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Huntington Bancshares (NASDAQ:HBAN)

Q2 2011 Earnings Call

July 21, 2011 10:00 am ET

Executives

Daniel Neumeyer - Chief Credit Officer and Senior Executive Vice President

Stephen Steinour - Chairman of the Board, Chief Executive Officer, President, Member of Executive Committee, Chairman of The Huntington National Bank, Chief Executive Officer of The Huntington National Bank and President of The Huntington National Bank

Donald Kimble - Chief Financial Officer, Senior Executive Vice President and Treasurer

Nicholas Stanutz - Senior Executive Vice President, Senior Executive President of Huntington National Bank and Group Manager of Dealer Sales - Huntington National Bank

Jay Gould - Senior Vice President and Director of Investor Relations

Analysts

Scott Siefers - Sandler O’Neill

Craig Siegenthaler - Crédit Suisse AG

Ken Zerbe - Morgan Stanley

Brian Foran - Nomura Securities Co. Ltd.

Jack Micenko - Susquehanna Financial Group, LLLP

Anthony Davis - Stifel, Nicolaus & Co., Inc.

Paul Miller - FBR Capital Markets & Co.

Erika Penala - Merrill Lynch

Kenneth Usdin - Jefferies & Company, Inc.

Robert Patten - Morgan Keegan & Company, Inc.

Operator

Good morning. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome, everyone to the Huntington National Bank Second Quarter Earnings Call. [Operator Instructions] Mr. Jay Gould, please go ahead with your conference.

Jay Gould

Thank you, Michelle, and welcome, everyone. I'm Jay Gould, the Director of Investor Relations for Huntington. Copies of the slides we will be reviewing today can be found on our website huntington.com. This call is being recorded and will be available as a rebroadcast starting about 1 hour from the close of the call. Please call the Investor Relations department at (614) 480-5676 for more information on how to access the records or playback or should you have difficulty getting copies of the slides.

Slides 2 through 4 notes several aspects of the basis of today's presentation. I encourage you to read these as always, but let me point out one key disclosure. This presentation contains both GAAP and non-GAAP financial measures where we believe it is helpful to understanding Huntington's results of operations or financial position. Where the non-GAAP financial measures are used, the comparable GAAP financial measure as well as a reconciliation to it can be found in the slide presentation and its appendix, in the earnings press release, quarterly financial review, quarterly performance discussion or in the related form 8-K filed today, all of which can be found on our website as well.

Turning now to Slide 5. Today's discussion, including the Q&A period, may contain forward-looking statements. Such statements are based on information and assumptions available at this time and are subject to changes, risks and uncertainties, which may cause actual results to differ materially. We assume no obligation to update such statements. For a complete discussion of risks and uncertainties, please refer to this slide and material filed with the SEC, including our most recent forms 10-K, 10-Q and 8-K filings.

Now turning to today's presentation in Slide 6. Participating today are Stephen Steinour, President and CEO; Don Kimble, Senior Executive Vice President and Chief Financial Officer; Dan Neumeyer, Senior Executive Vice President and Chief Credit Officer; Nick Stanutz, Senior Executive Vice President and Head of Automobile Finance and Commercial Real Estate. Also present is Todd Beekman, Senior Vice President, Assistant Director of Investor Relations.

Let's get started turning to Slide 7. Steve?

Stephen Steinour

Welcome, everyone. I'll begin with a review of our second quarter performance highlights. After my overview, Don will follow with his recap of our financial performance. Dan Neumeyer will provide an update on credit. Nick Stanutz will provide an update on our indirect auto segment. I'll then return for an update on our Fair Play and OCR, our optimal customer relationship strategy and a discussion of our expectations for the remainder of the year.

Turning to Slide 8. We reported $145.9 million or $0.16 a share. For the quarter, this represented a 15% improvement to net income from the first quarter. We were also very pleased to announce that the board has approved an increase of a quarterly common stock dividend of $0.04 per share from $0.01 per share. The dividend is payable October 3, 2011, to shareholders of record on September 19. Based on yesterday's closing stock price of $6.31, this equates to an annual dividend yield of 2.5%.

The board and management have been evaluating the company's capital position as we previously reported and its ability to organically generate capital. As such, we're very pleased with our financial strength, and performance had impacted -- and improved to the point that it enabled us to take this action. We view dividends as an important component of generating overall shareholder returns. We have established a targeted payout ratio or range, I should say, of 20% to 30% of net income. This is another step forward for our shareholders.

Overall, we're pleased with the second quarter results, representing our sixth consecutive quarterly increase in earnings, and it shows the progress we're making on a number of financial strategic fronts. Ultimately, it comes down to the level of returns we generate for the owners of the company. This quarter, our ROA of 1.11% took the low end of our long-term targeted range, but we entered that range this quarter. And nevertheless, we're disappointed that our $242.6 million in pretax pre-provision income was lower than expected as we elected not to expand the balance sheet.

We elected not to expand the balance sheet due to our view of risk adjusted returns and impacting pretax, pre-provision, also were expenses that were higher than expected. Don will provide some additional detail in a few minutes.

Fully-taxable equivalent revenue increased at $17.7 million or 3%. This reflected an $18.8 million or 8% increase in noninterest income as we saw increases in service charges on deposit accounts, electronic banking income and capital markets activity.

Net interest income increased only $1.1 million, meaningfully lower than what we had anticipated due to a balance sheet that was roughly $1 billion smaller than we previously expected. We shrank the sheet as an absolute level of interest rates and added competitive pressure on money market, and CD rates did not allow us to find attractive spread on these securities. As a result, average securities decreased $515 million or 21% annualized.

Mortgage originations remained at a relatively stable level with the first quarter, but we saw a $239 million decline in average loans available for sale. The negative impact of these declines was partially offset by $437 million or 5% annualized growth in average total loans and leases. This was led by very strong growth in average C&I and indirect auto loans with annualized growth rates of 8% and 18%, respectively.

The net interest margin decreased 2 basis points to 3.40%. NIM continued to positively impacted by the mixed shift to lower cost deposits, but the primary negative influences on net interest margin were lower loan yields and lower income from hedging derivatives. Noninterest expense declined $2.3 million or just under 1%.

Turning to Slide 9. Credit quality again showed improvement with a 41% linked quarter decline in net charge-offs and a 3% decline in nonaccrual loans. Our provision for credit loss has declined $13.6 million to $35.8 million, representing an annualized rate of 37 basis points of period-end loans. Our reserve coverage of total loans and nonaccrual loans of 2.84% and 181%, respectively, remain at healthy levels given recent economic trends.

In May, we first introduced to you some of our metrics around OCR and provided an update on some of the early successes of our Fair Play banking philosophy. During the second quarter, we launched our Asterisk-Free and Huntington Plus Checking accounts. We believe these represent the best checking account offerings in our markets, if not the country.

Customers agree as we experienced accelerated consumer checking household growth of nearly 10% annualized for the first half of 2011. These new households are not just focused around a single service. With use of our new sales process and MAX, our relationship management system, we've been able to continue to grow our share of wallet with new and existing customers. Now more than 71% of our consumer checking household customers have 4 or more products or services.

Household growth and increased cross-sell increased total consumer checking household revenue by 5% from the first quarter of 2011. We're now 6% above the levels in the second quarter of last year and have overcome the impacts from both Fair Play and Reg E.

Internal capital generation continued to improve. Our period-end tangible common ratio is 8.22%, up 41 basis plus, and our Tier 1 common risk-based capital ratio increased to 9.92%, up 17 bps. Our regulatory Tier 1 and total risk-based capital ratios ended the quarter at 12.14% and 14.89%.

Turning to Slide 10. We continue to move forward with our positioning growth with the implementation of strategic initiatives designed to accelerate customer growth, increase convenience and grow revenue. As I just mentioned, today we launched the Asterisk-Free Checking and Huntington Plus accounts. We continue to increase convenience and create the best experience for our customers.

We rolled out mobile applications for Android and iPhones. We now have 19 Giant Eagle in-store branches opened, and we'll have over 30 opened by the end of the year. While it's still early, the initial in-store branches are ahead of plan and look to be on the path to break even before our goal of 24 months. We also implemented extended hours in all of our banking markets.

Michigan is a key market for us, and we've been heavily investing in it for the last 2 years and as a result -- or as part of our commitment to Michigan and to our Midwest footprints, we announced a groundbreaking public-private partnership with the State of Michigan and the Michigan Economic Development Corporation by committing $2 billion in commercial and small business lending throughout the state over the next 4 years. Huntington's expertise in small business lending made it the #1 SBA lender in our region, inclusive of Michigan.

So now let me turn to Don to review the financial details.

Donald Kimble

Thanks, Steve. Slide 11 provides a summary of our quarterly earnings trends. Many of the performance metrics will be discussed later in the presentation, so let's move on.

As shown on Slide 12, our net income for the second quarter was $145.9 million or $0.16 per share. The $33.7 million increase in pretax income reflected the benefits of an $18.9 million increase in noninterest income, a $13.6 million decline in provision expense and a $2.3 million decrease in noninterest expense, which were partially offset by $1 million decrease in net interest income. I will detail these changes in subsequent slides.

Turning to Slide 13. We show the trends on our revenues and pretax pre-provision on the left-hand side of the slide. Primary reflecting the lack of growth in interest income, our 2011 second quarter pretax pre-provision performance did not improve as much as expected. With interest rates continuing at their absolute low levels, reinvestment rates available to us barely exceeded the incremental cost to grow interest-bearing deposits.

Given this environment, our deposit growth efforts focused on low or no cost transaction accounts, allowing some of our interest-bearing deposit categories to decline. This, combined with a slightly lower loan growth than we originally expected resulted in a smaller earning asset base with over $1 billion for the quarter. Our expense level did not decline as much as expected, reflecting a temporary increase in deposit and other insurance costs and higher levels of professional services.

Slide 14 depicts the trends of our net interest income and margin. During the second quarter, our fully-taxable equivalent net interest income declined by $1 million, reflecting a 2 basis point decrease in our net interest margin to 3.40%, and a $0.3 billion decrease to our average earning asset base.

The 2 basis point decline in net interest margin reflected the impact of 3 primary factors: first, an 8 basis point increase from the reduction in deposit rates and improvement in deposit mix; next, a 7 basis point reduction related to the impact of the extended low rate environment on loan yields.

This quarter, on Page 9 of the quarterly financial review, we provided the impact of swaps on our commercial loan yields. This summary shows that our commercial loan yields, absent the impact of swaps, only declined by 1 basis point this past quarter despite a 6 basis point decline in LIBOR. So our pricing remains disciplined, that is our C&I loan growth reflects our increased efforts of generating new loans, but this growth is not a result of discounted pricing.

Finally, a 5 basis point reduction coming from lower benefit from interest rate swaps. This reduction reflected the impact of previous termination of swaps. Our forecast would show a very modest reduction in this line item going forward assuming the rates remain at their current level.

Continuing onto Slide 15, we showed continued improvement on deposit mix over the last 5 quarter. We reduced our noncore and core CDs from 29% to 24% of total average deposits. Perhaps more important is the increase in the DDA balances over the last 3 quarters, as this category has increased from 30% to 34% of our total average deposits. The improved deposit mix reflects the efforts of Fair Play banking for the consumer category and our treasury management focus for our commercial businesses. Also of note, third quarter begins another round of higher rate time deposit maturities, with $1.9 billion maturing at an average rate paid of 2.63%.

Turning to Slide 16. We showed a $0.2 billion decline in average core deposits. This was driven by our decision to run down some of our higher cost money market accounts and CD accounts and replace them with significantly lower cost demand deposits.

Slide 17 shows the trends on our loan and lease portfolio. Total commercial loans are flat. This reflected the anticipated growth in commercial and industrial offset by the decline in commercial real estate balances. The $0.2 billion or 8% annualized increase in C&I loans came from several business segments including business banking, large corporate, middle market, asset-based lending and equipment finance.

Total consumer loans were up $0.5 billion from the previous quarter. The $0.3 billion increase in average automobile loans and leases reflected continued strong originations of $1 billion this past quarter. These originations continue to reflect very high credit quality and reasonable returns.

We did see a small linked quarter increase in both home equity and residential real estate loans. This growth reflected the stronger origination activities from our retail franchise.

Slide 18 shows the trend in our noninterest income, which increased $18.8 million or 8% from the prior quarter. This reflected increases in service charges on deposit accounts and electronic banking income of $6.4 million and $2.9 million, respectively, primarily due to seasonal factors. Other income increased $7.3 million or 19%, reflecting improvements in various capital markets-related activities and revenues.

Electronic banking income in the third quarter is expected to increase modestly from the second quarter levels. We will anticipate fourth quarter levels will decline about 50% as the new debit interchange fee structure is implemented on October 1. We also expect to see continued growth in earnings contribution from other key fee income activities, including capital markets, treasury management services, brokerage and all reflecting the impact of our cross-sell and product penetration initiatives throughout the company as well as deposit impact from our strategic initiatives.

The next part is a summary of our expense trends. Total expenses were down $2.3 million from the prior quarter. This reflected an $18.2 million decline in other expense as the first quarter included a $17 million in addition to the litigation reserves. For this reason, and as Steve noted, we're disappointed that the decline was not greater.

The benefit of the decline was partially offset by increases in professional services of $6.6 million, deposit and another insurance expense of $5.9 million, outside data processing and other services of $3.6 million and marketing costs of $3.2 million.

The increased professional services was higher than originally expected and reflected the incremental costs, therefore, and evaluate the impact of Dodd-Frank and other regulatory changes. The increase for deposit and another insurance was temporary and should return to levels consistent with that in the first quarter and for the second half of this year.

Slide 20 reflects the trends in our capital position. Each of our ratios improved over the prior quarter, reflecting the strong internal capital generation. The TCE ratio increased by 41 basis points to 8.22%, and our Tier 1 common ratio improved by 17 basis points to 9.92%. Both these ratios reinforce our message of having a very strong capital position.

As Steve mentioned, the board has increased the quarterly common dividend to $0.04 per share. Along with that increase, the board has established a targeted payout range of 20% to 30% of net income, and this declared dividend falls within the middle of that range. Even with the targeted payout range, going forward, we expect organic capital generation to drive continued growth from today's level of capital.

Let met turn the presentation over to Dan Neumeyer to review the credit trends. Dan?

Daniel Neumeyer

Thanks, Don. Slide 21 provides an overview of our credit quality trends. The second quarter continued to exhibit improved credit quality trends in both commercial and consumer loans. Notably, the net charge-off ratio fell significantly from 1.73% annualized in the first quarter to 1.01% in the second quarter. This reflected the results of our proactive recognition of emerging problem loans and focus on aggressive resolution that has been underway for the past 2 years. The improvement was broad-based, but was particular evident in the commercial segments, which experienced significant reduction despite a still anemic economic environment.

Loans 90 days plus past due and accruing continued to fall and were 15 basis points on total loans at the end of the quarter, the lowest level experienced in several years. Delinquencies, in general, continued to show improvement in both the commercial and consumer segments in both 30- and 90-day categories. There are slides in the appendix that detail these trends. The nonaccrual loans, nonperforming assets and criticized asset ratios all showed continued improvement in the quarter, although the improvement was slowed somewhat by an uptick in problem loan inflows.

The allowance for loan and lease losses and the allowance for credit loss ratios fell modestly to 2.74% and 2.84% from 2.96% and 3.07%, respectively. The coverage ratios remain very strong, however, as the lower allowance levels were offset with lower nonaccrual loans and nonperforming assets. The ALLL and ACL to NPA ratios actually remained flat quarter-over-quarter.

Slide 22 shows the trends in our nonaccrual loans and nonperforming assets. The chart on the left demonstrates the continued reduction in the level of both nonaccrual loans and nonperforming assets.

Nonaccrual loans fell 3.5% in the quarter. With regard to nonaccrual inflows depicted on the right-hand side, we did experience a small uptick in the quarter. We view this increase as reflective of the uneven nature of the commercial activity, including several unrelated credits that migrated in the quarter, rather than a reversal of the positive trend that's been developing and that is expected to continue.

Slide 23 provides a reconciliation of our nonperforming asset flow. NPAs fell by 5% in the quarter. The increased inflows were more than offset by a stable level of loans returning to accrual status, loan and lease losses, payments, along with a modest level of loan sales.

Turning to Slide 24. We provide similar flow analysis of our commercial criticized loans. Over the past year, we've seen a consistent decline in the level of commercial criticized loans. As already mentioned, criticized inflows were up in the quarter, although this inflow is more than offset by the level of upgrades to Pass during that same period. Along with pay downs and charge-offs, this resulted in an 11% reduction in criticized commercial from the prior quarter.

Reviewing Slide 25, the loan loss provision of $35.8 million was lower than net charge-offs by $61.7 million. The ratio of ACL to NAL fell slightly to 181% from 185%, although this level of coverage remains very strong and we expect we'll continue to compare favorably with our peer banks. Given the continued improvement in the risk profile of the portfolio as evidenced by virtually all of our key credit metrics, we view the resulting ACL ratio of 2.84% as sufficient and appropriate. Overall, we remain very pleased with the direction of credit quality across the portfolio and expect continued improvements the subsequent quarters.

Now let's turn the presentation over to Nick Stanutz.

Nicholas Stanutz

Thanks, Dan. Turning to Slide 26. For the last 6 months, there has been an increasing level of attention on Huntington's indirect automobile portfolio. Today I'd like to provide additional data that should help clarify most of the questions and/or issues that are asked about this business.

In the next 3 slides I will: one, show you Huntington has been able to hold pricing higher relative to the industry, while at the same time originating record production by expanding into Eastern Pennsylvania and the New England markets, all the while maintaining our strong underwriting standards; two, describe to you the current portfolio by vintages and rates, so you can see the loan pricing has mirrored the decline in 2-year swap rates, the rate of decline has significantly decelerated over the last year and a half, still leaving us with sufficient margins; and three, provide you with details that this bank, not the manufactured captive finance companies that have a dominant market share position in the financing of new and used vehicles sold to franchise dealers, which is our core market focus.

Captives have minimal market share of the used segment, which is as large as the new segment and which account for over half of our auto loan production. These captives mission is to support the manufacturing and selling of new vehicles to consumers. They do not play in the used vehicle space where we do.

As you know, we originate super prime indirect automobile loans. The chart on the left shows the industry rate for super prime new and used vehicles. Our originations had an average FICO score of 760 and have been very stable for years. Huntington's comparable rates are shown on the right, again, segregated between new and used autos.

With regards to loans on new vehicles, the average rate in 2011 first quarter for super prime loans were 3.64%. This rate was down 74 basis points from the year earlier. For Huntington, our average rate in 2011 first quarter was 4.27%, or 63 basis points higher than the industry average. Further, this was down 34 basis points from the prior year or less than half the industry decline in similar super prime credits.

The story is similar for used car loans. For the industry, the average rate in the 2011 first quarter for super prime loans is 5.06%, a 95 basis point drop from a year earlier. In contrast, our average rate in the 2011 first quarter was 5.86%, or 80 basis points higher than the comparable industry average. Further, this was only down 7 basis points from the prior year or 88 basis points less than the industry decline for similar super prime credits. As show in the table on the right, our combined yield is basically in line with the decline in the 2-year swap rates.

The question I get asked most frequently is how do we accomplish these metrics? You've heard me say it starts with our long-standing, unwavering history of support for the dealer community. For over 60 years, we have been there for the dealers regardless of the cycle.

In 2009, auto industry uncertainties allowed us to once again demonstrate our support for dealers. When companies like Allied couldn't provide their historical support, we were there. Our business model is quite unique. It is local, which is very different from our competition. By having sales and underwriting in the local market, we know our dealers, we know our economies and they know us. The combination of longevity, commitment, being local and easy to do business with collectively drive our results.

Keep in mind that when a dealership uses our rates, which might be 20 to 50 basis points higher than the market, that only increases the monthly payment of the customer by $5 to $10. Good experienced F&I managers can sell that all day long to applicants. The bottom line is that for those loans that are in and out of this market who operate on the fringes, they can only compete on rates. This is their only option.

On the other hand, for Huntington, where we compete on the total relationship and total service provided basis, that is the difference. This makes us best in class in not only things like approval time, like, 4 seconds or less on 75% of our applications or on our same-day funding of loan contracts, our dealer-centric approach gives us pricing leverage and superior dealer loyalty.

Slide 27 shows automobile loan origination vintages that currently comprise our $6.2 billion automobile portfolio. The average rate for our customers in this portfolio is 5.91%. The key points are decline in yields throughout our entire portfolio over the last 2.5 years has been slightly greater than 150 basis points. Importantly, that decline is slowing because over 70% of our current production had been originated in the last 18 months at an average rate of close to 5%. And while there continues to simply runoff of our older higher yielding loan, the increase origination volume and resulting increase balance levels more than offset the impact in dollars to the net interest income.

Turning to Slide 28. I would like to dispel the notion that what banks do in the auto finance space is driven or dictated by the captives. This graph shows the relative percentage of new and used vehicle financing markets allocated between the major players.

Banks are the largest player in this market with nearly 40% of the total volumes and nearly double that of the manufacturer. This is because the market for new only includes that, but not -- also the used vehicle market. As a matter fact, the used vehicle market sold through franchise dealers is just as large as the new markets.

So whenever you hear the industry talk about the new vehicles seller rate being whatever, the used vehicle market is just as large as the new. Therefore, when you add the 2 markets together, the new and the used as shown here, banks dominate. In fact, captives represent less than 10% of the used car market, and that is significant for us when you consider that over 50% of our originations are used vehicle loans.

Let me turn the presentation back to Steve

Stephen Steinour

Turning to Slide 29. As I mentioned in my opening comments, our Fair Play banking philosophy has been strongly resonating in the market and driving new customers for Huntington. Along with these new customers, we continue to benefit from higher retention rates.

In May, we reported our consumer checking household growth. At that time, first quarter 2011 growth was running at a 9.1% annualized rate or 1.6% above our initial plan. Over the second quarter, several competitors announced they were adding fees or reducing product features to try to offset lost revenue. Customers reacted. Our consumer checking household growth further accelerated.

I'm very happy to report that our annualized growth rate for the first half was nearly 10%. This is more than 30% above the initial goals we set last September and more than a threefold increase compared to what we were generating in 2009.

Turning to Slide 30, where we show the product penetration trends. Our optimal customer relationships we refer to as OCR is more than just getting new customers to the door and keeping the old ones happy. The key to our strategy is to grow Huntington's share of wallet from the total base of customers.

Driving this is a broad ray of services and products coupled with the rigorous and disciplined sales management process, all of which is supported by robust sales and cross referral technology. Over the last 4 quarters, we've increased the percent of households with 4 or more products from just over 68% to now over 71%.

While that might seem -- or like, while it might not seem like a large number, remember that the entire customer base of over $1 million households is reflected in the number. So even if you don't factor the new accounts, this means that we sold over 30,000 new products and services just this quarter alone.

Turning to Slide 31. You can see that this has resulted in a significant positive impact of customer checking account household revenue. Total customer checking account household revenue in the second quarter was $260 million. That's an increase of $11 million or 5% from the first quarter. What we believe is even more meaningful is that consumer checking household revenue is $15 million or 6% higher than the year ago quarter, but growth in checking account households and deeper banking relationships has more than offset the impacts from our Fair Play action, our investments in Fair Play, and Reg E.

Turning to Slide 32. I just want to recap our current thinking. The economy, we expect to be stable but not to meaningfully improve, and this is an adjustment from our perspective just a quarter or so ago. We expect this for the remainder of the year. We're seeing fragility, early signs of it in borrower and consumer confidence in the second quarter that we, a couple of quarters ago, did not anticipate as well.

Our net interest margin should be stable and with regard to loan growth, we expect the recent trends to continue with their overall modest loan growth, driven by continued strong growth in auto loans, meaningful growth in commercial industrial loans, modest growth in home equity being offset by expected declines -- continuing declines in commercial real estate portfolio.

We anticipate fee income growth will be mixed as we see continued growth related to Fair Play banking, positioning, strategic initiatives and other key banking activities. In the fourth quarter, we expect implementation of the new interchange fee structure will reduce electronic banking income by approximately 50% from the second quarter levels.

Noninterest expense is expected to be relatively stable as continued investment and strategic initiatives should be offset by continued low credit costs -- credit-related costs and improve expense efficiencies. Nonaccrual loans and net charge-offs are expected to continue to decline throughout the rest of the year. The primary driver of net income growth throughout the rest of the year is that we expected modest revenue growth coupled with disciplined expense control.

In closing, while there was many positive aspects of the quarter as we continue to drive for higher and more stable returns, there were some aspects where we can do better and we will do better.

So thank you for your interest. Operator, we'll now take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Ken Usdin from Jefferies.

Kenneth Usdin - Jefferies & Company, Inc.

Steve, I just wanted to ask you about the rate of expenses versus the rate of revenue improvement. You're obviously still -- I guess if you can just tell us your rate of incremental investment versus trying to hold the line against the flattening out in pretax, pre-provision. What levers do you have? Have you changed at all the way you're thinking about investments versus letting some fall to the bottom line if revenue get a little tougher?

Stephen Steinour

We're working at that dynamically now. Some of our expense increase in the second quarter was related to Dodd-Frank issues where we're, frankly, trying to get ahead. An example would be hearing what some of the large mortgage servicers we're working on. We invested in looking at our shop based on what seem to be emerging standards with outside consultants. So there will be continued investments in the business segments as well. But at this point, with the change in our economic outlook, we'll be rationing those investments more dynamically than we had anticipated at the start of the year, Ken.

Kenneth Usdin - Jefferies & Company, Inc.

Okay. My second question is just on the NIM. With the swap income pretty much robust and pretty big deposit repricing still to come in the back half of the year, stable margin seems pretty conservative. So can you give us the puts and takes with regards to what you're expecting on loan yields versus what you're expecting on liability costs?

Daniel Neumeyer

That's a great question, Ken. We do expect the loan yields to continue about the same level. As we talked about, our commercial loan yields on average after your backup the swap impact, are fairly flat, have been relatively consistent over the last 5 quarters. If you take a look at that commercial loan yield and back off funding from the money market account growth, you're not at that 340-plus type of margin. And so that's why we think even though with the improved mix of the deposits, the growth will still maintain a relatively stable margin going forward.

Kenneth Usdin - Jefferies & Company, Inc.

So the delta would just be if loan growth keeps up with -- so could the margin go up as loan growth keeps up with deposit growth?

Daniel Neumeyer

I'm sorry, if the loan growth keeps up with -- can you repeat the question again, Ken? I'm sorry.

Kenneth Usdin - Jefferies & Company, Inc.

Yes. So I guess if loan growth kept up with deposit growth, could the margin go up? What would be the scenario in which the margin could actually see some upside? I'm just asking if -- does the earning asset growth need to keep up with the deposit? Does the loan growth need to keep up with the deposit growth?

Daniel Neumeyer

I think you would need to see a continued shift of the balance sheet away from investments to see those margins improved. And so to your point, if deposit growth funds the loans growth and you keep the portfolio stable, there could be some opportunity there for some slight expansion.

Operator

Your next question comes from Ken Zerbe from Morgan Stanley.

Ken Zerbe - Morgan Stanley

Just on the C&I guidance, you're talking about meaningful C&I or meaningful growth in C&I. What's the sensitivity around that? I mean, how -- obviously, you've had some improvement in C&I so far, but are you looking at an acceleration in C&I? And how confident are you that you can actually get that given your initiatives versus sort of the more cautious economic outlook?

Donald Kimble

Ken, this is Don. As far as our outlook, for each of the last 3 quarters, we've been growing C&I loans on an annualized basis of 8% to 10%. We would continue to expect to have growth rates in that range. And so it's really been a reflection of the concerted effort we've had as far as the call in activities and the execution of our sales efforts throughout the organization. And so we still believe that will continue. Some of the challenges against that, to be honest, there are just potential concerns about the economy. So we have seen it slowed in this past quarter, and then Steve said we think it's a little bit more fragile. And we are continuing to see more aggressive pricing from the competitors, and we want to maintain our pricing discipline. But we're seeing more aggressive pricing on large corporates and large middle markets and even going into the more regular middle market lending and also on the floor plan lending. And so we want to maintain our discipline. And at the same time, we believe, because of our sales efforts, we can drive consistent growth from that 8% to 10% range.

Ken Zerbe - Morgan Stanley

Okay. Understood. And then just on -- in terms of the CD portfolio. I think you mentioned $1.9 billion of higher rate CDs coming due. As those continue to, I guess, reprice lower, right, and the customers are determining whether or not they want to stay with the bank or they leave the bank, are you comfortable shrinking the securities portfolio as a result of that such as your balance sheet shrinks? Or do you actually -- or do you think that loan growth could actually help offset the security reduction, hence, flattish balance sheet going forward?

Donald Kimble

Our expectation would be is that the balance sheet should be flat to up, and that's driven by the loan growth. And as you saw this past quarter, we worked on for allowing that CD book to decline, and the investment portfolio declined just because we didn't think the risk reward was in balance for us. That if you look at where our alternative investment yields were for, say, a 3-year related type of asset, it didn't provide enough margin for us to raise the rates on growing the deposit book, and also concern in this rising rate environment that we didn't want to put our lower rate, lower yielding investments in our portfolio.

Ken Zerbe - Morgan Stanley

Understood. And that's exactly what I was asking because it almost seemed that the scenario is about the same again this quarter, but you're a little more confident in your ability to grow loans to offset the balance sheet reduction.

Donald Kimble

We are confident that we can continue to grow commercial. We have a good track record as far as the indirect. And as you can also see, if you look at the end of period deposit balances, they're flat with where we were for the average for the quarter. And so that gives us some confidence we can maintain that as well perspectively.

Stephen Steinour

Ken, we also are using a strategy of moving some of the CD maturities into our investment portfolio. We've got a very strong broker-dealer. So there's a customer sort of management retention element to this as well.

Operator

Your next question comes from Paul Miller from FDR.

Paul Miller - FBR Capital Markets & Co.

Steve, relative to competition out there, especially some of your large competitors in your region have talked about very aggressively growing their loan book in somewhat of a, I still think, a flat environment. Are you seeing increased competition from some of your bigger regionals in your footprint? I know a year ago you thought that a lot of these other guys were focused on other regions. I'm just wondering if that's still the case.

Stephen Steinour

Well, the Midwest has performed relatively well over the last year. A consequence of that is just probably a little more competition than there might have been a year ago. The manufacturing sector of the U.S. economy, for example, you would see performing again relatively well, whether it's a combination of market circumstances, including foreign exchange, things like that, for exporters. And we're going to -- our footprint is in the manufacturing zone. So we are a little more competitive, to bottom line your answer.

Paul Miller - FBR Capital Markets & Co.

And on the price side, there are a couple of banks that we've talked to said that if the banks that are better growing their portfolios are really being price competitive, are you able -- I know you talked about the auto side of it, that you're able to maintain your higher rates while also growing the book. Are you finding that across-the-board on the C&I and commercial also with your relationships?

Stephen Steinour

We are, and we had some noise in the first quarter number related to our derivative position and how we have allocated it into various books. We've tried to with disclosures make it very clear what was price pressure flow-through versus hedging. And hopefully, we'll be able to do that. Essentially, we're flat within a couple basis points year-over-year.

Donald Kimble

And Paul, you want to take a look at Page 9 of that quarterly summary, it shows the detail in the bottom of that page where we break out the commercial loan yield trends versus what the impact of the swaps.

Paul Miller - FBR Capital Markets & Co.

I'm just wondering, like, are you continuing to seeing that favorable trend? I mean, we're just hearing a lot of anecdotal evidence of some people really coming into different areas and undercutting people. I'm just wondering, I know relationship banking is your bread and butter. I'm just wondering if that's starting to show itself in your region?

Stephen Steinour

It's more competitive today, Paul. It's not sort of at a feverish pitch. It's likely to be more competitive in the future than less as well, but there's not some massive sea change that has occurred over the last quarter or 2 from what we can tell because of our forward pipeline management. We don't see a sea change at least in the near term.

Operator

Your next question comes from of Brian Foran from Nomura.

Brian Foran - Nomura Securities Co. Ltd.

Just following up on the auto detail, which was very helpful. On Slide E3, you also have expected cumulative losses for each quarter of production currently running around 88 bps. So if you have a weighted average new origination rate, I guess, running just below 5% and 88 basis points expected cumulative loss, what does that translate in to in terms of incremental ROEs on new production?

Donald Kimble

Brian, this is Don, and I'll ask Nick to jump in here as well. But generally, our credit adjusted spread is just around 2.25%. And we've been maintaining that for some time. And as far as ROAs and ROEs, that we're probably closer to the 1% ROA. And we're also looking at the ROEs in being in the midteens. Keep in mind that cum loss estimate is for the life of the loan. And so if you got a 2-year duration of that asset, the average credit costs would be in the 40 basis point range as opposed to the 88 bps that we're showing.

Brian Foran - Nomura Securities Co. Ltd.

And when you think about used car pricing, which is, I guess, currently in all-time high, but maybe there's some argument that it should be an all-time high and that's sustainable. I mean, do you use the Manheim or whatever index you use where it is today? Or do you haircut it down when you're thinking about that expected cumulative loss?

Nicholas Stanutz

Brian, the way we think about our pricing model is that we do not take into account what's going on with Manheim. We typically look at historically what cars have brought at auction. So today, we've got a tailwind because obviously, as you pointed out, the Manheim is at record levels. That does not influence our pricing model at all today because 2 years from today, there's a chance that, that is going to be different. And so we do not use something we can't control as we think about pricing, and that is obviously used car prices.

Operator

The next question comes from Tony Davis from Stifel, Nicolaus.

Anthony Davis - Stifel, Nicolaus & Co., Inc.

I guess to follow up on the credit demand issue here. Steve, you describe customers as fragile. Could you give us a little color maybe about where you ended the C&I backlog at the end of the quarter or as opposed to what it looked like during the quarter and sort of your sense as we sit today in terms of incremental borrowing intentions, vis-à-vis, say, a month or so ago?

Stephen Steinour

Let's start with the outlook, Tony. We expect that we got a steadily improving economy throughout the year, and that appear to be the case at least from our opinion based on some of the information we can access. Our pipeline, to answer your question now, was flat at the end of the quarter compared to where it began in the quarter or ended the prior quarter. And we have confidence in our near-term forecasting and disciplines around sales management of that pipeline over the last 2 years. That's been part why we project the confidence in being able to grow the book notwithstanding -- we think we have a different economic outlook today than we would have in the fourth quarter for the second half of this year.

Anthony Davis - Stifel, Nicolaus & Co., Inc.

And just also, I wonder if you could give us a sense about your regulatory compliance cost. You talked about professional services in Dodd-Frank. Looking back a year ago when this thing passed, any sense of what the expense increment has been to date as you add staff and gear up for reporting purposes, et cetera, that we can look at?

Donald Kimble

Tony, as far as the current quarter, I'd say it's probably about $5 million incremental spend this quarter because of complying to Dodd-Frank review and other issues like that. But more of that is just gearing up, understanding and relying on some external expertise there that we have a continuing investment in our risk management activities and functions. I think it'd be hard for us to define how much is Dodd-Frank specific, but we continue to support these initiatives as part of our objective of having an aggregate moderate to low-risk profile. And so I think it would be very difficult for us to describe how much of that increase in the risk management is attributed to just Dodd-Frank.

Anthony Davis - Stifel, Nicolaus & Co., Inc.

Understand, Don. Finally, Asterisk-Free, a little more color perhaps on that rollout, what your expectations were in terms of new account growth there and kind of what you're actually seeing?

Stephen Steinour

So we had a quarter that exceeded expectations as we should, Tony. Frankly, we don't know. We're challenging ourselves as to how far we can take this and whether we can sustain it, whether it's a one-time sort of moment here. But we're very pleased. We're, as I reported, we're above what we communicated last September and we had good growth quarter-over-quarter, but it's early. Asterisk-Free came out with marketing way mid-second quarter, so we need another couple of quarters to get -- to be able to answer that question with confidence, I think.

Anthony Davis - Stifel, Nicolaus & Co., Inc.

I did think one other one. The 75 Giant Eagle branches that are under previous banking agreements, I'm just wondering, Steve, about the timing of when the majority of those will switch over.

Stephen Steinour

The majority will be '13 and '14, Tony. I think there may be a dozen or so next year now. The situation is fluid. Our partner could elect to pullback. One of the other partners could elect to pullback, and in which case, we'd step in on an accelerated basis.

Operator

Your next question comes from Erika Penala from Bank of America.

Erika Penala - Merrill Lynch

I was just wondering, and I apologize if you had already answered this in conjunction to Tony's question, but could you give us a sense of how your competitors have responded to your Asterisk-Free Checking product? Or is the response going to be it's still too early given that we just got the final Durbin rules?

Stephen Steinour

I don't think -- I think it's too early to answer you directly, just for competitive reaction, if there's going to be any. There was a lot of product change across the industry, Erika. And those product changes were just implemented if not the second or first quarter, late fourth quarter in most cases. So I'm sure there's some further adjusting that -- or I imagine there's some further adjusting that's going on. But don't expect to see any wholesale response from our competition based on where we are. Fair Play is going well from our perspective, very well. And it's benefiting both account acquisition and much stronger retention. And so I believe we've got a couple of quarters before we'll really -- and maybe longer before we'll see any sort of competitive dynamics.

Erika Penala - Merrill Lynch

Okay. And my second question was in regards to your resi and real -- your resi and home equity credit quality. I was just wondering if there was anything in particular that slowed down the improvement in these categories. Or is it just generally the economic fragility that you mentioned during your prepared remarks?

Donald Kimble

So the increase, Erika, in the nonaccruals in the quarter was just due to a policy change. We grew more conservative on our nonaccrual recognition. We moved from 180 days to 150 days, so that accounted for the addition there. And otherwise, we view the portfolio as pretty stable.

Stephen Steinour

We announced that policy change last quarter, Erika. So it's recent.

Operator

Your next question comes from Craig Siegenthaler from Credit Suisse.

Craig Siegenthaler - Crédit Suisse AG

It's Craig Siegenthaler from Credit Suisse. I do have one left, and I appreciate the outlooks on the C&I and auto segments. However, I'm wondering if you can provide us some help or some expectation for loan growth in both the home equity and the residential mortgage portfolios?

Daniel Neumeyer

I would assume some very modest growth in those categories, and then we would expect to see over the next several quarters continued decline from the commercial real estate book. So those would be the only categories that we didn't comment specifically.

Craig Siegenthaler - Crédit Suisse AG

And on the residential mortgage, with that new growth coming in, what's the composition there from conforming mortgages?

Daniel Neumeyer

Most of all, we keep on our balance sheet are either adjustable rate mortgages or some of our private banking type of mortgages. And so I would say the private banking, they typically wouldn't be the ones you would sell to Fannie or Freddie because they tend to be in the jumbo category. But our ARMs, generally, are underwritten with similar underwriting standards to what we have with conforming loans.

Operator

Your next question comes from Bob Patten from Morgan Keegan.

Robert Patten - Morgan Keegan & Company, Inc.

Steve, big picture question. I'm wondering, following up Paul's sort of question on pricing. Obviously, it's aggressive. If you look back at any cycle back to the '80s, it's never been this aggressive coming out of a credit cycle, but there's no demand. Do you think if we go forward a couple of quarters and the economy slowly gets better, with the pressure on ROEs for the larger banks, do you think this pricing is going to stabilize and start to normalize?

Stephen Steinour

Great question. I do think it will in part because I think what is happening is a combination of events will come together. First of all, we don't have size ratios in the U.S. yet. At some point, we have to get those. The higher capital charges for the larger banks, I think, will cause a rationing allocation that will go even beyond where it is today. And so to the extent pricing continues to heat a bit in some of these markets, I think it may cause a redistribution or reallocation. It's not clear to me that some other, the very large banks, in fact, won't try to manage their balance sheet size differently. So I don't think there's going to be some kind of sea change that reverts to a norm. I think it's going to be more challenging in the future, but the rate of pricing competitiveness may abate it.

Operator

[Operator Instructions] Your next question comes from Scott Siefers from Sandler O'Neill.

Scott Siefers - Sandler O’Neill

You guys have started to give some pretty good color on the consumer household revenues and stuff like that over the past couple of quarters, which I appreciate. I was wondering if you can talk about maybe household profitability, how you're looking at that. And I guess just as I look at things, the household acquisition has been very, very strong over the last several quarters, basically since you changed the strategy last year. But I think on a per household basis, the revenues are still below where they were prior even though that metrics been improving. Is there a point where you kind of targeted that to be sort of accretive relative to where you were before? Or what point do you think the change of strategy will be overall positive from a profitability standpoint?

Donald Kimble

Scott, this is Don. If we would look at here, you're right. The revenues per household is probably down slightly compared to where it was a year ago. But you got to take in consideration the Reg E and other initiatives cost us probably 8% of that revenue base. And so those were areas that were outside of our initial control. We could have gone through and charge additional fees to our customers. But we feel that the strategy we've taken on is going to be better for us in the long run. And then we think that you're seeing that flow through in a way that our low-cost demand deposit accounts are growing. Noninterest-bearing demand deposit is up 26% on an annualized basis this past quarter. Also, we consider the household growth that we're picking up. There really is a very small incremental cost to bringing that household. And so we think that the profitability is going to be maintained and retained in appropriate level. And the core piece here too is that we want to use the household relationship as a start point, so we can deepen that relationship and crossover that customer and get additional services that will differentiate us compared to where our competition may be seeing. So we're very pleased with where we are. It's still early in the process, and we think that we'll have more to come as we continue to move it forward.

Stephen Steinour

And then Scott, fundamentally, we've taken approach to try and take advantage of the cycle, notwithstanding the complications of regulation and other things and that attitude is not going to change. So irrespective of the Durbin impact and setback that's going to provide to household profitability, we've taken a longer view and it starts with market share and share of wallet. And we'll keep coming back to that.

Scott Siefers - Sandler O’Neill

That's helpful. And then Don, I wanted to follow up on the comment you made about kind of incremental cost for new customers. Are you able to say kind of roughly where you are in the process of the overall investment in the new strategy, kind of sixth, seventh, eight inning, et cetera?

Donald Kimble

I don't know that I'd ever want to define our game as anything past about the third inning. We're always looking at a way that we can improve and enhance and deepen that relationship with the customer. But each one of these are staged as part of the development.

Stephen Steinour

We rolled our the 24-Hour Grace. We rolled out Asterisk-Free. We made enhancements here recently to system mobile and some of the electronic channels that we have available to us. And so if we ever start to get past seventh or eight inning, I think that you can have a problem and then start to force us to go into a new game. So I would just say that we're always innovating and creating new solutions here.

Operator

Your next question comes from Jack Micenko from SIG.

Jack Micenko - Susquehanna Financial Group, LLLP

Maybe one for Dan, just sort of a broader credit question. Looking at -- relative to NIM as we look at NPA ratios, charge-off ratios, maybe a little bit better than peers; reserve ratio, a little bit higher than peers. And obviously, you've been releasing back since 1Q '10. And you're not privy to other credit meetings of your competitors, but just thinking through, is there any reason your reserve is a little healthier and your reserve improvement or your declining reserve ratios is a little slower? Any specifics there? Any thoughts on to why that is?

Daniel Neumeyer

Conservative management. There's a lot of volatility. It's seems like we go through multiple cycles last year and we're in one this year. We changed fundamentally over a couple of quarters. We intend to stay on the conservative side of the spectrum.

Operator

I have no further questions at this time. Mr. Gould, I'll turn the call back over to you for closing remarks.

Jay Gould

Thank you very much, everybody. Thanks for participating in this quarter's call. If you have other questions, you can always follow up Todd or I and we'll be happy to answer your questions.

Thank you again. We'll see you next quarter.

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