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Sterling Bancshares (NASDAQ:SBIB)

Q3 2010 Earnings Call

October 28, 2010 11:00 am ET

Executives

Graham Painter - EVP of Corporate Communications

Downey Bridgwater - President & CEO

Bob Smith - EVP and CCO

Zach Wasson - EVP & CFO

Analysts

Bob Patten - Morgan Keegan

John Pancari - Evercore Partners

Brett Rabatin - Sterne Agee

Brad Milsaps - Sandler O'Neill

Kevin Reynolds - Wunderlich Securities

Dave Bishop - Stifel Nicolaus

Tom Alonso - Macquarie

Mike Zaremski - Credit Suisse

Matt Olney - Stephens, Inc.

Operator

Ladies and gentlemen, thank you very much for standing by. Welcome to today's Third Quarter 2010 Sterling Bancshares Earnings Release Conference Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session with instructions given at that time. (Operator Instructions). As a reminder, this conference is being recorded and information on accessing the replay at today's conference will be given at the end of today's call. With that, I'd like to turn the conference over to our host today, Mr. Graham Painter. Please go ahead sir.

Graham Painter

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

I'd like to remind everyone of the Safe Harbor statement included in today's earnings release. The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements including statements made during the course of today's conference call. These forward-looking statements are based on the company's current expectations and beliefs concerning future developments and their potential effects on the company. There could be no assurance that the future developments affecting Sterling will be those anticipated by the company. Factors that could cause actual results to differ from those projected in the forward-looking statements are set forth in today's earnings release, which has been posted on the Investor Relations page of our website at bancsterling.com.

For additional detail on these matters and other risks that could affect the company, please refer to the company's annual and quarterly reports which are filed with the Securities and Exchange Commission and available online at sec.gov.

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

Downey Bridgwater

Thanks Graham and welcome everyone. We appreciate you taking the time to join us on the call. Hopefully you had a chance a review our third quarter 2010 results which we released this morning before the market opened. We reported a net profit of $4.5 million or $0.04 per share for the third quarter which is an improvement of $0.03 per share as compared to the second quarter of this year. The improvement in earnings is a result of the lower provision for credit losses and decrease in ordinary costs and an increase in non-interest income.

The decrease in provision is the product of stabilization and the credit quality of our loan portfolio as well as lower overall loan balances. We have been working to improve our credit quality and are pleased to see some positive results. Non-performing loans, ORE and past due loans decreased during the third quarter and our net charge-offs remain at very manageable levels for the second quarter as well.

Assuming the property values continue to remain somewhat stable, we would expect net-charge offs to remain fairly consistent for the last couple of quarters excluding any possible future bulk NPA sales. Our allowance per credit losses to loans currently stands at a healthy 2.88%, an increase of 13 basis points over June 30th 2010. Based on what we are currently seeing in our loan portfolio, we don't expect to fill the allowance above credit levels. This of course assumes we bought another downturn in the economy.

Period-end loans were down approximately $129 million same quarter, about 65% of the decrease or $84 million was due to reductions in CRE and construction and development loans. The remaining decrease was in C&I which was impacted by continued low line usage and by a large commercial mortgage warehouse line paying down during quarter due to increased secondary market activity.

Our funded energy loans were flat for the quarter and loan demand continues to be low overall. In our discussions with customers and in reviewing the financial results. We're beginning to see some potential increased activity. A number of our commercial customers are showing improved liquidity and profitability due to their aggressive cost cutting efforts put in place during the early stages of the recession.

As the economic recovery continues and there is additional clarity in the political and regulatory environment, we would anticipate that more of our business customers will begin to expand and grow their businesses. Sterling is extremely well positioned from capital and liquidity standpoint to take advantage of these future opportunities to serve our Texas markets. For the remainder of the year, we expect total loans to be flat to slightly down with modest growth coming in C&I including Energy, owner-occupied commercial real estate and our residential and consumer loan categories.

Our bankers will continue their aggressive customer calling program, actively perusing these types of relationships. We continue to grow our core deposits in the third quarter. Deposits excluding jumbo and brokered CDs were up $26 million during the quarter as compared to the second quarter of 2010 while non-interest-bearing deposits were down slightly on a period-end basis quarter-over-quarter they were up on an average basis by $27 million during the quarter. Year-over-year period-end deposits excluding jumbo and brokered CDs have increased by $244 million or 7.5%.

Additionally, due to a continued low interest rate environment we took the opportunity to reduce the interest rate on some of our higher cost deposits during the third quarter. We continue to evaluate our deposit pricing strategies, our record of prices to ensure that we are competitive yet adjusting for overall market conditions. If rates continue to move downward, we have the ability to re-price certain deposits lower if necessary to support our manager's margin.

Our overall cost of deposits for the third quarter was 62 basis points approximately 10 basis points lower than the second quarter of 2010. Our attractive deposit base continued to be one of the fundamental strengths of our franchise. Non-interest bearing deposits make up approximately 30% of our total deposit base and we'll continue to look for waste to maintain and grow these relationships.

During the third quarter, we put the finishing touches on our move to a more formalized line of business structure by creating two additional distinct lines of business; commercial real estate and commercial banking. Bankers in these two groups are organized like those in our other business lines such as international banking, private banking and energy lending. The CRE group focuses on all non-owner occupied commercial real estate relationships. And the commercial banking group focuses on serving the banking needs of smaller medium size businesses by providing working capital, equipment loans, owner occupied real estate financing and full array of treasury management solutions and deposit products. This move not only leverages our bankers' expertise for the benefit of our customers, it also puts our bankers in the best position to identify opportunities and manage risk at appropriate levels.

In addition to these two groups being more effective, they also more efficient. With this restructuring, we identified and eliminated several redundant positions which will save the bank approximately $3 million annually in salary and benefit expense. During the past year we have also consolidated several underperforming and/or overlapping branches which we estimated will give us additional hard cost savings of approximately $850,000 annually. We're also currently evaluating some of our longer-term brokered deposit relationships to determine the effect they continue to make strategic sense to maintain and disload interest rate environment which may last for an extended period of time.

A reduction in these types of deposits which help to reduce non-interest expense through decreased deposit brokered fees. In addition to improving our productivity and efficiency, we'll continue to bring revenue generating experienced relationship bankers to our company from some our larger regional bank competitors.

From a macro perspective, the good news is, is that the economy is recovering both nationally and in Texas. The not-so great news is that the recovery is progressing at a somewhat slower pace than expected and it appears that there is still significant amount of uncertainty among consumers and businesses which seem to be a hindrance for economic growth.

Despite slower growth, Texas still continues to perform better than the nation. The labor market continues to be stronger in Texas with unemployment rates improving. Unemployment expanding faster the national the national pace. Additionally, our recovery energy industry is helped offset some weakness in construction and housing.

Despite a challenging environment we expect improved performance in 2011 due to the steps we are taking to decrease credit cost and lower non-interest expense. While we can't control interest rates and regulatory costs, we positioned Sterling to take advantage of future growth opportunities by enhancing our liquidity positions as evidence by our loan and deposit ratio of 72% and by building a strong capital base.

Sterling remains one of the best (inaudible) banks of most peers. At quarter end, our tangible tier 1 and total risk-based capital ratios were a strong 9.1%, 15.2% and 17.9% respectively.

I'll now turn the call over to Bob Smith, our Chief Credit Officer to discuss asset quality. Bob?

Bob Smith

Thanks, Downey. We experienced stabilization in a number of our credit quality metrics during the third quarter. Non-performing loans totaled $164 million at the end of the third quarter reflecting a net decrease of approximately $2.4 million as compared to June 30, 2010. The inflow of non-performing loans slowed considerably in the third quarter.

We added approximately $20 million of new non-performing loans in the third quarter as compared to 65 million and $56 million added in the first and second quarters of 2010 respectively. Non-performance assets decreased approximately $6 million during the quarter. We continue to successfully sell foreclosed properties decreasing ORE by $3.6 million to $14.6 million at quarter end. In the third quarter, we sold ORE properties with a total book value of $8.5 million. We continue to experience good demand for foreclosed properties. We actually had a net gain of $400,000 on our ORE sales, net appearing cost during the third quarter of 2010 compared to net losses and carrying cost of $1.4 million in the second quarter of 2010. We would expect to see a sizable increase in ORE over the next couple of quarters as we have a number of properties scheduled for foreclosure.

Based on our progress, we would expect to foreclose on approximately $15 million to $25 million of non-performing loans in each of the next two quarters. It has been our experience that once we are able to take control of the collateral on our non-performing loans, we have been successful in selling the properties on a timely basis at leasable prices.

Another positive development in the third quarter was the decrease in the past due accruing loans for the second consecutive quarter. Accruing loans 30 to 89 days past year decreased from $19.3 million in the second quarter to $16.2 million at the end of the third quarter. Net charge-offs were fairly stable at $7.4 million or 1% of average loans in the third quarter as compared to $6.3 million or 83 basis points in the second quarter of 2010.

The property types making up the net charge-offs in the third quarter were primarily related to non-owner occupied commercial real estate, multi-family and some C&I. Of the total net charge-offs for the quarter, $2.2 million was related to out of state commercial real estate loans. One area of credit that we didn't experience improvement in during the quarter was the amount of potential problem loans. Potential problem loans were $170 million at September 30th 2010 and increase of $27 million link quarter. The bulk of the increase was due to an internal downgrade of two commercial real estate relationships located in the Houston area.

At the end of the quarter we had approximately $317 million in out of state commercial real estate loans down from $330 million at the end of the second quarter. As we have noted these out of state commercial real state loans had contributed a disproportionate amount of problem loans over the past 18 to 24 months. However the good news is that we have started to see some stability in this portfolio. Currently, $52 million of this loan portfolio or 16% is non-performing compared to $54 million in non-performing loans a quarter again. No general allowance is carried for non performance loans as they have all been marked down to fair value. The non-performing loans in this portfolio have been marked down by approximately 20 to 25%. We have approximately $15 million or 5.6% in general allowance allocated to the performing loans in this portfolio.

Another portfolio that has contributed a dis-propionate share of problem loans has been our hospitality portfolio. As of September 30th, 2010 our hospitality portfolio totaled $295 million with approximately $221 million of hotels securing these loans being located in Texas and $74 million located outside of Texas. As of September 30th, 2010 $39 million or 13% of our hospitality portfolio is non-performing.

Of this total, $26 million is located in Texas and $13 million is located out of state. Our hospitality portfolio consists of mid-prices hotels and motels, the majority of which are nationally branded properties in major MSAs. There are no resort type or luxury type properties included within this portfolio. The hotels in our portfolios are primarily geared towards the business or extended state traveler.

While there has been slight improvement in this industry, overall as occupancy the average daily rates and revenue per available room have begun to stabilize in the last couple of quarters. It is still an industry that remains under pressure from a revenue standpoint. We will continue to monitor these loans very closely and worked to exit the less quality relationships.

As of quarter-end, our allowance for credit losses totaled $82.2 million, up slightly from $82.5 million at the end of the second quarter. The provision for credit losses totaled $7.7 million which was $269,000 more than net charge-offs for the third quarter. At September 30, 2010 the allowance for credit losses was 2.88% of period-end loans, up from 2.75% of total loans at June 30, 2010 and up significantly from 2.18% of total loans at September 30, 2009. As Downey mentioned, unless there is another slowdown in the economy or an expected down trend in the real estate values, we would not expect to build the allowance above the current levels.

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

Zach Wasson

As mentioned with reported net income of $4.5 million or $0.04 per diluted common share for the third quarter, up from $596,000 or $0.01 in the second quarter of 2010. The improvement in earnings as a result recording approximately $1.6 million less and provision for credit losses and increase in non-interest income of $965,000 and a reduction in other non-interest expense of $3 million. These categories were all positively impacted our improved credit quality results.

Before I go through some of the income statement detail, let me first take a few minutes to discuss our net interest margin. The tax equivalent net interest margin was 3.68% for the third quarter, down 6 basis points from 3.74% for the second quarter of 2010. The net interest margin was negatively impacted by two primary factors, a decrease in average loan balances and a reduction from the interest rate page gain that was fully amortized during the first month of the third quarter of 2010. The reduction in average loan balances of $117 million impacted the third quarter margin by approximately 8 basis points and the reduction in hedge gain income negatively impacted the net interest margin by an additional 13 basis points when compared to the second quarter of 2010.

We were able to offset half this negative 21 basis point impact by investing some of the excess cash into the arms during the quarter and lowering cost from interest bank deposit accounts. Our average deposits and financial instructions decrease from $362 million in the second quarter to $260 million in the third quarter. With the difference invested in bond.

As mentioned, we were also able to lower certain higher cost deposit during the quarter decreasing our overall average rate on demand and cadence accounts from 85 basis points in the second quarter to 71 basis points for the third quarter. Additionally the declining rate of non-performing loan formation in the third quarter of benefits and net interest margin down approximately 6 basis points due to a decrease in interest reversal as compared to the second quarter.

Keep in mind that we did have the full effect of the reduction and the hedge gain income in the third quarter as we still have had the income for one month. Therefore the fourth quarter net interest margin will have a headwind of approximately 6 basis points as compared to the third quarter of 2010. Given the outlook that rates could remain low for an extended period of time, our expectations are there for net interest margin will still be under pressure in the near term.

Of course we will continue to look for ways to counter some of this pressure, by continuing to reduce rates on the higher cost deposits and by investing excess cash into our securities portfolio where appropriate. Although with rates moving even lower recently, we will be more selective with the amount of purchases in our security portfolio in the near-term as we wait for better opportunities. Additionally, decreasing the amount of non-performing assets would also be a significant benefit to the net interest margin something we are hopeful to see play out over the next year. We estimate the overall drag on the net interest margin from non-performing assets for the third quarter was approximately 22 basis points.

While we will continue to look for ways to support our margin in this difficult interest rate environment, we still remain very asset sensitive and positioned to benefit on the interest rates they begin to arise. As September 30, 2010 assuming a static balance sheet, we estimate that a 300 basis point upward movement in rates would increase net interest income by almost 14% and increase it by 11% with the 200 basis point upward movement in rates.

Non-interest income totaled $9.5 million in the third quarter of 2010, an increase of $965,000 linked quarter. There were a few favorable items totaling approximately $500,000 that positively impacted other non-interest income in the third quarter. Total non-interest expense for the third quarter of 2010 was $37.8 million, a decrease of $3 million on a linked quarter basis. The majority of the decrease and non-interest expense was due to having gains from the sales of OREO, net of carrying cost of $400,000 in the third quarter as compared to net losses in carrying cost of $1.4 million in the second quarter of 2010.

Additionally third quarter non interest expense was approximately $600,000 lower than the second quarter due to operating losses related to various litigation settlements recognized in the second quarter. We expect ORE carrying costs increase incrementally over the next few quarters as we transition additional non-performing loans into ORE.

At the end of the third quarter of 2010 our securities portfolio totaled approximately $1.4 billion or 29% of total asset, an increase of $99 million as compared to the second quarter. On an average basis, our securities portfolio was up approximately $173 million during the quarter. The securities portfolio as on September 30th 2010 had an effective duration of 1.8 where the tax equipment yield of to 3.2% down from 2 and 3.5% respectively as of June 30th 2010.

Additional increases in the securities portfolio will be a function of future loan demand, deposit growth and as I mentioned the behavior of interest rates. With our securities purchases, we'll continue to look to keep the duration short minimized interest rate risk and not take any unnecessary credit risk. At quarter end our tangible capital was a strong 9.1% out of our regulatory capital levels, well above the minimums to be considered well-capitalized. As of September 30th, 2010 tier one leverage ratio was 10.5%. Tier one risk-based capital stood at 15.2% and our total risks-based capital was 17.9%.

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

Downey Bridgwater

Thanks Zach. Our strategy for Sterling has not changed. We'll continue to focus on providing competitive banking products and services for all consistencies within the small and medium sized business segment in our Texas markets. We pride ourselves on building long-term relationships with our customers, knowing their business and helping them achieve their goals.

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

Question-and-Answer Session

Operator

Thank you. (Operator instructions). And our first question will come from the line of Bob Patten with Morgan Keegan. Go ahead please.

Bob Patten - Morgan Keegan

Zach, I was looking over the last quarter's transcript and we talked about the marginal (inaudible) as the strategies. And the one difference that you thought would be, loans would be stable. Obviously we're still seeing a decline in loans. We don't understand why. But if you talk about six basis point headwind going into the start in the quarter with all other things being equal, probably looking about double the rate of decline over the next couple of quarters in terms of net interest margin. Is that sort of the way…

Zach Wasson

Bob, if you just did assume that we did not touch or address some of the margin pressure within the other strategies that might be correct assumption but we are continuing to evaluate our cost deposits. We continue to adjust those rates stand incrementally every pricing made in and in a way if you look in our deposits, the last quarter you will see we had a decrease in the jumbo CDs which normal are your higher costs and a subsequent increase in average balance on your non-interest bank DDAs. So there are a lot of strategies where using and manage this pressure that we see on the net interest margin.

Bob Patten - Morgan Keegan

Yes and I mean everybody's going through the same thing, Zach. I didn't mean to say it was just you guys. But I guess what's your CD portfolio that's rolling off over the next couple quarters that's going to give you the most bang for your buck in terms of offset?

Zach Wasson

Its going to be some of the jumbo CDs and our own portfolio is relatively short and last quarter on average it was roughly at 1.3% and we like everybody else surprising CDs in the 40-50-60 basis point range. So there is still room for that portfolio that drove down and still room for non-interest paying deposits to grow.

Bob Patten - Morgan Keegan

Do you have a number what's rolling off in the next fourth quarter, first quarter, just so we can sort of put a number on it?

Zach Wasson

At least 50% of portfolios, six months or less and I want to verify this and 75 is within a year.

Operator

Next we will go to the line of John Pancari with Evercore Partners. Go ahead please.

John Pancari - Evercore Partners

Can you talk a little bit, Downey about the plans for the non-Texas portfolio? I know you've been evaluating options for that book. Can you talk about the options to sell it and what type of interest you are seeing in that book? Yes, we are still evaluating the sale of that book and the interest is very high. So we are working through that and we'll hopefully make a determination here sometime within the next couple of quarters.

John Pancari - Evercore Partners

Okay, all right and then looking for a little bit more color on the lower utilization on the impact on the loans this quarter. Can you just give us a little bit more detail there, what you're seeing and what your expectations are at this point in the fourth quarter?

Downey Bridgwater

We added several new customers in additional lines of credit that just have nothing wrong and then the customer base that we have, they continue to pay down on those lines. But we've had significant amount of growth and new customers that are just utilizing the lines.

What we do see in terms of growth in the portfolio showed up in owner occupying real estate, residential real estate. We also had a little bit of lift in energy to the point where period-end it was lower at the beginning of the quarter, higher at the end of the quarter but remains flat for the period-end really late quarter.

But we expect to see energy grow as well. Our CRE book obviously was de-leveraging that part of the loan portfolio, we had some net down paydowns in our overall portfolio. We expect that to slow somewhat overtime but the quality of the portfolio continues to improve. So while there is some activity as I mentioned on the call earlier in our customers in terms of new requests, certainly through the higher level of business activity. I don't know that it's going to translate to growth necessarily until a level of certainty comes from both the regulatory environment as well as the political environment. Our customer base is just concerned and they're just kind of taking a wait to see how to.

John Pancari - Evercore Partners

Lastly if I could just ask about that mortgage warehouse line, it seems like that was a bit unexpected in terms of the size of that pay down. Can you just give us some detail on how big that was and then how many other such relationships you have and the size of that type of portfolio of those loans?

Downey Bridgwater

It was $28 million and it was pretty sizable, but it was a pay down but we expect them to fund again here because their level of activity picks up also. And this is the type of business that has the full faith and credit of the US government behind it, so it’s a very, very solid relationship, long-term being here for many, many years. So we expect that to hit the flow, it’s just that the activity of the secondary market picked up and they were able to move these things out into really permanent financing if you will, much faster than they thought. So their pipeline is building. We expect greater utilization of that line going forward.

John Pancari - Evercore Partners

And that's a total line to several mortgage brokers or is that a…

Downey Bridgwater

It’s a single customer.

John Pancari - Evercore Partners

Okay. Then what's your portfolio of the total such lines?

Downey Bridgwater

That’s really the only one that we have right now. Commercial mortgage relationship, residential is very few so we just don't have a lot of that stuff there back.

Operator

Next we will hear from the line of Brett Rabatin with Sterne Agee. Go ahead please.

Brett Rabatin - Sterne Agee

I wanted to first ask on the energy piece. You said you were expecting some growth. Is that a function of upstream, midstream and are you looking for any natural gas growth there?

Downey Bridgwater

The portfolio is growing on a reserve base and the most activity of course is somewhere related some gas. It’s all onshore domestic production and for the near term we expect a growth to come through the reserve base side. There may be some midstream as we go forward but on a very selective basis. It will be to those companies that are very strong financially with significant resources. So, for the near term we expect to continue to see additional funding in our energy group that is as you know, additional C&I.

Brett Rabatin - Sterne Agee

Okay. And then Downey, we've kind of talked about the challenges of the environment on the margin. And you've indicated earlier that the ORE carrying costs would be higher going forward as you move some of your problem assets through resolution. As we move into 2011, are there any initiatives that you anticipate in terms of additional expense items that you could get a little more juice out of to improve efficiency, or can you give us some thoughts on how you view the environment to improve pre-tax profitability aside from the margin?

Downey Bridgwater

Sure. Let me give a little background color on the real estate type, too. The ORE will actually lift, it’s really a transition from non performing loan to ORE. And as you know, as you’ve seen in the last few quarters we have been able to sell ORE at a fairly fast pace, and we have been able to sell it for virtually what we have on the books or either a slight gain or a slight loss, but we’ve been, I think fairly accurate in what we have done in terms of writing those down and booking them into ORE. So we don’t expect ORE expense to go up necessarily, but we do expect the overall net balance to transition somewhat from non performing loans over to ORE, and then we continue to sell it thereafter. In fact we expect that it be successful and in foreclosing on between 15 to $25 million per quarter for the next two quarters. So that should have a healthy effect on the reduction of our non-performing loans and frankly our overall non-performance provided that we can continue to sell them.

Now to your expense part of question, and absolutely, we have additional areas where we are looking. I mentioned on the call that we've got some broker deposit relationships that we are looking at and we’ll return to determine if a relationship standpoint make sense hanging on to those or does it really benefit the bank to have those exit the bank at this time, because of the excess liquidity that we have and the rate environment we think we are going to be in for some time.

Continued on the operational front, we will also look for ways in which to either increase the revenue by reducing the non-performing loans is one way of course, reducing fee waivers and other things in that domain, but reducing one-time cost or temporary conditions that exists on our balance is another thing we continue to look at to improve our overall profitability. So yes, we’ll look to reduce further non-interest expense and interest expense going forward.

Operator

Next we will hear from the line of Brad Milsaps with Sandler O'Neill. And your line is open.

Brad Milsaps - Sandler O'Neill

Downey, as you think about what you have renewing in terms of CRE exposure in 2011 versus 2010, would it be more or less or about the same in terms of what you guys are looking at in the renewal cycle for next year?

Downey Bridgwater

I think it’s probably about the same. Bob, what do you think?

Bob Smith

Yes, I don’t have stratification. If we need to get specific, I can get back, but the bottom line is that is fairly consistent what we are seeing in the form of renewals at CRE.

Brad Milsaps - Sandler O'Neill

And I assume that, well, maybe I shouldn't assume, but in terms of your 2011 renewals, I'd be curious how far you guys have already maybe taken a look at those in terms of getting your arms around what you've got coming, that you're going to have to take a harder look at in 2011.

Downey Bridgwater

We review relationship in the bank, a million and over on a quarterly basis, all the way down to the level of the banking officer that’s managing the portfolio. So, we are constantly reviewing larger relationships before they can determine what our strategy to what respect to developing additional business with any C&I type customers or whether there are CRE deals that we need to exit, but those are constantly under review.

Brad Milsaps - Sandler O'Neill

Obviously, you guys talked about your success in moving some of the OREO out. Can you kind of talk about the in-state OREO versus the out-of-state OREO and kind of which has been easier versus more difficult and the marks on each?

Downey Bridgwater

The instate portfolio has been easier from the standpoint that Texas is not a judicial foreclosure state so we have been able to proceed the foreclosure in a much more rapid manner within the state than we have outside of Texas. As it turns out we are progressing to the point that we have gotten a substantial number of opportunities to the point where we can schedule foreclosure in California, in Florida, in New York, et cetera. And that’s why we are anticipating that we will have a higher level of foreclosure activity in the fourth end of the first quarter 2011.

Bob Smith

As far as sales go they have been really equally about the saying. Certainly we have had more in Texas so the volume is higher in Texas but we have been able to sell successfully on a fairly quick basis even though the properties outside of Texas so far. We really haven’t had lot of hanging around in ORE, growing whiskers. So, that’s the good news.

Zach Wasson

And the other thing Brad is, we have been relatively accurate on adjusting our net book value on these properties to what we can get from the sale. In the first quarter we slide giving second quarter, a slight loss. And this quarter a slight gain, but again the numbers are not very large. So, we’ve been very accurate on that to date.

Brad Milsaps - Sandler O'Neill

And then final question for Zach. Some of the expense saves that you outlined, did you expect those to start showing up as soon as the fourth quarter or is it more going to be kind of in the 2011 run rate?

Zach Wasson

Some of them will show up in the fourth quarter.

Operator

Thank you. Next we will go to the line of Kevin Reynolds with Wunderlich Securities. Go ahead please.

Kevin Reynolds - Wunderlich Securities

Most of my questions have been answered on the asset quality front. But I wanted to sort of ask you guys, what's the competitive landscape like today? I know we've had a lot of regulatory uncertainty, a lot of political uncertainty that hopefully ends to some degree next week. And Texas is kind of standing out. It's holding up better than most. Is that attracting more competition from the outsiders, and I guess maybe even some of the banks that have acquired in through some failures? Some of the larger ones, are they looking to deploy more resources there on the ground? Is it becoming tougher to recruit the employees, customers, et cetera?

Downey Bridgwater

I'll just work your question backward from the last part. We've been able to recruit customers, we have been able to recruit bankers, mostly from the former regional banks that have presence here and have subsequently been sold. So, we have been very successful on that front across the franchise, whether it's commercial bankers or retail bankers or those even in some of our other lines of business. And as far as the overall competitive landscape, the good news is everybody's reducing costs on deposits. So, that’s a very healthy thing and deposit inflows continue for us and for most of the other banks in Texas.

Everybody is pursuing to CNR so there certainly is some competition going on there that we are seeing, its in pricing certainly not a lot on the credit underwriting, I think everybody who seems to be doing about same thing being reasonably conservative. But I think there is any competition and maybe on some terms and conditions but mostly on the pricing area. So, what I think most especially those domicile peer like us have been successful at bringing over additional customers. I think once we see some clarity and some certainty from both regulatory side as well as the political side, your customers will have better idea on what their cashes are going to be, their healthcare costs are going type be. And frankly, what it's going to cost them to run their business going forward. So once that becomes stable and clear everyone I think will see heightened activity and ultimately loan growth on our side.

Kevin Reynolds - Wunderlich Securities

And I think one of your competitors yesterday said that the mantra of their clients had been call me back after the election.

Downey Bridgwater

It's November 2nd, that also happens to be my birthday, so hopefully we will be having a celebratory refreshment for the right reasons.

Operator

Next we will go through the line of Scott Valentine with FBR Capital market. Go ahead please.

Unidentified Analyst

This is John for Scott. A couple of my questions have already been answered, but just kind of looping back on the asset quality side, small uptick in potential problem loans. Could you maybe share a little thought on the mix and what your thoughts are about reserve levels and fills?

Downey Bridgwater

The uptick that we had is we had indicated was primarily in two relationships here in Houston, and those are CRE, those are secured by commercial real estate. We really don’t see potential loss in those at this particular time. We feel comfortable with our projections as far as our fourth quarter provisions unless we see a big downturn in the economy or in the real estate values here in the state.

Unidentified Analyst

And then one second question. With the offshore drilling moratorium pulling off here this past quarter, any thoughts about how that eventually kind of worked its way through and impacts your reserve lending?

Downey Bridgwater

It really doesn’t impact our reserve for an additional. Ours is offshore domestic. And in fact onshore activity has picked up. The retail continues to rise.

Unidentified Analyst

And I guess maybe my general question was how that might impact the Houston MSA as activity picks up there and how long you think that might take to see the impact to a lot broader market there in the Houston?

Downey Bridgwater

Sure. Well, we expected that to be positive, any time you have in industry that comprises approximately half of your economic activity in a given region, Houston in particular, it will have a negative impact. The good news it hasn’t been that material but as I think most of the companies saw that this was a somewhat temporary condition. There has been greater clarity around it now and the moratorium lifted, technically, so that when they do combine with new regulations that activity will flow according. So, we expect that to be a positive overall for the Houston area, both in terms of new jobs and overall economic activity.

Operator

Next, we will hear from the line of Dave Bishop with Stifel Nicolaus. Go ahead please.

Dave Bishop - Stifel Nicolaus

Could you go over in terms of the OREO sales this quarter, obviously a slight gain there on the sale this quarter. Was there a change in maybe in the mix of assets, maybe you can compare and contrast this quarter versus last. And has there been any sort of change in buyer appetite there, any difference in the types of buyers we are seeing come into the market for a foreclosed property?

Downey Bridgwater

Sure. The level of activity and the interest in buying foreclosed properties remains the same. It’s very active and our properties are being sold for cash. So we are not having the financial properties and it’s actually brisk. As we mentioned, we actually sold $8.5 million worth of properties for the quarter and we foreclosed on $5.2 million for this quarter. So we're actually selling more than foreclosed in the third quarter. As we said though, we expect the foreclosure rate to increase even though we expect the sales level to continue. I mean it’s very brisk.

Dave Bishop - Stifel Nicolaus

In terms of the $8.5 million sold this quarter, was that in-state? I'm sorry, any of that out of the hospitality, commercial real estate? What's the breakdown there?

Downey Bridgwater

It was a mix across all of them, everyone you mentioned. And that of course mostly in-state, but there was some out-of-state too.

Dave Bishop - Stifel Nicolaus

And Zach, in terms of other fee income, I think you had mentioned there were a couple of items that totaled $500,000 in terms of positive impact, any sort of quasi, one-time items in those items?

Zach Wasson

A good portion of them were one-time items and that every quarter you have some going positive, some going negative. So, the 500 this time was all favorable.

Operator

Next we will hear from the line of Tom Alonso with Macquarie.

Tom Alonso - Macquarie

Most of my questions have been answered. Just a couple of quick follow-ups here. On the OREO that you guys are expected to have roll in over the next two quarters, I assume that a good portion of that is out-of-state given that it seems like you've had to go through the courts. I mean have the borrowers here exhausted all their options now or are you going to get to the court and they're going to declare bankruptcy and things start over again?

Downey Bridgwater

We all think so, no, because we pushed them. We actually have, probably twice of that now posted. We will probably end up being 50 to 60% successful. So that’s why we gave to you that lower number of 15 to 25 million per quarter. That’s our success rate.

Zach Wasson

And that’s based on our review of those borrowers that have in fact exhausted all of their options.

Downey Bridgwater

Most of the out-of-state here, exactly right. It’s going to last 18 months, so some of them take a lot longer, a heck of a lot longer than Texas.

Tom Alonso - Macquarie

And then on the energy group, the midstream stuff that you guys were talking about, that you would consider putting on would be sort of larger, better credits. Would that be probably more on sort of a shared national credit side?

Downey Bridgwater

Most likely. And it is going to be very selective and very limited, because the vast majority of our portfolio now and going forward will be reserve based.

Tom Alonso - Macquarie

And then just lastly, you added some bonds to the portfolio, you said you offset some of the margin pressure by buying some securities, right, I heard that correctly earlier? Can you just tell me what it was you guys were buying or kind of what kind of rates you were getting?

Zach Wasson

Right, I mean we were buying basically your Fanny, Freddie, Ginnie, mortgage-related securities, some CMOs, some NBSs, and the yields we were between 2 and 3%, three and a quarter. We are still, like I said, staying short, we aren’t pushing the effective duration up on that portfolio, but even at these levels it is still much more attractive than our 25 basis points Fed fund rate.

Operator

We will hear from the line of Mike Zaremski with Credit Suisse, and your line is open.

Mike Zaremski - Credit Suisse

Just one question. I believe you've alluded to a potential bulk problem loan sale if the prices were right. Would a sale encompass performing loans as well? I ask this because I'm trying to think should we think about earning assets potentially dropping on the loan side if you were able to sell a lot of loans?

Downey Bridgwater

Let me answer it this way, we are looking and evaluating and selling either portions or all of the out-of-state portfolio that we have, the CRE portfolio which is roughly $317 million. Now, in order to not hammer our earnings we most certainly would consider providing some financing on a meaningful portion of that portfolio if we were to sell the whole thing. We'll consider a litany of different options and that's what we are evaluating now, but we most certainly don’t want to negatively impact earnings by having a significant profit overall earning assets in one quarter. So, as we know it’s difficult to replace those very quickly. So, we most certainly will entertain looking at some financing if we find the right buyer at the right price.

Operator

Next we will go to the line of Bob Patten with Morgan Keegan. Go ahead please.

Bob Patten - Morgan Keegan

One last question. Zach, how should we think about the tax rate going forward? It sounds…

Zach Wasson

That’s right. It should be relatively where it is this quarter.

Bob Patten - Morgan Keegan

For the next couple of quarters or?

Zach Wasson

Yes.

Bob Patten - Morgan Keegan

Do you see it going up? It seems everybody is confused about what the tax rates for all the banks should be if they either return to profitability or profitability picks up. What's keeping the tax rates so low?

Zach Wasson

Part of it is all of us have tax exempt income, and when you are just making a lot of money that tax exempt income has impact. Our effective rate would probably be between 32 and 34% on a go-forward basis.

Operator

(Operator Instructions). We’ll go to the line of Matt Olney with Stephens, Inc. Go ahead please.

Matt Olney - Stephens, Inc.

Hey, good detail on the OREO sales in 3Q. I'm curious how the pipeline looks for OREO sales so far in the fourth quarter?

Downey Bridgwater

They are moving along at a similar pace. So, we are tracking with the expectations that we have internally. So they are moving along the same run rate.

Matt Olney - Stephens, Inc.

And then, as far as the potential problem loans, do you guys break those out Texas versus out-of-state loans, and how has that been trending in recent quarters?

Bob Smith

As we indicated, the bulk of the additional problem loans added were Texas downgrades, but I’d have to get more specific information to give you a breakout.

Operator

Thank you. And no further questions in queue at this time speaker, so please continue

Downey Bridgwater

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

Operator

Thank you very much. And ladies and gentleman, this conference will be made available for replay starting at noon Central Time this afternoon and running through the 4th of November at midnight. You may access the AT&T Executive Playback Service at any time by dialing 1-800-475-6701 and entering the access code 173152. International participants, dial 320-365-3844. Those numbers once again are 1-800-475-6701 and 320-365-3844, with an access code of 173152. That concludes our conference today. We appreciate your participation and for using AT&T Executive Teleconference and you may now disconnect.

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