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Executives

R. Smith - Chairman, Chief Executive Officer, Member of Executive Committee and Ex-officio Member of Risk Management Committee

Charles Nugent - Chief Financial Officer and Senior Executive Vice President

E. Wenger - President, Chief Operating Officer, Director, Member of Executive Committee and Ex-officio Member of Risk Management Committee

Laura Wakeley - Media Contact

Analysts

Eric Beardsley - Barclays Capital

Craig Siegenthaler - Crédit Suisse AG

Collyn Gilbert - Stifel, Nicolaus & Co., Inc.

Frank Schiraldi - Sandler O'Neill + Partners, L.P.

Richard Weiss - Janney Montgomery Scott LLC

Mike Shafir - Sterne Agee & Leach Inc.

Matthew Clark - Keefe, Bruyette, & Woods, Inc.

Bob Ramsey - FBR Capital Markets & Co.

Unknown Analyst -

Mac Hodgson - SunTrust Robinson Humphrey, Inc.

Fulton Financial (FULT) Q2 2011 Earnings Call July 20, 2011 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Fulton Financial Corporation's Second Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Laura Wakeley, Senior Vice President.

Laura Wakeley

Thank you. Good morning, and thank you all for joining us for Fulton Financial Corporation's conference call and webcast to discuss our earnings for the second quarter of 2011. Your host for today's conference call is Scott Smith, Chairman and Chief Executive Officer of Fulton Financial. Joining him are Phil Wenger, President and Chief Operating Officer; and Charlie Nugent, Senior Executive Vice President and Chief Financial Officer.

Our comments today will refer to the financial information included with our earnings announcement which we released at 4:30 yesterday afternoon. These documents can be found on our website at fult.com by clicking on Investor Relations and then on News.

On this call, representatives of Fulton may make forward-looking statements with respect to Fulton's financial condition, results of operations and business. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond Fulton's control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements.

Fulton undertakes no obligation other than required by law to update or revise any forward-looking statements whether as a result of new information, future event or otherwise.

In our earnings release, we've included our Safe Harbor statement on forward-looking statements, and we refer you to that statement and that's incorporated into this presentation. For a more complete discussion of certain risks and uncertainties affecting Fulton, please see the sections entitled Risk Factors and Management Discussion and Analysis of financial condition and results of operations set forth in Fulton's filings with the SEC.

Now, I'd like to turn the call over to your host, Scott Smith.

R. Smith

Thank you, Laura, and good morning, everyone. We're pleased you could join us. After some introductory remarks, I'll turn the call over to Phil Wenger and Charlie Nugent to discuss credit and financial details.

We had a good second quarter, reporting diluted net income of $0.18 per share, an increase of 6% over the first quarter, and we are encouraged by the improvement we've seen in a number of areas, and we'll discuss those this morning.

During this time of slower economic activity, a difficult regulatory climate and uncertainty about required capital levels going forward, we are focused on improving our earnings and return on assets.

In the release, you saw that we increased our ROA by 6 basis points to 0.91%, and we are committed to managing the assets we have available to us more efficiently and profitably.

Our team members share the same commitment to growing the company profitably and enhancing the value we create for customers and shareholders.

This is not to suggest that we'll be any less concerned about the profitable return on and deployment of our capital. However, until industry regulatory capital standards are better defined, ROE is difficult to meaningfully manage. And as you know, our capital position has always been and remains a strong.

On our last call, we said we would consider increasing our cash dividend as business conditions in our financial performance permit, and as the Board of Directors deems prudent. We were pleased to follow our $0.01 increase in April by the same amount again this quarter.

Our progress is also evident on our second quarter asset quality numbers, as Phil will discuss, we saw improvement in all our core credit metrics and while we still have a great deal of work ahead of us, it's very encouraging to see these across the board improvements.

We continue to aggressively pursue our new business development efforts with customers and prospects. These sales efforts have enabled us to grow existing relationships and attract new ones. As business and consumer confidence improves, we would expect our work to produce increased levels of new business.

Another development occurred during the second quarter was a further decrease in funding cost that helped us expand our net interest margin. As you would know, there are a lot of moving parts to this number and there can, of course, be economic as well as seasonal fluctuations. The key is that we continue to grow lower cost deposit balances, particularly, in the non-interest checking category. These are primary transaction accounts from customers and businesses that help us grow households and create new cross-selling opportunities.

We do not publish our specific household growth numbers for competitive reasons, however, we attribute our very strong year-over-year demand deposit growth, and more than 6% increase in small business accounts to aggressive segment management, calling efforts and promotional activity. All parts of our ongoing growth strategy.

As you know, Dodd-Frank Regulation Q changes allow a financial institution to pay interest on businesses accounts effective tomorrow. We have developed several new account options for our business customers, the impact of this change on our cost of funds is expected to be minimal in the current rate environment.

In the face of increased regulatory pressure on deposit account related revenue, good performance from a number of our supplemental business lines helped us show a healthy increase in non-interest income. These includes Fulton Mortgage Company, merchant services, corporate services and consumer debt card activity. Fulton Financial Advisors, our investment management and trust services area, is growing its base of reoccurring income as a result of a strategic change made several years ago.

Two weeks ago, the Fed issued final regulations regarding interchange income. We have a lot of -- we have done a lot of planning in anticipation of this ruling. For all intents and purposes, it looks like the number will be $0.24 per transaction for us.

While we did get an increase from the initial number, as well as the delay in the implementation date, there still will be a negative revenue impact. We are in the process of implementing some changes that we had planned, and additional changes we make will depend on responses and timing from competitors. Charlie will provide greater detail in his financial discussion.

And as you know, we controlled our expenses well. Because of our good revenue growth during the quarter, we were able to show improvement in our already excellent efficiency ratio.

Going forward, our primary management priority is profitable organic growth. As I mentioned earlier, we believe the small business sector offers an excellent opportunity for continued core deposit, and eventually, loan growth. We have added and we'll continue to add mortgage originators in all of our markets to leverage our outstanding reputation as a mortgage lender. And to provide -- and to position ourselves to take advantage of the changing competitive landscape.

Reoccurring income from investment management and trust operations should continue to grow, as equity markets remain a viable alternative to the current rate environment. New branch expansion remains a priority in markets offering the greatest potential for growth and profitability.

Of course, we will continue to maximize all our non-interest income opportunities. And since we know that one of the opportunities to improve our earnings is to reduce the loan loss provision over time, ample resources will remain committed to constantly improving our asset quality.

In summary, our goal is to continue to produce meaningful improvement in our financial performance quarter-by-quarter, in our quest to return to pre-recession earnings levels.

At this time, Phil and Charlie, I'll turn it over to Phil and Charlie to provide details on second quarter credit progress and on our second quarter financial numbers. When they conclude, all 3 of us will be happy to respond your questions. Phil?

E. Wenger

Thanks, Scott. We were again, pleased this quarter to achieve reductions in our core credit metrics of non-performing loans, charge-offs and overall delinquency. The reductions for the quarter, absent a robust economic recovery, are reflective of our ongoing effort to reduce problem assets and maximize recovery wherever possible.

In light of this performance, we reduced our loan loss provision by $2 million for the second quarter, from $38 million to $36 million. Now let me give you some specifics. My comments will be linked quarter, unless I indicate otherwise.

First, with regard to delinquency. As you saw on the chart on Page 5 of the press release, we had a 7 basis point or $10 million reduction in overall delinquency. 30-, 60- and 90-day in over delinquencies all decreased. Increases in commercial and commercial mortgage delinquencies were more than offset by declines in residential mortgage and construction delinquencies.

Once again, this quarter, our total delinquency is the lowest it has been since December of 2009. Non-performing loans, which include nonaccrual loans and accruing loans over 90-days delinquent also declined.

Non-performing loans decreased $7 million or 2%, to $311 million from $318 million. Increases in commercial and commercial mortgage non-performing loans of $8.8 million and $5.4 million, respectively, we're more than offset by reductions to residential and construction non-performing loans of $6.8 million and $14.5 million, respectively.

The increase in commercial non-performing loans was anticipated and was driven by the addition of 2 larger accounts to nonaccrual. One that was tourism related and one related to the construction sector.

Again, this quarter, we saw an increase in payoffs of nonaccrual loans. Payoffs increased to $21.5 million this quarter, versus $16 million in the first quarter, and $7 million in the fourth quarter of 2010.

We believe the improved pace resulted from greater investor interest in projects we have marketed. Other real estate remained flat at $37 million.

Net charge-offs were $38.5 million, versus $42.3 million in the first quarter or 1.3% of average loans on an annualized basis. Increases in commercial as well as residential mortgage net charge-offs of $1.5 million and $2.6 million respectively, were more than offset by reductions in construction loan and construction mortgage net charge-offs of $5.9 million and $1.6 million respectively. There was one charge-off in excess of $1 million, associated with the nonaccrual addition I mentioned earlier.

We continue to see a decrease in our construction exposure with the ending balance in our construction portfolio declining by $66 million or 9% this quarter.

In December of 2006, our construction portfolio was $1.44 billion. We ended the quarter with a balance of $682 million. While we may continue to see reductions to our construction loan balances in the short term, given the lack of housing demand, we have achieved a construction loan exposure level, which we are comfortable with.

Troubled debt restructuring totals declined to $121 million from $137 million. Of this total, $77 million or 63% are accruing loans, versus $81 million or 59% last quarter. There were declines across all types of TDR loans, primarily driven by payoffs or paydowns by these customers.

A new accounting standard that provides clarifying guidance for evaluating whether a restructuring constitutes a troubled debt restructuring became effective on July 1. The adoption of this standard did not have a material impact on Fulton as our TDR policy is consistent with the new standard.

Now moving to loan demand and activity, the overall borrowing climate remains fairly quiet as evidenced by our commercial line usage remaining flat with last quarter at 44%.

Average outstanding loans declined by $38 million link quarter. The construction loan reduction I mentioned previously, has been partially offset by growth in other loan types throughout the footprint.

Commercial mortgages increased in our Pennsylvania markets including, the Lehigh Valley, Bucks, Montgomery and Lancaster Counties. Commercial loans increased nicely also in our Pennsylvania markets at the Lehigh Valley, Dauphin, Berks, Bucks and Montgomery Counties.

These increases are being driven by our teams and seasoned relationship managers taking advantage of market disruption and gaining solid new credit relationships.

If we exclude the impact of construction loan reductions, which was approximately $300 million over the last 18 months, our outstandings would be up by roughly 2% over that period. General market conditions are improving in Pennsylvania, Maryland, Northern Delaware and Virginia. Conditions remain challenging in New Jersey.

With regard to mortgage activity, applications were up from the first quarter to $477 million, versus $397 million. Closings did decline to $302 million from $341 million. However, the pipeline is up to $215 million from $161 million last quarter. 54% of the pipeline is for purchase activity.

So in summary, while loan demand is soft, we're taking advantage of good opportunities in our markets, and we are pleased with the continued incremental improvement in our credit metrics.

Now, I will turn the discussion over to Charlie Nugent for his comments. Charlie?

Charles Nugent

Okay, thank you, Phil and good morning, everyone. Unless otherwise noted, comparisons are of this quarter's results to the first quarter of 2011.

As Scott mentioned, we reported net income of $0.18 per share for the second quarter, up 6% from the first quarter. Net income was $36.4 million in the second quarter, as compared to $33.9 million for the first quarter, at $2.6 million or 8% increase.

The improvement in our net income resulted mainly from increases in net interest income and other income, and a decrease in the loan loss provision.

These improvements were offset by a slight increase in operating expenses and income taxes. Pre-provision pretax income increased 2%, from $84.2 million to $85.5 million in the second quarter.

Our net interest income increased by $1.1 million or 0.4%, mainly due to one additional day in the quarter. A slight decline in average earning assets was offset by an improvement in our net interest margin.

Our margin increased from 3.91% in the first quarter, to 3.95% in the second quarter. The total cost of our interest-bearing liabilities decreased to 1.19%, from 1.24% in the first quarter. The cost of interest-bearing deposits declined to 0.87% in the second quarter, from 0.93% in the first quarter, with decreases in all deposit categories.

During the second quarter, $906 million of time deposits matured at a weighted average rate of 1.47%. While $825 million of certificates of deposit were issued at a rate of 0.80%.

In the third quarter of 2011, $841 million of time deposits are scheduled to mature at an average weighted rate of 1.23%. Yields on average earning assets declined slightly to 4.88% in the second quarter, compared to 4.90% in the first quarter. Average earning assets declined $146 million during the quarter.

Average investments decreased $180 million or 6%, and the ending balances decreased $34 million. During the second quarter, payoffs in maturities of investment securities exceeded purchases. We continuously monitor both our portfolio holdings and current investment options in making purchase or sale decisions.

Average loans declined $38 million as decreases in construction, commercial and consumer loans were partially offset by increases in commercial and residential mortgages. Average deposits increased $50 million at $229 million or a 3% increase in demand and savings deposits, being offset by a $179 million or 4% decline in time deposits.

Noninterest-bearing demand deposits increased $124 million or 6%, in both business and personal accounts. Interest-bearing demand deposits grew $31 million or 1%, almost entirely in personal accounts. Savings deposits increased $74 million or 2%, primarily in municipal accounts.

Our other income to the second quarter increased $3.8 million or 9%, excluding the impact of security gains and losses. The increase in other income is realized in most fee categories. Service charges on deposits increased $1 million or 8%, which included a $460,000 seasonal increase in overdraft fees, and a $340,000 increase in service charges. The service charge increase was due to both growth in deposits and an increase of certain fees.

Investor management and trust service income increased $430,000 or 5%, due to brokerage fees and insurance commissions. We have been transitioning our brokerage business from a transaction-based model to a relationship model, to improve the level of reoccurring income.

And during the second quarter of 2011, brokerage fees were approximately $3.7 million, with more than 1/3 representing reoccurring revenue. Prior to this change, which began in 2008, reoccurring brokerage revenue was negligible.

Mortgage sale gains increased $440,000 or 10%, due to both an increase in new loan commitments and a slight increase in spreads.

Other fee categories seeing increases during the quarter included debit card fees, $410,000 or 10%, and merchant fees, $370,000 or 17%. Both driven by increases in transaction volumes, which we historically see between the first and second quarters.

The Federal Reserve recently issued revised pricing guidelines regarding interchange income on certain debit card transactions, and delayed the implementation date to October 2011. The revised pricing guidelines are higher than the original proposal, but are significantly lower than current rates.

Total debit income was $4.6 million in the second quarter. Under the revised pricing guidelines, this income would have been approximately $2.2 million less. To mitigate the decrease in interchange income, we will have -- we will make certain changes in our fee structure, which will be implemented during the third quarter of 2011.

We expect that these changes will allow us to offset approximately 50% of the decrease in interchange income. Additional fee increases have been identified and are being considered.

Operating expenses increased $915,000 or 1%, in comparison to the first quarter. Salaries and benefits increased $1.8 million or 3.2%. Total full-time and part-time salaries increased $1 million or 2.6%, primarily representing merit increases. Other real estate and repossession expenses increased $600,000 or 31%, as disposition and valuation losses were $630,000 in the second quarter, compared to $180,000 in the first quarter.

Other real estate gains, which are reflected in other income, were $1.6 million in the second quarter, compared to $700,000 in the first quarter. The $1.2 million increase in other expenses included the $610,000 increase in state taxes, and a $450,000 increase in operating risk loss. The state tax increase was caused by higher sales tax recoveries and other credits received in the first quarter.

The increase in operating risk loss reflects recoveries of $900,000 in the first quarter, compared to $500,000 in the second quarter. Offsetting these expenses was a $1.5 million decrease in FDIC insurance expense, due to the effect of the change in the assessment base from deposits to assets less tangible equity. Marketing expense also decreased $970,000 or 34%, in the second quarter, due to the timing of marketing expenditures.

Okay, thank you for your attention and for your continued interest in Fulton Financial Corporation. Now, we'll be glad to answer your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Craig Siegenthaler with Credit Suisse.

Craig Siegenthaler - Crédit Suisse AG

Just first question, what drove the increase in the securities yield, kind of, quarter over quarter?

Charles Nugent

Craig, it was primarily due to what was -- totally due to a decline in the amortization of premium. The premium on mortgage-backed and CMOs.

Craig Siegenthaler - Crédit Suisse AG

Got it. So no impact to the security portfolio duration there?

Charles Nugent

No. Prepayments -- they were heavy in the fourth quarter. In January -- just in the month of January, we received total cash flows of $66 million. And in June, it had declined to $30 million. So it's a reduction in prepayments on mortgage-backed and CMO securities.

Craig Siegenthaler - Crédit Suisse AG

Got it. Second question, can you help us identify the level of CDs that are going to reprice and mature in the third? And then in the fourth quarter? And also what the average rates are? And where you're currently pricing them down to? I'm just trying to think about the potential decline in your deposit cost?

Charles Nugent

Yes, in the third quarter, Craig, we have $841 million of CDs maturing -- scheduled to mature, at a rate of 1.23%. And during the second quarter, we put on CDs of $825 million, and the average rate was 80 basis points. So potentially, the difference between the 2, is 43 basis points.

Craig Siegenthaler - Crédit Suisse AG

Got it.

Charles Nugent

All right, in the fourth quarter, we don't have -- I don't have that with me, but I can get it for you, it's disclosed in our filings, but you'd see a slowdown in the reduced rate of the rollovers. Do you know what I mean?

Craig Siegenthaler - Crédit Suisse AG

Yes.

Charles Nugent

The average weighted rate, which is 1.23% in the third quarter will go down in the fourth quarter.

Craig Siegenthaler - Crédit Suisse AG

Got it. And I'd just few more, so that we can follow up with that, kind of analysis, after the call.

Charles Nugent

Okay.

Operator

Our next question comes from the line of Bob Ramsey with FBR.

Bob Ramsey - FBR Capital Markets & Co.

I noticed there was a pretty big drop in the securities portfolio this quarter. Could you just talk about looking at the average balance? Could you just talk about whether that's temporary or whether that sort of reflects your reinvestment opportunity status? What you are thinking in terms of the size of securities booked and the types of securities you did buy in the quarter?

Charles Nugent

We were down on average quarter-to-quarter $180 million. And we constantly look at rates and they were a little volatile. We did some buying. If you go back a year, I think we're down to $270 million. And we're just a little apprehensive to invest in this environment because we think that rates could to go up and there wouldn't be a lot of upside for us. I think it would help us temporarily. Instead of keeping money in fed funds, we'd get a higher yield in the mortgage-backed. So the quarter, we would get a 240 basis points. But we're a little apprehensive of buying right now. And then the tenure rates of 290, we're just apprehensive about buying mortgage-backed to CMOs at this level.

Bob Ramsey - FBR Capital Markets & Co.

I can understand that. Without a great loan demand out there, without sort of attractive opportunities on the securities front, as you guys' capital ratios continue to build. Obviously, you did increase the dividend this quarter, maybe just could you share some updated thoughts on capital, your aboves for your historical targets? What are the uses you all see today?

R. Smith

As I mentioned in my -- this is Scott. As I mentioned in my comments, our strategy is to continue to profitably manage the assets we've got. And as you and Charlie just talked about, there could be some time here where they're not going to grow substantially. So if we do that and the capital base continues, I think we still want to continue to look at the dividend and we'll do that quarterly. And as we've said in the past, when we think it's prudent to move it up, we will do so. There are going to be some opportunities for acquisitions as we go forward and we will always have that option to use some of our capital that way. And then finally, I think, once we get into a more uniform understanding of where capital ratios are going to need to be, I think then after that, we might look at more significant buybacks or whatever, if assuming that our ratios will be above those guidelines. But until we get more clarity about that, I think we will be careful about our capital base.

Bob Ramsey - FBR Capital Markets & Co.

Okay. And maybe one last question and then I'll pass it on. But you guys have some nice margin expansion this quarter, obviously with rates falling through the quarter. I know that must get sort of harder and harder. As you sort of look forward, do you think we're likely near peak level right now or just kind of what are your thoughts on margin outlook?

Charles Nugent

Everything affects margin, and Craig asked about the CDs, and our time deposit costs will continue to go down. The thing that usually happens in the third quarter is we have a lot of municipalities who bank with us and they collect their real estate taxes. And usually, from July to October, we'll have a pick up in municipal balances of between $200 million to $300 million. When that comes in, that will probably go into our fed account and that will reduce the margin. The yield that those assets we're bringing in, I mean, it's going to be a quarter. That will put pressure on the margin. So you have to reduce the time deposit because you have this municipal money coming in. Put pressure on it. And I would think it could get down 1 or 2 basis points or maybe stay even. And then as we discussed with Craig, in the fourth quarter, the yields and the interest rates paid on our CDs are not as high as they -- the ones maturing right now.

Operator

Our next question comes from the line of Frank Schiraldi with Sandler O'Neill.

Frank Schiraldi - Sandler O'Neill + Partners, L.P.

Just a couple of questions. Scott, you mentioned in your opening remarks a focus on profitable organic growth. And just wondering if you could give a little bit of color on potential branch expansion, maybe specific geography and numbers we could expect to see going forward.

R. Smith

Well, let me see the numbers first. That will be somewhat budget driven. We would like to open more branches than I think the budget is going to permit at least short-term but we'll see how that all evolves. But we have identified specific counties where we need more critical mass and we've looked at what level of critical mass that needs to be in these specific counties and now are in the process of finalizing fairly detailed plans about where we want to do branching, where we think we can get the most impact in the short term. And if you look at the map and you look at where we are, you'll see that we need some critical mass between where I sit right now in Philadelphia. We need some critical mass in all parts of Virginia where we're located, parts of Maryland. South Jersey, I think we feel like we've got good coverage there. And for the moment, Delaware, although we do have some thoughts about parts of that. And then Northern Jersey, some but some need for additional. So there's a lot of places, I think, if you do look at the demographics and where we have some branches but not critical mass levels, we'll go to the ones where the demographics are the best. And then finally, wanting to put a branch up and actually getting it done can be 2 different things. So it's a matter of locating the real estate, getting the appropriate municipal approvals to put a branch in there and then constructing it. So all of that is in the planning process and we know where we want to go. We've identified some real state. We'll continue to do that. And then we'll see what the budget permits us to do.

Frank Schiraldi - Sandler O'Neill + Partners, L.P.

Is it then just maybe too early to talk about specific numbers or you think -- can you quantify maybe 5 a year more or less or is it just too early to say?

R. Smith

Well, I think it's year by year as the October time frame rolls around and we do budgeting, finalize budgeting for the following year, we kind of decide at that point in time what the numbers could be. Five would be -- I would think on the lower side. But again, it depends if we're looking at zero loan growth next year, that's one thing. If we're looking at some pickup in the economy, then 5 to 10 would be a better number. And if things get moving rather quickly, we'll ramp that up but -- so I would say if I had to guess now, 5 to 10 next year.

Frank Schiraldi - Sandler O'Neill + Partners, L.P.

And then I just wanted to ask, historically, acquisitions have played a big part in the overall strategy. You mentioned acquisitions before, do you think that's maybe not as true going forward?

R. Smith

Well, acquisitions are very difficult. Branches, I can tell you have probably -- and we can control whether we open 5 or 6. Acquisitions as you know are opportunistic, so it will depend on what's available, who else is interested, what prices they're willing to pay and all of that. But we do know how to do acquisitions, we've done them in the past. And my suspicion is, we can do -- we'll do some in the future. We'll see how things unfold and what's available and how strategic it is. As we look at the situation right now, we're basically saying we are letting investment bankers know that we would like to know if there's a bank in our footprint that's available, and we'll do our analysis. And if we think it's strategic and important, then we'll move forward. If not, we'll hold.

Frank Schiraldi - Sandler O'Neill + Partners, L.P.

Okay. I don't know if you can share this with us, but have you, to date, moved forward in looking at some strategic -- we've seen some activity now in Pennsylvania and in the footprint. Have you moved forward past just the initial looking phase on anything yet?

R. Smith

Well, I think we signed a confidentiality agreement on everything that we look at. And I think given that, it would be inappropriate for me to be make any comment other than investment bankers know we're interested and we see most of the deals that happen.

Operator

Our next question comes from the line of Matthew Clark with KBW.

Matthew Clark - Keefe, Bruyette, & Woods, Inc.

On the loan growth front, it had some pretty meaningful runoff in this construction book, which is obviously deliberate and probably a good thing. But could you give us a sense for the pace of decline. It sounds like you're comfortable with the exposure here now. I guess I'm trying to get a sense for whether or not we might be able to begin to see net growth here? The source of the growth, I mean, the growth here has been commericial real estate. That's a decent size portfolio for you guys. I can imagine you want to grow it meaningfully from here. So just trying to get a sense for what the pipeline might look like from a loan type perspective?

E. Wenger

This is Phil. First, I'd make a comment on the construction loan decline this quarter. We did have 2 large commercial projects that's converted from construction to permanent. So that did skew that number and that constituted about half of the decrease. So we still do think that that portfolio, the decline in that portfolio will slow. The pace of decline will slow. We continued to try to get solid CNI relationships throughout our footprint. We've been most successful in Pennsylvania doing that. Although we are working in all our areas to increase that portfolio and that will continue to be an area of emphasis. We continue to look at good commercial real estate deals and we believe when the consumer start borrowing, we can pick up some consumer loan outstandings also.

Matthew Clark - Keefe, Bruyette, & Woods, Inc.

Okay. And how would you compare your pipeline this quarter versus last?

E. Wenger

It's similar.

Matthew Clark - Keefe, Bruyette, & Woods, Inc.

Okay. So how's the converted to turn, it looks like the [ph] balances were up just call it 0.5% then? If you back that up? Okay. All right. And then on the fee front, I know that you guys have been doing some things to help mitigate Durbin. Just trying to get a sense for how much you may have done already in terms of maybe rating prices on some of the products and what's left to do relative to the revenue that you expect to take on an annual basis?

E. Wenger

We have -- we're in the process of notifying customers of some increases that will take effect in September, and that should offset about half of our Durbin impact. Actually, a little more than half. And then we've outlined a number of additional increases that we could do that we're going to hopefully be able to determine how they stack up from a competitive standpoint and move forward on those when appropriate.

Matthew Clark - Keefe, Bruyette, & Woods, Inc.

Okay. And the updated impact from Durbin, I think previously, it was, I think it's soft of $9 million to $9.5 million. What is that number now do you estimate?

E. Wenger

We have said it was around $10 million. That was based off of last year's number. We've seen continued growth in debit interchange. I think it's up about 15% this year. So the -- where we stand now, using the initial guidelines, that $10 million actually would have been close to $12 million. And we believe that the impact with what's been put in place is going to be $8.8 million. Around $8.8 million.

Matthew Clark - Keefe, Bruyette, & Woods, Inc.

Okay. And the process of notifying customers that you said would begin in September that would help to mitigate over 50% of that, say, $8.8 million. I guess, how much of that is in the numbers already? Would you say?

E. Wenger

Well, I would say, none of those are in the numbers. There would be a small amount. I think service charges for the quarter might have been up around $400,000. So that was some of the things that we had done earlier. There were some fee increases that went into effect throughout the second quarter.

Operator

Our next question comes from the line of Rick Weiss with Janney.

Richard Weiss - Janney Montgomery Scott LLC

Can you talk just a little bit about the loan growth? What their -- is it coming from other competitors or is there any kind of just odd growth in the market?

E. Wenger

Rick, it's coming primarily from competitors.

Richard Weiss - Janney Montgomery Scott LLC

Okay. And is it from your larger competitors or are you doing it on price or how are you managing to take business from others?

E. Wenger

I would say, it's primarily coming from larger competitors. And I don't think it's on price.

Richard Weiss - Janney Montgomery Scott LLC

Okay. And then what's your feeling with regards to the core deposit growth, particularly the non-interest bearing. Will that change do you think for you or for the industry in general if interest rates are going up?

R. Smith

I think we all -- this is Scott. I think we all suspect that some of that money on the sidelines will get put to use. I think we all hope it does as the economy improves, but it looks like we're a few quarters away from that at least at this point in time. So yes, I think both consumers and businesses have some money in DDA accounts that's either going to be invested or saved in different forms when the world changes. So the question is when is that going to happen.

Richard Weiss - Janney Montgomery Scott LLC

Okay. And Scott, do you think it's any different like today than it was when you reported March numbers, in terms of that shift happening?

R. Smith

You mean the shift from people who's beginning to invest other than DDA accounts and..

Richard Weiss - Janney Montgomery Scott LLC

Yes, exactly. If you're seeing any kind of improvement at all or is it just about the same it was 3 months ago?

R. Smith

Well, the numbers actually went up. So there's more there. And I think some of it is just -- given the rate environment, either not wanting to commit to any maturity at this point in time in hopes that rates gets better, or just -- and frankly, not worth the effort to get a CD when the rates are where they are. I think businesses are being cautious. I'll let Phil answer any questions where he thinks maybe there's some mood change in terms of businesses spending money.

E. Wenger

I would say that there has not been and just saying it anecdotably talking to some customers, I think we actually have seen some plans be put on hold again. So I don't think that there's been much change from the businesses perspective as far as spending money.

Operator

Our next question comes from the line of Mike Shafir with Sterne Agee.

Mike Shafir - Sterne Agee & Leach Inc.

And I was just wondering, the 2 relationships in the CNI and CRE book, it's the tourism and the construction. Could you just quantify those?

E. Wenger

The 2 combined were $11 million. I'm sorry, I'll get you a better number. $16 million.

Mike Shafir - Sterne Agee & Leach Inc.

And the construction project, how big was that?

E. Wenger

A little over $5 million.

Mike Shafir - Sterne Agee & Leach Inc.

And you guys said that ultimately, you kind of anticipated some of that and it was on the radar?

E. Wenger

Yes, both of them were.

Mike Shafir - Sterne Agee & Leach Inc.

And then just moving forward in terms of looking at that CRE portfolio and the CNI portfolio, how do you guys feel now? Is there other stuff that's kind of on the watch list that you feel potentially could transition or?

R. Smith

This is Scott. I've been in this business long enough to know not to make any guesses about what to happen or not happen. We feel like we've got our arms around where we are and we've reserved appropriately. But the phone can be ringing right now for Phil that somebody telling him somebody just blew up. But we don't -- we feel like we're where we need to be and our expectation is that credit will continue to improve over time, but it could be lumpy quarter-to-quarter because of the kinds of situations that we just talked about. So we're not -- this economy certainly isn't robust, so there are going to be some marginal customers that continue to have some issues.

Mike Shafir - Sterne Agee & Leach Inc.

And then just going back to Durbin for a minute. You said that kind of updated number as you're looking at around $8.8 million as a potential annual impact. And then you're going to try to put some new practices in place that potentially could mitigate 50% of that loss?

R. Smith

They're already out. The customers have been notified.

Mike Shafir - Sterne Agee & Leach Inc.

Okay.

R. Smith

Now we're looking at the rest of it now to see what might be able to be done to mitigate the rest of it.

Mike Shafir - Sterne Agee & Leach Inc.

Okay. So then potentially, are we really looking more towards like a $5 million impact if things go according to plan?

E. Wenger

Well, our goal is to have no impact.

R. Smith

If they go according to plan, it won't have any impact, but I'm not betting my life on that, okay?

Mike Shafir - Sterne Agee & Leach Inc.

Right. But I mean, I'm really talking about your plan and not the government's plan.

R. Smith

We can't be totally out of the competitive market. So we've got -- we've got some time now so I think it's going to be a little while till some of the banks show their hands. And so we kind of have to work through this and stay competitive so that we don't lose customers over it. But if we get the opportunity from a competitive standpoint to make some of these other changes, we will, and we'll be back to zero. But I don't think that's likely in the next couple of quarters. I think it may take some time to work through that.

Mike Shafir - Sterne Agee & Leach Inc.

I appreciate all that clarity, guys.

Operator

And our next question comes from the line of Collyn Gilbert.

Collyn Gilbert - Stifel, Nicolaus & Co., Inc.

Just a follow-up quickly on Mike's questions about the 2 CNI loans. Phil, the -- excuse me, $11 million hotel, could you just give a little bit more color, maybe the geography of it? The sort of the scale of it? That just seemed like a larger loan.

R. Smith

This is Scott. First of all, we didn't say it was a hotel. We said it was in the tourist industry. And for customer confidentiality reasons, I just don't want to get into a lot of detail because people in the market can start putting two and two together. And I think we owe it to the customer just to say well it's basically in the tourist business and it was something that we saw deteriorating and prepared for it, and now we've got it behind us.

Collyn Gilbert - Stifel, Nicolaus & Co., Inc.

Okay. When did you first put it on the watch list, both of those credits?

R. Smith

I don't know that we know that. It's been a while.

Collyn Gilbert - Stifel, Nicolaus & Co., Inc.

Okay. Okay. And then Scott, just your comment about the M&A environment. It seems as if you're language would suggest you're more open to M&A than perhaps you were coming off of the first quarter. Is that a function of feeling more comfortable where Fulton and kind of Fulton's core business is? Or is that a function of being more reactive to the market around you?

R. Smith

I'm not sure that my mood has changed all that much. I think we've always said that we don't want to miss this strategic opportunity to exist. We have not been aggressively pursuing acquisitions from an outreach standpoint, but we constantly look at, as I talked earlier, about critical mass and important markets and how we might achieve it, and our planning includes where we think branching is the best option and where acquisition is the best option. The acquisition market is changed a little in terms of volume since we last talked. So I guess maybe I'm reflecting that -- if that volume continues, then the likelihood of us doing something might be a little higher than where it was when we're only seeing a deal or 2 a quarter and those were fairly stressed situations. So, I mean, it's just, it's impossible to predict what could happen but we're certainly not going to pass off an opportunity to do something that's very strategic and important for the company. But having said that, we haven't seen any yet.

Collyn Gilbert - Stifel, Nicolaus & Co., Inc.

Okay, that's helpful. And then just one final question. The mortgage banking revenue this quarter came in higher than certainly what I was expecting. What is your outlook there? Are you still seeing good application flow? Do you expect that flow to continue?

E. Wenger

Well, our backlog is up and we are seeing a good influence right now, and it's a combination again of purchase and refinance. So it looks okay right now but that area changes quickly depending on rates.

Collyn Gilbert - Stifel, Nicolaus & Co., Inc.

Okay. So for right now, though, the trend is still positive and still just as strong as you saw in the second quarter?

E. Wenger

Yes, it is.

Operator

Next on the line, we have Eric Beardsley with Barclays Capital.

Eric Beardsley - Barclays Capital

Just wondering, you're talking about how you're still waiting for clarity on regulatory capital. I'm just wondering if you could share any thoughts on how those discussions have evolved. It seems like some of the larger banks are getting some more clarity and maybe how that change over the past several months.

R. Smith

This is Scott. Frankly, that's news to me. I mean, from what I read in the press, the Europeans and the U.S. regulators are still in discussion about what might be what. And if you have some insight, I'd like to hear it because -- and I'm not faulting anybody. I think, several things have to happen. The regulators have to get comfortable and the industry and you investors have to get comfortable with what level of capital is going to be appropriate. I don't know it'll just be an edict from regulators. I think we're going to have to feel our way through it. And I don't think it will ever be as specific as it once you was, where you could -- we have certain requirements that were kind of benchmarks for everybody. I think it's going to be more risk-based and so each individual company is going to have capital ratios based on that. And that's going -- how much is that's going to need to be is going to be interpreted by the regulators and by investors. And until we get to that level -- and what I'm trying to say is that when we manage the company, we're focused on ROA. And if the ROA is right when we finally get to a point where we feel like, okay, this is the capital level we need, then we adjust the capital level to that. And if the ROA is where it needs to be then the ROE will be where it needs to be as well. That was the point of what -- and given the expectation of not a lot of asset growth over the next couple of quarters, but what I'm saying is, we're going to manage the assets we've got as effectively as we can. We're not going to leverage up the bond portfolio to try to get short-term earnings out of it. And we're not going to make the loans that we can't collect later to grow that. So as we work our way through this, we're going to be very focused on growing the profitability of the company by being very efficient about how we manage the assets that are available to us.

Operator

Our next question comes from Mac Hodgson with SunTrust.

Mac Hodgson - SunTrust Robinson Humphrey, Inc.

Just 2 quick questions. Charlie, did you say there was a $1.6 million gain on an OREO sale and other income?

Charles Nugent

Yes.

Mac Hodgson - SunTrust Robinson Humphrey, Inc.

Okay. And that compare to what in the prior quarter?

Charles Nugent

It was just $700,000 in the prior.

Mac Hodgson - SunTrust Robinson Humphrey, Inc.

And compared to most banks I look at and to the one usual to get gains, is that something you expect to continue to have some small gains going forward as you work through stuff?

Charles Nugent

Boy, how do you say -- I don't know.

R. Smith

This is Scott. We're certainly not looking at it as a new line of business we want to go into. Okay.

Mac Hodgson - SunTrust Robinson Humphrey, Inc.

And then on the advertising or marketing expense, I think you said it was seasonally down this quarter. What's a good, I guess, what's a good kind of run rate, I guess, that we should think about?

Charles Nugent

I would think about $2.8 million but it goes up and down constantly. We could see that.

Operator

Our next question comes from the line of Casey Harris with Jefferies.[ph]

Unknown Analyst -

My question is on -- apologies if I missed this. But my question is on the reserve bleed, which has been slowing down last couple of quarters. Should we be thinking about a $225 million reserve ratio going forward? Near term?

E. Wenger

That's really hard to say, Casey. And it's really going depend on a number of items, including delinquencies, charge-offs, non-performing levels. So...

R. Smith

Add the economy into that.

E. Wenger

Overall trends on risk ratings and...

Unknown Analyst -

Okay. Just switching gears to the M&A topic, could you just review some of your hurdles for an M&A deal, be it EPS, IRR and specifically, the level of tangible book value dilution you'd accept on a deal?

Charles Nugent

Casey, we've always had the same way we evaluate the acquisitions, and the first one is the effect on earnings per share. Second one is internal rate of return. The one after that is dilution to tangible book and how quick it comes back. And we would do 2 -- it takes a while to build. If we didn't do the acquisition, where would we be in x amount of time? So we've looked at 2 pass; one, by ourselves, one, with the acquisition and what the long-term effect would be. And then we also look at the overall effect on our capital ratios. They'll be the 4 primarily that we look at.

Unknown Analyst -

Right. But have you guys put any numbers around that in terms of minimums or thresholds?

R. Smith

This is Scott, that's deal by deal. If we see a unbelievably strategic situation that is compared to one that would be nice to have, then that becomes a different -- and as Charlie said, it's relative to where we would think we would be at that time. So to say, to put a number on it and tell you what it is, it's hard to do because in -- pick a day, October 12, we might have a different situation that we do our projections from that. So we're going to do acquisitions that create value for shareholders, and that will depend on what the numbers are at the time and what that strategic -- level of strategic importance it is.

Operator

At this time, I'd like to turn it over to Scott Smith for any closing remarks.

R. Smith

Thank you. I'd like to end the call by thanking everyone for joining us today, and we hope you'll be able to be with us when we discuss third quarter of 2011 earnings on October 19, at 11:00 a.m. Eastern Time. Goodbye.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. Everyone, have a great day.

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