Sterling Bancshares, Inc. Q2 2010 Earnings Call Transcript

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 |  About: Sterling Bancshares, Inc. (SBIB)
by: SA Transcripts

Operator

Ladies and gentleman, thank you for standing by and welcome to the second quarter of 2010 Sterling Bank shares earnings results conference call. At this time all participants are on a listen-only mode. Later there will be a question-answer session with instructions given at that time. (Operator Instructions)

At this point I’ll now turn the meeting over to our host, Mr. Graham Painter. Please go ahead.

Graham Painter

Thank you and good morning everyone, I’m Graham Painter, Executive Vice President, Director of Corporate Communications. This morning Sterling Bancshares released results for the second quarter ending June 30, 2010. To discuss those results with you today are Downey Bridgwater, Chairman, President and Chief Executive Officer; Zach Wasson, Executive Vice President and Chief Financial Officer; and Bob Smith, Executive Vice President and Chief Credit Officer.

I’d like to remind everyone of the Safe Harbor statement included in today’s earnings release. The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements including statements made during the course of today’s conference call. These forward-looking statements are based on the company’s current expectations and beliefs concerning future developments and their potential effects on the company.

There can be no assurance that future developments affecting Sterling will be those anticipated by the company. Factors that could cause actual results to differ from those projected in the forward-looking statements are set forth in today’s earnings release, which had been posted on the Investor Relations page of our website at bancsterling.com. For additional detail on these matters and other risks that could affect the company, please refer to the company’s annual and quarterly reports which are filed with the Securities and Exchange Commission and available online at fcc.gov.

On today’s call, our speakers may reference certain non-GAAP financial measures, which we believe provide useful information for investors. If necessary, we’ll post reconciliations of these non-GAAP numbers to GAAP results on the Investor Relations page of our website. Sterling assumes no obligation to update the information presented on this call including any of its forward-looking statements.

And now I’d like to turn the call over to our CEO, Downey Bridgwater. Downey.

Downey Bridgwater

Thanks Graham and welcome everyone. We appreciate you taking the time to join us on the call. Hopefully, you had a chance to review our second quarter 2010 results, which we released this morning before the market opened. We reported a net profit of $596,000 or $0.01 per share for the second quarter, which is an improvement of $0.08 per share as compared to the first quarter of this year.

Improvement in earnings is a direct result of a lower provision for credit losses. The decrease in provision was due to several factors, but was primarily related to a substantial reduction in FAS 114 write-downs of CRE loans during the second quarter, as net charge offs total $6.4 million as compared to $21 million in the first quarter of 2010.

While we continue to receive new appraisals in the second quarter, we then experienced the same level of deficiency in valuations that require major adjustments to loan carrying values as we experienced during the first quarter. Even though economic growth may now be a little slower than some experts had predicted, although national and Texas economies appear to be in a recovery phase and the bottom to the CRE market seems to fall. It will take some time for the CRE sector as a whole to heal completely as demand for new space will ultimately depend on sustained employment growth and business expansion.

But it appears that Texas business activity seems to be moving in a positive direction. We continue to see incremental improvement in key economic indicators that lead us to believe the worst of the recession is behind us. In May, every major metro area in Texas added jobs and the unemployment rates continue to improve albeit slightly and still remain below U.S. average. The population growth continues in all of our Texas markets.

Oil and natural gas prices have remained relatively healthy and are expected to increase slightly over the remainder of this year and into 2011 based on the latest forecast from the Energy Information Administration which should benefit our markets. The U.S. active rig count is up over 70% from this time last year and the active rig count in Texas is more than doubled what it was in July 2009. Because energy represents a considerable part of our economy in Texas, let me take a few moments to address the potential impact of the Gulf oil spill on our markets and specifically Sterling.

For Sterling, we don’t expect to see any direct impact to our loan portfolio and as of June 30, 2010, we have approximately $125 million in funded direct energy loans. These loans are primarily secured by onshore domestic oil and gas production. We do not have any direct offshore exposure.

To date, only a very small amount of oil from the Deepwater Horizon has washed the shore on Texas beaches. Therefore, we would not expect to see any meaningful negative impact on tourism or other businesses along the Texas coast. Even if for some unexpected reason that were to change, our loan portfolio would still not be at risk, as we don’t have any material loan exposure to any industry along the Texas Gulf coast.

The biggest uncertainty for us regarding the oil spill is not necessarily related to the spill itself but more on its potential impact on the future of the offshore drilling industry and its effect on the overall Houston economy. The Deepwater Offshore Drilling Moratorium has already affected several firms that have a significant presence in Houston. These firms face the decision of whether to ride out the Moratorium or begin to make plans to move rigs out of the gulf to other locations around the world.

As you can imagine, increased safety standards and regulation will most likely result in higher costs for the industry and could eventually impact jobs in the Houston area and along the gulf coast. However, it’s just too soon to know the ultimate impact but we’ll continue to monitor the situation closely. To impact our results for the quarter, period-end loans were down $115 million as compared to the first quarter of 2010, approximately $75 million or two-thirds of the decrease was a result of pay downs in midstream energy loans.

Additionally construction and development and construction and commercial real estate loans decreased $20 million and $40 million during the quarter respectively. We have some growth in the second quarter in C&I loans excluding energy. Year-to-date total loans are down $246 million with a $137 million or 56% of a decrease coming for midstream energy loans.

As of June 30, 2010, our energy portfolio consists primarily of onshore reserve base production levels. We expect to grow our energy loan portfolio in the second half of this year and for the full year of 2011. For the remainder of the year, we are forecasting home loans to be flat to slightly up with large growth coming in the C&I or occupied commercial real estate and consumer loan categories.

Our bankers will continue their aggressive calling program actively in pursuing these types of relationships while we maintain our average to reduce our exposure to nonowner-occupied CRE. Even though loan growth has remained difficult in this environment, deposit growth has continued. Total period-end deposits increased for the sixth consecutive quarter.

In the second quarter, we had growth in non-interest-bearing demand deposits of over $99 million ending the quarter at approximately $1.3 billion. With 30% of our total deposits are non-interest-bearing and as a result our average cost of total deposits for the second quarter was 72 basis points. Sterling remains a core funded franchise with a loan to deposit ratio of 72%. Ideally, we’d like to maintain over the long-term a loan to deposit ratio in the 70% to 80% range.

Our attractive deposit base continues to be one of the fundamental strengths of our franchise. While these deposits are given less value by investors in this extremely low interest rate environment, we certainly understand the long-term value of core customer deposits and we'll continue to look for ways to maintain and grow those relationships. Due to the possibility of an extended period of low rates, we’ll continue to look for opportunities to decrease deposit cost and improve yields in other areas.

During the first half of 2010, we’ve been successful on tracking talented bankers to join Sterling from some of our larger regional bank competitors. We’ve been able to add to our commercial and business banking teams, as well as to our retail and international banking teams. As in the past, we’ll continue to accurately recruit revenue generating experience relationship bankers to our company.

While we still have some nonperforming assets we’re working through, we position Sterling to take advantage of future growth opportunities and to benefit from arising interest rate environment, which we believe will begin to materialize next year. Sterling remains one of the best capitalized banks among its peers. At quarter-end are changeable Tier 1 and total risk based capital ratios were a strong 9%, 14.5%, and 17% respectively.

I’d now like to turn the call over to Bob Smith, our Chief Credit Officer, to discuss our asset quality. Bob.

Bob Smith

Thanks Downey. Nonperforming loans totaled $166 million at the end of the second quarter for a net increase of approximately $30 million as compared to March 31,, 2010. During the second quarter, we continued to see a migration of certain commercial real estate loans to nonperforming status. While we are not pleased with the level of nonperforming loans, we are taking the necessary steps to work through these troubled assets. The bulk of the increase for the quarter was primarily due to the downgrading of the $10.7 million multi-family loan and the moving of several hotel loans to nonperforming status, which was a direct result of our recent review of our hospitality loan portfolio.

All the majority of these properties are presently operating in cash flowing, we determined that moving these loans to nonperforming status would provide us with maximum flexibility to either rehabilitate these borrowers or to work these assets off of our balance sheet.

Despite the increase in nonperforming loans, we did see several positive asset quality developments during the quarter. As Downey mentioned, we did not have the level of write-downs on collateral dependent loans as compared with the first quarter, which led to significantly lower charge-offs in the second quarter.

Additionally, for the second consecutive quarter, potential problem loans decreased. Potential problem loans were down approximately $30 million during the quarter. We defined potential problem loans as any loan that is graded sub-standard but still performing.

Another positive development in the second quarter was the significant decrease in the past due accruing loans. Accruing loans 30 to 89 days past due decreased from $46.4 million in the first quarter to $19.3 million at the end of the second quarter. In fact, 30 to 89 day past dues are at their lowest levels in the last five consecutive quarters.

As we have detailed in previous quarters, we have approximately $330 million in out-of-state commercial real state loans that have contributed a disproportionate amount of problem loans over the last 18 months. Currently $54 million of this loan portfolio or 16% is nonperforming.

While nonperforming loans from this portfolio increased during the second quarter, the good news is that the overall pace of deterioration in the form of past dues and new potential problem loans has slowed considerably. In fact, 83% of our total past due and nonperforming loans are currently managed by our special assets group. Another portfolio that has contributed a disproportionate share of problems loans has been our hospitality portfolio

As of June 30, 2010, our hospitality portfolio totaled $299 million with approximately $220 million of hotel securing these loans being located in Texas and $79 million being located outside of Texas.

Our hospitality portfolio consists of mid-priced hotels and motels and majority of which are nationally branded properties in major NSAs. There are no resort type or luxury properties included within this portfolio. The hotels in our portfolio are primarily geared towards the business or the extended stay traveler.

During the first half of this year, we completed a detailed review of approximately 85% of our hospitality portfolio. Specific to this review, we identified an additional $6.3 in problem loans, moved an additional $5 million to nonperforming and recognized approximately $2.5 million in charge-offs.

As of June 30, 2010, $38 million or 12.7% of our hospitality portfolio is nonperforming. On this total, $21 million is located in Texas and $17 million is located out of the state. For the quarter, net charge-offs totaled $6.4 million. In addition to $3.5 million hospitality related charge-off, the remaining $3.9 million was attributed to various other loan types. Of the total net charge-offs in the second quarter, approximately 55% or $3.5 million were related to property secured by collateral outside Texas.

Foreclosed real estate was up approximately $869,000 in the second quarter as compared to the first quarter of 2010, for a total of $18.2 million at quarter-end. In the second quarter, we sold properties with a total book value of $3.6 million. We have additional properties with a total book value of approximately $7.7 million currently under contract or scheduled to be sold in the third quarter. We continue to experience good demand for foreclosed properties.

We continue to build our allowance for credit losses this quarter. The provision for loan losses totaled $10.7 million, more than covering the $6.4 million in net charge-offs recognized in the quarter.

On June 30th, the allowance for loan losses totaled $81 million or 2.70% of period end loans up from $76.6 million or 2.46% of total loans at March 31, 2010 and up significantly from $53 million or 1.5% of total loans at June 30, 2009.

I will now turn the call over to Zach Wasson, our Chief Financial Officer, to provide some additional insight into our financial results. Zach?

Zach Wasson

Thanks Bob. We appreciate everyone taking the time to join us on the call this morning. As mentioned, we reported net income of $596,000 or $0.01 per diluted common share for the second quarter of 2010. The improvement in earnings linked-quarter is direct result of recording approximately $14 million lost in provision for credit losses. Additionally, non-interest income was up $2 million compared to the first quarter. As a reminder, non-interest income in the first quarter was negatively impacted by $2.6 million due to write-downs in certain loans held for sale.

In the second quarter of 2010, we had $400,000 in write-downs on loan sale for sale. The variance of non-interest income for the second quarter 2010 as compared to a year ago, this quarter is primarily related to the interest rate hedge in affecting this gains that we recorded in the second quarter of 2009. Adding back the $400,000 loss on [Inaudible] loans, the amount of non-interest income earned in the second quarter of 2010 is in line with what we expect to see in each of the next couple of quarters.

Overall, there wasn’t a significant amount of noise or unusual items in the second quarter; however, there were couple of target normal expense items both of which impacted other non-interest expense, which was approximately $2.8 million linked-quarter.

In the second quarter of 2010, we had an increase in costs related to ORE of $1.6 and recorded additional operational losses related to various litigation settlements totaling $600,000. Without these elevated expense items, total non-interest expenses would have been down slightly for the quarter.

Tax equivalent net interest income for the second quarter of 2010 was $43.3 million, down $1.2 million on a linked-quarter basis. The tax equivalent net interest margin was 3.74% for the second quarter, down 28 basis points from 4.02% for the first quarter of 2010.

Net interest income and margin during the second quarter were negatively impacted by an increase in lower yielding interest earning cash, a reduction in loans and an increase in nonperforming assets. The primary negative factor impacting the margin in the second quarter of 2010 as compared to the first quarter was a combined effect of the decrease in average loan balances of $140 million and the increase in average cash balances of $168 million, this hurt the margin by approximately 15 basis points.

An increase in our borrowing rate impacted margin by 3 basis points. Additionally, interest reversal and interest fall down as a result of increased non-accrual assets reduced the net interest margin by another 3 basis points. When combined, these factors had a negative 21 basis point impact on the net interest margin during the second quarter, given the expectation that rates remain low for an extended period of time.

In loan growth would be challenging in the short term, our expectations are part of the net interest margin will still be under pressure in the near term. Also we have mentioned before we will no longer have the benefit of the hedge gained amortization in our net interest income at August 1, 2010.

The hedge gain income represents an approximate 19 basis point base to the second quarter net interest margin. Due to these additional pressures on our net interest margin, we are taking several steps to help stabilize our net interest income and our near current levels while still maintaining our overall asset sensitivity.

Strategies that we are evaluating and employing includes keeping more of our excess cash invested in our securities portfolio, as well as reducing rates on some of our higher cost deposits. Additionally while not something we can fix in the short term, decreasing the amount of nonperforming assets will also be a significant benefit to the net interest margin.

We estimate our overall growth on our net interest margin from nonperforming assets in the second quarter was approximately 27 basis points. While taking all or some of these actions will moderately reduce our benefit to rising rates, we still remain asset sensitive in position to benefit when rates begin to rise. At June 30, 2010 assuming a static balance sheet, we estimate that our 300 basis points upward movement in rate with increased net interest income by almost 13% and increase it by 10% with a 200 basis point upward movement in rate.

We continually evaluate the trade-off between increasing current income and reducing our benefit from possible increasing rate. Our securities portfolio as of June 30, 2010 had an effective duration of 2 with a tax equivalent yield of 3.5%. At quarter end, our intangible capital ratio was a strong 9% out of our regulatory capital levels well above the minimum to be considered well capitalized. At June 30, 2010, Tier 1 leverage ratio was 10.3%, Tier 1 risk based capital stood at 14.5% and our total risk based capital was 17%.

With that, I would like to turn the call back over to Downey before we open the call for questions. Downey.

Downey Bridgwater

Thanks Zach. Despite the challenging environment, our strategy at Sterling hasn’t changed. We'll continue to focus on providing competitive banking products and services to all constituencies within the small and medium size business segment in Texas.

With that, I like to open the call for questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Dave Rochester from FBR Capital Market.

Dave Rochester - FBR Capital Market

Hey, good morning guys.

Zach Wasson

Good morning Dave.

Dave Rochester - FBR Capital Market

You had some really good DDA growth there. Can you talk about the drivers of that and whether this is a function you are taking market share from competitors?

Zach Wasson

It’s a little bit of several factors, some of it’s market share gain, some of it’s just a continued process that our customers are going through from paying down lines of credit and continue to hoard cash. So our deposit growth has continued now six quarters in a row and DDA analysis remain strong. So we expect that to remain fairly constant given the environment we’re in and unless there is some significant change in the overall economy.

Dave Rochester - FBR Capital Market

Okay and you mentioned doing some cash flowing loans to NPA status. What portion of your NPA book right now is cash following at this point?

Zach Wasson

Well, we have several of our non-performing loans that are making payment.

Dave Rochester - FBR Capital Market

Right.

Zach Wasson

So, I don’t have the percentage, Bob…

Bob Smith

The bulk of the NPAs are still making payments or we would have taken a full write-off on those. I mean, we have written then down to a point where the cash flow.

Dave Rochester - FBR Capital Market

Okay and if I missed this I apologize, did you guys, inflows for the quarter?

Zach Wasson

No, we did not. That would be around a total of $50 million. We did have REO sales, we did have some note sales and we did have some pay downs on some of the NPLs. So we only had a net increase of around 30.

Dave Rochester - FBR Capital Market

So the gross number was 50, which is down from about 65 last quarter?

Zach Wasson

Correct.

Dave Rochester - FBR Capital Market

Okay, great. Now I know you said before that all options were on the table with regard to the out of state portfolio. Can you update us on any buyer interest you are seeing out there for that and what the appetite has done just given the market jitters recently and if there are still interested parties?

Zach Wasson

There still seems to be interested parties and as we have said before we are evaluating those opportunities at this time and as we’ve also said we are certainly not interested in dumping these loans for a significant loss because the vast majority of the portfolio is performing. So we’ll continue to evaluate these options and we’ll certainly take what we believe would be the best course of action.

Dave Rochester - FBR Capital Market

Alright, great. Thanks guys.

Zach Wasson

Thanks, Dave.

Operator

And our next question comes from the line of Mike Zaremski with Credit Suisse.

Mike Zaremski – Credit Suisse

Good morning gentlemen.

Zach Wasson

Good morning Mike.

Mike Zaremski – Credit Suisse

Could you guys speak to what drove the net charge-offs down so much this quarter?

Zach Wasson

Specifically, we had a lot lower level of FAS 114 write downs. We review those - the collateral that is supporting the impaired loans on a quarterly basis and we had a significant decrease in appraisals that came back showing that we had additional exposure and therefore our write downs were substantially less.

Mike Zaremski – Credit Suisse

But do you think this could be something that continues to frustrate or it will be choppy?

Zach Wasson

What we’re seeing at this time is and we continue to do appraisals, not just on what we believe are impaired loans but loans that we have our portfolio and as I alluded to in my comments, there appears to be kind of a bottom forming on the CRE side, valuations are coming in fairly stable and if they are down, they are only down slightly, the rate of drop in those valuations has really slowed down.

Michael Zaremski – Credit Suisse

Okay and on the out of state portfolio, so the nonperforming assets are up to $54 million, I think you said. Are you guys able to sell any of this stuff and if you are, are you seeing much charge-offs, I believe it’s SBA. So I know you guys are more senior tranche, I think there’s a government tranche and equity that the borrower has, what’s going on there?

Zach Wasson

Okay, the non-performers in the out of state are up to 44 million.

Michael Zaremski – Credit Suisse

44, okay.

Zach Wasson

And there is interest in selling those out of state loans and in the SBA portion if you recall, they are SBA 504s.

Michael Zaremski – Credit Suisse

Okay.

Zach Wasson

But we have a first lien on the collateral, and it’s usually backed up by a second lien from another entity such as the CDC and the borrower -- at least a minimum of 10% equity, sometimes little more. So, they are SBA related but they are certainly not a guarantee and so the value of those loans really counts to the primary lien holder with the additional equity if you will on the loans. So the interest in those loans is still reasonably high and we’ll continue to pursue those opportunities, we’ll just have to see.

Michael Zaremski – Credit Suisse

And real quick last question, are you guys going to continue letting the cash equivalents go up or are you going to kind of start investing more?

Zach Wasson

No, we have been investing the cash and cash equivalents and I think if you know this we did invest some last quarter and the average balance should be a little bit higher this quarter. We with rates where there are people continuing to extend the period of time that we will have low rates. We are buying additional investments, securities, but we are trying to keep them very conservative from a credit perspective and also from a maturity perspective.

We still want to maintain this asset sensitive balance sheet, but the cost of maintaining is much; asset sensitivity is getting rather expensive now, so we are looking at alternatives to increase that investment more but in a conservative manner.

Mike Zaremski -- Credit Suisse

Okay. That helps. Thank you guys.

Zach Wasson

Thank you.

Bob Smith

Thanks Mike.

Operator

We do have a question from the line of Brett Rabatin with Sterne, Agee.

Brett Rabatin – Sterne, Agee

Hey guys, good morning.

Zach Wasson

Good morning Brett.

Brett Rabatin – Sterne, Agee

Wanted to ask, I got the numbers on the motel portfolio, but I missed the total out of market portfolio size, what is that and then did you also have the in and out of market on the retail side available?

Zach Wasson

We don’t have any out of state; we are out of territory retail. The out of state commercial is down to about $330 million.

Brett Rabatin – Sterne, Agee

330, okay.

Zach Wasson

Yes, it continue to pay down and so on.

Brett Rabatin – Sterne, Agee

So you don’t have any out of market retail? What is the size of the retail portfolio, would you have that handy?

Zach Wasson

Consumer loans are 47 million.

Bob Smith

Very small.

Zach Wasson

A scenario that we’re emphasizing, in our retail growth, a lot of growth opportunity there.

Brett Rabatin – Sterne, Agee

Sorry Zach, I don’t mean retail, like consumer loans. I mean, retail oriented commercial real estate.

Zach Wasson

I’m sorry, I have answered the question -- its $360 million, $350.

Brett Rabatin – Sterne, Agee

Okay and I assume some of that is indeed out of market, correct?

Zach Wasson

Yes, it is. The out of market retail is $65 million.

Brett Rabatin – Sterne, Agee

$65 million, okay. And Zach, if I heard your comment correctly when you were discussing the margin, it sounded like you were saying that going forward potential improvement in the non-performers might be an offset to the hedge impacting negatively the margin. Are you essentially implying or giving implicit or explicit guidance for non-performers to be lower in the second half of the year?

Zach Wasson

I’m going to let the credit guys answer that. We’ve saw a lot of benefit, I mean in some of what I would call the leading indicators of credit quality and the accruing 30 to 89 day loans were down 27 million. Our potential problem loans down 30 million. Our nonperforming assets only went up 30. So in some respect, we are seeing some stabilization in our credit metrics.

Bob Smith

I would add to that except for one blip in about the last six months, we have seen continued improvement in the past new trends in the out of state portfolio.

Brett Rabatin – Sterne, Agee

Okay. So, it doesn’t sound like you are willing to necessarily give guidance for lower MPAs, but it sounds like you are just obviously pointing out the indicators would suggest so.

Bob Smith

Correct.

Brett Rabatin – Sterne, Agee

Okay, great. Thanks for the color.

Zach Wasson

Okay, Brett.

Operator

I have a question from the line of Terry McEvoy with Oppenheimer.

Terry McEvoy - Oppenheimer

Thanks. Good morning.

Zach Wasson

Good morning Terry.

Terry McEvoy - Oppenheimer

With the noticeable difference in the level and amount of appraisals that came in Q2 versus Q1 that maybe would have suggested the lower FAS 114 write-down or was that a pretty consistent amount? And then as you look out into the third quarter, is there a pickup at all that could maybe suggest an increase in those write-downs which would obviously have an impact on the quarterly results?

Zach Wasson

Terry, I’m sorry, I couldn’t hear your question very clearly. Could you repeat that?

Terry McEvoy - Oppenheimer

Sure. Was there a larger amount of appraisals that came in the second quarter than the first quarter or a lower amount? And as the appraisals came in the first quarter, we saw the impact on the provision in terms of the FAS 114 write-down. In the second quarter, was there just a lower amount of appraisals that came in that would have brought that FAS 114 write-down lower in the second quarter?

Zach Wasson

I think the number of appraisals remain somewhat consistent because we do go back when indicated and update those, but I just believe that, we have been very aggressive in the latter part of 2009 and in the first quarter of 2010 and we are just not seeing as much additional write-down. Sometimes some of these properties we’ve had, or these loans we have had to go back and get revaluations two or three different times. So I think that explains the bulk of it is that we are not seeing as much write-down at this point.

Terry McEvoy – Oppenheimer

And then on the expense side, the banking centers are down, employees are down; we’ve seen some nice reductions on the salary and benefit side. Directionally, will there be further improvements on overall expenses within the salary line and is that another potential positive to earnings going forward?

Zach Wasson

Yes Terry, your observations are correct. We closed five branches in the last eight months. We have another one that’s going to be consolidated at the end of this month. So you’ll continue to see pretty steady reductions in overall operating expenses in future quarters as we continue to focus on becoming more productive and allocating our resources what we believe are in appropriate domains, so yeah.

Terry McEvoy – Oppenheimer

Appreciate it. Thank you.

Zach Wasson

Thank you.

Operator

We’ll now move on to the line of Jennifer Demba with SunTrust.

Jennifer Demba – SunTrust

Good morning. Downey, I just want to make sure, I can understand your body language right. It seems to me you guys think that you are not going to see much more deterioration in this non-Texas CRE book or the hospitality book?

Downey Bridgwater

Well, what we are seeing -- the colors we are making specifically around appraised values, those appraisals are coming in at a fairly stable base. We think the foundation is really beginning to form, so we will continue to be visual on that and as Bob mentioned we continue to get updated appraisals on both performing and nonperforming credits on a consistent basis.

So we’ll continue to monitor that pretty closely, but what we are seeing so far and even into this quarter, those values are kind of holding in. So that’s been the bulk of our provisions and our charge-downs over the last few quarters have been related to FAS 114 activity.

So, if that continues to remain debated, then we’ll continue to see lower levels of charge-offs and related provisions. Hospitality, specifically we struck the vast majority of that portfolio, we did identify some additional potential problem loans and we did put some non-performing, we charged-off a few. So we’ll continue to stay on top of those, but occupancy and rev-pars have improved somewhat over the last few months, but clearly off a very low base. So we’ll just keep watching it very closely but so far things have improved a little.

Jennifer Demba – SunTrust

What percentage of the loans in both of those portfolios have been appraised?

Downey Bridgwater

We’ve got recent valuations on all of our nonperforming loans certainly and virtually all of those that are potential problems…

Zach Wasson

And we were looking at our potential problem hotel loans and I believe we had five that we didn’t have an appraisal within six months and all of those were within the last year.

Downey Bridgwater

So, virtually all.

Jennifer Demba – SunTrust

Okay. Do you have the stats in terms of potential problem loans within those two sub-categories?

Downey Bridgwater

We can certainly call you with that, we don’t have it in handy. Why don’t you let us call you with that Jen?

Jennifer Demba – SunTrust

Okay, thanks. Appreciate it.

Operator

And we now have a question from the line of Bob Patten with Morgan Keegan.

Bob Patten – Morgan Keegan

Hi Downey. Most of my questions have been asked, I just want to get a view of what kind of strategies that can employ in this kind of a rate scenario? Obviously, it’s tough for anybody and there is either duration risk or cost and with the heads rolling off I’m just trying to get a feel for the margin outlook.

Zach Wasson

You know Bob, we do expect some pressure on the margin, but we are - during this quarter we are going to reduce our cash equivalents. We are buying one, two, three, sometimes up to four-year type duration securities, that’s not a great yield but it’ a lot better than 25 basis points in the fed funds market. We are looking at allowance being stable this quarter, relatively stable versus $140 million decrease an average balance last quarter. That will have a significant impact.

We are also looking at all of our deposit accounts, looking at any that are at the upper hand of our pricing, notching those down. We started that in June, we really didn’t see the benefit during the second quarter, but we should see some of that benefit going forward.

So there are a number of factors coming into play that will help but of course we do have hedge amortization rolling off during this quarter which would be a negative for the margin.

Bob Patten – Morgan Keegan

Yes, and I guess, can you just remind me what is the percentage of your loans that are fixed rate versus floating and what kind of floor percentages do you have on the floating rate.

Zach Wasson

It’s kind of about 60:40 floating to fix and we have floors on approximately $650 million of the prime based loans. We build all of that into a model so that we do pick up the impact of these floors when the first 100, 200 basis points move in rates.

Bob Patten – Morgan Keegan

Alright, thanks very much Zach.

Zach Wasson

Thank you.

Operator

And we’ll move on to the line of Jon Arfstrom with RBC Capital Market.

Jon Arfstrom – RBC Capital Market

Downey, a question for you in the energy portfolio. I guess I am heading agnostic on it, but could you give me the size of the portfolio, I know you are bullish, you are cautious on it and maybe long-term view and what you’d like to take the size of that portfolio?

Downey Bridgwater

Sure. It’s a $125 million funded right now and as we mentioned it’s onshore production and frankly since the Deepwater Horizon tragedy, the onshore activity has picked up significantly, a number of rigs being filled, rigs being deployed; interest in new leases and property acquisition has continued to improve.

So we expect since our focus is on onshore production, our funded balances to increase in our overall commitments in this reserve based activity continue to move up incrementally. We are certainly not going to push the envelope and grow this in expediential amount we’ll keep it within our risk tolerances, but I think you could comfortably see an increase in this portfolio over the next few quarters on an incremental basis.

Jon Arfstrom – RBC Capital Market

Okay, good. And then just you made some comments earlier about job growth in Texas, but is any market tougher than others in terms of your geographic spread?

Downey Bridgwater

Not really. We’ve seen reasonable population growth and job growth pretty much in all the metropolitan areas so far. Like I said the impact of the Offshore Drilling Moratorium may have some impact here in Houston, but we just don’t know, we’ll just have to watch that pretty closely.

Jon Arfstrom – RBC Capital Market

Okay. Then the last question I think, I think I know the answer of this, but I’ll ask it anyway. Anything in financial regulatory reform that bugs you or impacts you, I’m assuming that debit and overdraft is very small, but also think about the repeal of the probation paying interest on commercial deposits and whether that’s others you had owned? If there is anything else you want to add or talk about?

Downey Bridgwater

The impact on consumer related income should be pretty minimal to our franchise and other impacts like change in interest rates or commercial deposits are going to affect everybody. I think we’ll probably all end up with a relatively similar impact but the overall cost and impact of the new financial rigs are -- it’s too new to rig right now. We know some will be more cost and I’m afraid we just don’t know how much yet.

Jon Arfstrom – RBC Capital Market

Okay. And then just the commercial deposit interest with your high, low cost, no cost EDA. You assume that that’s something that you would just make up for in rate on the other side if that becomes maybe a larger threat than you anticipate right now?

Downey Bridgwater

Yes, hopefully. We also have a significant amount of dollars that are swept off balance sheet…

Zach Wasson

In a lot of…

Downey Bridgwater

Come back on so.

Zach Wasson

Lot of commercial accounts from cash management, so in a way we’re already paying interest on them with the earnings credit rate. So we’ll, like Downey said, it’s too early to tell but we’ll manage through that also.

Jon Arfstrom – RBC Capital Market

Okay, that makes sense. Thanks guys.

Downey Bridgwater

Okay.

Operator

And we do have a question from the line of Tom Alonso with Macquarie.

Tom Alonso – Macquarie

Just a real quick one for you. Downey, I think you know as you guys had some CNI growth in the quarter, is that better line utilization or is that just new accounts coming on and moving lines over?

Downey Bridgwater

No, those are market share gains.

Tom Alonso – Macquarie

Okay.

Downey Bridgwater

People are still not really utilizing their lines very much.

Tom Alonso – Macquarie

Okay, that makes sense. And then just a modeling question, what’s a good tax rate for you guys going to go forward basis?

Downey Bridgwater

That’s a good question, somewhere probably, well 36% or somewhere in that area.

Tom Alonso – Macquarie

Okay, fair enough. Thanks very much guys.

Operator

We move on to the line of Dave Bishop with Stifel Nicolaus.

Dave Bishop --Stifel Nicolaus

Hey, good afternoon gentleman. The improvement in problem loans we saw this quarter, was that more a function of reclassification into improvement your underlying borrow fundamentals or did some of that spill over to non-performing loans, just thought I’ll get color there.

Zach Wasson

It’s a combination. There are some that did move from potential problem loans to nonperforming, but some paid off, paid down, some we foreclosed on, some charged down, so it’s really a mix of different things. There is really no one of those categories that really dominated the change.

Dave Bishop -- Stifel Nicolaus

If you could give some color in terms of the other real-estate owned activity this quarter. How much did that impact the other expense category in terms of…?

Zach Wasson

$1.6 million.

Dave Bishop – Stifel Nicolaus

I’m sorry.

Zach Wasson

$1.6 million.

Dave Bishop – Stifel Nicolaus

Okay, got you. And I think I missed it but there is a discussion in terms of potential pipeline to resolve additional credits there, first quarter?

Downey Bridgwater

We have another $7.7 million under contract right now to close in this quarter. Our re-sales are healthy. I mean I almost call them brisk. So there is demand and capital available for those things and we are beginning to finally get our hands on some of the underlying collateral on some of the nonperforming loan. So, we expect the rate of foreclosures to increase. So, the transition of nonperforming loans into -- should begin to pick up here for the rest of this quarter, maybe into the fourth, so.

Operator

We now have a question from the line of Matt Olney with Stephens Inc.

Matt Olney - Stephens Inc.

Yes, most of my questions have been answered, but it sounds like the lien indicators for credit quality are improving throughout Texas and I think while your peers would agree with that statement, but is there any other data you can give us that shows us the improvements of credit quality that shifts outside of Texas?

Downey Bridgwater

That will have to be on a market-by-market basis. When we do trap some of those in and some of our markets but we have to -- I think the most important one would be just a relative stabilization of real estate values and there is some interest in even buying some of those that we have been fortunate enough to foreclose on, so.

Matt Olney - Stephens Inc.

I guess you guys don’t break out your potential problem loans with in-state versus out of state?

Zach Wasson

We don’t know at this time, we can look into that in the future, but one thing we’ve seen on our out of state that is when we compare this quarter to last quarter, we've seen a stabilization in the delinquencies and other credit metrics in it. So, the rate of decay in that portfolio is definitely slowed versus '09.

Downey Bridgwater

I think another -- it’s more of a broad perspective, but the rate of transfer of loans we have in the portfolio managed by our bankers being transferred to special assets as slowed significantly to levels that we frankly haven’t seen for couple years and that includes the out of state loans, so those are beginning to bottom our we think.

Matt Olney - Stephens Inc.

Okay. Thanks for the color.

Operator

(Operator Instructions) And we do have a follow-up question from the line of Brett Rabatin with Sterne, Agee.

Brett Rabatin - Sterne, Agee

I like the pronunciation, it’s fun, Sterne, Agee. I wanted to ask the review you guys typically have from the regulators, I think that’s coming up in the second half of this year, is that, cant remember if it’s the late 3Q or early 4Q event?

Downey Bridgwater

You sure it’s a ballpark.

Brett Rabatin - Sterne, Agee

No, specific color on that.

Zach Wasson

No, we cant rally comment on that.

Brett Rabatin - Sterne, Agee

Okay, and then just wanted to make sure I understood Zach your comments regarding the - it sounds like the ORE you are selling is basically like you mentioned the one piece that was under contract, but I think it was 7.7 million. It sounds like from here the ORE you are not experiencing much in the way of additional write-downs on that book or don’t expect to and so the ORE expenses you had this quarter should be diminished going forward, is that a fair assessment?

Zach Wasson

That is correct.

Brett Rabatin - Sterne, Agee

Okay. That’s what I wanted to know, thank you.

Zach Wasson

Alright.

Operator

We’ll return to the line of Mike Zaremski with Credit Suisse.

Mike Zaremski – Credit Suisse

Thanks. Two quick follow-ups on loans. First is what has been the driver of the energy portfolio contracting so much, it doesn’t seem to have a correlation with the rig counts that have increased. And two, what’s behind you that’s feeling good about loans, maybe being flat to up, is it the new people you hired or just kind of the macro indicators?

Downey Bridgwater

First question on energy and as I mentioned in my comments the vast majority of the pay downs we had loans 75% during the quarter, linked-quarter, was related to midstream credits. We have made a strategic decision to reduce our exposure to midstream companies overall.

We are still pretty much focused on growing our reserve base loans and that should in fact bleed over into the next – answer to the next question, and that will certainly support some of our growth on additional reserve base loans and the balance should come from additional market share gain.

Mike Zaremski – Credit Suisse

And I guess I’m going to ask you also what’s wrong with midstream credits in terms of energy?

Downey Bridgwater

There is nothing wrong with them necessarily, but the companies themselves are fairly highly capital [Inaudible]. They also have seen significant reduction in margins due to the nature of their business and if they are transporting natural gas, natural gas liquids across the U.S. so it’s been a challenge for several of those companies within that segment of the industry.

Mike Zaremski – Credit Suisse

Okay. I appreciate it.

Operator

And at this time we have no additional questions in queue, please continue.

Downey Bridgwater

Okay. Well, thanks everybody for joining us today. We appreciate your interest in Sterling. I look forward to talking to you next quarter. Goodbye.

Operator

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