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Commerce Bancorp (CBH)

Q4 2006 Earnings Call

January 16, 2006 10:30 am ET

Executives:

C. Edward Jordan, Jr. – Executive Vice President / Investor Relations

Vernon W. Hill, II - Chairman of the Board and President, Commerce Bancorp, Inc.

Douglas J. Pauls – Executive Vice President / Chief Financial Officer

Analysts:

Kevin St. Pierre - Sanford Bernstein Co.

Matthew O’Connor – UBS

Joseph Dickerson – Atlantic Equities

Meredith Whitney – CIBC World Markets

Robert Hughes - Keefe, Bruyette & Woods

Adam Barkstrom - Stifel Nicolaus

Heather Wolf - Merrill Lynch

Wilson Smith – Boenning & Scattergood

David Stumpf - A.G. Edwards & Sons

Mark Fitzgibbon - Sandler O'Neill & Partners

Andrew Marquardt – Fox-Pitt Kelton

John Coffee - Putnam Investments

Thomas Purcell - Viking Global

Gary Townsend - Friedman, Billings & Ramsey

Jason Goldberg – Lehman Brothers

Robert C. Rutschow - Prudential Equity Group

Paul Delaney - Morgan Stanley

Gerard Cassidy - RBC Capital Markets

Bryan Keane - Citigroup

Presentation

Operator

Welcome to the Commerce Bancorp fourth quarter 2006 investor conference call. Today’s call is being recorded. Now at this time I would like to turn the conference over to the director of Investor Relations, Edward Jordan. Mr. Jordan, please go ahead.

C. Edward Jordan, Jr.

Good morning ladies and gentlemen, this is Ed Jordan, director of Investor Relations. I would like to welcome you to Commerce Bank’s fourth quarter 2006 earnings conference call. We hope that everyone has had an opportunity to read our detailed press release which we issued earlier this morning. I would like to remind you that today’s conference call is governed by the forward-looking language appearing at the end of today’s release. With us today is Chairman and CEO, Vernon W. Hill, and Doug Pauls, our CFO.

Mr. Hill will provide some overview highlights of the fourth quarter and for the year 2006, and afterwards we will open the call for Q&A. At this time I would like to turn the call over to Chairman Hill.

Vernon W. Hill

Good morning and welcome to the call. We’re pleased to report on our fourth quarter results and also our results for all of 2006. Let me talk about first, the value driver here.

For the year, core deposits grew 18% or $6.2 billion. That includes $1.5 billion for the fourth quarter. Our core deposits-per-store was $17 million. Several deposits for the year grew $6.6 billion, up 19%.

During ‘06, as most of you know, was a difficult year and deposit pricing was somewhat…what we felt was unreal pricing and we were very disciplined about our pricing and deliberately allowed some of our higher-cost money to leave. So, all in all we were pleased with our growth in deposits.

As you see in the press release, again, New York City led growth in deposits growing 43% on a yearly basis. And in New York City, where we now have 57 stores, is growing $39 million a store.

Florida also had a very strong year growing 23% for the year. Income for the year was up 17% while expenses grew 18% and I might point out even pre-charge in the fourth quarter, we had a positive operating leverage. Net income for the year was $315 million, up 11% over the reported number for 2005. EPS for the year was $1.63, roughly flat with 2005.

In the fourth quarter we made $0.40 a share despite opening 26 new stores. That was up 11% against the fourth quarter in ‘05 before we took the special charge in the fourth quarter of last year.

Some of the other points I want to make are in the press release.

We did open 55 new stores in 2005, including, I believe 26 in the fourth quarter. Our goal is to increase our store base about 15-20% a year, and in the press release there is an estimate of where the store openings will be in ‘07. Metro New York will again be the area where we can expect to see the most store openings.

For those of you who have the press release on page 3, we show you the commercial side of the business that is actually driving the loan and deposit side. Commercial deposits on a year-to-year basis grew 27%. And commercial loans grew 25%. For those of you who have the release on page 4, non-performing assets were basically unchanged quarter to quarter at 0.12. Our asset quality remains pretty much the same.

On page 5, for those of you who have the press release, we put out these 5-year growth targets. We have somewhat lowered our growth targets going forward in growth-per-store and income and so forth and I think it’s just a reflection of the more difficult operating environment we all face right now. You can see in these slightly-revised growth targets we compare them to our five-year compound growth-rates and what happened in 2006.

On page 6, we broke it down, our deposits by markets and growth by store. As I said earlier, New York City continues to lead the pack.

For those of you who have the press release, on page 8, it talks about growth and deposits by type. Consumer deposits for the year grew 11%. Commercial deposits led our growth rate and grew 27%. I think that’s a reflection of the more difficult pricing in the consumer side of the business and our concern about margin and rate.

I’ll turn it now over to Doug Pauls, our CFO, now, with some other information on margins and so forth.

Douglas J. Pauls

Thank you, Vernon. I would like to spend a few minutes discussing our financial performance in the fourth quarter of 2006. The margin for the quarter was 3.25%, within the range we projected on last quarter’s call. The margin of debt; slightly two basis points from the third quarter and down 27 basis points from the fourth quarter of 2005.

Our funding costs for the quarter were aligned with our expectations remaining basically flat from the third quarter. They were up two basis points. And our funding costs benefited from our decision to significantly reduce our wholesale borrowings during the second half of 2006.

The year-long earning assets in the fourth quarter remained flat compared with the third quarter, reflecting competitive market pricing for loans and the timing of deposit inflows that resulted in some higher levels of Fed-funds sold than we normally see, and in addition spreads on both fixed and floating rates investment securities tightened which impacted the yield on our purchases for the quarter.

We, along with all banks, continue to be impacted by the inverted yield curve. To the first half of 2007 we project our margin will be in the range of 3.25% plus or minus 5 basis points. Our margin will continue to be impacted by the level of short-term interest rates.

We do not anticipate any meaningful increase in our net interest margin percentage until we see a positively sloped yield curve. The more meaningful benefit to our results will occur when the Fed begins to cut rates. Despite a 27 basis point drop in year-over-year margin, the income from the quarter was up 19% over the fourth quarter of 2005 when you exclude non-recurring charges from last year of $19.3 million.

It’s worth noting the loan-loss provision in the fourth quarter of ‘06 was up roughly $5 million than the fourth quarter of 2005. And in addition as already mentioned, when you exclude last year’s non-recurring charges we had year-over-year positive operating leverage for the fourth quarter of about 16.5% versus 14.5%, almost 200 basis points.

This reflects the strength of our business model as our continuing ability to grow deposits overcame margin compression caused by the current rate environment. This also reflects our continued focus on control and costs. Non-interest expense growth was 18% for 2006, down from 22% in 2005, despite the expenses related to the Florida acquisition in December of ‘05 and e-money in February of 2006. This is below the level we projected at the beginning of 2006.

Controlling expenses will again be a focus for us in 2007 as we continue to fight our way through this difficult rate environment. We remain well capitalized by regulatory standards and our leverage ratio increased by 18 basis points year-over-year to 6.22% with December 31st 2006.

In August of 2006 we reduced the monthly maximum optional cash contribution in our dividend reinvestment plan from $10,000 per month to $2500 per month and that will reduce our new share count in 2007 as compared to 2006. We have no plans to restructure our investment portfolio and at this time we have no plans to issue additional capital in 2007. Balance sheet growth will dictate our need for capital over the next several years.

Any future capital needs will first be met by our ability to issue $900 million in trust preferred securities which could be included in tier one regulatory capital.

I would also like to speak briefly about the other matter noted in our earnings release. Reviews of related party transactions have been part of the supervisory process at Commerce. We have been advised that an investigation is being conducted by the officer of the controller of the currency in conjunction with the board of governors in the Federal Reserve System. This company investigation includes but is not limited to transactions with its officers, directors and related parties, including transactions involving bank premises. Commerce is co-operating fully with the OCC and Federal Reserve with respect to the investigation. A special committee consisting solely of independent members of the board has been formed to oversee the company’s activities regarding the investigation. Because this is a regulatory investigation in its early stages we are not able to answer further questions on this matter.

At this time we would be happy to answer any questions on the financial information included in the release.

Question-and-Answer Session

Operator

Very good. Today’s question and answer session will be conducted electronically.

(Operator instructions).

Our first question will come from Kevin St. Pierre with Sanford Bernstein.

Kevin St. Pierre - Sanford Bernstein Co.

Good morning gentlemen. I was a bit surprised by the sequential increase in the cost of interest bearing demand deposits. It was my impression that a large percentage of these were indexed deposits which would be priced at the lower of the three month or the ten year. With the inversion of the curve it appeared to me that the index would have declined by about 30-35 basis points sequentially and yet we saw a 7 basis point uptake in the costs on those deposits. Could you help me with that?

Vernon W. Hill

Yes, Kevin you’re right. A portion of them are indexed. We did see some deposit shift mix in terms of that mix in the fourth quarter so that’s the reason for that.

Kevin St. Pierre - Sanford Bernstein Co.

O.K. Shift from index accounts out?

Vernon W. Hill

Well, more from, and reflecting also the competitor environment shifting from being indexed to the what we’re of to some indexed back to the three month.

Kevin St. Pierre - Sanford Bernstein Co.

O.K. I understand. And then separately, DC. When I look at deposits by markets sequentially, DC through the third quarter have been going like gangbusters and then we appear to have a significant decline in deposits in 4Q. Could you tell me what’s happening?

Vernon W. Hill

Kevin, I’ve been saying consistently about DC that we don’t have enough stores and enough time to get those numbers to mean anything. There’s some government money in there that goes in and out. We just opened, I believe, our seventeenth store down there and they’re all brand new so I’ve been saying to you and everyone else I wouldn’t put too much weight on those per store numbers in DC yet.

Kevin St. Pierre - Sanford Bernstein Co.

O.K. Thanks very much.

Operator

Our next question, then comes from Matthew O’Connor with UBS.

Matthew O’Connor – UBS

Good morning, a couple of various questions here. In all other fees it seems to have to jumped up a bit late quarter. I know there’s some moving pieces there but I was wondering if you could just reconcile the increase. I think it went from 23% to 29%?

Douglas J. Pauls

I just want to make sure which piece you’re talking about, Matt?

Vernon W. Hill

Other income you’re talking about, Matt?

Matthew O’Connor – UBS

Yeah.

Vernon W. Hill

Again, just to make sure. The other piece of the other operating income?

Matthew O’Connor – UBS

Correct. I think it was $23 million last quarter, it went to $29 million this quarter.

Vernon W. Hill

Two things in there Matt. There’s a lot of stuff that went to that line item and we’ve got some increases and decreases and some other things. But there were two things. There was an increase in income related to some investments we had in venture capital type funds, limited partnerships. I would not characterize that as non-recurring because we expect to see revenue like that in the future but we don’t control the timing of that. It depends on the fund’s performance. We’d record that on the equity method. And the other thing was that we had some warrants of a company that went public. That was about $2.5 million, that piece.

Matthew O’Connor – UBS

And that line also has e-money in it too, right?

Vernon W. Hill

E-money is also in there. So if you’re looking year over year, e- money would impact that but I think you were asking from the third to the fourth quarter, Matt, if I understood your question?

Matthew O’Connor – UBS

Correct. That’s helpful.

Separately, expense growth was only 13% year-over-year. I know you had some noise in the year ago period but just in general over the last couple of quarters you’ve done a really good job managing the expenses. Quite a bit below the 20% that you’ve talked about being the minimum growth going forward. I’m just wondering what your outlook is on expense growth?

Vernon W. Hill

I think our expense growth was 18% for the year. Am I correct on that, Doug?

Douglas J. Pauls

Correct.

Vernon W. Hill

I think we have done a better job than we’ve projected in the past and as we get tired of waiting for the yield curve to improve we have to do a better job on the expense side. I’m not sure that we’re ready to give you our guide going forward on expense growth but it certainly should be in the same range.

Matthew O’Connor – UBS

O.K. And I have gotten the question a couple of times today just regarding the regulatory investigation. Does this impact on your expansion plans for the foreseeable future?

Vernon W. Hill

We see nothing on the horizon now that will impact our ability to meet our expansion plans in ’07.

Matthew O’Connor – UBS

O.K. Thank you very much.

Vernon W. Hill

Thank you, Matt.

Operator

Our next question is from Joseph Dickerson with Atlantic Equities.

Joseph Dickerson – Atlantic Equities

Hi, my first question is basically on the changes to annual growth targets. Can you just elaborate a little bit more? You talked about how you brought down some of your deposit growth numbers. Is there anything structural that is driving that as opposed to just sort of cyclical and some sort of short term competition?

Vernon W. Hill

Well, there's really two numbers here that matter in these growth targets. One is the deposit growth. We have left their deposit growth per store unchanged, which I believe is the key number. We have lowered our core growth number, partially we'll work it off a larger base, but it is tougher to grow deposits right now than it has been in the past. The revenue and the income targets have come down somewhat, all of that, margin. It’s all of that, margin.

Joseph Dickerson – Atlantic Equities

And then, just from the big shift in the index deposits. Can you just clarify in your response to Kevin's question about were there moves out of index deposits and into non-index deposits within the interest-bearing deposit line item that drove that change, because I was a bit surprised as well in the tick up there.

Vernon W. Hill

What we saw Joe was not a shift out of index deposits but into a different product type that is indexed just at a three-month as opposed to the lower of the three month to the 10 year.

Operator

Our next question comes from Meredith Whitney from CIBC World Markets.

Meredith Whitney – CIBC World Markets

I've got two questions. One is on the margin. Is there a tone shift? What happened during the fourth quarter to give you guys a sort of more negative tone? What I understood was that, on the third quarter call, that margin stood sort of a chance of improving on a sequential basis. That's my first question.

Vernon W. Hill

Right after we made that statement, the yield curve went inverted. I don't know the number Meredith, but 40-50 basis points worse. We made that statement, if I'm correct, based on where the yield curve was at the time, and we projected about the same.

Douglas J. Pauls

And Meredith, it's really more on the yield on the assets side, the re-index rate. The funding side was pretty much in the range where we expected, but obviously the yield on the earning assets was flat, so that impacted that.

Meredith Whitney – CIBC World Markets

OK, and then, in terms of how we should approach this regulatory issue, what are your plans in terms of updating investors and will we hear something on a quarterly basis or as progress continues? Can you give us a sense of timing over the course of how long this will last or any type of help?

Douglas J. Pauls

As to your second question, no, we can't give you any idea on that, and obviously we will comply with the disclosure rules that are out there.

Operator

Ms.Whitney, is there any follow-up?

Meredith Whitney

No, I'm good, thank you.

Operator

OK, thank you. Our next question comes from Robert Hughes with KBW.

Robert Hughes - Keefe, Bruyette & Woods

Hey, good morning guys, just a follow-up question on the Washington deposit numbers. I was surprised to se the number down pretty significantly, and I understand it's a little early to call things. I was wondering, a while back you guys ceased giving us disclosure on deposits in each market by category. I'm wondering if you could tell us, what, say, government deposits did quarter-to-quarter versus consumer and commercial in the Washington market?

Vernon W. Hill

I don't really know, Robert. We stopped that a long time ago. Nobody else discloses it, but I really don't know the answer, but there is a government component down there of a very small base, so I don't know the exact facts.

Robert Hughes - Keefe, Bruyette & Woods

Would you say that it was the government component that accounted for most of the decline in the quarter?

Vernon W. Hill

Yes.

Robert Hughes - Keefe, Bruyette & Woods

OK. Doug, I'm sorry, but I missed your answer and response to the first question on other income. Venture capital, you said, was the first piece that you referenced that contributed to billing quarter improvement?

Douglas J. Pauls

Yes.

Robert Hughes - Keefe, Bruyette & Woods

How much was that overall?

Douglas J. Pauls

Roughly 3 million bucks.

Robert Hughes - Keefe, Bruyette & Woods

And then I guess the final question, on the margin I think the piece that kind of surprised me was the loan yields being down sequentially and across several of the categories. What would be your explanation for that?

Douglas J. Pauls

Yeah, I think it is just a reflection of the environment out there Robert, it is competitive pricing.

Vernon W. Hill

We were a little surprised too. I'm not sure we know the answer. It must have to do with the mix Robert, we're not ready to give you a really detailed answer to that.

Robert Hughes - Keefe, Bruyette & Woods

OK. All right. Thanks guys.

Operator

Our next question comes from Gerard Cassidy, with RBC Capital Markets.

Gerard Cassidy - RBC Capital Markets

Thank you. Good morning guys. The question I had was on the 2-year. In the third quarter you guys gave us the stores-open two years or more quarter-deposit growth. What was that total number? I may have overlooked that in the press release, but I couldn't find it.

Vernon W. Hill

Well, we switched on this release to doing one year comps because nobody else reported the way we did, no retailers and no other banks. But we broke down the stores that were in the count, right Doug? We didn't put it in this time, but if you like it, we will give it to you. I don't have it here. Oh, I'm wrong, Doug does have it. Go ahead Doug.

Douglas J. Pauls

The two year number was 13%.

Vernon W. Hill

But his question is what number stores were in each count.

Gerard Cassidy - RBC Capital Markets

No, no, the 13% was the number I was looking for, which was the same as the third quarter, Doug, it looks like?

Douglas J. Pauls

Yeah, I'm looking up-side down but I think you’re right. I think that's right. But going forward, we will just be disclosing the one-year.

Vernon W. Hill

Yeah, actually I have the third quarter, it was 13%.

Gerard Cassidy - RBC Capital Markets

Great. The other question I had, you guys showed really strong deposit charges service fee growth in the fourth quarter because of all of the debit cards that are used for Christmas shopping, and according to what you reported this quarter, it looks like that growth sequentially was up about 5.5%. Last year, the fourth quarter '06 to third quarter '06, the number was up about 10%. Any particular reason for the sequential slow-down in rate of growth this year versus last year?

Vernon W. Hill

We raised some fees last year that kicked in November-December, so those fee increases last year were beginning to be felt in the fourth quarter.

Gerard Cassidy - RBC Capital Markets

Great, thank you.

Vernon W. Hill

Thank you.

Operator

Our next question comes from Adam Barkstrom with Stifel Nicolaus.

Adam Barkstrom - Stifel Nicolaus

Hey, guys, good morning. Hey Vernon, I was looking at the loan growth in the metro New York market. It looks like I guess, linked, excuse me, year-over-year about $1.7 billion in growth. I wonder if you could share some more color as to what category that growth is coming in.

Vernon W. Hill

It's all in the commercial side, primarily. There is some commercial real estate, but it's mainly a C&I business in New York. I don't have the breakdown here, Adam, but it's very strong C&I market force, from small business to lower middle market to almost above-middle market, and it's where a lot of our bigger-ticket loan production is coming out of.

Adam Barkstrom - Stifel Nicolaus

OK. Your credit numbers continue to look very good. I guess another one of your, another regional competitor that I guess does some lending in some similar markets, M&T came out last week and reported some deterioration, modest deterioration in credit. Are you seeing anything in any categories that you are taking a closer look at, or any concerns as far as, would you just say return or normalization of credit?

Vernon W. Hill

Yeah, this is the normal credit for us, first of all. If you look at our numbers for 10 years, they are all…I've always said our non-performing numbers should bounce around between 0.1% and 0.2%, and that's pretty much the average. I would say if you look at this last year, credit in general was unbelievably good. Now it's very good. We're not really seeing any systemic problems.

Adam Barkstrom - Stifel Nicolaus

OK, and then, on the capital markets side - a nice quarter for capital markets. Any color there?

Vernon W. Hill

Nah, they just had everything working that quarter.

C. Edward Jordan, Jr.

Yeah, it's just very much momentum towards the end of the year leading into 2007, across...

Vernon W. Hill

We've been telling you that this is the business that we want to build, and invest in and as we rebuild it we were pleased to see some results in the fourth quarter.

Adam Barkstrom - Stifel Nicolaus

OK. Could you give us a sense of timing this new investigation stuff. When did you guys first learn about that?

C. Edward Jordan, Jr.

Adam, as I said, we cannot answer any other questions on this. I said that at the beginning.

Adam Barkstrom - Stifel Nicolaus

OK. Thank you.

Vernon W. Hill

Thank you, Adam.

Operator

Our next question comes from Heather Wolf with Merrill Lynch.

Heather Wolf – Merrill Lynch

Hi, good morning. Just a couple of questions on credit quality slash loan growth. Your loan growth was down quite a bit this quarter. Was that due to lack of demand? Was it due to pricing competition? Was it due to credit quality? Could you give a little color there?

Douglas J. Pauls

Well, first of all, our loan growth at 23% for the year is a gigantic number - better than anybody else's. So let's look at that in perspective.

Vernon W. Hill

Yes, it's down from the 29-30% that we saw earlier in the year. I would say that pricing is the key. We're seeing in the upper-middle market side ridiculous pricing and very liberal terms. And those of you who know me know that I like to get paid back on a fairly regular basis, and we are being very disciplined, both on our deposit pricing and our loan pricing, and I think, if there is a drop in the loan production, it's because of the deliberate choice that we make.

Heather Wolf – Merrill Lynch

OK. And just another question on credit quality. Your drawing down your reserve just ever so slightly this quarter. Can you give us a little bit of color on how much charge offs need to move up before you start building your reserve?

Vernon W. Hill

Well, last quarter we did build the reserves slightly, and I would like to build the reserves somewhat. We got a lot of loans on the last week of the year, which sort of brought this reserve down, so our goal in '07 will be to build the reserves somewhat.

Heather Wolf – Merrill Lynch

OK. And then, just one final question. The intra-quarter 8K, is that gone for the foreseeable future, or are you still considering whether or not you're going to do that on an on-going basis?

Douglas J. Pauls

Well, you know, on the last conference call, we asked people to give us feedback and nobody seemed to care, so I think we have discontinued that for good.

Heather Wolf – Merrill Lynch

OK. All right, so any incremental color that we get on the investigation is going to be on sort of an as-needed basis?

Douglas J. Pauls

We will follow the disclosure rules Heather, like I said.

Heather Wolf – Merrill Lynch

OK. All right. Thanks a lot.

Operator

Our next question will come from Wilson Smith with Boenning & Scattergood.

Wilson Smith – Boenning & Scattergood

Thank you gentlemen, but all of my questions have been answered.

Vernon W. Hill

Thank you.

Operator

We will next move then to David Stumpf with A.G. Edwards.

David Stumpf - A.G. Edwards & Sons

Good morning. Most of my questions have been answered as well, but two sort of follow-ups to things that have come up already. On the capital markets side, the success there and the momentum there, does it have anything to do with sort of the push of maybe more into the asset management kind of area versus…?

Vernon W. Hill

That's a good point, David. We are building up our asset management business, and as the company gets more commercial in all of the things that we do, it helps the capital markets business in lots of things, and asset management is an area we are building up.

David Stumpf - A.G. Edwards & Sons

OK, so it is included in there.

Vernon W. Hill

Right, it is.

David Stumpf - A.G. Edwards & Sons

Right, and then also as you look at branch openings for this year, Vernon, I know one of the focuses, it's always a little bit seasonal and you always seem like you have big fourth quarters, I know that's not necessarily the intent, and I know you have all been working on trying to smooth that out a little bit and make it a little bit less seasonal, I guess. Do you think this will be the year where you will see a smoother progression of new branch openings?

Vernon W. Hill

Well, it never gets smooth, let me say that.

David Stumpf - A.G. Edwards & Sons

OK.

Vernon W. Hill

But last year, in the first quarter, we opened none. This year, we see 5-10 in the first quarter, so that's a significant improvement. And as Florida comes on-line more, as we get through the approval processes in Florida, that will help us in the first quarter. For instance, in the first quarter, we had a couple already open that missed the fourth quarter, so we’re weak one way or another, but I am certainly trying to even this out.

David Stumpf - A.G. Edwards & Sons

OK. That's great. Thank you.

Vernon W. Hill

Thank you.

Operator

(Operator’s Instructions)

We'll next go to Mark Fitzgibbon with Sandler O'Neill & Partners.

Mark Fitzgibbon - Sandler O'Neill & Partners

Good morning. Vernon, I wonder if the yield curve stays the way it is or even gets worse, is that likely to cause you to slow the growth rate and perhaps branch openings?

Vernon W. Hill

That's a difficult question Mark to answer. First of all, these development processes have very long lives. It takes a couple of years from the time we say go to get a store open. But it's a long time to get them going and the processes are very long. We've given you a range of openings of 15-20% store increase. We're at the low end of that range now, so I would say on one side the answer has been, yes, we're working at the low end of store openings, rather than the high end of store openings. If the yield curve stayed this way or got worse for a long period of time, that's an option we might consider, but that's almost a last option.

Mark Fitzgibbon - Sandler O'Neill & Partners

OK. And then, secondly, and I know it's very early down in Florida, but it seems like year-over-year deposit growth is pretty slow, I think it was 1% year-over-year. Is there anything unique to that market, or you just haven't really ramped up yet with your marketing and advertising?

Vernon W. Hill

The bank that we bought had $50-$60 million of very high cost money, and we basically ran that out and replaced it with a typical commerce, localized for deposit. So even though the number is roughly flat year-to-year, as we've gone through the switch and the conversion, the mix has improved. So we were relatively happy with what happened in Florida, and there will be a lot of new stores in Florida this year, and we'll really all get to see, including us, how strong the motto is there.

When you convert an old bank, Mark, you've heard me say this before, no matter what we do with the buildings, the conversions never grow as fast in the early years as the ones we build from scratch.

Mark Fitzgibbon - Sandler O'Neill & Partners

Thank you.

Vernon W. Hill

Thank you.

Operator

Our next question comes from Andrew Marquardt with Fox-Pitt Kelton

Andrew Marquardt – Fox-Pitt Kelton

Morning guys. Can you update us on what the level of index deposits is for the fourth quarter?

Vernon W. Hill

It's been fluctuating between $12 and $13 billion.

Andrew Marquardt – Fox-Pitt Kelton

Okay. And then next, can you tell us, what are your underlying assumptions for the interest-rate outlook heading into '07? Has that changed materially since the last time we spoke?

C. Edward Jordan, Jr.

No, we don't anticipate too much improvement to the first half of the year. We think there may be some improvement in the second half of the year, and that's really based on some of the economic projections from, you know, our economists. But we don't expect much improvement through the first six months.

Andrew Marquardt – Fox-Pitt Kelton

Okay. And you had previously talked about how you didn't expect year-over-year margin improvement until the third quarter of '07. Is that going to be thrown out at this point, or should we still think about that as a potential?

Vernon W. Hill

Well that's a tough... I think there's potential for that. Again, some of that is going to depend on what happens with rates, Andrew.

Andrew Marquardt – Fox-Pitt Kelton

Okay. And then the last question I had would actually fall into, I think, Matt's question earlier on expenses. You'd mention that one should sort-of certainly expect a similar rate for expense growth. Were you referring to kind-of the target for '06 of, you know, about 18%-20%, or similar to what it actually came out?

Vernon W. Hill

I think that we actually did better than the target numbers we gave you.

C. Edward Jordan, Jr.

Yeah, in '06 we had said we had said we were going to be below 22%, and we ended off at 18%. And for next year, you know, it's 18%-20% is probably reasonable.

Andrew Marquardt – Fox-Pitt Kelton

Okay, thanks, guys.

Operator

Our next question comes from a John Coffee with Putnam Investments.

John Coffee - Putnam Investments

Yeah. About two and a half years ago, when the Philadelphia situation arose, I recall on a conference call you discussed, I think trying to achieve the gold standard in... I don't remember whether it was corporate governance or what have you. But I also recall that you were going to hire some pretty high-powered third-parties to come in and look at a lot of corporate-governance related issues. And I recognize that you can't comment on this specific investigation that you announced today. However, would it be fair for me to assume that that whole process that you undertook a couple of years ago looked at a lot of the issues that are disclosed in the proxy?

Vernon W. Hill

I didn't quite get the point of your question, but the related-party issues have been disclosed in our proxy. We made lots of changes since 2002, and it's something our board reviews on an ongoing basis. So, I didn't quite get your point, John, but that's what we've been doing.

John Coffee - Putnam Investments

Yeah, I guess my point was that, didn't you hire some independent third parties to look at all these issues? I mean, there are a couple of real-estate related transactions that have been disclosed consistently in the proxy, and, you know, I'm just trying to connect the dots here, but it seems to me like a lot of that has been vetted... At least, what's been in the proxy has been vetted in the past by independent third parties.

Vernon W. Hill

Well, John, you know, this is an ongoing process. And all I would say is, you know, let's have some respect to the OCC and Fed, and let them go through their process, and that's it.

John Coffee - Putnam Investments

Okay, thanks.

Operator

Our next question comes from Tom Purcell with Viking Global.

Thomas Purcell - Viking Global

Hi fellas. Just two questions. One is on the partnership in the DC income. I guess I hadn't seen that before. What's the balance, I guess, that you guys have invested in venture-capital funds or partnerships that give rise to this, just to kind-of guess, annually, of what you ought to earn?

Vernon W. Hill

Roughly $45 million at December 31.

Thomas Purcell - Viking Global

Alright, and one other quick one on the investigation. In terms of the independent committee, who on the board is going to be on that? Can you disclose that or no?

Vernon W. Hill

We haven't really disclosed it, but the chairman is going to be... is Joseph Vassalluzzo, a relatively new director who was the retired vice-chairman of Staples.

Thomas Purcell - Viking Global

Alright, thanks.

Operator

Our next question is from a Gary Townsend with Friedman-Billings.

Gary Townsend - Friedman, Billings & Ramsey

Questions have been answered, thank you.

Vernon W. Hill

Thank you, Gary.

Operator

Next question, then, is from a Jason Goldberg with Lehman.

Jason Goldberg – Lehman Brothers

Thanks. Most have been addressed, but I guess. You changed your net income target to 15%-18%. Is it the way to think about that, kind-of, to expect earnings to stay in this 40% range as it's been since the last several quarters, and then as the Fed begins to eventually cut rates, you'll kind-of gradually move back towards that 15%-18% quote trajectory?

C. Edward Jordan, Jr.

Yeah, I think that's a reasonable way to look at it, Jason.

Jason Goldberg - Lehman Brothers

Great. Thank you.

Operator

Our next question, then, is from Rob Rutschow with Prudential Equity Group.

Robert C. Rutschow - Prudential Equity Group

Hi, good morning. Just a question on the expenses. If your revenue growth is going to slow down a little bit, and you're still opening branches at roughly the same pace, I guess there should be some expense offsets. Can you give us a little more detail on where you think you can cut expenses going forward?

C. Edward Jordan, Jr.

Well, I think it's really consistently with what we've been saying for the last, probably, six calls. You know, we tend to over invest in the business, you know, there were years where we were probably investing two years out in front of the business, and yet we can cut that down into investing, you know, 18 months ahead and save money. It's those types of...

Vernon W. Hill

It's generally in the support areas, not very much on the branch side.

Robert C. Rutschow - Prudential Equity Group

Okay, thank you.

Operator

Our next question is from Paul Delaney with Morgan Stanley.

Paul Delaney - Morgan Stanley

Good morning. I just had two quick questions. One, any plans to retire the rest of the debt? I think there's $260 million left.

Vernon W. Hill

We have no debt outstanding.

Paul Delaney - Morgan Stanley

Okay. And the second question is, with the regulatory investigation underway, does that in any way prevent you from raising trust-preferred capital?

Vernon W. Hill

Not that we're aware of. But we don't plan to raise any this year. Doug mentioned that we wanted to raise it. We have the capacity to raise approximately $900 million.

Paul Delaney - Morgan Stanley

Okay. Alright, thank you.

Operator

We'll next go to Gerard Cassidy with RBC Capital Markets.

Gerard Cassidy - RBC Capital Markets

Thank you. I have a follow-up question. Your growth in the loan portfolios has been spectacular on a year-over-year basis, as well as sequentially. Can you share with us, I noticed the construction load outstandings were down both sequentially and on a year-over-year basis, and it’s a concern for many investors. What are you guys seeing out there that concerns you maybe even more than some of us?

Vernon W. Hill

Well, there are some markets. Our construction-loan portfolio had been coming down for some time as a percentage, as our growth has been more in the C&I. Also the cost of a little bank we bought in Florida had a lot of that stuff, and that sort-of ran out. I think that you have to underwrite in the new world, which means slower markets, more time, and we've been fairly careful about that.

As a result, well, of course the number... I'm sorry, I wasn't looking at the number. The number is only 280. That's primarily single-family tract jobs, and that's a very small number, maybe the lowest it's ever been at Commerce. That's because the builders are starting less projects, because housing is selling slower. I think that's more a factor of demand than it is anything we do.

Gerard Cassidy - RBC Capital Markets

Thank you.

Operator

There are no further questions in the queue at this time... I'd like to take that back. Again, as a reminder, it is *1, and we will next go to Bryan Keane with Citigroup.

Bryan Keane - Citigroup

Hi, good morning. I had two questions. One, surprised, I guess, by the indexed mixed shift. Are these, you know, deposits under contract, or are the customers free to kind-of swap into the higher of the three months, or the 5-year treasury or the 10-year treasury?

And then two, I think there is some confusion about how much that stuff is actually priced-off of lower of, or just the three months. So if you'd provide an update that would be great.

Vernon W. Hill

On the contract side, some percentage of the governments have term agreements. They're semi-worthless. We don't put any stock on them. These people move whenever they want to move. Although I might point out that our government funding base has been growing very stable for a long period of time.

Now as to pricing doubling, answer that…

Douglas J. Pauls

It's running now at 45% or so. That's the lower of.

Bryan Keane - Citigroup

Okay, great. Just one other question. The 15-18% EPS target, you know, in the past you've talked about how the EPS can kind-of grow with your core deposits. Now you're at 20% for deposits versus that 15-18% EPS, so just kind-of curious what kind of yield-curve assumption goes into that EPS target.

Vernon W. Hill

Yeah, I don't think we have a specific yield curve. I guess I'm less optimistic today about the yield curve getting steeper than I was when I did it last time we talked. So it's sort-of our more pessimistic view of the shape of the yield curve for a while.

Bryan Keane - Citigroup

Okay, thanks.

Vernon W. Hill

Thank you, everybody.

Douglas J. Pauls

Thank you, all.

Operator

This does conclude today's conference call. Again, I would like to thank everyone for joining, and wish everyone a good day.

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