Fifth Third Bancorp Q2 2007 Earnings Call Transcript

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Wall Street Breakfast

Fifth Third Bancorp (NASDAQ:FITB)

Q2 2007 Earnings call

July 19, 2007, 8:30 AM ET


Jeff Richardson - Sr. VP and Director, IR

Kevin T. Kabat - President and CEO

Christopher G. Marshall - EVP and CFO


Michael Mayo - Deutsche Bank Securities

Brent Erensel - Portales Partners Inc.

John McDonald - Banc of America Securities



Good morning. My name is Dushanka and I will be your conference operator today. At this time, I would like to welcome everyone to the Fifth Third Second Quarter 2007 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you.

Jeff Richardson, Director of Investor Relations of Fifth Third, you may begin.

Jeff Richardson - Senior Vice President and Director, Investor Relations

Hello and thanks for joining us this morning. We will be talking with you this morning about our second quarter 2007 results, as well our outlook for the remainder of 2007.

As a result, this call contains certain forward-looking statements about Fifth Third Bancorp, pertaining to our financial condition, results of operations, plans and objectives. These statements involve certain risks and uncertainties. There are a number of factors that could cause results to differ materially from historical performance, in these statements. Fifth Third undertakes no obligation to update this... these statements after the date of this call.

Now I'm joined here in with by Kevin Kabat, our President and Chief Executive Officer; and Chris Marshall, our CFO. During the question-and-answer period, please provide your name and that of your firm to the operator. And with that, I will turn the call oven to Kevin Kabat. Kevin?

Kevin T. Kabat - President and Chief Executive Officer

Thanks, Jeff. Good morning and thanks for joining us. I have a few comments and then I will turn it over to Chris, who will review our balance sheet, revenue and expense trends, and also talk about our outlook for 2007.

First of all, we posted a good quarter, especially in this tough operating environment. We showed a strong revenue and net income growth, and expenses were well controlled. So there is a lot to feel positive about in our operating results during the quarter. I will let Chris walk through our reported results, so let me focus on our lines of business.

In our payments business, as you probably know, we landed the U.S. Treasury Account several quarters ago, and we brought about half of the relationship on line in the later part of this quarter. We expect the remainder to come on over the next 6 to 12 months. Additionally, we signed Walgreens credit card processing business a couple of weeks ago, and we expect that to convert to our systems in the second half of third quarter. As you know, Walgreens is one the largest retailers in the country, and we now process for most of the large pharmacy chains in the U.S. I continue to feel very good about this business, and I expect to maintain our strong mid-teens growth rate here.

The credit card business is one of our main strategic initiatives. We continue to see great results in terms of credit card account originations, which were up about 50% versus a year ago, and balances were up 22% sequentially and 57% versus a year ago. In commercial, our C&I growth remained solid at 6% over last year. This was mitigated by an absence of growth in our commercial real estate lending, which reflects both our appetite as well as softening demand. Corporate banking fees were very strong, as we continue to see increased capital markets produced sales, particularly in costumer derivatives activities and loan syndications.

Our investment advisors business turned in a record quarter, and as you'll recall, last quarter we were able to complete and file tax returns earlier than in previous years. This moved a few millions in fees into the first quarter, we would have normally realized in the second quarter. Brokerage results were very strong with fees up 11% sequentially. We've talked about improving the quality and productivity of our brokers, and we're beginning to see the results from our strategies and new management here. And of course, stronger equity markets have helped across all of IA [Investment Advisors].

In retail banking, we saw a strong bounce back in deposit service charges. Retail DDA production and balance growth remained very solid in a very tough environment. Pricing remains fairly rational in our markets, and we continue to see the benefit in deposit pricing of our Everyday Great Rates deposit strategy, as Chris will discuss. We feel very good about our de novo activity. We added six net new branches during the quarter and remain on-track to add a net 45 to 50 branches to our network in 2007.

Our consumer lending business saw better results than we expected, coming into the quarter. Mortgage originations were strong, so margins narrowed on loans we sold. As you know, the volatility of the first quarter made predicting second quarter activity fairly difficult, we're pretty happy with where we ended up. We also saw a continued growth and solid spreads in the auto business.

Let me turn to credit. Charge-offs came in at 55 bps and NPAs were up 7%, both largely in line with our expectation. Clearly these levels are elevated from last year and we expect credit issues to remain on the front burner for a while. In Midwest, where economic conditions are weak and Florida, which is enjoying solid economic growth, are both working through some commercial and real... and residential real estate issues. That said, credit remains manageable; we have the controls, processes and staff in place to manage through the cycle. Chris will talk more about over looking for rest of the year in few minutes. But generally our expectations haven't changed. And just because we are prepared for this, doesn't make it easier on our customers. We are experiencing very tough times here in the Hartland. I know when you look at national economic statistics; the U.S. economy is still strong. The significance parts of the Midwest had been in recession-like conditions for several years. This particularly applies to the Eastern Michigan and Northern parts of Ohio and Indiana, where the domestic auto belt is centered. We don't expect to rebound in a quarter or two, but we do expect things to turn around. And we remain committed to doing everything we reasonably can, to help our customers through this, as our business.

The last thing I'd mention is that we are feeling good at this point about our acquisitions of R-G Crown Bank, down in Florida. We announced this transaction in May, and we are still targeting the closing, sometimes in the fourth quarter. It's early, but so far integration activities are proceeding as planned, and we found nothing thus far as the negative surprise. With that, I will turn things over to Chris to talk about second quarter results, and the 2007 outlook. Chris.

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Thanks Kevin and good morning everyone. Well first I'd agree with Kevin that our financial results were pretty good for the second quarter. I am going to go through the details of the income statement in the balance sheet, then we will wrap up with our updated outlook for the full year. But first, let me just take a second here and summarize our EPS.

As you have seen, our earnings per share were $0.69. That included $0.02 of benefit from the sale of single products, credit card accounts. All the accounts we sold were single product relationships here, because we were unable to effectively cross-sell them all because of natural customer attrition. Now as we've said before, strategically we are focused on building our credit card business by growing multi-product relationships through our retail distribution network. Those accounts as you know are cheaper to originate, intend to be more profitable and have a significantly lower risk. In fact that the portfolio that we just sold has a charge-off rate of more than double, our overall average charge-off rate.

So given that strategy, you can expect us to continually sell these kinds of accounts going forward as they develop due to normal attrition, although estimating potential volumes will be very, very difficult for us. And offsetting that $0.02 was a penny of one-time cost associated with the expense initiatives I discussed with you last quarter. I am going to say a little bit more about expenses in a minute. But in general, I am very pleased with the progress we have made. By comparison, we had $0.65 of EPS last quarter and $0.69 in the second quarter, a year ago. If you remember, that last year's results included a $0.02 net gain associated with sale of MasterCard shares.

Alright, let me move on now to revenue; starting with net interest income. NI was up $3 million from last quarter, which is flat on a percentage basis. Earnings in assets were up slightly about a 1%, but NIM [net interest margin] was down 7 basis points to 3.37%, which was right in line with our forecast. NI growth was driven by consumer deposit production and modest reductions in consumer deposit rates, as well as some loan growth in the additional day count... I mean the additional day in the quarter. These benefits were offset by the impact of the first quarter issuance of trust preferred securities, as well as our share repurchase activity during the first and second quarters. And as I just mentioned, the net interest margin was down 7 bps sequentially, and as I told you last quarter, we expected the margin to be down 6 basis points due to the full impact of our March hybrid issuance and share repurchases, as well the effective day count. The additional basis point was due to share repurchases that were higher in the quarter than we've forecasted in April. Other than that, there was no significant change in the margin.

I'll turn you to the balance sheet, starting with loans; I'll categorize loan growth as pretty solid. It's up 2% sequentially and 5% year-over-year. It would have been 6%, if we had excluded the run-off of our consumer lease portfolio. Obviously, our growth has slowed, particularly in commercial and residential real estate sectors, as I am sure you all will have expected. Breaking things now a little bit; average commercial loans grew 2% sequentially and 5% versus the second quarter. C&I loans were up 3% sequentially and 6% comparable to last year. And commercial mortgage loans were up about $500 million, and that just reflects the permitting [ph] out of construction loans, which were down by just about the same amount.

Overall, given the state of the economy and specifically the difficulties that Kevin just mentioned in certain parts of the Midwest, as well as just general credit conditions, we feel pretty good about our loan results. Growth is slower than we expected at the beginning of the year. But given the realities of the market, I am pretty comfortable with how we have been performing.

Average consumer loans were up 1% sequentially and 6% year-over-year, or 2% sequentially and 8% excluding the lease run-off. We continue to see strong growth in auto loans, which were up 3% sequentially and as Kevin just mentioned, credit card balance growth was also very strong. It was 22% sequentially and 57% year-over-year. As I am sure you remember the credit card growth initiative, was just kicked-off in January. So we have got a long way to go with it. But our results today have clearly exceeded our expectations and really, due to the successful deployment of point-of-sale technology that lets us efficiently sell cards to our existing customers, when they are in their branches conducting transactions. We are just beginning to leverage that same technology in our call centers. We are in the process of training our call center staff to effectively sell cards, proactively when customers call in with service issues. So we expect more upside there. And then finally we are in the process of enhancing the technology, so that it's going to wok really effectively through our online bank channel and we will be rolling out upgrades to that channel very, very soon.

And offsetting those strong results to some extent was residential lending, particularly in the home equity area. As you know, these loans are largely time-based, and with higher rates borrowers returning half to traditional fixed rate mortgages. Our mortgage business obviously benefits from that, but that shows up as mortgage banking fee income and standalone balances.

Moving on to deposits; average core deposits were up 2% annualized from the first quarter, and up 1% from a year ago. We saw continued good retail core deposit growth offset by modestly lower commercial balances, which I am going to elaborate on in just a second. Retail core deposit growth was about 2%. Increases in savings, demand in money market balances more than offsetting our modest declines in interest checking and retail CD. Now that's exactly the makeshift we've been targeting and that we have discussed with you in the past, specifically last quarter. In general, we continue to see good consumer DDA momentum. Retail DDA balances were up 2%, which I feel really good about given the normal seasonality of customer tax payments in the second quarter.

On the commercial side, our core deposits were down about 3% sequentially and about 7% from a year ago. Now our reported core deposits don't include about 1.4 billion in Eurodollar sweep balances, which a number of our peers do include. While these are classified as foreign deposits on our balance sheet, and if we were to include those, commercial core deposits would have been pretty much flat from last year. And now it's important to consider those Euro sweep balances, I mean they have got real value to us. We pay about 16 basis points higher rate on them in money markets, but we avoid collateral costs and FDIC insurance costs. So the economic benefit to us is really the same as money market balances. We are obviously not doing ourselves any favor in the way we have been reporting these balances and we are going to take a little bit closer look at the classification and decide, whether or not we should change that going forward. We see most of the money coming into those Euro sweeps, coming out of commercial money market balances and as you can see those are down $650 million from a year ago.

Now overall commercial DDAs remain a little soft. They are down about 0.5% from last quarter. We have got more opportunity here. We have got a lot of focused effort. But we really need to pick up the pace in the third quarter and I expect we will.

Now looking at some of our reported deposit line items; and the second quarter is a traditionally weak one from an IBT standpoint, as customers have historically used these balances to pay their taxes. Our interest checking balances declined 3% sequentially, and were down 12 % from a year ago. But most of that drop happened last year. We are still seeing some shift from IBT to other higher rate paying products, but it continues to slow and I consider this to be largely stabilized at this point.

Our savings balances grew 7% sequentially, and they are up 21% from a year ago. And as we have told you in the past, we try to price this product so that rates are attractive enough to draw some natural CD investors, and that strategy seems to be working very well. Retail CDs were up 3% year-over-year, but down 3% sequentially, in line with our plans and our expectations.

If you look it as a whole, our weighted average rate paid for interest-bearing core deposits was 3.39% down from 3.43% in the first quarter. As Kevin said, we continue the price deposits in line with our Everyday Great Rates strategy which is, as you know, is designed to find the point for each product with a customer value proposition strong, but that will really optimizing the trade off between volume and rates. And that seems to be working very well for us.

So, moving on to non-interest income; the trends were very good for the second quarter really in every category. Our payments processing results continue to be outstanding, processing fees were up 8% sequentially and 15% from a year ago, quite in line with the expectations. Sequential growth was driven by the comparison to the seasonally weak first quarter we've talked about on our last call, as well as the impact from the U.S. Treasury business that Kevin just mentioned.

Looking at the payments business in a little bit more detail; merchant revenue is about half of our processing business, and it was up 12% sequentially and 19% from a year ago. This business is doing exceptionally well and we expect that to continue in light of the Walgreens win we just mentioned, as well as several other large merchants that are now in the process of converting. The U.S. Treasury business is going to come on... come online over the next... in the course of the next 12 months. And as Kevin mentioned, about half of that converted in the second quarter. And we think we have got a real advantage right now in our merchant space. We got arguably the best platform in the industry; we process for some of the largest... many of the largest merchants in the country. And given the transition, several of our competitors are going through, we sell really well poised and are positioned to take... continue to take share here.

Our financial institutions revenue is about 30% of the business. And that was up 2% sequentially and 11% from a year ago. As you know, this is a volume-driven business and volumes were good this quarter. As we've mentioned, we'll continue to experience the margin compression in this space, as contracts continue to roll over. A bottom line, this is and will continue to be a very attractive business for us, despite that margin compression.

And then finally our card-related revenue, which represents a little less than a quarter of our business, was up 10% sequentially and 13% from a year ago. And that's driven by interchange among our loan credit and debit card customers. The debit interchanges are about two-thirds of our overall card fee revenue, while our credit card interchange has grown 43% from a year ago. So we are really seeing the impact of our card initiative here and we expect that to continue.

Now... let's see... let's look at deposit service charges. We are up really strong 13 % sequentially and 6% from a year ago, and that was obviously a welcome development for us, given the soft results, we've got about in last two quarters. Consumer service charges drove the increase of growing 23% sequentially and 11% year-over-year. Now this increase reflects the typical upswing we see from the seasonally weak first quarter, as well as very solid retail DDA production. And at this point, you can now assume that we've fully recovered from the unusual weakness that we experienced just this past fourth quarter.

Commercial service charges grew 2% sequentially. They were down 1% year-over-year, which is largely reflecting the residual effect of the hedged rate hikes in the second quarter of 2006, as well as candidly the sluggish... relatively sluggish DDA growth we have over the last year.

Let's see, investment advisory revenue increased 2% sequentially and 1% versus a year ago. As Kevin mentioned, this was a record quarter for us, despite the $3 million in trust tax fees being earned earlier in the first quarter of year. Adjusting for the timing of those fees, IA revenue would have been up 8% sequentially, which was a bit better than we were expecting. In the private bank, which is about a third of IA revenue, fees were down 8% sequentially and 5% year-over-year, due to that same trust tax fee timing issue. Otherwise results would have been up 11% sequentially, 4% from a year ago.

Retail brokerage constitutes about 30% of our IA revenue. Our brokerage fees were up 11% sequentially and 6% versus last year. And then finally, institutional trust and mutual funds are each about 15% of the business, and here we solid 3% to 4% growth sequentially, a mid single-digits year-over-year growth. That was really just driven by the strong performance in the markets.

Corporate banking revenue was up 6% sequentially and 8% year-over-year basis. We continue to experience really strong growth in institutional sales, our costumer derivatives activity, as well as in our loan syndication activity. Our mortgage banking revenue rose $1 million in the first quarter. Now that's not much obviously. But as Kevin mentioned, we didn't have a lot of visibility in the mortgage banking revenue coming into the quarter. So we feel relatively satisfied with where we finished. Originations were very strong, the gains on sale margins were tighter. So gains on our sales and deliveries were flared... flat sequentially. Mortgage servicing revenue was up on our origination volume, and given the backup in the rates, we picked up about $3 million from the MSR valuation.

In last quarter, there were several questions about Alt-A production. So it's worth mentioning here that we successfully cleared our quarter end Alt-A warehouse in April, right at the pricing levels we were expecting. We now hold about 45 days of production, which is what we plan to hold in a steady state going forward. So there is really no story here in terms of Alt-A. And then finally, I want to mention given all the folks on are sub-prime, I want to remind you and I will probably keep reminding you for the next few quarters that we don't originate any sub-prime loans, and we don't have any intention to do that. And then finally, in other non-interest income, the variance there was... from last quarter was solely due to the $60 million gain on the sale of credit card receivables, that was $89 million of balances that I have already mentioned.

Alright, moving on to the expenses; I'd characterize our expenses as really well managed this quarter. Our reported expense growth is 1% sequentially and 6% compared to last year. But when you adjust for the $7 million in one-time costs from our expense reduction initiative this quarter, expenses were fairly flat sequentially and were up 5% versus last year which is exactly what we were looking for.

Now salaries, wages and incentives expense were up 6% sequentially including the severance expenses I just mentioned, which was about 2% of that increase. And other drivers there were the effect of our normal annual merit increases and stock awards, as well as higher revenue-based incentives in the quarter. Year-over-year growth was really well contained at 2%. Our benefits expense was down 19% sequentially, due almost entirely to the seasonally high FICA and unemployment expenses that I talked about with you last quarter.

The payments processing expense, I should mention that reflects FDPS [First Data Prepaid Services] and bankcard processing; was up 20% year-over-year. Now this expense line is obviously volume-driven and our TRAC, transaction activity is growing about 20%. But we expect growth in this line to be couple of percentage points higher in the next two quarters, due to the conversion of national merchants and the effect of product makeshift. Now our merchant acquiring business is our most processing expense-intensive business and it's also our largest and fastest growing payments business. So that's the main driver of the optical relationship you see here. Our merchant... our margins are stable and very attractive. So this isn't in anyway something to be concerned about, and looked at as a whole, our dollar growth in revenue year-over-year basis is almost double the growth in processing expenses.

As we mentioned in April, our expense growth overall which was at 8% was clearly higher than we were comfortable with in, but couldn't really be justified, given the revenue environment we were seeing develop for 2007. And as result of that, we undertook a very, very focused effort to identify areas where we could reduce expenses and the expense growth, without impacting in anyway revenue growth or customers service, or our ability to continue funding our growth initiatives. And we have largely completed those activities. And as result, we have reduced our work force by about 650 positions across the entirety of our franchise. And that reflects both the reduction of current positions, as well as open positions that we were due to fill over the remainder of the year. Breakdown there would have been about 400 and 250 in terms of future positions.

Now, we may see a little bit of further one-time expense in the third quarter, just lead over due to timing, but I don't expect that is going to be very significant. All those actions are going to reduce annualized expenses by about $45 million, which is what we had forecast $40 million to $50 million. We're going to end up right in the middle of that. About 80% of that will show up in the salaries line and the remainder in the benefits expense line. You are going to see that play out in lower expense growth than we would have seen otherwise, rather than lower absolute expenses in dollars, because as we have said we're going to continue to fund our growth initiatives throughout the business.

Now you are going to see in our outlook that we continue to expect mid-single digit expense growth for the year, in line with the expectations we shared with you in April. Payments, processing growth and de novo expense growth, two of our key value drivers, are going to continue to represent a disproportionate part of our expense growth. So we feel pretty good about expenses right now.

So if we move on to taxes; looking at our effective tax rate which was 28.1 that was a little bit lower than we were expecting, we feel good about that. Unfortunately, we're watching a legislative development right now and we know that it's signed by the governor. It's going to affect everyone doing business in the state, including us. And if there's no change in developments there, it's going to cost us a one-time of about $0.02 in the third quarter, and then ongoing the effect will be about half penny each year starting in 2008.

Now as you will see in our outlook, we expect our tax rate for the full year to be in the 28.5% to 29% range. And that outlook includes the effect of this Illinois legislative change, which we... at this point, we fully expect that it's going to happen. And I think you are going to be hearing more about this from other banks and big business is in that region, within that state.

Now turning to credit, starting with charges-offs; they were 55 basis points for the quarter, largely in line with our expectations, maybe a couple of basis points higher than we were forecasting in April. The charge-offs were up as expected, from a very low 39 basis points that, we saw in first quarter. And that puts us at 47 basis points year to-date and our full year outlook which you'll remember is booked for charge-offs to be in the low 50 basis points for the full year and that outlook remains completely unchanged.

I will talk a little more about that, but commercial net charge-offs were $47 million or 44 basis points versus a low of 27 basis points in the 1st quarter. And the sequential increase there was evenly spread between C&I and commercial real estate categories. Our C&I book is obviously a good bit larger than the real estate book. So we are feeling much more pressure on the real estate side. In terms of size, we have three charges-offs in the $4 million to $6 million range, which as you know are of early large for us, two of which were real estate related; one as a matter of fact was the $19 million Florida commercial developer, that I mentioned on the call last quarter. I think I'd mentioned or estimated that about the charge-off might be $6 million than it would have been $4 million. Then the remainder of our charge-offs were in the $2 million range and below.

During the quarter we sold $27 million in commercial NPAs, representing $3 million of losses. And as a comparison, we sold $39 million in NPAs at a loss of $5 million in last quarter. The consumer charge-offs were $55 million or 68 basis points versus 53, that's in the first quarter at an increase of $13 million. $10 million of that increase resulted from first quarter recoveries on the sale and charge-off loans that we discussed last quarter. But home equity losses were up $3 million and residential mortgage losses were up $2 million, largely due to a healthy market conditions in the Northern part of our franchise.

Let's see here; provision expense was up $121 million and exceeded net charge-offs by $90 million to increase the allowance ratio to 1:6. We'd expect to see provision continue with the charge-offs for the near future, as we reserve for our expected loan growth. And we expect to see continued growth in NPAs increase those assets as we continue to move through the cycle. And I'll talk a little bit more about that.

Alright, moving on to NPAs and delinquencies; NPAs were $500 million to $528 million or 70 basis points of loans, up 4 basis points from last quarter. This increased $34 million or 7% from the first quarter, which was right in line with what we were expecting. Consumer NPAs were up $22 million, and this was driven by continued growth in OREO, which increased just about $10 million primarily in Michigan, and also higher levels of repossessed autos which were up about $8 million. As we noted last quarter, we implemented an accelerated repossession cycle and that's resulting or has resulted in a higher level of repossessed autos that we hold in the inventory, that's been about 20% higher than typical. While obvious tightening in the credit policies has increased NPAs, we think it will reduce our losses, going forward. So it's the right thing for us to be doing at this point in the cycle.

Our commercial NPA is the kind of a $12 million of the NPA increase, and they were about evenly divided between the commercial mortgage and the commercial construction books, and was largely concentrated in Eastern Michigan. Just to note that we had four NPA inflows over $5million in the quarter and the largest one was about $9 million... $9.5 million.

The loans 90 days pass due we were up $59 million to $302 million. Our growth was a little higher than we were expecting, as partially due to timing. To give you a little more color here, about two-thirds of the delinquency growth was in commercial; again, largely in commercial real state and construction and from primarily at Michigan, as well as in South Florida. Our consumer delinquencies were also largely in residential real estate, about half of which, of those losses or those delinquencies were in the South Florida as well.

I'm going to talk about credit in terms of our outlook in just a second. But for now, I'd say that our credit... our outlook for credit losses and general credit trends are really haven't changed. We don't expect things to improve anytime soon, conditions are tough for everyone and they are particularly tough in certain parts of the Midwest. But we were expecting the environment to be tough, and we just need to continue to work through it, the way we have been.

Right, I am going to wrap up the balance sheet with capital. Our intangible equity ratio was 693, down 73 basis points. We're still very strong compared to our peers. The decrease here reflects the share repurchases of $693 million during the quarter, which is higher than we had forecasted last quarter. We would expect repurchases over the next couple of quarters to continue, driven by excess capital generation and just as a reference point, we generated about 10 bps in excess and PCE each quarter depending on assets growth.

Now, let me turn to the outlook for the full year. You will find that on page eight of the earnings release. We are going to continue to update this each quarter and you will see that we have highlighted the line items, where we have made an adjustment to the April outlook. And there have been a few tweaks here and there. But I don't think there is anything really significant overall with the exception of the tax legislation hit in the third quarter that I just mentioned. Now, first of all, we lowered our NII outlook from the mid... the high single-digits to mid single-digits and this reflects a couple of things. The shares repurchase activities and debt issuances are replacing free funding with the debt and that's obviously lowering NII and the offset is obviously in EPS.

We continue to expect some sluggishness in commercial loan growth. C&I growth remains good, but we see very little CRE demand and in this environment we feel that slower loan growth is a better option than for us to start chasing credits. Consumer growth has been running in the 6% to 8% range, and that field is sustainable for us. Although the shift to fixed rate mortgages, as I just mentioned, reduces our balance sheet growth compared with home equity. So as a result of those developments, we brought our loan growth forecast down to the mid single-digits from mid to high.

Core deposit growth is clearly not going to make it up to the mid single-digits. We are seeing good retail core deposit growth, but we have less visibility at this point for strengthening on the commercial side. We do have a lot of focused effort there particularly on DDAs as I mentioned. But for now, our outlook is low to mid single-digits for core deposits rather than mid. And again, this excludes the growth in our Eurodollar sweeps, which would add something like 2% to our full year core deposit growth rate, and put us back towards that mid single-digit range.

Now the net interest margin was lower than the first quarter as we expected. Now that we have two quarters in, I feel comfortable with a tighter range of 3.35 to 3.40 for the year. The full impact of our hybrid issuance and share repurchases as well as lower core deposit growth are pushing the margin into the lower half of the range we provided earlier in the year. At that point, we said the range was 3.35 to 3.45. Our underlying margin behavior is pretty stable. And I expect it to continue that way, though I would expect a carry through effect of second quarter share repurchases to reduce the margin a few more basis points in the third quarter.

Now, turning to non-interest income; overall no change to the fee outlook. The payments business continues to perform very, very well. And we still feel good about our mid-teens growth expectation there. We expect deposit service revenue growth in the mid to high single-digits, after the nice rebound we've talked about in the second quarter. Corporate banking revenue is expected to grow in the high single digits as the production from our capital markets activities is going to continue to provide a greater relative contribution. But there's still some uncertainty in the mortgage area. We expect originations to be consistent. The spreads have compressed some and we expect that to continue in the near term and we will have to see how that goes.

Our outlook for expense growth remains in the mid single-digits. We are at 7% year-to-date and I'd expect that the 5% growth we saw in the second quarter to be sort of the low end of the remaining quarters. We are probably going to end up in the 6% to 7% kind of range for the full year, depending on revenue performance. Almost half of that growth will be in processing and de novo expense growth. So, all in all, I think 6% to 7% is okay. I want to point out that we will incur about $7 million in pension settlement expense in the third quarter. As a reminder, we had $8 million in the third quarter of last of year.

Now net charge-offs were higher this quarter than in the first and that was completely expected. But we continue to expect charge-offs for the full year to be in the low 50 basis points area. So that suggests it will be somewhere in the mid 50s for the second half, compared with the 47 basis points we saw in the first half. Right now, we are pretty comfortable with our outlook. But we still expect NPAs and delinquencies to continue to trend upwards, and of course we may well see some volatility in charge-off and NPA trends from quarter-to-quarter. But otherwise we are comfortable with our outlook. Finally, we have reduced our effective tax rate outlook to 28.5% to 29% for the full year.

Alright at that point... at this point, I guess I want to wrap up, looking at time here. I hope you all agree that this was the... the quarter was pretty good in what continues to be a very tough environment for the industry. Our businesses are performing well and under the circumstances that we feel good about that. We are obviously very focused appropriately so on doing the right things to stay on top of credit, as well as on executing the strategic plans that we discussed with you earlier in the year. So I am going to stop here and thank you for your attention and we'd be happy to answer any questions you have.

Question And Answer


[Operator Instructions]. Your first question comes from the line of Mike Mayo with Deutsche Bank.

Michael Mayo - Deutsche Bank Securities

Good morning.

Kevin T. Kabat - President and Chief Executive Officer

Good morning.

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Good morning, Mike.

Michael Mayo - Deutsche Bank Securities

It's more than six months now with new leadership and I was just wondering any tweaks or evolution to the strategy overall, and if you can give us an update on merger appetite?

Kevin T. Kabat - President and Chief Executive Officer

Mike, it feels like six years, not six months. But again, I think in terms of our focus, we continue to really look at our focus on continued productivity improvements in terms of the strategy. The strategy feels good to us and we're getting good, as Chris and I mentioned in terms of the course of our comments, we think we're getting good traction in those initiatives. Again our focus has been on improving productivity and focus there. So...and that will be ongoing Mike. I don't know if we ever will ever stop from that standpoint. So you can expect us to continue to tweak both our models and our strategies as we go forward, continuing to expand and look for opportunities for improvement as we move down the pipe from that perspective.

Michael Mayo - Deutsche Bank Securities

And deals?

Kevin T. Kabat - President and Chief Executive Officer

In deals, yes. We continue to look aggressively in terms of the marketplace. Again we're staying... nothing has changed. Strategically though we discussed with you Mike in terms of, why don't we expand the footprint and some of the diversity, as well as opportunities that may exist within the footprint of taking our competitors. So, nothing's changed from our standpoint. Obviously pricing has continued to be a challenge, but we are always on a lookout though.

Michael Mayo - Deutsche Bank Securities

And then, you guided lower in the few line items there offset by the tax rate. So are you guiding lower for earnings overall or?

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Mike this is Chris. We feel... the lower guidance is really a reflection of what we've seen year-to-date in most those categories and maybe a little more of prudence in terms of commercial real estate growth, than we were expecting at the beginning of the year. Other than that, we feel pretty good about the guidance, we have given. In the terms of earnings, we are pretty comfortable.

Michael Mayo - Deutsche Bank Securities

On that last topic, the commercial real estate growth I guess, there is some banks who said they initiated new appraisals for Michigan and that makes them to more significantly increase or reverse the potential problem loans. Have you done any recent appraisal in that market or what's that process? Thanks.

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Yes, and that's a good question very timely for us. We just completed an extremely thorough review of our Michigan business and specifically went through loan by loan in certain areas like Detroit. We also had our... just went through regulatory review of the same portfolios and there were no adjustments there. So we feel good about... I think we are being very, very careful about those areas that we were very focused on, I mean that review, I feel good. We had an ongoing effort there, but the review that we just went through didn't result in any need to change any of our treatment of any of those portfolios.

Michael Mayo - Deutsche Bank Securities

Alright, Thank you.


[Operator instructions] Your next question comes from the line of Brent Erensel with Portales Partners.

Brent Erensel - Portales Partners Inc.

Good morning. Brent Erensel with Portales Partners.

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Goodmorning, Brent.

Brent Erensel - Portales Partners Inc.

I have got a question on the margin. You mentioned a lot times that the share repurchase is affecting the margin. But you seem to ignore the impact of the yield curve and the non-performing asset increase. Could you talk about those dynamics and the second question, unrelated... on the U.S. Treasury business; if you talk about the revenue metrics there and possible profit dynamics?

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Yes, Brent. Thanks for the question. Look, I am not sure what to say on the yield curve. It's tough for everybody. We don't expect big changes. So I am not sure how to respond to the question other than what is eagerly awaiting seems deepening, just like any other bank portfolio. With regard to NPAs, there is obviously growth in NPAs, more than $528 million. I guess to allay any, we are not any but some concern in that growth. I guess I'd say, of those NPAs 75% to 80% of them are a fully collateralized in terms of feedback by real estate or to some much smaller level orders, and a vast majority of that have been charged down, already charged down to what their fair market value is. So I think we are carrying them at the right amount and we don't expect there to be a significant hit to charge-offs as a result of that growth. I think that was the essence of your question.

Brent Erensel - Portales Partners Inc.

Actually, if I could follow up right there; margins were down 7 basis points and you said that most of that was due to the share repurchases. But I am wondering, when you have increase in NPA sometimes there are interest reversals. And I am wondering if that had any impact on the margin?

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

No I guess, what we were... the only thing I was thing trying to tell you in the margin was the difference in our expectations from last quarter. Most of the other stuff we had already expected and forecasted for.

Brent Erensel - Portales Partners Inc.

Great, okay that's helpful.

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

And then in terms of the... last part of your question had to do with U.S. Treasury business and I am sorry, Brent would you --

Brent Erensel - Portales Partners Inc.

Just, if you talk about the revenue and profitability?

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

Specific revenue... we couldn't, I am not sure we could provide that to you account by account. I apologize. It is a big account, but we can't break up the revenue from each one of those accounts.

Brent Erensel - Portales Partners Inc.

Fair enough, thank you.


The next question comes from the line of John McDonald with Banc of America Securities.

Kevin T. Kabat - President and Chief Executive Officer

Good morning John.

John McDonald - Banc of America Securities

Good morning guys. Because I think you kind of just answered the NPA question I had to ask. Your outlook there is just for some kind of modest increases in NPAs consistent with kind of what we saw this quarter, I guess?

Kevin T. Kabat - President and Chief Executive Officer

Yes. That's what I would say today. It is a little bit harder for us to predict NPAs and over 90s and that stuff does move around a little bit more... in a little bit more lumpy fashion in charge-offs but that's what we are predicting.

John McDonald - Banc of America Securities

Okay. And I know this is hard to predict as well. But any insight into kind of what charge-off range might look like over the cycle for you guys, you have been able to kind of have any insight on that, it sounds like pretty stable for the second half of the year, this year. But as we grow through the cycle any thoughts about what the range might be?

Christopher G. Marshall - Executive Vice President and Chief Financial Officer

No. I wouldn't forecast beyond that at this point. No, I can't elaborate on that at this point John.

John McDonald - Banc of America Securities

Okay. Okay. That's great. Thanks.

Christopher G. Marshall - Executive Vice President and Chief Financial Officer



[Operator Instructions]. At this time, there are no further questions. Mr. Richardson, are there any closing remarks?

Kevin T. Kabat - President and Chief Executive Officer

Yes I'll just... this is Kevin, I just wanted to take a moment to thank everybody for your attention this morning, and tell you that we feel good about the quarter, we feel good about the efforts that we're really approaching, the strategies that we're attacking and really doing well in a very tough environment. And we will keep our focus and keep working on the things that we think will add long-term value for the company. So we appreciate your attention, and have a great day. Thanks everybody.


Thank you. This concludes today's conference call. You may now disconnect.

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