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Regions Financial (NYSE:RF)

Q2 2010 Earnings Call

July 27, 2010 11:00 am ET

Executives

John Owen - Head of Consumer Services, Head of Consumer Services Group -Regions Bank and Senior Executive Vice President-Regions Bank

David Turner - Chief Financial Officer, Senior Executive Vice President and Member of the Executive Council

O. Hall - Vice Chairman, Chief Executive Officer, President, Chief Operating Officer, President of Regions Bank, Chief Operating Officer of Regions Bank and Director of Regions Bank

M. Underwood - Director of Investor Relations

William Wells - Chief Risk Officer, Senior Executive Vice President, Head of Risk Management Group, Chief Risk Officer-Regions Bank, Senior Executive Vice President -Regions Bank and Head of Risk Management Group-Regions Bank

Analysts

Albert Savastano - Macquarie Research

Kevin Fitzsimmons - Sandler O'Neill

Craig Siegenthaler - Crédit Suisse AG

Ryan Nash

Brian Foran - Goldman Sachs Group Inc.

Betsy Graseck - Morgan Stanley

Paul Miller - FBR Capital Markets & Co.

Christopher Marinac - FIG Partners, LLC

Marty Mosby - Guggenheim Securities, LLC

Heather Wolf - UBS Investment Bank

Matthew O'Connor - Deutsche Bank AG

Operator

Good morning, and welcome to the Regions Financial Corp.'s Quarterly Earnings Call. My name is Christie, and I will be your operator for today's call. [Operator Instructions] I will now turn the call over to Mr. List Underwood. Please go ahead, sir.

M. Underwood

Thank you, operator, and good morning, everyone. We appreciate your participation. Our presenters today are our President and Chief Executive Officer, Grayson Hall; and our Chief Financial Officer, David Turner; also here and available to answer questions are Bill Wells, our Chief Risk Officer; Tom Neely, our Director of Risk Analytics; and Barb Godin, our head of Consumer Credit.

Let me quickly touch on our presentation format. We prepared a short slide presentation which will accompany David's comments. It's available under the Investor Relations section of regions.com. For those of you in the investment community that dialed in by phone, once you are on the Investor Relations section of our website, just click on Live Phone Player, and the slides will automatically advance in sync with the audio of the presentation. A copy of the slides is available on our website.

Our presentation this morning will discuss Regions' business outlook and includes forward-looking statements. These statements may include descriptions of management's plans, objectives or goals for future operations, products or services, forecast of financial or other performance measures, statements about the expected quality, performance or collectibility of loans and statements about Regions' general outlook for economic and business conditions. We also may make other forward-looking statements in the question-and-answer period following the discussion.

These forward-looking statements are subject to a number of risks and uncertainties, and actual results may differ materially. Information on the risk factors that could cause actual results to differ is available from today's earnings press release and presentation in today's Form 8-K, in our Form 10-Q for the quarter ended March 31, 2010, and in our Form 10-K for the year ended December 31, 2009.

As a reminder, forward-looking statements are effective only as of the date they are made, and we assume no obligation to update information concerning our expectations. Let me also mention that our discussions may include the use of non-GAAP financial measures. A reconciliation of these to the same measures on a GAAP basis can be found in our earnings release and related supplemental financial schedules.

Now I will turn it over to Grayson.

O. Hall

Good morning, and thanks for taking the time to join our conference call. As announced earlier today, Regions reported a second quarter loss of $0.28 per share, which included a charge related to Morgan Keegan regulatory proceedings. Concerning this charge, as you may recall, administrative proceedings are brought against Morgan Keegan and Morgan Asset Management on April 7 by the SEC, FINRA and a joint state task force of security regulators. Although we have not reached final settlement, based on the current status of negotiations, we recorded a nontax deductible $200 million charge representing the estimate of probable loss.

Excluding this charge, second quarter's loss was $0.11 per share, representing an improvement from first quarter's $0.21 per share loss, giving us additional confidence that we have the right strategy in place to return Regions to sustainable level of profitability. It just requires that we continue to focus on execution of our plans.

Although we are making progress, and we are even slightly ahead of our own internal forecast, we are clearly not satisfied. The economic environment, while slowly improving, is challenging and fragile and it is too soon to know the ultimate impact of the Gulf oil spill and regulatory reform legislation. But our focus is to improve our credit metrics, while managing aggressively our expenses. The slow nature of the economy requires that we remain cautious and prudent with our actions. We are encouraged by second quarter's core improvement. On a linked-quarter basis, total adjusted revenues grew 3%, adjusted noninterest expenses declined 4%, and our net interest margin and credit metrics both improved.

Balance sheet risk was further reduced, and we continue to see solid low-cost deposit growth. Credit-related cost, while moderating, clearly remain elevated, with loan loss provision and OREO expenses having a $0.36 per share negative effect on second quarter's earnings. However, we believe that the earnings that are burdened from the elevated provision expense should begin to moderate going forward.

Our proactive efforts to recognize and resolve problem assets are providing a favorable impact. We are not anticipating nor are we forecasting a double dip recession for the economy, but the nature of the slow economic improvement has resulted in a much more conservative low-growth forecast for our business and requires that we exercise extreme care in the management of our credit risk. As many of you are aware, our focus on customers and cross-sell opportunities, along with strong customer service, has resulted in strong growth and new checking accounts and low-cost deposits. This continued in the second quarter. Average low-cost deposits rose 4% versus the second quarter, and we are on track to open approximately 1 million new business in consumer checking accounts again this year, matching or exceeding 2009's record level.

The ongoing positive shift in our deposit mix had resulted in a favorable improvement in funding costs driving our net interest income and resulting margin even higher. It should continue to do so. Second quarter's margin increased 10 basis points and is very much on target to reach our goals. Not surprisingly, there was a 3% decline in our loans outstanding near the second quarter, and balances are expected to remain challenged for the remainder of the year. We did experience an increase in loan production volumes in the second quarter, but it was substantially below normalized levels. Reduced demand from credit-worthy borrowers, both consumer and businesses, and deleveraging from loan payoffs and pay downs are all contributing factors. Also, as been the case for several quarters now, average loan outstandings also reflect our disciplined efforts to reduce exposure to high-risk portfolio segments, specifically, investor commercial real estate.

The Investor Commercial Real Estate portfolio declined $1.5 billion in the second quarter, bringing our total outstandings to $19 billion. This means that we've brought over the past 12 months a reduction of $4.7 billion to this portfolio. Our small business and middle-market bankers are trying to position ourselves to take advantage when loan demand returns. We're actively calling on existing customers and importantly, potentially new customers. Our strategy leverages our extensive branch network to aggressively call on the targeted Small Business Banking segment. We are also active in the Commercial Middle Market segment and we have recent success with specialized lending groups.

Commercial line of credit commitments remained strong, but utilization rates have stabilized at historically low levels. Commercial lending pipelines are showing signs of strength, but have yet to materialize into increased outstandings.

On the consumer lending front, we are aggressively working to improve consumer loan volume production, while maintaining pricing discipline. Along those lines, we are increasing loan advertising, expanding direct-mail programs and extending preapproved point-of-sale offers and importantly, our sales plans are focused on properly priced and prudently underwritten loan production to drive these programs. Our second quarter total consumer loan production was up by 40% over first quarter, with our year-to-date yield on new home equity production is 171 basis points of our prime, but our loan production volumes across consumer segments are far below normalized levels, and we anticipate a slow growth economy with high unemployment and low interest rates.

Our customer demand has shifted from home equity to more direct loans and other consumer lending products. As such, we've made a strategic decision to re-enter the Indirect Auto Lending business with our activity in this business resuming in the third quarter. With the increased demand for auto loans as well as the loss rates in this sector performing better than expected during the economic downturn, this move will help us to diversify our consumer lending portfolio and improve our concentration mix and at the same time, providing dealerships with an avenue for their customers to finance their auto lending needs.

With respect to mortgage lending, second quarter production was up 31% linked quarter to $1.8 billion in originations. We continue to increase our market share, providing outstanding customer service and enhanced speed and simplicity of the entire mortgage process. Overall, consumer lending is showing signs of improvement that demonstrating a net increase in outstandings is proving difficult.

Moving on to a couple of other issues, I am confident about the clear strategy we have in place and our leadership team's commitment to successfully executing the strategy. However, two second quarter events, the Gulf oil spill and the financial regulatory reform legislation, added to our challenges. The Gulf oil spill is a tremendous environmental and economic challenge. We are carefully evaluating the potential impact to our business and developing the necessary risk mitigation strategies to lessen the financial impact to our customers and our financial performance. It is difficult, if not impossible, for anyone to accurately estimate the environmental and economic impact at this particular point in time. But it does appear that substantial progress has been made in stopping the flow of oil from the oil into the Gulf.

We have confidence and the resilience in the individuals and the businesses located on the Gulf Coast as they have weathered a number of storms over the years. But we are proactively contacting our customers along the Gulf to determine how they're being impacted and how we may help in being part of the effort to restore the economies of these markets. Regions has a strong history in dealing with environmental disasters and how they impact our customers and the communities that we serve.

When Hurricane Katrina hit the Gulf, we were armed with a disaster response plan and went to work immediately. We are following that same proven and disciplined process now with the oil spill. And as the number one bank on the Gulf Coast, we are in a great position to assist many individuals and businesses. We have set up a task force dedicated at collecting on-the-spot reports and updates from Regions' team members and Regions' customers that live and work in the affected markets, and we are coordinating our efforts to quickly, clearly and confidently communicate to local customers and businesses about Regions' ability to help, as well as availability of Small Business Administration direct programs, state programs and BP assistance efforts

With respect to potential exposure, we had to make a number of assumptions regarding the geographic impact area. First, we reviewed businesses and consumer lending relationships in a geographic area ranging from Lake Charles, Louisiana to just North of Tampa, Florida. The exposure area totals four Regions, $3.1 billion in loans outstanding and $8.4 billion in deposits.

We thoroughly analyzed exposures to high-risk industries including tourism, commercial fishing, sport fishing, hospitality, restaurants and condominium. Specific to consumer exposure, we stress tested all the residential mortgages within 25 miles of the coastline. We stressed these loans using two stress scenarios. One was a straightforward doubling of our highest historical loss rate and the other was even more adverse. It included shocking state employment levels for all impacted markets, as well as reducing residential home prices a further 20% from already existing low levels, while also reflecting negative GDP in these specific markets. Using this conservative methodology, we estimate total financial losses for Regions to be approximately $100 million in the most adverse case.

Let me point out that our loss estimate is conservative, and assumes no benefit from private insurance payments, government support or stimulus money that BP has committed, any of which would potentially reduce our forecasted losses. As a historic reference, using essentially the same discipline methodology, I'll note that we initially estimated our losses from Hurricane Katrina to be approximately $70 million. And at the end of the day, our losses turned out to be less than $10 million. When we made that estimate, we did not consider the amount of payment that we or our customers will receive from public or private sources. As you can be assured, we will continue to closely monitor our portfolio and actively work with customers to mitigate any possible negative financial impact. And furthermore, we anticipate that this financial impact will occur over an extended period of time.

Now let me speak directly to the other recent event, regulatory reform. We are assessing the potential impacts on our revenue, expenses, capital and our business models. And we're evaluating steps that we can take, adjustments that we can make to our business models to mitigate the business impact. We know for instance that the Durbin amendment will put downward pressure on interchange revenues, which in total for Regions is approximately $330 million annually. But the extent of the interchange pricing reduction is not currently defined, so before we can provide a valid estimate, we need to see clarity regarding exact rules, regarding interchange price setting. What we are promptly adjusting our business model is in anticipation of these revenue challenges to provide a substantial level of earnings impact mitigation, while still being committed to and providing products and services that our customers value.

In addition, our expense base, we pressured from many regulatory provisions included in this legislation. Regardless, we will continue to consider and implement ways to improve our operating efficiency.

As for the capital implications of this reform, trust-preferred stocks, we phased out as an allowable component of Tier 1 capital. This change does not create a particularly challenging problem for Regions since trust prefers only represent $846 million or 86 basis points of our Tier 1 capital, which was a strong 12% at the end of the quarter. We, like all the financial institutions, we will face the challenge of a likely higher capital requirements once regulatory authorities work through the new guidelines. We believe that we are well prepared to handle any new capital requirements in a timely fashion.

In summary, I am confident that Regions remains firmly on the path to return to sustainable profitability. We are forecasting a slow but improving economic environment, modestly higher net interest income and a continued improvement in expense management. Our actions serve to offset the challenges post our revenue streams. Our core business fundamentals are strong. We have a solid franchise operating in good markets that will remain desirable over the long-term. Regions does have a potential for long-term success, and we are focused on the disciplined execution of our business plans.

So with that, David, I'll now turn the discussion to our second quarter financial details.

David Turner

Thank you, and good morning. Let's begin with a summary of our second quarter results on Slide 1.

As Grayson mentioned, our second quarter loss amounted to $0.28 per diluted share or $0.11 per share, excluding the regulatory charge. While we are not satisfied with the second quarter loss, we are pleased with another quarter of steady improvement in our core business, highlighted by improvements in pretax pre-provision net revenue or PPNR, and our improvements in asset quality metrics.

In summary, all three categories of our PPNR improved linked quarter. Net interest income increased $25 million, and the resulting net interest margin improved 10 basis points to 2.87%. Noninterest income increased $22 million or 3%, linked quarter, excluding first quarter's securities and leverage lease termination gains. And noninterest expenses decline $42 million or 4% first to second quarter, excluding the Morgan Keegan regulatory charge and first quarters' loss on early extinguishment of debt and branch consolidation charges.

Regarding credit quality, nonperforming assets, excluding loans held for sale, declined $297 million or 7% during the quarter, and is reflective of continued improvement in our credit quality trends. Our provision for loan losses decreased to $651 million from $770 million in the previous quarter, and was essentially equal to net charge offs.

Now let's take a deeper look at the quarterly results beginning with credit. Slide 2 shows that net nonperforming assets not only declined $297 million, but gross inflows also declined, again, led by investor real estate. Our proactive sales program coupled with aggressive marks and transfers to held for sale have accelerated the decline in nonperforming assets. During the second quarter, we sold or transferred $779 million of loans and problem assets, bringing the total to over $4 billion over the last seven quarters. Discounts on problem asset sales and loans that were mark-to-market were a little changed at 24% on average this quarter, from the first quarter's 23% and fourth quarter 2009's 29%.

The decline in NPA has exceeded our earlier expectations and reflect the first improvement in several quarters. While we are encouraged by this improvement, we remain cautious concerning the outlook for NPAs. Although our internally risk-rated problem loan trends remain favorable, the slow and fragile nature of the economic recovery requires that we remain cautious until we see clear signs of strength in this economy.

Net charge-offs declined $49 million to $651 million or an annualized 2.99% of average loans compared to first quarter's annualized 3.16%. The decline in net charge-offs continued to reflect efforts to derisk our balance sheet and dispose some problem assets. Given the improving credit quality trends, provision cost declined in the quarter. As you can see on Slide 3, our provision of $651 million essentially match net charge-offs, and declined $119 million in the second quarter, marking the second consecutive quarterly reduction.

Our loan-loss allowance to loans ratio increased 10 basis points, linked quarter, to 3.71% at June 30 due to a lower level of loans outstanding. As I stated earlier, we are being cautious, and our actual level of NPAs and provision expense will be dependent on our asset quality metrics, which will reflect economic conditions, especially unemployment and housing data. Further, while the Gulf oil spill will be a challenge, we believe it will be financially manageable. Having said that, we will be closely monitoring the situation and our provisioning will incorporate any deterioration in effective portfolios to the extent necessary.

Let me give you some detail on troubled debt restructuring or TDRs, and why despite the relatively large balance, they are not expected to translate into substantial losses. Keep in mind that nearly all of our consumer TDRs, which comprise about 89% of total TDRs, are a function of our proactive Customer Assistance Program. And very importantly, 95% of consumer TDRs are accruing interest.

Through our Customer Assistance Program, we proactively contact consumer borrowers even before they become delinquent, often making modifications to loan terms such as deferring a payment or reducing an interest rate. Any such concession to a borrower experiencing financial difficulty requires a loan to be classified as a TDR. While these concessions may not be significant, they have proven very helpful to borrowers in need. Importantly, the re-default rate has been very low as our foreclosure rate, which is less than half the national average.

These metrics and the monthly conversations we have with each and every borrower give us confidence that our program will continue to benefit borrowers and Regions alike over the long-term.

Turning to the balance sheet. Slide 5 breaks down this quarter's change in loans and deposits. Note that $1.5 billion of the $2.2 billion decrease in loans reflects our efforts to reduce investor real estate loans. However, new commercial lending remains challenging when utilization rates that were largely unchanged versus the previous quarter. Most commercial customers are still waiting on confidence in the sustainability of the economic recovery before drawing down lines. In any case, we remain positioned to grow balances as the economy improves, and customers begin to rebuild inventories, make new capital investments and start expanding their businesses. However, we are encouraged by the increases we have recently seen in June and July commitments.

On the liability side of the balance sheet, low-cost deposit growth mostly money market and interest rate balances were strong. Average balances were up $2.7 billion quarter-over-quarter. This reflects outstanding customer acquisition and retention, bolstered by service and satisfaction levels that are higher today than at any point in our history.

Average low-cost deposit growth allowed us to reduce higher cost time deposits by $2.8 billion in the second quarter. And as noted earlier, resulted in lower funding cost for the quarter. Importantly, opportunities exist for further improvement in our deposit mix and cost over the coming quarters.

Slide 6 provides a quick view of the relationship between growing low cost deposits and improving total deposit cost. Average time deposits as a percentage of total deposits declined from 30.3% in the first quarter to 27.5% in the second quarter. Coupled with our deposit pricing efforts, we lowered deposit cost 21 basis points this quarter to 0.79%.

Looking closer at the top line, net interest margin and net interest income are significantly benefiting from the positively changing mix and cost of our deposit base. As noted on Slide 7, fully taxable-equivalent net interest income of $863 million was up nearly 3%, linked quarter, despite a lower earning asset base.

Our resulting net interest margin expanded 10 basis points to 2.87%. Our emphasis on improving both deposit mix and cost will be a primary driver of the margin improvement. As a reminder, we have approximately $8 billion of CDs maturing over the remainder of this year, which will be repriced to market rates as they mature. These CDs currently carry an average 1.71 interest rate, implying a meaningful positive benefit to our overall deposit cost.

Pricing momentum will carry into next year too when we have another $4.1 billion of first quarter maturities, about $1.5 billion of which carry a 4.55% interest rate.

Before moving on, I want to make it clear, we currently expect interest rates to remain low until well into 2011. All else being equal, a persistently low rate environment will put pressure on the margin. In consideration of that, we have extended our short-term hedge position to help maintain the margin and net interest income in the event that rates do remain low well into next year. These hedges now mature in the fourth quarter of 2011, reflecting a nine-month extension of the hedge period since our last earnings release.

Turning to Slide 8. We were able to grow adjusted noninterest revenues, 3%, while reducing adjusted noninterest expenses, 4%. The main noninterest income driver was an $18 million increase in brokerage revenues, owing largely to strong fixed income business, higher private client revenues, as well as strong investment banking activity. Noninterest income also reflects a 5% increase in service charges, primarily from higher interchange transaction activity. Note that NSF/OD policy changes related to the dollar limit and daily occurrence caps took effect on April 1. However, while these did reduce service charges, the effect was offset by an increase in customer transaction activity.

Policy changes associated with Regulation E began in the second quarter, and will be fully implemented during the third quarter. The results of our program to educate customers on the impact to them regarding Regulation E are continuing. To date, we have successfully reached approximately half of the users of our standard overdraft service with 90% deciding to opt in or participate in our overdraft protection program, while 10% have opted out.

As you may remember, we originally estimated the impact of this legislative change would be a net reduction of service charge revenue of $72 million in 2010, and we continue to believe this is our best estimate. Mortgage income declined $4 million, linked quarter, primarily due to a reduction in benefits from hedging mortgage servicing rights. However, origination volume of $1.8 billion was up versus the prior quarters' $1.4 billion, with June representing the highest monthly volume this year.

The pipeline remains strong as well, and in the second quarter, unclosed loans were up 40% versus the March 31 level. Also of note, 59% of second quarter volume represented purchases compared to 45% last quarter and just 24% a year ago.

As mentioned earlier, the decline in adjusted non-interest expenses was largely due to lower salaries and benefits costs as we remain focused on fine-tuning staffing models and improving personnel efficiency. In fact, we have reduced headcount by nearly 2,000 or 6.5% in the last year alone and approximately 300 since end of the last quarter.

Lower payroll taxes were also a factor, declining for first quarter's seasonally high level. We have an intense focus on expense management, and we will continue to control discretionary expenses and improve operating efficiency. However, certain headwinds, including higher FDIC premiums and credit-related costs, will continue to impact the bottom line for the foreseeable future. Having said that, given that many of these costs are tied to other real estate and workout costs, we believe the decline in non-performing assets serves as a leading indicator of an eventual decline in credit-related costs.

Let's finish up with capital. As you can see, capital ratios remain strong at quarter end, with a Tier 1 capital ratio that now stands at an estimated 12% and a Tier 1 common ratio estimated at a very solid 7.7%. In addition, we have provided a pro forma capital estimate, which excludes trust preferred securities from our capital. As Grayson mentioned earlier and as illustrated here, we do not have much trust preferred in our capital and are not as impacted by this legislation as others will be in the industry.

To sum up, we are pleased with Regions' second quarter progress, thanks to the effort of our hardworking team. And while we have a lot of hard work ahead of us, you can be assured that everyone at Regions remains firmly focused on returning the company to a sustainable level of profitability as promptly as possible, while continuing to improve our risk profiles. We have a strong franchise, with solid underlying business fundamentals as evidenced by this quarter's core results. We have high expectations for Regions and are committed to delivering for our shareholders, customers and associates.

And with that, operator, we will now take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Brian Foran with Goldman Sachs.

Brian Foran - Goldman Sachs Group Inc.

Your share count, up about 5% on an end-of-period basis and then also your Tier 1 common, up 60 bps. Both were a little higher than I had modeled and just wondering what drove them and where they relate it.

David Turner

Yes, Brian, this is David. What we did is, we elected to early convert our mandatory convertibles preferred, which by its term, would have converted into common stock in December. And we chose to do that based on the economics that are embedded in the agreement. And so we added roughly 63 million shares in total, some of which, on an average basis, would have come through in the quarter. And we did that towards the end of the second quarter, so you don't have the full weighting of that yet, but that was really the difference, probably, in your model.

Brian Foran - Goldman Sachs Group Inc.

And understanding the averaging effect, is that now fully in the end of period or is there more to come at some point in the future?

David Turner

No, it's fully in the period.

Operator

Your next question comes from the line of Paul Miller with FBR Capital.

Paul Miller - FBR Capital Markets & Co.

A little bit about your experience in your loan sales. In other words, I believe, correct me if I'm wrong, that you said you have your NPAs marked down roughly $0.25 on a dollar. Are you selling them at those prices? Or what prices are you moving some of these assets off the books?

O. Hall

Paul, this is Grayson. Listen, I'll answer and I'll ask the folks in our credit team to comment a little bit further. First of all, we're still continuing to see strong demand for our stress credits. We sold approximately $620 million in stress credits in the quarter. And as David mentioned, we wound up with a discount of roughly 24% off of those. And in fact, the loans that we are selling out of OREO, or the property we're selling out of OREO are the loans we're selling out of held for sale, are coming in very close to our marks. And in fact, in some cases, we're realizing gains on those sales. So still strong demand, strong sales and we're continuing with that strategy. I'll stop and let the credit team add to that.

William Wells

This is Bill Wells. Again, we had a very good quarter in sales. And as Grayson mentioned our marks held pretty true to what we thought. Not only did we have a good quarter of sale problem loans, but out of OREO, I think we sold a little bit of 1,600 properties. And then we had a good bid of sales out of our held for sale. So we believe our marks have been holding pretty true. And we continue to see active interest going into this quarter also. We've had about $50 million in sales and we've got another, about, $50 million in pending contracts. So we continue to see good progress.

O. Hall

Will and Paul, one other point is that if you look at our charge-off number this quarter of $651 million, there still is a fairly substantial number related to valuation charges. That being said, we are seeing some stabilization in our markets and the valuation charges on our OREO held for sale and NPLs is starting to decline due to that stabilization.

Operator

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

Craig Siegenthaler - Crédit Suisse AG

Just looking at the trend in your non-interest expenses, I'm wondering, was the biggest driver down there little less than the OREO side?

David Turner

That was not the biggest contributor, but that was one of the contributors. The first quarter from the salaries-and-benefits standpoint is, you have seasonally high payroll tax expense in that first quarter and that was a piece of the pickup as well, with the remainder being the reduction in staffing, as I mentioned earlier, continuing to benefit the SMB line.

Craig Siegenthaler - Crédit Suisse AG

And that also is to actually other non-compensation? I thought that was higher up in the income statement?

David Turner

In the other, we would have also the held for sale. We had some held for sale gains that were in that other line that you're looking at.

Craig Siegenthaler - Crédit Suisse AG

And then just on Regulation E, it looks like you implemented some of your changes this quarter. Was there any positive revenue from these implementations? Any higher checking on maintenance fees? So when we think about kind of the run rate, anything unusually positive, which will stay there, but I'm just trying to compare the second quarter from the first quarter run rate?

O. Hall

Yes, when you look at the regulatory changes we put in the first and second quarter, really, at the end of the day, you sort of a net negative, minor, but net negative, but minimal impact. Where impact really starts to hit is in the third quarter. We really do have a number of changes that we've made to existing checking account product offerings that'll start to mitigate some of that impact. And we are pleased so far with our success and in talking to customers. If you look at roughly our 4 million checking accounts, 30% of those accounts would have had an NSF in the last 12 months. So that 30% of those customers, of that 30%, half of them has made the decision. And as David had indicated up earlier, 90% of them are either opting in to our standard overdraft process or signing up for overdraft protection, and only 10% are electing to go without either product. And so we're encouraged by that, but we still think that $70 million estimate is a good estimate for the balance of the year. I think full year next year is a bigger question. How much of that can we mitigate and offset with changes in our product offerings and changes in our customer behavior.

Operator

Your next question comes from the line of Betsy Graseck with Morgan Stanley.

Betsy Graseck - Morgan Stanley

One follow-up to that question, which is that therefore, we should assume a $35 million head to each of, well, two or 3Q that carries through to 4Q? Is that what you're saying?

David Turner

Yes. The $72 million actually gets a little higher in the third quarter, in the $40 million range with the fourth quarter being in the $40 million range. So I think that we still have mitigation that we have to put in place, and that's why it's getting -- it's a little more difficult to predict for the next year in terms of just leveraging off the run rate.

O. Hall

But I think, Betsy, what you're saying is, is that when you look at that $72 million when you annualized that over next year, obviously, it's not a full impact for full third quarter. There's only part of third quarter not impacted that. So if you didn't have any mitigating factors, it could be slightly more than twice that number next year. But we do have mitigating actions that we're taking and we'll be prepared at some juncture to share with you what we think the 2011 number will be. But it'll be better than what the annualized effect of this year

Betsy Graseck - Morgan Stanley

And is that because opt in? The people who have opted into your new products that don't start to pay for them until next year?

O. Hall

Well, I mean, a couple of things. One is that the people who have opted in, either through overdraft protection or our standard overdraft process, that is one set of customers. The other set of customers are new accounts we're opening and what decisions are they're making. And as customers are impacted by this change, we're reaching out to those customers and giving them a second opportunity to make a decision. And when we do that, many are coming back that had previously opted out and opting back in once they really fully understand the implications of their decision.

David Turner

Yes. I think, this is David, Betsy, as people learn what it really means to not have not opt in and they've had that first experience as disappointing to them and they call the call center, we think we'll have another opportunity to give them another option so to speak.

Operator

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

Matthew O'Connor - Deutsche Bank AG

Two unrelated questions. First, it seems like your regulatory capital benefited in a pretty meaningful way from disallowed deferred tax assets coming down. It seems like there's a $500 million boost from that. And I guess I'm wondering what drove that and you still have a bunch of disallowed DTA, how quickly can the remaining amount come back?

David Turner

Yes. Let me kind of talk about all the capital. As I mentioned earlier, we early converted the mandatory convertible that picked up about 26 basis points in Tier 1 common. The second component of our capital change was the decline in our risk-weighted assets of approximately $2 billion. And then the final fees, Matt, you mentioned on disallowed deferred tax assets was reduced about half this quarter. And it's important to note that this calculation is defined by regulatory rules and it differs from GAAP, from the view of GAAP when you're talking about realizing DTAs. So what we do is, we look out over the next 12 months of taxable income as defined by the regulatory rules to determine how much of our DTA is allowed versus disallowed. As our PPNR and credit metrics have improved, we make adjustments to that projection, and we will continue to do so each and every quarter. The pace at which that comes in is hard to determine because it's depending on our credit metrics. And while we, as you heard our prepared comments, felt good about where they're going, we do remain cautious there and we hate to forecast the timing of the return of the DTA in the capital. It is important to note, though, that, that is temporary. And that ultimately, as we show our return to profitability, that, that remaining DTA of well over $400 million will come in to capital.

Matthew O'Connor - Deutsche Bank AG

So is it fair to say then that your outlook for the next 12 months in terms of return to profitability has increased meaningfully versus last quarter? Because the biggest driver, it sounds like that.

David Turner

I think that if you were to look at our expectations of return to profitability have changed from one quarter to the next, and clearly, you can look at our major components of PPNR, our improvement in credit metrics as being the indicators as to why we're feel that way.

Matthew O'Connor - Deutsche Bank AG

And then just separately, the re-entry into the Indirect Auto business, this interest in the past month I've had a bank told me that spreads are too thin so they're getting out of it. I've had a bank coming, the spreads are pretty good, so they ramping up production. I'm just wondering if you give us some sense of what pricing is out there for you guys and how much volume you expect from here?

O. Hall

Well, when you look at our history, we were in the Indirect Auto Financing business for years. And at the beginning of this credit cycle, we made the decision to exit that business and we only exited that business in terms of origination. We have still been servicing a portfolio throughout the cycle. It's obviously a declining portfolio as customers have paid down and paid off, but we're still servicing that portfolio, still very cognizant of what the credit performance in that portfolio has been. We still have many of the people on our team who had participated in that business for a number of years. And getting back in it, it's not a particularly difficult feat for us since we still have the platform and we still have a lot of the leadership. And so we are going to re-enter this quarter, we believe from what we've seen some of the businesses, the dealerships we've spoken to, that there's a need for this product. In fact, what drove this decision more than anything else was consumers returning to our branches, asking for auto loans. We had not seen that for years. It's a strong indication that there is a need for financing for autos. We believe we know how to price it. We believe we've got the discipline to price it. I think the bigger question, important question you ask is, how much volume can we generate? We're not ready to predict that yet, but if we didn't think we could generate some decent volume, we wouldn't be getting back in it.

Operator

Your next question comes from the line of Marty Mosby with Guggenheim Partners.

Marty Mosby - Guggenheim Securities, LLC

David, the comments you made about the net interest margin and extending out the hedging that you have, you're obviously thinking that rates are going to stay low as we all kind of do for a long period of time. Are we getting any more, maybe not anxious is the right word, but kind of looking forward to trying to lengthen the asset as well to try to use some of the yield curve since we are so asset sensitive, and it looks like the benefit of that is going to be delayed so far?

David Turner

Marty, we think our duration on our portfolio is fairly consistent with our peer group. We're probably on our investment portfolio in the 2.5 year range maybe up to three. We have discussed whether or not we want to go out and take more duration to pick that up. And that's certainly is one thing we consider. But we have not done so at this time and I'll tell you, we will have ongoing dialogue in our ALCO process that will ultimately determine that. If you look at our investment portfolio in particular, we derisk that portfolio when this cycle started by selling off any CMBS and municipal securities, and so we're about 99% agency guaranteed in the investment portfolio today. But as loans have come down and we start reassessing the risks that we're taking in totality, and so we actually, from a risk-weighted asset position are pretty low on our risk rates, and it gives us an opportunity to perhaps take some additional risk, whether it be credit or duration. And we're going to be smart about how we use that opportunity, so that we don't lock ourselves into a problem for the long haul. We are all about what is the best interest for us in the long term. There are things we can do in the short term to generate profitability that we think works against us in the long term. And one of those is including our -- we have at quarter end about $800 million to unrealized gains in our investment portfolio that we did not take. We didn't take security gains because we don't think that's the long-term best interest of this franchise. And so to your point, we will continue to look at duration and other matters as we go into the next...

O. Hall

And Marty, this is Grayson. I just want to emphasize the point David just made. There's a number of things we could do to demonstrate stronger earnings short term, but would not be particularly wise decisions over the long term. And we are trying to build a franchise of strength for the long term. And if you look at our quarterly earnings, you'll see that there are a lot of things that we did not do that we could have to have demonstrated stronger earnings. But we, again, believe that we ought to stay in the course in trying to build the franchise for the long term. We did not take any security gains to offset any other expenses we had. We continue to carry a large unrealized gain in that portfolio, but those assets will provide a tremendous benefit for us and will do so for quarter to come. And we'll keep the duration relatively short compared to peer. There are peers with much longer duration in investment portfolio, but we do not want to take any undue risk at this point in the cycle.

Operator

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

Ryan Nash

Yes, this is Ryan Nash from Jason Goldberg's office. Grayson, I think you talked about in prior guidance about NPAs and NCOs peaking at the end of the second quarter, and now with both coming in better than expectations and NPA formation declining. Combined with that, your outlook seems a bit cautious with the Gulf economy and other macro events but then on the flip side, your DTA is down substantially due to an improved outlook. How should we think about reserves for the back half of the year? I know in the past you talked about not adding any more, but should we start to think about you guys either potentially with the leasing reserves?

O. Hall

Well, I think the best way to look at that is, if you ask yourself, what's changed since last quarter? Certainly, our credit metrics have improved substantially, but our economic outlook has been tempered since then with all the advancement incurred on a macro basis. Our long-term economic forecast is a very slow-growth forecast, and we're adjusting our business expectations for that. The credit trends are favorable, but we're going to stay very disciplined on our allowance reserve methodology and let the numbers speak for themselves. If look at our reserve today, the allowance to loans is a strong 3.71% and our coverage ratio is about 92%, which puts us relatively in the middle of peer. We feel that our reserve is efficient today and we feel good about where we're at in terms of how that might change between now and the end of the year. In large part, I believe, it's going to be driven by the level economic improvement. That, at this point for us, as you heard the word encouraged, but cautious, that sort of where we're at today.

Ryan Nash

You made reference that you're expecting to continue to reach your goals on the margin. I know in the past quarter you talked about potential 3% by the end of the year, are you guys still expecting to reach that or is there something maybe impact in the margin that could change your outlook?

O. Hall

No, we set that target several months ago, and we still are remaining confident in our ability to reach that target, and know of nothing at this juncture that's stand in the way of us achieving that.

Operator

Your next question comes from the line of Heather Wolf with UBS.

Heather Wolf - UBS Investment Bank

Just a quick follow-up on the margin question. As you look into 2011, I'm wondering if you can quantify the additive impact of the hedge extension and whether or not you think that's enough to offset asset yields grinding lower without taking incremental interest rate and credit risk in your securities portfolio.

David Turner

Yes, we think, Heather, this is David. We think that the impact of that hedge really, as things level off, that the hedge will protect us from the downside. To the extent rates stayed low longer, we did not want to run the risk that our margin actually dips down below that 3% level that we've talked about, and to the extent that we're all wrong and things are that much better, and GDP is improving and everybody's feeling better, then the interest rate environment may go up and will ride with that. That's a very different environment than the protection on the low side. And that's what the hedge is intended to do.

Heather Wolf - UBS Investment Bank

And just one quick follow-up on commercial real estate, it looks like you had some upward pressure on non-accruals in the term mortgage buckets. Can you just talk a little bit about what you're seeing there?

O. Hall

Yes, on commercial real estate, I think, you may have been talking a little about some of our evaluation charges that we did see on that. What I would say is that there was one particular credit that we've been watching for a particular time, over a period of time. We've got some new information in and we took a charge on that. Other than that, we've continue to derisk the portfolio, our balances are coming down. Everything that we've seen has been going as we felt that it could as far as investor real estate.

John Owen

Bill, why don't you comment just briefly on the construction book and where that stands today?

William Wells

One of the things that we have been watching very closely as a company is our construction book. At the time of the merger, it was almost $12 billion. Over the past year, a couple of years, we have worked that down to about $3.8 billion. So we've taken a good bit of risk out of that investor real estate portfolio. And our non-performings in that construction has been about 20%, and that's held pretty much true over the last several quarters.

Operator

Your next question comes from the line of Christopher Marinac with FIG Partners.

Christopher Marinac - FIG Partners, LLC

I wanted to ask about TDRs on the commercial side and why you haven't used more of those, and do you think that may change in future quarters?

O. Hall

Well, Christopher, what we tried to do is, too really focus early on, on trying to dispose of stressed assets on the commercial side. We tried to work with a number of customers on restructuring, which is what we wind up in the TDR. Quite honestly, the market was deteriorating in such a pace that the opportunity to do that has been somewhat limited. We're having more success with that recently, but that continues to be a challenge for us. And I'll ask Bill to speak about that a little more.

William Wells

Well, I mean, it is that, that our focus has been recently over the last several quarters on the disposition effort. We're continuing to look at that. We think we're going to have another good quarter of sales. But as Grayson mentioned, we're looking at particular credit that we can restructure and that's what one of our goals this quarter to do, is to do or if our customers are available to it, is to do more of the restructuring.

Operator

Your next question comes from the line of Kevin Fitzsimmons with Sandler O'Neill.

Kevin Fitzsimmons - Sandler O'Neill

The one thing I would just throw in, Grayson, is most of the conference calls, you've mentioned how do you feel about TARP repayment. I would guess given just your comments about the economy and then the uncertainty in the Gulf, you're not going to be in any hurry to do that? Just if you had any other comments on that?

O. Hall

No. I mean, really, no update. No change in guidance on how we're viewing TARP repayment. We continue to be patient in that regard. We continue to believe that our focus ought to be on credit improvement and returning to profitability. And that issue will resolve itself.

Operator

Our final question will come from the line of Al Savastano with Macquarie.

Albert Savastano - Macquarie Research

Just on the Gulf exposure, can you just confirm that you didn't take any reserve this quarter?

O. Hall

Now what we've done, we take no specific reserves on the Gulf exposure itself. If you look at our loan loss allowance methodology, we do go in and adjust our allocation factors based off of environmental issues as we see them are in changes in our loss forecast for particular segments of our portfolio. But we do not have a Pacific allocation for a Gulf oil spill. It's embedded in our methodology.

Operator

I will now turn the call back over to Mr. Hall for closing remarks.

O. Hall

Well, in closing, let me say thank you for your time and attention. We appreciate you being here and your bulk of questions were helpful and appreciated as well. So thank you, and have a good day.

Operator

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

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