Zions Bancorporation (NASDAQ:ZION)
Q3 2010 Earnings Call
October 18, 2010 5:30 p.m. ET
James Abbott – SVP, IR and External Communications
Harris Simmons – Chairman, President and CEO
Doyle Arnold – Vice Chairman and CFO
Ken Peterson – EVP and Chief Credit Officer
Brian Klock – Keefe, Bruyette, and Woods
John Pancari - Evercore Partners
Marty Mosby - Guggenheim Securities
Ken Zerbe – Morgan Stanley
Steven Alexopoulos – JPMorgan
Joe Morford – RBC Capital Markets
Jennifer Demba – SunTrust Robinson Humphrey
Brian Zabora – Stifel Nicolaus
Peter [inaudible] with Carlson Capital
Good day ladies and gentlemen and thank you for standing by, and welcome to the Zions Bancorporation third quarter 2010 earnings call. This call is being recorded. I would now like to turn the time over to James Abbott, director of investor relations. Please go ahead.
Thank you. We welcome you to this conference call to discuss our third quarter 2010 earnings.
I would like to remind you that during this call we will be making forward-looking statements and that actual results may differ materially. We encourage you to review the disclaimer in the press release dealing with forward-looking information, which applies equally to the statements made in this call. We will be referring to several schedules in the press release during this call. If you do not yet have a copy of the press release, it is available as an Adobe Acrobat file at zionsbancorporation.com and can be downloaded and printed.
We will limit the length of this call to one hour, which will include the time for you to ask questions. During the Q&A section, we will ask you to limit your questions to one primary and one follow-up question to enable other participants to ask questions.
I will now turn the time over to Harris Simmons, chairman and chief executive officer. Harris?
Thank you very much, James, and thank you to all of you who are joining us this afternoon for our call. We are quite encouraged with our third quarter results, with core pre-tax, pre-credit income relatively stable, moderating rate of decline in our loan balances, and a broad-based improvement in credit metrics, specifically the continued decline in problem credits and a significantly lower rate of inflow into the various problem credit categories.
Looking at our results, there were several items that obscured some of our core operating trends and we've identified them throughout the release. A good example would be our FDIC indemnification asset. As our credit quality has improved, we write that asset down, it actually increases our non-interest expense. There's some offset non-interest income but you really have to pull some of those items out to get a clear picture.
When you adjust for these items, you'll see, I think, that we have relatively stable core earnings before credit costs when compared to the prior quarter. On a GAAP basis, we reported a loss of $0.47 per common share to shareholders, an improvement from a loss of $0.84 per share in the prior quarter.
We're pleased with the credit performance - non-accrual loans, delinquent loans, net charge-offs, and provisions all declined compared to the prior quarter. We still have, certainly, work ahead of us. We certainly not have declared victory yet, but we're encouraged with the [inaudible] rate of new, non-accrual inflows and a healthy rate of problem credit resolution.
In the third quarter, we resolved more than 20% of our non-accrual and real estate-owned assets, which is consistent with the resolution rate year to date in terms of the amount of the beginning balance that we've been able to resolve during the quarter.
As we look at various macro-economic trends within our footprint, we see more signs of emerging optimism than pessimism these days. In the real estate markets we're seeing rental income, though still declining moderately within various major markets within our footprint, is showing signs of stabilizing. Vacancy trends are stable to improving across the majority of our footprint. Furthermore, cap rates are showing some consistent signs of stabilizing during the last several months across a wide variety of geographies and property types.
All of these factors facilitate faster problem credit resolution. Importantly, non-accrual term commercial real estate loans declined for the second consecutive quarter, are now down 19% from their peak. Losses from these loans also declined to about a 1.6% annualized charge-off rate of total term CRE loans, down from 2.1% in the prior quarter.
Finally, we further enhanced both our GAAP and our regulatory capital ratios during the quarter through the issuance of common shares, warrants, preferred stock via sub-debt conversion, and by reducing the risk weighting of certain securities. So we've been very busy this quarter.
With that overview, I will ask Doyle Arnold, our vice chairman and chief financial officer, to review the quarterly performance.
Thank you Harris. Good afternoon everyone. As noted in the release, we posted a net loss applicable to common shareholders of $80.5 million or $0.47 per diluted common share for the third quarter. That's a significant improvement over the prior quarter and the same quarter a year ago. I'm going to highlight primarily three key areas: revenue, credit, and capital, and then we will take your questions.
First, the revenue drivers. The GAAP NIM expanded 26 basis points to 3.84%, from 3.58% in the prior quarter. A big driver of that was the fact that the adverse impact of subordinated debt amortization on the NIM was only 35 basis points this quarter compared to 64 in the prior, and that is because a significantly smaller amount of sub-debt exercised its right to convert [its first shares] this quarter than compared to the prior quarter.
The core NIM, which [inaudible] amortization of sub-debt and items related to FDIC loan performance compressed 11 basis points to 4.03%, from 4.14%. That's primarily due to the, again, an increase in the average cash balances on our balance sheet as we remain in a very highly liquid position. The yield on loans, excluding the FDIC-supported loans, was stable at 5.60%.
Regarding funding, during the quarter we actively worked on reducing excess liquidity where possible, pruning funding sources to better optimize profitability and capital ratios. We worked with a number of business and governmental customers to help them move excess balances into sweep accounts at third-party money market funds, which was the major driver of the linked quarter decline in non-interest-bearing deposits.
We were careful to maintain the relationships with the customer, and we anticipate the ability to bring these deposits back on the balance sheet if and as loan demand improves. But loan demand has been soft, although as I'll mention in a minute, as Harris mentioned there has been some improvement.
While deposits remain very strong and we still have more cash than we believe desirable on our balance sheet, nevertheless we did shrink the balance sheet by about $1 billion this quarter by reducing these excess deposits in the way indicated. But cash remained a relatively high percentage of total earning assets at 11%, pressuring the net interest margin by more than 40 basis points, compared to historical norms.
We will continue to try to reduce our excess liquidity during the next several months, ideally through increased lending activity, but also by running off non-core deposits while at the same time retaining core relationships.
In addition to the excess cash balances, the margin is compressed or pressured by more than 25 basis points due to the level of non-accrual assets and interest reversals as loans are moved into non-accrual status.
The other key component of revenue is our earning asset base. Period-end loans held for investment declined $459 million to $37.7 billion, or about 1.2% for the prior quarter. That $459 million number is a significant improvement over the prior three quarters, each of which had seen declines in excess of $1 billion. And excluding construction, land development, and FDIC-insured loans, period-end loans were almost flat, declining by only 0.2% sequentially.
The loan runoff was concentrated almost entirely in construction and development loans, as well as our working down of FDIC assets and there continues to be relatively little demand for construction and development lending and we're still trying to manage those totals downward.
After several quarters of moderating rates of decline, both C&I and owner-occupied commercial loans showed moderate signs of growth as we discussed borrower demand with our lenders we do get the sense that lending demand is emerging in some areas. Pipelines are getting a bit stronger, although de-leveraging continues to be the more dominant theme.
The components of non-interest income and non-interest expense contain several items that somewhat obscure core operational results. Starting at the top of non-interest income, capital markets income is stronger due to favorable marks on certain securities purchased for asset liability management purposes. That's the fourth line under non-interest income on page 11, from $10.7 million to $13.2 million second quarter to third quarter. But we do not expect to repeat this gain in the fourth quarter.
A little further down, fair value and non-hedged derivative income had an adverse charge of $21.9 million due to the addition of the total return swaps as described in the release and releases earlier in the quarter. This expense is essentially the amount of the premium for the first year of the swap. Assuming that we keep the total return of swaps in place, the next expense for the TRS would occur in the third quarter of next year in an amount of approximately $5.3 million.
The fixed income securities line contains income related to the repurchase by Global Investment Bank of certain auction rate securities that we hold on our balance sheet. We had purchased these back from our customers when the markets became illiquid and they were held by us at a discount to par so we recognized the loss previously when we bought them from our customers at par but marked them to market on our balance sheet. This bank then in turn purchased them from us this quarter at par.
We still have some of these auction rate securities on our books that we had repurchased from customers, but the remaining discount that we are carrying is less than $10 million and therefore not likely to be material to future earnings.
Other fee income, the very last line under non-interest income, of $20.2 million, was larger than usual. The primary driver was a $13.8 million gain recognized on the sale of most of the assets and business operations of our net deposit remote check capture software and service business.
Moving to expenses, we have broken out a new line item for you. We've collapsed a couple of others that we thought were of less interest, but we've broken out from other a line called "credit related expenses." These are things like foreclosure expense prior to the transfer to OREO, property taxes, legal, appraisal costs, and so on.
That number was $17.4 million this quarter, compared to about $17.7 million last quarter and just under $17 million the prior quarter. But a year ago it was running at less than $50 million a year and much much lower than that if you go back a few years prior to the financial crisis and credit downturn.
So it's now running at an annualized rate of about $70 million. In addition to provisions and OREO expense, this, we think, represents upside to our earnings momentum as credit conditions continue to improve as the economic recovery holds and strengthens.
The one-time structuring fee, or the total return swap, of $11.6 million, appears in "other non-interest expense." That's the very last line under non-interest expense and that particular expense will not occur for the life of this particular TRS.
Also included in the "other non-interest" expense line item is the FDIC indemnification asset expense of $15 million, or about 80% of the gain recognized in the interest income line. The accounting for the FDIC asset is not intuitive and in fact in many respects is actually rather strange in my humble opinion, and so we have tried on page two of the release to give you a bit of a roadmap to make some sense out of this. But I think rather than dwell on that, if you have questions I'll defer them to James after the call.
The bottom line message is that we acquired these assets for a price of less than we thought they were worth at the time and as you may recall we booked significant additions to capital through the bargain purchase gain and while there are various pools here, some are doing a little worse, some about the same, some better.
The net net of all of that is they are doing better even than we expected at the time that we purchased them. So we purchased them for cheaper than we expected to get, and we're doing a little better than we expected. That's what you really need to know. For the details, good luck, and James will try to walk you through it.
In that other expense line, if you take out the $11.6 million one-time TRS and the indemnification asset expense, it's a bigger expense than the prior quarter. That other non-interest expense line is relatively flat also on a recurring basis.
Finally, I want to highlight the OTTI, the other than temporary impairment of our CDO portfolio. This increased somewhat from the prior quarter to $23.7 million from $18.1 million. The driver of the increase is the Dodd-Frank Act, and that component of the act, as some of you may know, is the Collins Amendment, which on a phase basis disallows the inclusion of trust-preferred securities for tier one capital purchases by larger banks.
We expect that this will result in early redemptions of trust-preferred by banks that are strong enough to do so and therefore increase the pre-payment speed. And this in turn has the impact of reducing the support to the rest of the CDO structure, particularly the lower-quality tranches. So we've modified our modeling assumptions to take that into account and if not for that change the OTTI reported here would have been $12.1 million, just based on actual bank failures as opposed to the $23.7 million that we reported.
Given the reduced number of banks newly deferring, and an apparent stabilizing rate of bank foreclosures, our long-term expectation is that expense will continue to be stable to declining over the next few quarters.
Moving to credit quality, as you've noticed there was a broad-based improvement in credit this quarter, some of which we alluded to at a conference in September, at a high level, non-accrual loans, excluding FDIC loans, declined by about 8% sequentially. You can find the actual numbers on page 13 of the release. The earliest leading indicator of problem credits, so-called special mention loans, actually fell by 17%, which was a significant acceleration compared to the prior quarter's 6% decline.
New, non-accrual loans, i.e. loans that were first placed on non-accrual status in the quarter, were $426 million, down from $591 million in the prior quarter. So we're seeing a reduced rate of inflow of new non-accruals and new special mention inflows were a very small total percentage of the total balance, which is encouraging.
On the other side, our quarterly resolution rate of problem loans remained relatively stable. We're resolving in the 20% to 25% of the total pile of NPAs - at the beginning of the quarter we're resolving by the end of that quarter - and additionally during the third quarter a higher percentage of the NPA resolutions came from favorable resolutions as opposed to unfavorable. Nearly three quarters of the resolutions came as the result of upgrades and pay-downs and pay-offs, rather than charge-offs and charge-downs, etc. And that three quarters favorable rate is up from about 60% just six months ago.
In conclusion, combining the slowing inflows and diminishing deterioration up the pipeline we expect to see further improvement in NPAs in coming quarters, assuming that the economy remains reasonably stable. The ratio of allowance to credit losses was essentially unchanged as a percent of loans, 4.34% versus 4.37% last quarter, which is consistent with our position on releasing reserves. We felt it was still a bit too early in the economic recovery to release a significant amount.
Construction and land development non-accrual loans fell by 11%. Within construction, we continue to experience a strong rate of decline in commercial construction problem loans, down by more than 35% since year end. Residential construction problem credits also declined and are down nearly 30% since year end. Problem loans here means classified loans, our more severely graded loans, and that's a category that has driven most of our losses as you might well understand.
Term commercial real estate non-accrual loans fell by about 6% compared to the prior quarter's level, and owner-occupied commercial real estate non-accruals also fell at a similar rate, which is consistent with the prior quarter's rate of decline. And finally, C&I non-accrual loans declined about 11% sequentially.
Switching to losses, net charge-offs to loans fell 14 basis points to 2.50%, from 2.64% in the prior quarter. So basically what you've got are a declining loss rate and a declining pile of problem loans from which most of those losses are emerging and therefore we do expect losses to trend lower as we move through the remainder of this year and throughout 2011. Actual charge-offs declined in several categories this quarter, including term CRE, construction, and owner-occupied commercial.
And finally, a little bit on capital during the quarter. We did raise a net of $110 million of common equity, net of fees and commissions, with about two-thirds coming through the issuance of new common shares and one-third through our auction of warrants to buy common shares in the future.
As noted, our tangible common equity ratio increased 17 basis points to 7.03%, at 6.86% in the prior quarter. The tier-one common improved by an estimated 86 basis points from the prior quarter to approximately 8.77% from 7.91%. Our risk-weighted assets declined by approximately $4.5 billion, or 9.5% sequentially. Most of that, about $4 billion of the risk-weighted asset reduction, was due to the total return swap, and about $500 million was the decline in loans.
Summary of guidance for the next few quarters, first on the balance sheet, loan balances appear to be shifting from significantly declining rates to stability in some categories, particularly when you exclude construction and FDIC-supported loans. Whether or not the overall balance increases or declines in the near term is difficult to forecast. Over the longer term, however, we do believe that nascent signs of stability in categories such as C&I and owner-occupied loans may develop into more consistent growth.
Anecdotally we are hearing from a number of our banks that their pipelines of commercial type lending opportunities are strengthening, and are better than they have been in some time. You'll see in the release the information about the number of gross new originations and renewals during the quarter.
We will continue to try to work down excess liquidity and reduce these non-core deposits as a way to shrink the overall size of the balance sheet and the drag on earnings that results from parking that cash at the Fed. Therefore, we would expect the core margins may be stable to improved somewhat in the fourth quarter due to reduced cash balances and those ongoing efforts to reduce non-relationship deposits.
Although there's a fair amount of chatter among investors within the industry regarding the industry's inability to reduce deposit costs, we believe that we still have some leverage to pull in this area, and furthermore organic loan production, including renewals, continues to be accretive to the margin, despite the increased pricing pressure by some major national banks. And long-term, we remain asset sensitive, which means we think we're quite well-positioned for a rising rate environment.
To guard the credit quality, we expect charge-offs to generally decline over the next several quarters, although it will be somewhat lumpy. The decline in the fourth quarter may be modest because [inaudible] to press our banks to aggressively recognize losses and reduce problem loans and get them dealt with. But as I mentioned earlier, the general credit quality trends are very encouraging at this point.
We'll expect, therefore, non-accrual loans and other adversely graded loans to continue to recede at a healthy pace, and we continue to experience modest declines in the allowance for loan losses although again we'll be cautious about reducing it significantly until there is a greater degree of certainty regarding the strength of the economy.
What we see internally looks good, but we are mindful that external observers like IHS Global and others have weaker forecasts for the next year in the economic environment now than they did a quarter ago. So that's the source of our caution.
Tax rate. For those of you building your models we know this number has been a bit erratic for us as estimates of taxable and non-taxable income have changed over this year. We expect the effective tax benefit rate will be between 46% and 47% in the fourth quarter.
And finally, as a result of selling a majority of the assets of net deposit, a few line items will change going forward, but rather than spending a lot of time on that, the net impact of net deposit, apart from the gain we reported this quarter - the impact on earnings was, I think, about a loss of a penny or two a share annualized over the last couple of quarters. So it has very little ongoing impact on earnings and to the extended debt it's probably slightly positive.
With that, I think we will turn to your questions, so operator, if there are any already queued up we'll take them. Otherwise we'll wait for you to pose a question and then we'll be happy to talk to you.
[Operator instructions.] Our first question in queue comes from Brian Klock with Keefe, Bruyette, and Woods. Your line is now open. Please go ahead.
Brian Klock – Keefe, Bruyette, and Woods
Doyle, I'm looking at the end-of-period balances. So deposits have come down compared to average and so have the money market assets. Maybe you can kind of give us an idea, where do you think the margin could be headed here into the fourth quarter versus that core adjusted margin that you guys disclosed during the third?
A couple of comments. First of all, a lot of the reduction, particularly the reduction in DDA balances that occurred in the third quarter occurred in the month of September, so if nothing else changed we would see a further decline in average balances in the fourth quarter in deposits just because of the pattern of when that occurred. I don't think we expect to have as dramatic a change in the actual balances in the fourth quarter, but you'll get a few hundred million at least of average balance decline.
And we do continue to try to push out some non-relationship CDs as they come up for renewal, etc. So I think what I said with regard to the margin is that margins probably stable to maybe slight upward pressure, but I think we're comfortable that the core margin is in the low fours, but I can't pin it down to within a few basis points for you.
Okay. And then my last question here, just on the construction. You continue to work the construction down. Was there any of that, or can you kind of gauge how much of that was termed out, anything that rolled over from construction to permanent?
I don't think we have that with us here today. We will try to find an investor forum later in the quarter perhaps to get that. But we have not analyzed that yet.
Our next question in queue comes from John Pancari with Evercore. Please go ahead.
John Pancari - Evercore Partners
Could you talk a little bit about, in terms of your outlook for loan growth, can you give us a little bit of detail on where the utilization rate stands right now by - I don't know if you have any detail by loans. And where do you expect that you could see some improvement on that front?
The utilization rate is unchanged linked quarter. There was some movement month to month, but unchanged, and it's around 38% or so.
It's up just one percent from last quarter.
On a percentage point, yeah. [Laughter.]
On a percentage point from 37% to 38%, really down from a high in the low forties a year ago.
It's been stable, relatively stable, in the high 30s now, for about three quarters.
Doyle, I know you mentioned that reserve releases are probably modest near term, I guess if you can just help us understand the timing of when you think, given its trajectory right now in non-accruals and in your delinquency trends, how soon we could expect a more material reduction in the reserve levels.
Well, that is a very good question, and I will just point out the obvious, that there's probably a real tension between what the regulators would like to see, which is little or no reserve release ever, and what GAAP would indicate, which is if the likelihood of a recession that begins to fade, and therefore the loss content inherent in the portfolio today continues to look more favorable, then we've got to release more reserves at some point. The qualitative adjustment to the quantitative reserve calculation, which was - that adjustment between what the pure quantitative factors would indicate was a bit over $200 million last quarter. It was over $300 million this quarter. So the qualitative adjustments have gotten larger and that may not be sustainable for more than another quarter or two before we have to start making some change in the reserves, unless the economic outlook does continue to be very cloudy. And as I indicated there are some macro-observers, including the Fed, that clearly have come to believe that the macro outlook today is not as favorable as it was a few months ago. So we're going to remain cautious until it becomes clearer that the recovery is on a firm footing.
And then lastly, if I can just ask on capital, and particularly on TARP. Are you getting any additional color from the government in terms of the capital raise that could be required to get out of TARP or are they really going to look at how much you've already done and take that into consideration. Just trying to get some type of detail around how much you could have to raise.
We have no clarity. In fact we've had no meaningful conversations on that point to date.
Our next question in queue comes from the line of Marty Mosby with Guggenheim Securities. Please go ahead with your question.
Marty Mosby - Guggenheim Securities
Yes, I have two questions. One was as we're seeing asset quality, especially non-performers, delinquent loans, OREO all starting to move down nicely, it starts to put us on the back side of the asset quality cycle, and we've raised $1.2 billion, $1.3 billion worth of the capital in the last two quarters. How are we starting to feel about - with TARP out there and with the capital that we need, how much more capital issuance should we expect as we're really starting to move on the back side of some of these pressured issues?
Well, I think as we indicated on last quarter's call we will probably continue to raise very modest amounts of capital as long as we are not profitable, and in particular not sufficiently profitable to cover the preferred dividends. But those numbers are getting generally smaller every quarter now and eventually will go to zero. As we get closer to that point that's when it would be more appropriate to have discussion with the Fed and others about TARP repayment plans. In addition to having a very large loan loss reserve in the face of significantly improving credit metrics, we've also pushed a lot of capital down into our banks, and that's where those credit metrics are improving. So at some point we would hope to withdraw some of that capital back to the parent. But what the mix is going to be of all of that to repay TARP not sure, but there's no plan to raise significant amounts of capital right now prior to having that TARP discussion, just very modest amounts for reasons that we've previously indicated.
I think too that a significant factor in all of this is what happens to commercial real estate losses, in particular the term portfolio. That's been a source of concern for a lot of observers. So far that is not playing out in our portfolio and has been reasonably benign around the industry and a lot of indications are that that market's commercial real estate is stabilizing and even strengthening. If you look at CMBS spreads and some other indicia of this it's appearing that maybe we're not going to see the kind of storm some had predicted. But I think until it's clear, it's going to take another two or three quarters perhaps before it's really clear, that there aren't substantial losses around the industry in that product type and if that happens my hope would be that regulators would become more comfortable with reliance on existing capital and capital ratios as we start to think about what it will take to repay TARP.
And Doyle, I wanted to recap some of the items, just real quickly. On the favorable side this quarter we had $4 million on mark on securities. We had about a net $7 million security net gains, and about $14 million gained on the sale from the net deposit unit. That's about $35 million of favorables. If you take the two total return swap issues, $22 million in the premium and then $12 million on the structuring, which at least next three quarters aren't there, that's about $34 million. So those two things kind of net out. And then you end up with $28 million negative from discount accretion, and then another $24 million in trust impairment. You put those together and you've got about a $50 million negative left hanging out there. You could see some pretty strong improvement over the next couple quarters. So to the degree a lot of your losses are coming out of these two items, and leading capital to just cover these two things, if they improve you should see some relief I would think.
I would think. [Laughter.]
Any other thoughts about the progress on those two line items?
We will announce later this week, I guess about an hour and 12 minutes ago was the deadline by which holders of sub-debt eligible for conversion had to give notice if they planned to convert. So we will announce within two or three days what amount we'll convert this quarter and our estimate of the drag fourth quarter on earnings from that. It will, based on what we've seen so far, that number will continue to be meaningful in the fourth quarter and I won't try to narrow it down any more than that.
I think your other one was the TruPs OTTI, was that the other one you highlighted?
Barring a big surprise there, the general trend is that we think the worst of that's behind us and the trend is stable to improving there. So you've got those two items and then the other one is of course the one we've already had several questions on, which is reserve release, or how much under-provision can we prudently allow to take place going forward.
Our next question in queue comes from Ken Zerbe with Morgan Stanley. Please go ahead.
Ken Zerbe – Morgan Stanley
When you think about your non-performing loan balances, it looks like in total the NPA reduction is accelerating, and that's great. But when you look at the composition it looks like a lot of the reduction is coming from the construction loans with less of a decline in commercial, but still down of course. One of your competitors highlighted the risk that as more of the non-performers became commercial as opposed to construction the pace of NPA reductions would decline. Do you find that might be the case in your portfolio as well, or is there any reason to think you can more quickly resolve a lot of the commercial non-performers?
I think we do have several large commercial non-performers that are headed toward favorable resolution and as I cautioned James earlier today in how we characterize this I'll caution you in the use of the word "accelerating". That is a true statement historically over this quarter compared to prior. I don't know how far out to extrapolate a positive second derivative on top of a favorable first derivative. But we're not at the point yet where we think that it's going to get a lot harder to resolve C&I credits compared to construction and CRE credits.
Our next question in queue comes from Steven Alexopoulos with JPMorgan. Please go ahead.
Steven Alexopoulos – JPMorgan
I just want to follow up on John's question regarding the reserve release. Doyle, given the tension you talk about with the regulators who want to keep the reserve higher, what's the key variable you need to see change to give you the flexibility to really drop the reserve here? Is it more a function of the inflows into non-performer, the charge-off levels, or is this view on the broader economy really key here?
How many angels can dance on the head of a pin? [Laughter.] I don't -
I think that clearly substantial reductions in non-performing assets, our internal grading of assets, if that significantly improves that is a very substantial factor in the way we calculate reserves and is likely to remain so for some time. As that's coming down, we are trying to be very careful about not simply letting non-performing asset levels drive the reserves entirely then. We're trying to make sure we're reasonably conservative in what is still a very uncertain economic climate. But I do think internally the pressures to release reserves will accelerate as non-performing assets continue to come down. I think there's no question about that. Otherwise, too much of this becomes simply qualitative concern about future and certainly we don't have any corner on views as to what the future's going to be. But we're trying to be careful about it.
Harris, maybe if I could follow up - on prior calls you had expressed the hope at least to reach profitability by the end of this year. Is your optimism at least to get the provision down below pre-tax pre-provision? Has your optimism been tempered a bit? In other words, has that view been pushed out here?
First thing I'd say is our view about releases is not linked to any determination as to when we want to become profitable. I wanted to become profitable long ago. So we try to make a determination about what we're going to do with reserves independent of any goal that we might have to be profitable in a particular quarter. And I think all of you are smart enough to be able to do math and figure out - you'll have your own views as to core profitability, etc. So I think it's becoming clear to us that the trends in non-performing assets, classified loans, etc. are improving at a pace that we are likely to be profitable here reasonably soon. I don't know if that's the fourth quarter or the first quarter, but I expect that we're going to see - if the internal trends we're seeing continue to play out, in terms of resolution problems and a significant decrease in the amount of new problems coming into the front end of the hopper, that the calculations will be such that you'll see increased releases. It's really premature for us to be hazarding a guess as to the amount of that, and thus the timing of returning to profitability.
What we've said, I think, for at least two quarters now, maybe even longer, was that we thought return to profitability late this year or very early next year. I still stand by that. Trying to narrow it down any more than that is very difficult because there are three or four really big moving parts here. The core pre-tax, pre-credit cost earnings have held up remarkably well through all of this. We're very very pleased about that. The credit costs are trending favorably. The OTTI costs are trending favorably. But then we have this other thing that is not necessarily economically linked and is out of our control, which is the sub-debt to preferred conversions, and those can be large enough that they could postpone profitability at quarter. They could send us back to unprofitability for a quarter after returning to profitability. They're a non-cash item. It just depends on how you're modeling and recommending to investors to look at that. And I don't know how all of you are treating that item. The things that are somewhat under our control are generally looking fairly good, and that one's a bit more volatile.
Our next question in queue comes from Joe Morford with RBC Capital Markets. Your questions please.
Joe Morford – RBC Capital Markets
I just wondered if you could talk a little bit more about the progress you made this quarter on terms of deposit re-pricing and specifically in lowering some of your money market rates in the quarter, and how much of that would have been reflected in the third quarter and maybe more in the fourth.
I would say that we've really put the pressure on our banks to take another hard look at this in meetings we had with them in August. One of our banks, for example, in late August or September, dropped its rate on term CDs, if you have no other product with us, from 40 basis points to 5 basis points, which means basically it's a not open for business sign for that product, and we're basically not opening any more of those. A lot of the adjusting that took place took place in September, so I do think you'll see more. The full impact didn't show through in this quarter. You could expect more reduction, I think, in funding costs in the fourth. It's not going to be dramatic, because you've got to wait for CDs to renew, etc., but mid-single digits basis point reduction is not unreasonable to expect I would think. You have a different view James?
No, that's probably fair. One of the things I was going to highlight is the cost of CDs sitting in the 120 range for the quarter on the balance sheet and new production for CDs for the quarter was down around 60 or so basis points.
I would think in September it was probably lower than that.
It was actually relatively stable, but anyway. That gives you kind of an order of magnitude on what costs can do on CDs. Money market there's a wide range of ways to look at that, but maybe we'll take that question off line as far as how to look at the industry there.
Okay. And then I guess a separate follow up question was just following up on the loan growth. It sounds like across the board you're seeing some more stability. I was curious if any of the banks or markets are showing stronger trends than others, more positive trends than others, and do you have much of an appetite right now at all for non-owner-occupied term CRE lending?
I think yes. You know, there's stuff that you can finance now. Generally it's well structured, it's well supported by owners' equity, favorable, good terms and rates, so yes, we are making new term CRE loans.
And again, just a reminder. Our market is not the trophy high rise office building major city downtown, it's a different, more exurbs, suburbs, middle market type of CRE. I don't think the cap rate swings and other valuation indices are as violent as they are in some of those trophy CMBS type markets.
And are those opportunities coming across your footprint, are you seeing some markets better than others?
They're primarily coming in the Texas and California markets. That's where the sun is starting to shine a little earlier than the other states.
Our next question in queue comes from Jennifer Demba with SunTrust Robinson. Your line is open.
Jennifer Demba – SunTrust Robinson Humphrey
Just wondering if you had any changes in thoughts about M&A versus a couple of months ago now that credit costs are continuing to decline.
No change in our thoughts at the moment. We're not seeing attractive things to bid on at the FDIC. And the terms offered by the FDIC are worse, the pricing on the successful bids are worse, and the quality of the franchises are all much worse than what we actually bid on and won a year ago.
And one follow up question on origination -
I would just add one other thing. You know, one of the things that seems to be happening, at least in our territory, and you're probably aware of this, is that those institutions that are troubled enough to probably want to consider selling but not so troubled that there's no franchise value have had some success in recapping themselves during the quarter as opposed to selling themselves. So you are seeing the sick get sicker and go down, but those that had pneumonia but there's a doctor at hand are curing, and that frankly is helping our trust-preferreds recover as well. So just a little elaboration on my previous answer.
The origination jump you had from second quarter, was any of that seasonable do you think in nature?
Seems to be more of a trend line. I think if you went back a couple of quarters earlier the gross new origination somewhere late last year or very early this year were down about $1 billion or so or even slightly less than that. And we've seen increases of a few hundred million each quarter, still not enough - so we're double the low point but it's still not quite enough to fully offset the charge-offs and the pay-downs and other things, but we're getting closer.
Our next question in queue comes from Brian Zabora with Stifel Nicolaus. Please go ahead.
Brian Zabora – Stifel Nicolaus
Just a question on competition on loan size, which you touched on a little bit, but is, compared to say 90 days ago, is competition still mostly in the larger high-quality, investment-grade C&I loans, or do you think it's spread at all?
Just anecdotally I think it's still in remains in larger investment-grade or call it [inaudible] you see it most significantly. As I said everybody's looking for good earning assets. I'm sure there's some of that at other levels, but where we're hearing about it tends to be with the larger clients.
And just a question on charge-offs in the C&I category. It's up a bit from last quarter, $72 million versus $52 million in second quarter. Was there any sizable charge-off in there?
I don't think there was any one noteworthy one.
Our final question for today comes from Peter [inaudible] with Carlson Capital. Please go ahead.
Peter [inaudible] - Carlson Capital
I wanted to applaud the moves you guys took on the high-cost funding and the lending origination and renewals. It all looks like headed the right way for the P&L, and thank you for sharing the qualitative reserve with us, because we can do a little bit of math and figure out where you would have been without it, which looks good.
I was wondering, we saw the warrant issue, right? Was that in addition to the $200 million DRIP, or was that part of the $200 million DRIP.
Well, we announced that we had authorization for a $200 million DRIP. We did not indicate that we expected to use all of it ever, and we didn't use all of it in the quarter, so this was a separate capital issuance, but you shouldn’t necessarily take the warrant and add it to the $200 million and say they're going to go issue $235 million of common equity.
Well, here's what I'm trying to do, right? We're all trying to gauge, as we talked about on the call, reserve release, when, if, depends on the environment, Q4, Q1, profitability, well we don't know, but it looks like we're headed in the right direction. What I'm trying to figure out is can I use this $200, right? Take out the $75 million that you issued, that you told us in the release, take out this $36 - $100 all together is $90 million, right? And I'm trying to say is it reasonable if I extrapolate the current environment and I know everything's conditional, but if nothing else were to come up on the environment to the negative side is it reasonable to assume that that is the cumulative pain that you guys see that is left?
Boy, you're trying to nail me down with it. You're basically trying to get me to forecast the cumulative losses over the next two quarters and say they're not - [Laughter.]
I know I'm not going to be able to nail you down, Doyle. Directionally, am I in the ballpark?
You're more or less in the ballpark, but again, back to some of the earlier questions -
Right, the caveats. Gotcha.
The caveats about TARP in particular. We've had some discussion about to what degree, what will "count", etc., etc.
No, I'm just trying to get in the green. I know the Feds are a whole other issue, but hopefully they'd give you some credit for where your tier one common is and your TCE is, blah blah blah, right? The reserve levels. So I've got to imagine some people over there doing some math, but hey listen, thanks for taking my call guys.
If the Fed and the OCC are listening on the call please take careful note of what the gentleman has said. [Laughter.]
Well, NPA formation down 28%, that was my key. That, to us, is early-stage. You guys see stuff way up further the pipe that's early-stage to you, but we feel cool when we're looking at the [Y9Cs and CMPA] formation down 28%, because that should lead to lower charge-offs in the future, so thanks for sharing that metric.
Okay, thank you very much everyone for your time. I will be available throughout the evening to take any additional questions or housekeeping items. You can reach me at 801-844-7637 and we look forward to talking to you intra-quarter. If not then, then at the next earnings call. Thank you.