impact of the termination of the Fed's mortgage-backed securities purchase program.
We continue to be very careful about managing the interest rate risk profile of our balance sheet. Although maintaining a neutral position in the environment costs us in current period earnings we believe that posture will serve us better with respect to long-term earnings quality and growth.
Average total loan balances were down 2% sequentially. While we would like to see better net results, we are pleased with our core production. We've always been a C&I focused lender and we are growing share and seeing good business opportunities there. We're also growing our customer base and while pay-downs and deleveraging continue, we know it will turn around and we will benefit from better activity and growth.
Average commercial loans were down 2% from last quarter, driven primarily by a 15% sequential decline in commercial construction loans. Loan production was up significantly from the first quarter but pay-downs also increased.
Let me make a few comments on specific components of the commercial portfolio. We suspended new home builder and non-owner occupied loans several years ago and we expect run off in those portfolios to continue. Commercial mortgage balances were flat sequentially and we'd expect those balances to drift down in the near-term as well. We also have lower CRE concentrations than most of our peers. So we do have some capacity. However our appetite there will remain limited in the near-term as we wait for the absorption over capacity to take place.
C&I loans were flat sequentially whereas we'd seen declines in the previous five quarters. So that was a positive development. Period and line utilization was 32.1% this quarter compared with 32.6 and 32.7% in the previous two quarters; so still fairly stable there. But that is down from about 39% a year ago and from normal levels in the low to mid 40s. Average consumer loans decreased 2% from the first quarter. Auto loan balances were flat sequentially but we would expect some modest growth in the auto loan portfolio in the third quarter.
Credit card balances were down 4% from the first quarter and flat year-over-year. Home equity loans were down 2% sequentially and 4% from a year ago. Residential mortgages were down 2% from the first quarter and 10% from last year as we continue to sell most of our new production. Deliveries during the quarter were 3.1 billion.
Looking forward, it's somewhat difficult to predict borrower behavior in this environment. Our loan pipelines remain intact in our building indicating that there is interest in investment. The borrowers are watching and waiting and are willing to defer borrowing decisions.
Continued economic growth will require further capital investments in working capital financing. So to see continued economic growth, we believe the companies will need to start borrowing. We're seeing reasonable stability in loan balances which is better than the industry trend. C&I loans and line utilization were relatively flat during the quarter as were most consumer loan categories.
Looking ahead, we would expect C&I loans to be fairly stable in the third quarter and auto loan balances to be up slightly. Mortgage balances should be flat to down, reflecting our sales strategy. Commercial real estate loans will continue to decline in the near-term due to lack of demand and tighter lending standards. For us all that adds up to an expectation that loans will be relatively flat next quarter or perhaps down modestly.
Our best guess currently is that the economy has enough momentum to start to generate some additional borrowing in the near-term. We've been close enough to flat that it wouldn't take much in the way of increased originations or lower repayments to tip that balance.
Moving onto deposits, average core deposits were up 1% on sequential basis and up 12% year-over-year. Consumer CDs included in core deposits declined 6% sequentially and 22% year-over-year. Excluding those consumer CDs, transaction deposits were up 2% sequentially and 21% year-over-year. The main driver there was demand deposits which were up 3% from last quarter and 16% from a year ago. Retail transaction deposits increased 5% sequentially and 12% year-over-year. We continue to have great success with our relationship savings product, which has now attracted over 6 billion of balances since inception.
In total, net new account production increased 22% sequentially and 56% on a year-over-year basis. Total commercial transaction deposits were down 2% from last quarter and up 41% from a year ago. Excluding public funds balances, average commercial transaction deposits increased 8% sequentially and 46% from a year ago reflecting excess liquidity among commercial customers and good account production.
Average public fund balances were down about 1.8 billion sequentially as we adjusted our pricing due to our excess liquidity position. We expect public funds balances to continue to run down as we manage our non-relationship account pricing, given our liquidity in the current environment for investing in that liquidity. As result, we'd expect deposit balances to be lower in the third quarter. Overall, the number of commercial deposit accounts is up and average balances per account are up as well.
With that background, our outlook for third quarter NII is for growth of 10 to 20 million to the $900 million range. We'd expect to have be driven by loan balances that are stable to modestly lower, CD run-off, continued deposit pricing discipline and lower premium amortization expense.
Turn to NIM, we expect NIM to expect to increase in the third quarter, but how much depends on the composition of our balance sheet. As you know NIMs in the industry right now are highly sensitive to the levels of liquidity.
We currently expect our third quarter NIM to increase 10 to 15 basis points or so to around 370 basis points plus or minus a few basis points. The increase is expected to be driven by lower excess liquidity, primarily from public funds deposit run-off, which is grossing up the balance sheet without really producing any NII. Those drivers should be in place in the forth quarter as well, although NIM improvement likely won't be as significant as in the third quarter.
Moving on to fees as outlined on slide 7, second quarter non-interest income was 620 million, down 7 million from last quarter but better than the 25 million decline we expected. Mortgage banking net revenue was down 38 million, a little more than our outlook. The key driver of this sequential decline was the net positive MSR evaluation adjustment of 51 million last quarter.
Fee income this quarter also benefited 10 million in gains on the FTPS warrants and puts. Last quarter we had 11 million in losses on the warrants and the total return swap related to visa litigation. If you exclude those items, fees were up $27 million and we're pleased with that.
Payment processing revenue was 84 million, up 11 million from last quarter which was driven by higher transaction volumes. That reflects some seasonality but was better than we expected off a pretty good first quarter result. We expect similar levels of processing revenue in the third quarter.
Deposit service charges increased 5% sequentially. Commercial deposit fees were relatively flat while consumer deposit fees increased 8 million from the first quarter. As you know Reg E went into effect for all new accounts in July and will go into effect for existing accounts in August. So far we're seeing opt in rates inline with our expectations and we still feel that a $20 million quarterly run rate effect is a good estimate.
We expect third quarter deposit fees to be down about 5 million, with 10 to $15 million in decline in electronic overdraft charges, partially being offset by growth and commercial and other consumer account service fees and then we would expect another 5 to $10 million drop in electronic overdraft charges in the forth quarter.
We've been proactive in developing deposit products that generate alternate revenue streams. We've eliminated free checking, unless the customer as a sizeable direct deposit or a minimum account balance and revenue from alternate products will also mitigate these changes overtime.
Investment advisory revenue decreased 4% sequentially but increased 10% on a year-over-year basis. The sequential decline is attributable to a seasonal benefit from tax preparation fees that occurs in the first quarter and the effect of the lower asset values during the second quarter.
We're expecting modest investment advisory revenue growth in the third quarter. Corporate banking revenue of 93 million was up 12 million or 14% from the first quarter. The sequential growth reflected strong syndication in lease re-marketing fees and higher FX in institutional sales revenue, partially offset by declines in business lending fees, and interest rate derivatives revenue.
We're not likely to match that level of revenue in the third quarter, which is typically seasonally soft, and we expect corporate banking revenue to be lower by about 5 million or so in the third quarter. Mortgage banking revenue as I mentioned was down $38 million. The MSR hedge in valuation adjustments produced revenue of 51 million in the first quarter, compared to $4 million negative adjustment this quarter.
Gains on sales were 80 million to 89 million this quarter versus 70 million last quarter due to the effect of rates on refinancing activity as well as the expiration of tax credits on new home purchases. We expect third quarter mortgage revenue to be strong as well given the deliveries of second quarter applications and the current rate environment up perhaps 10 to $15 million.
Within other income, credit-related costs recorded in fee income were 14 million in the second quarter, up from 1 million in the first. That was better than we expected in April primarily due to lower negative valuation adjustment on loans held-for-sale, and lower losses on sales of OREO properties.
We currently expect higher credit-related cost to impact non-interest in the third quarter with our current estimate being about 25 million. We reported equity income of 6 million from our interest in the processing JV in the quarter, compared with 5 million last quarter. Revenue from transition services agreement was 13 million during the quarter of the same level as last quarter, and those offset similar amounts of expenses.
As I mentioned earlier, we had 10 million in positive warrants on FTPS warrants and puts. Last quarter, those marks were a negative 2 million, and we also had a mark in the first quarter on the Visa totally return swap which was a negative 9 million. We are projecting a repeat of this quarters warrant benefit in the third quarter.
Overall, we currently expect fee income in the third quarter to be down about 20 to 25 million. This is somewhere around the 600 million range, or just below it, and that includes the initial Reg E impact that I talked about earlier.
Turning now to expenses on slide eight, non-interest expense of 935 million was down 21 million or 2% sequentially. In the second quarter, credit-related cost with an operating expense declined to 55 million from 91 million last quarter. Improvement came from lower mortgage repurchase expense, which was about 18 million down from 39 million in the first quarter. We currently expect credit-related operating expenses to be relatively flatten in the third quarter was about 20 million or so in mortgage repurchase expense.
In total, we expect third quarter expenses to be relatively stable, compared with the 935 million we just reported. A quick recap of PPNR; pre-provision net revenue was 567 million in the second quarter consistent with the 568 million reported last quarter. Our current expectation into the third quarter PPNR would be down slightly, but remain in the 560 million range. We will see in the release that the effective tax rate this quarter was about 20%. That's a bit higher than we expected last quarter.
The upward adjustment was really just driven by higher earnings than we have previously expected both for the quarter, and for the remainder of the year. Moving on to capital on slide nine. Our capital levels remain very strong. Tangible common equity was 6.55%, an 18 basis point improvement from the end of the first quarter. That ratio all the way we calculated excludes unrealized securities gains which totaled about $440 million. PCE was 6.9% including those unrealized gains. Tier 1 common increased about 25 basis points to 7.22% and the Tier 1 ratio increased 35 basis points to 13.75%, while the total capital ratio increased 56 basis points to 18.11%.
We would expect those ratios to continue to grow with ongoing profitability. Regarding TARP I don't really have any updates on TARP repayment. Obviously our results are progressing more favorably than we expected and we're building capital.
We will have discussions with the regulators as we move forward. Our aim is a result that is anchored to an appropriate level and composition of capital and that makes sense for us and/our shareholders as well as the regulators.
We said that we thought a resolution in the second half of 2010 seemed reasonably and that remains the case. That said we are willing to be patient, we believe that continued clarity on our results through continued positive trends and our future capital requirements through Basel III and other regulatory developments will provide us and the regulators with a better sense of what is an appropriate repayment plan.
Finally turning to slide 10, the President just signed the financial reform legislation yesterday and we have outlined some of the key provisions here. Obviously, this is not an exhaustive list of all the elements of the reform bill or the potential impacts especially given the most of the regulations to implement this law yet to be written.
But I do want to highlight two elements in my remarks here. One of the more significant potential issues at least from a direct financial standpoint is a debit interchange piece. Under the legislation the Fed is to study the cost of providing debit services and then set rates that are reasonable and proportional to those cost.
Obviously, we don't know and no one knows what those costs will include or what reasonable and proportional will mean. We obviously expect rates to come down that's what the legislation intends. But we don't have any evidence that for example, they will set rates, where banks actually lose money providing debit cards services.
That's what pricing at marginal cost would do and that certainly wouldn't seem reasonable and proportional. No one would benefit from that kind of disruption in the debit services that that would cost. Not us, not consumers, not even major retailers. The Fed study will highlight the pros and cons of the legislation which will be used in determining the appropriate interchange rates.
Until all that takes place we don't really no what we are dealing with. We have disclosed our interchange revenue and also the part that's related to debit which is shown on slide 10. Every 10 basis points reduction in interchange rates would cost us about $15 million annually and now as before any steps that we would take in mitigation and we do believe that much of this could be mitigated overtime as we and our customers adopt to whatever rules are written.
Another element of the bill is the Collins amendment which calls for the phasing out of trust preferred securities as a qualifying source of Tier 1 capital.
We currently have about 280 basis points of trust prefers within our Tier 1 capital structure. Excluding TARP, total non-common Tier 1 capital or 2/3rd is about 320 basis points.
Given the evolution in capital standards and expectations for higher common capital levels, that maybe more than we need long term in terms of non-common Tier 1. We will adjust our capital structure overtime as the new operating rules become clear.
We are comfortable with our ability to manage this change in a way that we don't really expect to be that costly or disruptive so that in the end we have a mix of common and non common capital that is appropriate under the new standards. We do have a healthy capital position and a fairly long phase in period for the trust preferred rules.
Turning now to slide 11, as I noted earlier a lot of financial reform is aimed at reducing or eliminating activities that aren't related to traditional banking, activities that are inherently volatile and that create systemic interconnections across financial companies and across borders. Firth Third has a traditional banking model that includes very few of those activities or a very small scales.
To cite one fact that I think is pretty telling, our daily VAR or Value At Risk is less than $500,000. That's because we just don't conduct the kinds of trading activities that are targeted by the legislation. There are any number of more qualitative aspects of the bill and I can't begin to forecast how all those will play out. The consumer financial protection agency and the way the new preemption rules will work are both major unknowns at this point.
That being said, we've never originated so called exotic consumer loans like our option [OREMs] or sub prime mortgages. We aim to provide good products and services that are relatively straightforward and have a fair price which is what the legislation is supposed to ensure. As we develop more clarity on all these issues, we will continue to share our thoughts with you.
That wraps up my remarks. I will turn it over to Mary to discuss credit trends and results. Mary?
Thanks Dan. Overall credit results continue to show broad based improvement. I'll get started with charge-offs on slide 12. Total net charge-offs of 434 million decreased 148 million sequentially with commercial charge-offs accounting for 117 million of the improvement.
Losses in Florida were significantly lower than in the first quarter and losses in Michigan continue to show stabilization with charge-offs relatively flat versus both first quarter and fourth quarter levels. Commercial net charge-offs for 225 million, down 117 million. Florida and Michigan accounted for 42 million of the decline. C&I net losses this quarter totaled 104 million, down 57 million with a sequential decline attributable to a broad base of industry segments. C&I losses in Michigan and Florida fell 20 million sequentially.
Commercial mortgage and commercial construction losses both showed significant improvement this quarter which reflects several factors. First the impact of the suspension of non-owner occupied commercial real estate and home builder lending two or three years ago. Second, we've burned through a lot of our more significant problems by dealing with problem credits aggressively during the cycle.
Finally loss severities in general have also improved with greater economic stability and more liquid markets. Commercial mortgage net charge-offs of 78 million decreased 21 million from last quarter. Commercial construction net charge-offs were 43 million, down 35 million. I note that our commercial construction balances are down over 50% since this time two years ago as we have reduced balances and the risk in that portfolio.
Across both commercial real estate portfolios Michigan and Florida represented 20 million of the improvement but still produced 52% of losses. Total home builder developer losses were 48 million, down 33 million from last quarter. You will recall that we suspend home builder originations over two years ago have already recorded significant charge-offs against that portfolio and it worked to reduce our exposure.
Portfolio balances declined 117 million sequentially to 1.2 billion, which compares with the peak balances of 3.3 billion back in mid-2008. We continue to expect losses from this portfolio to generally decline overtime. Given the fairly dramatic decrease in commercial charge-off seen over the past three quarters, we currently expect commercial net charge-offs to be flat to up modestly given our out performance this quarter, and a fairly stable outlook for trends.
As you know, the results of the [SIC] exam are also provided to banks in the third quarter. Based on our own exam, the end of more stable credit environment during industry exam, we don't have any reason to expect any negative surprises and haven't assumed any in our outlook. Our outlook does include our own assessment of all portfolio credit including next agencies by other banks.
Turning to the consumer portfolio, net charge-offs of 209 million were down 31 million, or 13% compared with the prior quarter. Net charge-offs in the residential mortgage portfolio were 85 million, a 3 million sequential decline. This reflected improving early stage delinquencies seen late last year, and through this year.
Home equity losses decreased 12 million sequentially to 61 million, which included 24 million of losses in the brokered portfolio. The net charge-off rate on brokered home equity was about 5.3% annualized, which is down from earlier peak, but it's still almost four times the loss rate on our branch originated book.
The brokered equity portfolio was 1.8 billion, down from about 3.5 billion a couple of years ago, and continues to run off. We saw improvement in both auto and credit card charge-offs as well, with auto losses falling 11 million or 36% sequentially to 20 million. This is largely due to better values received at auction, underwriting improvements and seasonality.
Credit card losses decreased 2 million or 5% sequentially to 42 million. We expect consumer losses to trend down slightly in the third quarter. Now moving to NPAs on slide 13. NPAs, including held-for-sale, totaled 3.1 billion at quarter end, down 236 million or 7% from the first quarter. Portfolio NPAs, excluding held-for-sale, totaled 3 billion, down 160 million or 5%.
Non-performing loans were down over 200 million sequentially over a 7% decline, while OREO was up about 48 million, largely commercial OREO. Overall, Florida and Michigan remained our most challenged geographies from an NPA standpoint, and accounted for 46 % of NPAs in the portfolio although, NPAs in those two states were down 51 million sequentially.
Portfolio commercial NPAs were 2.3 billion and declined 140 million from the first quarter, which was frankly better than we were expecting. Improvement in the commercial construction portfolio was the biggest driver, with NPAs down 87 million or 15%. This follows the drop last quarter of 138 million.
Lower NPAs in Florida and Michigan accounted for almost half the decline. Commercial mortgage NPAs were down 47 million, with improvement broad based across the entire footprint.
C&I NPAs were stable, up 4 million from the first quarter. Across the commercial portfolios, residential builder and developer NPAs of 431 million were down 90 million sequentially and represented about 19% of total commercial NPAs. Within NPAs, commercial TDRs on non-accrual status increased to 48 million from 39 million last quarter.
We expect to continue to selectively restructure commercial loans where it makes good economic sense to the bank. We currently expect commercial NPAs to remain relatively stable in the third quarter. We saw pretty significant improvement in delinquencies overall during the quarter, which I'll talk about in a minute, and so we're pleased with overall trends.
On the consumer side, NPAs totaled 695 million at the end of the quarter, a decrease of 20 million or 3% from the first quarter. Non-accrual consumer TDRs declined 25 million with the remainder of the consumer NPA portfolio increasing 5 million. Residential mortgage NPAs increased 28 million during the quarter to 549 million, with TDRs up 11 million sequentially. That did include effect of a change in our recognition of mortgage NPAs from after 150 days to 150 days which brought a month’s NPAs into the second quarter.
This addresses the monthly day count issue that you'll recall last year caused a swing or increase in NPAs from the second to third quarter. Home equity NPAs totaled 65 million at the end of the second quarter, down 5 million from first quarter levels. Auto NPAs were down 5 million, and credit card NPAs were down 37 million with the improvement in the current portfolio attributable to TDRs returned to performing status.
We expect third quarter consumer NPAs to be stable with the second quarter. Consumer NPA trend should continue to reflect a seasoning of more recent TDRs as well as the favorable delinquency in migration trend we've been seeing.
Turning to slide 14, we provide some data on our consumer troubled debt restructuring. We have 1.8 billion of TDRs on the books as of June 30, of which 1.6 billion were accruing loans, and 246 million were non-accrual. Of the 1.6 billion of accruing TDRs, 1.4 billion were current. And of current loans, over 1 billion were current, and were restructured six months ago were more.
Based on that experience in our re-default rates overall, we expect the vast majority of that 1.4 billion pool to stay current. In total, about a quarter of the loans we've restructured to date have re-defaulted. On a lag basis, re-default rates are just under 30% on modified loans, which is better than industry data.
We've updated our vintage default rate curves on the slides, so that you can see the tendencies for default by vintage. More recent vintages have shown lower re-default rates than loans we've restructured earlier in this cycle, and also constitute a larger proportion of the aggregate TDR pool.
Overall, we continue to be pleased with the results of our loss mitigation effort. And I think the information we've provided demonstrates that they're working and improving. Let me start for a minute and point you to slide 15, which is the role forward of our non-performing loans that we've included in the materials we released this morning. Our commercial non-performing loans inflows were the lowest we've seen in quite sometime at 310 million, compared with 405 million last quarter, and a quarterly range of about 550 to 830 million in 2009.
Consumer inflows increased to 200 million although we'd expected that to be down in the third quarter. The increase this quarter included the acceleration of mortgage NPA recognition I mentioned earlier. Total inflows, commercial and consumer were 515 million down from $542 million last quarter and the lowest we have seen since 2008.
To wrap up the NPA discussion, we have been proactive in addressing problem loans and writing them down to realistic and realizable values. Total NPA's commercial and consumer are being carried at approximately 56% of there original face value, through the process of taking charge offs, marks and specific reserves recorded through the second quarter. We believe that's appropriate and I think our recent charge off trends continue to be indicative of lower severities on new NPA's and reach simple carrying values over all.
Moving to slide 16, which outlines delinquency trends, commercial loans 90 days past due were a 142 million, up 22 million from the first quarter. Last quarters level was down 79 million to the lowest level we have seen in several years and so we're pleased with the continuing low level of 90 day delinquencies. Commercial loans 30 to 89 days passed over 277 million and decreased by a 124 million from the already low levels experienced in the first quarter.
As we discussed last quarter, consumer delinquency trends overall have continued to improve. Three key drivers of those trends are the seasoning of loans made in 2005, significant underwriting improvement in home equity and auto portfolios and the runoff of mortgages due to our salability strategy. These factors are having an increase in impact on the performance of the portfolio.
Consumer loans over 90 days past due were 255 million, down 61 million. Consumer delinquencies 30 to 89 days past due decreased sequentially by 13% or 62 million to 416 million. Total delinquencies this quarter were down 17% from last quarter and were at the lowest level since May 2007. We believe we are seeing signs of stabilization and don't currently expect a lot of movement next quarter, although delinquencies can move around a bit given seasonality and timing issues.
Now for a couple of comments on provision and the allowance which is outlined on slide 17. Provision expense for the quarter was 325 million and reflects a reduction to the allowance for loan and lease losses of a 109 million. Our allowance coverage ratios remain strong and actually increased sequentially despite the reduction in the dollar reserve.
Coverage of non-performing loans improved a 146% in coverage of second quarter annualized net charge offs increased to 212%. We've also updated our stress test models on slide 18. The macro forecasts are derived from the Moody's Economy.com base case and recession case scenarios.
As you see, under the updated base case scenario, 2010 losses would be expected to come in below 2 billion, significantly below our 2009 losses of 2.6 billion. Losses under the recession case, would not only be much better than the S cap adverse scenario results, but also better than our baseline S cap submission for 2010. While current levels of losses are elevated, they are much lower than fairly a year ago and our expectations for losses continue to be materially better than we were modeling coming into the year.
That wraps up my comments; I'll turn it back over to Kevin for closing remarks before we open the call up for Q&A, Kevin?
Thanks Mary, so just a wrap up, we've accomplished a lot that really shows in this quarters results. PPNR was consistent with strong first quarter results, credit trends and charge offs again improved significantly. We wouldn't be surprised for charge-off and NPA ratios move below those of the top 15 bank medium this quarter. We had a modest reserve release, but we showed earnings growth excluding it, and we moved solidly into profit territory. There may be uncertainties down the horizon, but we are performing relatively well on this side of it.
So, with that operator, why don't we open it up for questions? Ginger? Operator?
(Operator Instructions) and your first question is from the line of Kenn Usdin of BofA Merrill Lynch.
Kenn Usdin - BofA Merrill Lynch
Good morning. I just wanted to ask you two quick things. First of all on the Reg E impact, can you do, can you in anyway just size the total amount of overdraft revenues that you currently have and the run rate it is in the second quarter?
This is Jeff. We haven't disclosed that previously, so no we can't do that.
Kenn Usdin - BofA Merrill Lynch
And then on the question of NPAs being relatively stable, again is it more of just a mix question to why you've given the improvements in some of the forward-looking trends of why you won't fee the near-term continued improvement on the NPA side?
Yes. We've said in our guidance that we expect them to be relatively stable, and to your point there is a couple of factors that really drive it. One is there is a mix shift overall so a lower affect coming from commercial real estate than what we experienced earlier in the cycle. In addition, loss severities will make a difference in terms of our overall charge-off performance as we go further through the cycle. So, in terms of our overall outlook obviously, NPAs and charge-offs are part of that. There is a number of factors driving that relative to improvement in the cycle, mix shift as well as lower loss severities.
Kenn Usdin - BofA Merrill Lynch
Okay, and my third quick one is just contrary to a lot of other companies have reported mortgage banking was actually down this quarter for you guys versus up at a lot of others, can you just walk us through some of the moving parts there, and what were the incremental pressures if there were any for you guys? Thanks.
I think the overwriting factor with respect to overall mortgage results was the gain if you will that we record it relative to MSR valuation and hedging results in the first quarter. In the first quarter, we had $51 million in net gains on valuation and hedging. We talked at the time of about the fact that that was probably not something that we would replicate in the second quarter, and therefore we guided to a fairly significant decrease in mortgage banking revenue. Overall, I think we talked about something in the $30 million range. It came in the 38. I think our hedging results for the second quarter are more in line with what, with what one would normally expect. We had about $100 million in valuation, negative valuation adjustments on MSRs. Our hedges operated the way one would think they would, and offset virtually all of that. We had about $4 million net MSR hedging valuation item in the fourth quarter. So, I think those -- that was the key driver. The only thing I would point out is that our core mortgage banking activity in terms of gains on sales, we are actually up during the quarter, which is think is probably more consistently. It looks a lot you are referring to in terms of what others performance has been.
Kenn Usdin - BofA Merrill Lynch
Gotcha, all right, thanks a lot.
And your next question from the line of Todd Hagerman from Collins Stewart.
Todd Hagerman - Collins Stewart
Good morning everybody. Just a couple of quick questions, just first kind of a follow up on the Reg E question. Dan, I am just wondering, I know you guys have been diligently working on a number of new products and so forth in anticipation of some of these changes and I just noticed that again net account growth was pretty good again this quarter and one think just kind of struck me is with the guidance that you have given kind of $20 million kind of run rate if you will. A number of companies kind of narrowed their estimate in terms of the potential impact. I am just wondering if you could just give us a little bit more color in terms of what some of those assumptions might be in kind of little bit more in detail in terms of some of the success you have had in terms of implementing some of those new products and so forth.
Well first of all relative to the impact of Reg E and talking about assumptions and so forth. As Jeff, indicated earlier, we haven't disclosed detail about overdraft charges nor our assumptions in terms of the specifics of assumptions relative to our Reg E impact.
I guess I would point out that we have commented today that our prior estimate of $20 million per quarter. Our results are tracking to be inline with the $20 million per quarter impact that we have previously discussed.
Relative to development of other sources of revenue and mitigations impacts, we have had success with lot of our new deposit product offerings; we discussed some of those in the call and the script today. On an overall basis I think it is useful to look at overall deposit service charges trends and expectations. For instance in the third quarter we have talked about the impact of electronic overdrafts being down 10 to $15 million yet we expect deposit service charges on an overall basis to be down only 5 million. So, I think in those kinds of expectations you can begin to see the impact of some of the things we have done in terms of the introduction of new products and alternative revenue streams.
Todd Hagerman - Collins Stewart
Okay, that is helpful and then just secondly if I could just add Kevin maybe a little bit more perspective in terms of kind of the Mid-West economy. One thing I have noticed is that the manufacturing data regionally has been encouraging over the last couple of months. And I am just wondering if you could give a little bit more detail as you kind of tie that together with some of the positive comments whether that's on the stabilization rates on the C&I side holding steady or the dramatic drop in kind of the inflows on the C&I side.
Just trying to get a better perspective of what kind of the underlying activity you are seeing particularly as it relates to kind of your traditional commercial customers and how that maybe a function of what's happening there in the Mid-West.
Todd, I think from our perspective and we try to capture relative to tonality which is difficult thing as you might imagine in this environment but what we still are seeing particularly in the segment that you talked about which is the manufacturing segment has been holding up very, very strong. Our manufactures feel good about how they are positioned and are seeing some slight growth in terms of their wares and so they're well positioned, their balance sheets are strong. But we did see a pause particularly more toward the middle of the quarter as things got a little more elevated relative to Europe and credit issues here. So people really have stepped back from that standpoint but they are in very sound position. We think that when there is a bit of confidence that bleeds in that they're going to be well positioned to be able to take advantage of that we'll be there to help them. And from our standpoint, while we are seeing still the effects of some of that deleveraging going on, we think we're expanding our core base. We're getting some good clients on board. Our core production has been good. I think it will show up in a couple of different ways that I think it will begin to contribute to us in terms of overall growth going forward and so we feel well positioned from that standpoint as does the marketplace. So that's kind of the trends we're seeing. That's kind of the feelings that we're getting as we talk to our clients and prospects and we try to put that in but that just makes for a very difficult time to predict what to do talk about, how soon we're going to see some of the benefits to us.
That's helpful. Thank you.
And your next question is from the line of Paul Miller from FBR Capital.
Paul Miller - FBR Capital
Can you talk a little bit about your, going forward we got low rates, we got low treasury rates on how you're viewing balance sheet growth and the trade off between that and your securities portfolio? I know, a lot of people are repositioning their balance sheet and selling some of their securities but just how do you view what's going on in the world and how to deal with it going forward on your balance sheet?
Yeah, as we mentioned earlier we had or we did during the second quarter defer some of the reinvestment of cash flows off the portfolio and that was largely because of some of the things that you just alluded to in terms of some of the risks that are in this environment. As we look at it, I think we focus primarily on making sure that we are appropriately managing our interest rate risk. We've talked in the past about maintaining an overall approximately neutral position from an interest rate risk perspective. That continues to be our objective and I think that continues to be how we are positioned. That likely cost us somewhat in the short run in terms of current earnings but I think it positions us better for the future and I think while we would expect that we would resume investment of portfolio cash flows in the third quarter, we may well even invest some of the deferred cash flow from earlier quarters. That will be done with the overall objective in mind of maintaining a neutral position from an interest rate risk perspective.
Paul Miller - FBR Capital
And the other issue is your credit quality. I think a lot of people have seen credit quality stabilize here and a lot of people are guiding us including you guys to a more stable or decline in, an improvement in credit quality going forward. But we're seeing some bad macro data which is spooking some investors out there and what type of, where would the economy have to really hick up? In other words, would unemployment rate would have to really jump to 11, 12% for you to start seeing deterioration in credit quality. Again I don't think it’s going there but I think there is too much bad news out there. I don't think investors are really looking at what would have to happen for credit quality to start to take another dive.
I think a couple of factors are going to enter in there for that question. One is we've been very active in working through the portfolio for a long time now. We were aggressive on this already starting a number of years ago which included at that point a very forward looking view on what would the economic trends play out to be in the next couple of years and what actions could we take in advance to that. And that kind of stress testing approach that we already started a couple of years ago, we've continued to expand upon.
In fact in today's deck, we have another page, which shows you the impact of some of our most recent stress testing, it's something that is a continual part of our process, so that we can take into account not only unemployment trends, but also other trends relative to property prices as well as GDP. So, I think your question is a good one in terms of unemployment and what kind of impact could that have.
Certainly, that is a possibility, but we feel that we are able to manage through that in a pretty good way because of all of this activities and strategies and approaches that we put in place, starting a couple of years ago, and how we continue to work through the issues in a relative loan book.
And Paul, we -- the thing that we feel right now, again, it's just by visiting the markets. So, it's not out of one of the surveys, or out of specific data information, but we would tend to agree with you. We don't see a huge risk for a severe back fall if you will, or double dip, whatever you want to call it.
So, we're seeing kind of stable and steady as she goes out there, without a major change from that standpoint, just a lot of cautiousness relative to the current environment. And we think that's more of an impact today than what's actually occurring in the market place so.
Paul Miller - FBR Capital
Okay. Thanks a lot, gentlemen.
And your next question is from the line of Nancy Bush from NAB Research LLC.
Nancy Bush - NAB Research LLC
Kevin, I have a question for you, once again, related to the Midwest, and I take it that things are improving there. But one of the characteristics of the Midwest in previous cycle, it's been that when things start to improve, deposit pricing and the credit pricing get more competitive there than almost anywhere out in the nation.
Can you just speak to whether you're seeing that kind of pricing competition yet on other deposits or loans, and what your expectations are as things continue to improve?
Yeah, Nancy, you're exactly right, and we have been anticipating that. We have not actually seen that. Now, I would bifurcate those comments in two ways. We have not seen that at all relative to deposit pricing. As you can imagine, banks are fairly flush in liquid, and so we're not seeing a lot of competition or paying up from that standpoint. On the asset side, by and large, still good discipline we see out there, and still good asset class spreads and yields across the Board.
Obviously, though we're seeing now some of the better credits, sharping harder, and so we would expect a little bit more competition from that standpoint. And so, we're just seeing -- we're just beginning to see that now, Nancy. It hasn't been prevalent. You could see in our yields, even on sequential basis, we haven't seen major change, only down a point.
So, we are watching that. But, so far so good, but I think I don't want to be naive as we kind of continue on in the improvement, and the progress in terms of the economic recovery that we fully expect to go toe-to-toe in terms of the better clients and the better customers.
Nancy Bush - NAB Research LLC
Okay. And then one follow-up financial question, US Bancorp, a couple of days ago, put forward some numbers for increased FDIC expense based on the new base and the new pricing; do you guys have any kind of similar numbers?
Nancy, I think from an assessment base standpoint, I think I can speak to that. The increase in our assessment base would be from about 80 billion to roughly 97 billion which is a little over 20% increase. So, if you make an assumption of no-adjustment in the assessment rates, that would implied about a 20% increase in FDIC costs. I think it remains to be seen at what level those rates will be established but I think that probably gives you the information you need.
And I think I would add, I think you asked me, actually said that would be the assessment, if the assessment rates stay the same. There's no information in the bill that suggest but that's what they will do and obviously if they do leave the assessment rate alone that may lead to an increase of revenue to FDIC and we don't know whether that's what they're trying to do either.
Nancy Bush - NAB Research LLC
Okay, great. Thank you very much.
And your next question is from the line of Brian Foran from Goldman Sachs.
Brian Foran - Goldman Sachs
Good morning, good morning. On debit interchange, I know it's too early to tell and you gave a lot of helpful dimensions but just to follow-up to make sure if I am thinking about it right, first in the last 12 months debit interchange data, should we use that as a base or do we have to account for some kind of underlying growth rate maybe 10% or so and then second I know you're not giving a point estimate and with good reason there is no regulation yet but when you kind of think about the B of A guidance that was put out there and I compared that to your comment. Is it fair to interpret that you know maybe you're a little bit more optimistic that it will come down to that kind of extent?
And then third, how should we think about your signature versus TIN mix, can you remind me why you are overweight signature relative to the industry and is that a risk factor given higher interchange rates?
Yes, Brian, on and overall basis, as you indicated, hopefully we have provided information that is useful. Relatively to what some others have discussed, as we look at the rules and try to anticipate what the future might hold, certainly we're not of the belief that we're going to lose 80-90-100% of our debit interchange revenue. On the other hand, we do anticipate that there will be a significant impact to this. I think it's just too early to tell what that impact will be because we don't know what will be considered costs, what an appropriate return over and above those costs will be baked into the rates that are set ultimately.
And I think there's going to be lots of opportunity to mitigate whatever that impact is once we how the rules are set and what the kind of what the challenge that's laid out in front of us. So, on an overall basis, we would anticipate that it will be far less significant than what some others may have been estimating.
So I think there may have been second part to your question I didn't answer but.
Yes, the only other thing Brian, just to add to your question, you talked about signature versus PIN, there's really nothing, maybe geography is really dominant factor from that perspective but there's really nothing to read into our mix from that standpoint.
Brian Foran - Goldman Sachs
Thanks and then…
The other thing I think you asked was last 12 months. I think last 12 months, I was about a 185 million give-or-take in terms of growth I think, taking our most recent quarter and annualizing it's probably closer to 200 million rather than the 185, so you’re right in that range.
Brian Foran - Goldman Sachs
And then as I think about offsets in the mitigation, I know again it will be early, but should we think more about fees on and I am talking Reg E and debit together now since the offsets are going to be so overlapping, I mean if the fees on checking accounts, are we headed for a branch rationalization cycle, is it annual fees on the cards, is it migrating people to different products or is it just, we kind of have to test everything.
I guess ultimately what I'm asking is there are there opportunities to offset this stuff on the revenue side by charging consumers in other ways or is the consumer so ingrained with the free products that you have to really have go through a cost rationalization exercise if we are going to mitigate it?
Brain, again it's really early on this, but our orientation I think would be one that I think there is going to be a lot of different levers to pull relative to this particular issue and that in fact the industry and ourselves, specifically have already begun changing out, kind of a old orientation of free to value added services. We've talked a lot about that since what we did and began literally about this time last year and we will just continue on that.
It's been successful for us thus far, our customers, prospects and new product production has been outstanding and it continues to be, so I think we've kind of -- as we will going forward, continue to find the right combination of services, value creation, additional product offerings as well as some pricing opportunities that all will be contributory toward that mitigation strategy as we go forward.
So, I think we have demonstrated to ourselves at least that our value added opportunities that we can migrate from where we've been to where we are going, and that maybe what your reading into our optimism about how we view the challenges ahead of us.
This is Jeff, I guess I will just add that, debit is the most efficient form of payment there is, credit cards involve credit risk and floats and that's got to be priced into interchange, checks involve float and credit risk to get those cleared.
In debit, we guarantee payment to merchants and debit is cheaper than credit and that's all going to be recognized when studies are done and if we end up shifting towards credit cards because credit risk is being taken that's -- we'll adapt to all that.
Brian Foran - Goldman Sachs
That's all very helpful, thank you.
And your next question comes from the line of Betsy Graseck from Morgan Stanley.
Betsy Graseck - Morgan Stanley
Hi thanks, a couple of questions, one follow-up. Does it matter, that percentage to which your debit is signature versus PIN?
In the legislation, it doesn't, there is no reference to signature versus PIN.
Betsy Graseck - Morgan Stanley
Because you are more of signature, is that right?
Right. That's right.
Betsy Graseck - Morgan Stanley
Okay, and then separately on loan sales, could you just give us a sense as to how you do your portfolios that are up for loan sales, I'm thinking about distressed loan sales, I know there was little bit of what you did in the quarter and I'm wondering if that's a kind of a core part of your go forward strategy?
Yes, Betsy, we continue to evaluate loan sale opportunity, and we do that on a very active basis. We did not engage in any large scale asset disposition transaction this quarter. What we did was more just along the ordinary course of business looking for more individual and selective opportunities that made economic sense for us.
And we will continue to evaluate all strategies as we continue forward in the cycle. I'll tell you that we do continue to see some signs of improved pricing, and in demand for properties which you would expect to see I think at this point in the cycle given some of the cash that's on the sidelines and some of the excess liquidity. So, we'll continue to work through that strategy.
Betsy Graseck - Morgan Stanley
Okay. No incremental rate of change expected in the coming quarters though?
We've got nothing anticipated at this point, again we're going to be opportunistic as it arrives.
Betsy Graseck - Morgan Stanley
Obviously, you have a significant amount of reserves, so you probably march pretty effectively. It might -- I'm wondering if you had positioned like that in order to try to sell a little bit more aggressively, but I suppose the answer it no.
We'd always like to tell you but after we did it Betsy.
Betsy Graseck - Morgan Stanley
Yeah. I hear you. Thank you.
Ladies and gentlemen, thank you for participating in today's conference call. This does conclude today's conference call. You may now disconnect.
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