National City Q2 2007 Earnings Call Transcript

| About: National City (NCC)
Wall Street Breakfast

National City Corp. (NCC)

Q2 2007 Earnings Call

July 26, 2007, 11:00 AM ET


Thomas A. Richlovsky - Treasurer

Jeffrey D. Kelly - Vice Chairman and CFO

James R. Bell, III - Chief Risk Officer

Peter E. Raskind - President and CEO

Jill Hennessey - IR

Daniel J. Frate - Retail Banking

Philip L. Rice - President and CEO, National City Bank




Ladies and gentlemen, thank you for standing by and welcome to the National City Second Quarter 2007 Earnings Conference Call. At this time, all lines are in a listen-only mode. [Operator Instructions]. As a reminder, today's call is being recorded.

At this time then, I'd like to turn the conference over to the Treasurer of National City Corporation, Mr. Tom Richlovsky. Please go ahead sir.

Thomas A. Richlovsky - Treasurer

Thank you. Good morning everyone. Welcome to National City Corporation's second quarter earnings conference call. We have several members of the management team on hand here this morning, including Peter Raskind, President and CEO; Jeffrey Kelly, Vice Chairman and CFO; Jim Bell, Chief Risk Officer; Dave Daberko, Chairman; and Jill Hennessey, Investor Relations Manager.

Jeff, Jim, and Peter will each have some remarks on the results and outlook, to be followed by a question-and-answer session, which for our usual practice will be conducted by e-mail. If you'd like to ask a question, simply send in an email at any time during this event to We will take as many questions as time permits.

Before we get started, let me remind you that the presentations and commentary that you are about hear contain forward-looking statements. Such statements are based on presently available information and reflect the managements' current expectations. We believe these statements to be reasonable but they are subject to numerous risk and uncertainties as described in our Form 10-K and in other filings with the Securities and Exchange Commission. As a consequence, actual outcomes could differ materially from the views expressed today.

We may elect to update forward-looking statements at some future point, however, we specifically disclaim any obligation to do so.

With that I'll turn the call over to Jeff Kelly.

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Thanks Tom, and good morning everyone. The second quarter results relative to the first quarter reflect good core loan and deposit growth, decent credit quality and strong fee income, especially in the retail bank.

We also saw a modest improvement in the mortgage related businesses, less volatility in the performance of the sub-prime runoff portfolio, and from an earnings per share perspective, the benefits of a much lower share count. However, the net interest margin came in lower than we had been expecting and this aspect of our results was somewhat disappointing, so it's something I want to address right upfront in my comments.

From first quarter to second quarter, the margin dropped 10 basis points from $3.69 to $3.59. Looking at the components of margin as shown on page 13 of the supplement, you can see that the decline in non-interest bearing liabilities, or free funds, accounted for 7 basis points of that decline.

That portion of the decline was due in large parts to the reduction in shareholders' equity from share repurchases, and for the most part was accurately reflected in our internal forecast.

The other 3 basis points of the decline occurred in the spread between overall asset yields and liability rates, with asset yields up only 2 basis points while liability costs increased by 5 basis points.

The cost to liabilities was almost exactly what we have forecast, the shortfall has been an asset yield especially in commercial loans. For the last several months, we have been underestimating the degree of spread compression in the commercial book and therefore overestimating the yields in our forecasts. By way of example, the overall average loan spread in the regional corporate bank were 5 basis points below plan and 7 basis points less than the first quarter. Similarly, in the national businesses, average spreads were some 50 basis points under plan in the second quarter and 14 basis points below first quarter actual. Clearly, while we're growing the loan book we're facing intense competition for the available business there.

So, where does the margin go from here? In our first quarter conference call, we indicated that we expected the margin to be relatively stable in the second quarter and then expand slightly in the second half. That outlook was based on the belief that spreads in the corporate book would stabilize and that a more attractive funding mix would contribute to an expansion in the margin. The direction in the margin from here depends largely on the direction of spreads. Should loan spreads stabilize, we would expect a slight improvement in the margin in the third quarter, primarily from a larger free funds contribution.

On the other hand, there is no assurance that spreads have bottomed out in that book. So on balance, I would have to say that some further weakness in the net interest margin is a risk factor in the second half.

As I mentioned at the outset, mortgage banking results improved in the second quarter relative to the first quarter reflected in both the divisions that comprise this unit ... National City Mortgage and National Home Equity ... along with more favorable net MSR hedging results. While net MSR hedging costs reduced first quarter net income by about $32 million after tax, we recorded net hedging gains of about $6 million after tax for the second quarter despite net losses in April and May.

The increase in long term rates, and implied volatility in June, enhanced the value of the options positions in our hedges, basically the reverse of what had been hurting our hedge results in several of the previous months.

In addition, the value of the MSR benefited from several market-driven adjustments to our valuation model, primarily factors to account for slower rate of housing price appreciation.

Excluding MSR hedging, the mortgage company was also up on an operating basis. Volumes have picked up, the gain on sale margins have remained quite anemic. We've also been incurring costs associated with building a new loan origination system there.

With the mortgage market condition still unsettled, we would not expect to see any dramatic improvement in either, the mortgage company or home equity business in the near term. In fact, market conditions have gotten worse in July as buyers either stay on the sidelines or reject unusually large numbers of loans from pools put up for sale.

With respect to non-interest income and expense, there were no major unusual items during the quarter that I would call to your attention. On a fundamental basis, fee income was generally good led my continued strength in deposit service charges.

Non-interest expenses include about $20 million of merger integration costs, otherwise they were virtually flat with the year-ago quarter and reflect ongoing implementation of best-in-class programs, pretty much consistent with our original projections.

The last point I would make, would be around the balance sheet and our capital position. With our remaining indirect home equity and sub-prime mortgage portfolios in run-off mode, we are in the final phase of the transition to a business model, oriented largely to direct businesses with a smaller, more efficient balance sheet. With a smaller balance sheet and a lower risk profile, the economic capital requirements lower, and thus we lowered our tangible equity target range earlier this year.

While we were significantly overcapitalized at the beginning of this year, the return of some $3.2 billion of capital to shareholders in the first half from share repurchases has moved us to around the middle of our target range. In all likelihood, we will be out of the market for most or all of the third quarter due to restrictions associated with the MAF acquisition process, and in the mean time the tangible equity ratio will begin to move back up.

When the acquisition restrictions are lifted, we will again reassess our capital position and I would think we'd be back in the market relatively quickly with our stock at these levels.

With that I'll turn things over to Jim Bell to discuss credit. Jim?

James R. Bell, III - Chief Risk Officer

Thanks Jeff, and good morning all. I describe the first quarter's results, from a credit standpoint, as complex and interesting. I think the second quarter results are better described the straight forward, routine, and solid. You may consider them to be stronger than that.

In our footprint commercial and retail banking businesses, loses declined from the first quarter to the second and the outlook remained stable. In the run-off portfolios from National Home Equity and non-prime, gross loss development moderated during the quarter, and we also came nearer to agreement relative to claims payment with one of our mortgage insurers. The combined effect of those positive developments was a reduction in residential real estate loss during the quarter.

I will speak more on the outlook for those portfolios in a moment.

Turning to the core continuing commercial and retail businesses, which are principally footprint businesses, credit quality results were quite steady during the quarter. I want to preface my remarks here with a couple of comments about the Midwestern economy. While there is no commonly accepted definition of what constitutes a regional recession, it is clear that Michigan has suffered from falling employment for the last couple of years and also, at least, for the fifth Philadelphia fab index of coincident economic activity, year-over-year decreases in overall economic output.

It is fair to say that Michigan is probably in a state of regional recession, or recession-like performance. The balance of our Midwestern market, however, shows generally positive growth albeit at lower levels than the national economy as a whole. In short, the Midwest economy is not melting down nor is it broadly driving loan losses; certainly not in our businesses.

On the commercial side: the combined commercial, commercial real estate; commercial real estate construction losses for the quarter totaled on $20 million or about 15 basis points on an annualized basis. Non-performing loan levels were essentially flat with the very low levels of recent quarters with the exception of the addition of a single $20 million commercial real estate credit; credits unusual enough to merit further description.

That credit is a very seasoned first mortgage in the Central Business District of one of our Midwestern markets, where National City is the master lessee. We have reviewed and determined that we will not renew our lease when it comes due in the latter half of next year. Accordingly, we have reevaluated the loan against that property, decided to move it to non-accrual and to provide reserves for it accordingly.

I hasten to add, we have no similar Central Business District office exposure in that market. I also note in passing that National City has no private equity bridge financing commitments or bridge loans outstanding.

We did add reserves for the commercial portfolios during the quarter, but that reflected the over $1 billion in growth in those portfolios during the quarter not a declining credit quality. Our internal credit metrics remain stable and strong.

Turning to the retail businesses, losses and delinquencies both showed improvement from the already excellent levels observed during the first quarter. And this was true across all our consumer credit types. The credit scores on our existing and new extensions of consumer credit remain stable. This business is operating at cyclical credit lows from a loss standpoint.

Wrapping up the review of our continuing business portfolios, I would like to spend a minute or two on the construction loan portfolio at National City Mortgage company. As I mentioned during last quarter's call, we added reserves for this portfolio during the first quarter to reflect that many of these properties were not destined to be the owners primary residence.

I will remind you that these are the only loans that we originate in National City Mortgage portfolio, they are there for a short time during the construction period and they are issued against a permanent mortgage financing and they go back out into the market.

At the same time as we made those provisions during the first quarter, we also launched a loan-by-loan review of the portfolio for potential problems. So, we can proactively work with the owners to resolve those situations. We defined a potential problem as a loan that was delinquent, a loan where the builder was in bankruptcy, and although we knew then and confirmed now that we have no concentrations by builder, a loan where the owner and the builder are known to be in litigation or a loan where there has been no construction draw during the past 90 days.

The only meaningful concentration of potential problem borrowers in the portfolio was in the State of Florida. That was only approximately a thousand loans. We have made individual contacts with each borrower to confirm their plans to resolve the situation. And on loans that we're delinquent or in default, we've suspended the ability to access the credit facility to make interest pays. This is exactly the right thing to do. They will minimize our overall loses, allow for the timely restructuring of the portfolio as well as provision for those loses, but it does increase the reported National City Mortgage company delinquency level and you see that reflected in the delinquency statistics within the supplement.

Moving on in the housing space to the run-off portfolios of National Home Equity in the non-prime mortgage portfolio, the quarter's activity is summarized on pages 28 and 29 of the supplement. NHE loans and lines reduced by $470 million during the quarter, charge-offs were modest. Average credit scores held steady in the 730 range and delinquency rates actually improved.

The portfolio eligibility standards for this portfolio were, as you may recall, very tight and origination for portfolio essentially ceased in 2005. So, it shouldn't be too surprising, this portfolio continues to perform well even during wind down stage.

The non-prime mortgage portfolio reduced by $800 million during the quarter. Dollar delinquencies improved modestly during the quarter and net charge-offs moderate, principally because of an improvement in claims payment performance by one of our LPMI providers. While that performance is improved, it is not yet at the level of our expectations nor does it match the level of our other provider. We have accordingly not adjusted the claims paying in assumptions embedded in our reserve analysis, although obviously we reflect the claims paid on a dollar-for-dollar basis in the current results.

If we continue to observe sustained performance we will revisit the reserve assumption in the next quarter.

Leaving aside the noise of the insurance, the performance of the underlying loans through the first two quarters has been somewhat better than our expectation. You should recall that at the end of last year, troubled by the development of greater than expected early delinquency on the 2005 vintage loans, we projected what the performance would be if the delinquency, the transition of delinquency severity, and ultimately, loss rates continue to accelerate and grow.

And we set our loss reserve accordingly. Thus far the rate of loss development in 2007 has been below our original expectation. We have not, however, changed our loss development rate assumptions for the reserve. We have adjusted the start point of each quarter to reflect our actual experience.

Right now, our best estimate is that net losses in the second half of the year would be approximately the same as those for the first half. However, if the next two quarters outperform, as have the last two or if our LPMI provider continues to provide, to improve their claims paying performance, that estimate could prove to be too conservative.

On the other hand, those of you who followed National City in the performance of the First Franklin loans, that we've elected to retain over the years, recall that loses and payoffs both peak around the second anniversary, when the bulk of the rates reset and the prepayment fee falls away on the underlying loan.

The sub portfolio that contains the most risk is the remaining $1.88 billion of second mortgages which were originated during the second half of 2005. If the borrowers underneath this portfolio performed as did our borrowers from the first half of 2005, then we will be pleased. This is, however, the greatest risk to our forecast, and I look forward to knowing, rather than projecting, this outcome.

My final comment this morning will concern that subset of MPA comprised of other real estate owned. Just for clarification, when a real estate loan secured loan is foreclosed upon, we estimate the value of the loan based upon an updated appraisal and the expected expense of disposing the property, and we take a net loss against the loan loss reserve for the difference between the value and the carrying value of a loan.

Any subsequent loss or gain rolls through the OREO expense or income accounts. On the bottom of page 21 in the supplement, we provide a roll forward of all of the OREO balances. It should be evident to you from this that this not a stagnant and growing pool of problems, and our OREO expense is a low and stable percentage of the loans resolved during the quarters. Of the non-prime loans from the former First Franklin portfolios comprised approximately 55% of our OREO, and are resolving at selling prices of roughly 85% to 90% of the original mortgage amount, which I again, I'll note in passing is just somewhat better than ahead of our prime foreclosures.

With that I'll close, and turn the microphone back over to Peter for a broader view of the quarter.

Peter E. Raskind - President and Chief Executive Officer

Thanks Jim, and good morning. Let me sat right upfront that our second quarter and first half results did not measure up to where we had expected and planned for them to be at the start of this year.

While a number of our core businesses are in fact doing very well, the overall results have not matched what we set out to achieve this year, particularly in the mortgage businesses. Stating the obvious, we're facing a difficult environment, a soft housing market, a tough interest rate climate, recession like conditions, in a portion of our footprint, an incredibly intense competition for a finite or in some cases shrinking pool of business.

Now I say these things not as an excuse but as a realistic assessment of the conditions we face. That said, the entire industry faces these same challenges, and further the environment is obviously uncontrollable from our perspective. So, our focus is on the things that we can control, namely, the configuration of the Company, it's strategic direction, and most importantly, day-to-day execution.

National City's configuration and strategic direction are largely in place and we've used the phrase focus, invest, and expand as a short-hand description. We focus the Company dawn to a set of well-defined core businesses that are primarily direct in nature, providing the opportunity to deepen customer relationships over time, and that our synergistic and integrated with each other.

We have and continue to invest heavily in these businesses in every sense of the term with the goal of being the absolute best in each, to the end we're expanding selectively in both existing as well as new markets. The task in front of us, now, as I see it is to execute crisply to drive the most value in each business line. In some cases that means maintaining the momentum that's already there. I would put retail banking, and more recently, personal wealth management in that category.

Both businesses are having excellent years winning new business and we think generally outperforming the competition. In others, it means specifying a detailed roadmap which will assure a high level of competitiveness in the future. I would put our corporate banking and mortgage businesses in that latter category.

Now, obviously we can't single-handedly improve market spreads or change the business climate in our region, but at the same time our best-in-class research shows that we have room for further ... to further improve our sales management, relationship management processes and product capabilities, we will.

Execution in new markets is also of critical importance, our second Florida acquisition, Fidelity Federal, was successfully converted and integrated in April, and now our entire footprint is on the same set of systems with all product offerings available through all distribution channels. That includes the rollout of our industry-leading points from National City Rewards Program, which is completely new and unique in that marketplace.

Now, the real work begins. It will take some time, measured in years, to properly evaluate the success of these transactions. In the near-term, the Florida real-estate climate is, as you might expect, a headwind for us with loan growth lagging our initial plan. The MAF acquisition, which will greatly enhance our Chicago presence, as well as provide an initial entrée into Milwaukee is proceeding toward legal close as soon as this September with conversions to follow either late this year or early next.

To sum up, which the first half of this year has been more difficult then we expected, we firmly believe that this company is strategically in a much better place then it was one year ago. We've got a more attractive footprint, a lower risk profile and a better business mix. We're acutely aware of where we've fallen short of expectations and of the risks and challenges we face. National City harbors much more performance potential than we've been displaying in the recent past and we're working hard to convert that potential to clear results. And along the way we pledge to be very candid and forthright as we keep you apprised of our progress.

And with that let's move to the question-and-answer session.

Question And Answer

Jill Hennessey - Investor Relations

Jeff, I'll begin with you. Can you please discuss your philosophy regarding the level of share repurchases going forward, why not strengthen your balance sheet and erase your dividend more meaningfully instead of continuing the philosophy of stock price support?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Thanks Jill. Well let me state right upfront that we don't execute share repurchase for the purpose of supporting our share price. Our philosophy regarding share repurchase is that it is just one tool in the management of our capital position. I would say we've always attempted to balance our distribution of excess capital between share repurchases and dividend. Historically, we've embraced 45% payout ratio, and over the last several years, it's actually been a bit higher than that. We have also embraced a capital management philosophy, that like any other resource that shareholders give us, we should always seek to minimize the amount of capital leap we utilize. As a result, we try always to stay as close to our targets as is possible while still providing for the growth in our businesses.

I would say that our capital position this year, particularly earlier in the year, was highly unusual, in that, not only had we reduced our balance sheet risk for our originate-and-self model but we also significantly increased capital and reduce risk with the sale of First Franklin. At that time, we felt we had no use for the roughly $3 billion of worth of excess capital, so we made the decision to return it as expeditiously as possible. The result of the tender offer and the subsequent share repurchase activity got us to our capital targets and as a result we haven't executed any further share repurchases.

I would also say that share price is only a consideration in our decision whether to return excess capital via share repurchases or dividends. We thought the price of our stock were too high, we have to think about returning it via dividends rather than share repurchase.

As I said in my comments earlier, we are out of the market now due to restrictions related to the acquisition of MAF, when those restrictions are lifted we will again revisit our capital position and make whatever adjustments are necessary there to get back to our targets. As I said, I suspect, if our share price is anywhere near these levels, we adopt for further share repurchases as we believe that would certainly be an appropriate investment for our shareholders.

Jill Hennessey - Investor Relations

Can you remind us of the capital ratio target?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Sure our capital ratio targets are for the tangible common equity ratio are from 5% to 6%. At the end of June, we're roughly in the middle of that range and for our Tier 1 ratio in the 6.5% to 7% range.

Jill Hennessey - Investor Relations

If National City's stock price stays at its current level, Jeff, how many shares will National City have to issue to complete the MAF acquisition, and how does that figure compared to the original amount of shares you assumed that you would issue when you announced the deal. And lastly, by how much, does the extra shares, reduce your original IRR calculation on the MAF deal?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Okay. The original expectation in terms of shares to be issued to the MAF acquisition was 50 million shares. And at roughly $30 a share, we have to issue about 64 million shares. As it relates to IRR, share price, or the number of shares we issue doesn't impact the IRR at all, although it obviously will impact going forward the dilution or ... accretion or dilution of the deal.

Jill Hennessey - Investor Relations

Turning to, Jim. How much of your increase in recoveries from the prior quarter was due to payment of previously disputed reinsurance claims related to First Franklin? And please update the status on other previously disputed claims?

James R. Bell, III - Chief Risk Officer

Sum net insure during the second quarter we received $14 million in claims, and obviously in turn we also have $7 million of our own reinsurance expense associated with that. Claims payment thus far in the third quarter has been much more regular but it is not sufficiently sustained at this point that I want to make any projections on it.

Jill Hennessey - Investor Relations

And with regard to the 90 day past due loans, they have increased in commercial construction, commercial real estate, and National City Mortgage. How much have you increased your reserves, already, for this increase, and is there more reserve still to come?

James R. Bell, III - Chief Risk Officer

We take those as two separate categories one for the mortgage company, National City Mortgage, which I described previously, and the other for the commercial elements of construction and commercial real estate. We added $15 million to $20 million of reserves against the commercial portfolio during the quarter, based on the loss content inherent in our evaluation of each of those loans and the remaining portfolio performing loans. That is our best estimate of the current trajectory of all of those loans today. Obviously, that is subject to movement up or down as future facts play out. On the National City Mortgage company, consumer portfolio, consumer construction loans that was on the close order of $5 million of incremental reserve during the quarter.

Jill Hennessey - Investor Relations

And with regard to the CNI book, how large is your shared national credit book today and one year ago?

James R. Bell, III - Chief Risk Officer

CNI book ... our shared national credit book would approximate $10 billion, now that would be ... there will be commitments, just the normal measure there. About four of that is within our levered businesses and about six of it is within our footprint, both, deals we leave ... lead and deals that we participate investment grade companies in the footprint that happen to meet the slick definition. That aggregate total is down somewhat from a year ago, principally in the leverage book as we found less favorable opportunities to extend credit, but that would be a single-digit percentage decrease year-over-year.

Jill Hennessey - Investor Relations

How much of the drop in CNI yield is due to new past dues interest accrual reversal and are there any other explanations for the drop?

James R. Bell, III - Chief Risk Officer

If you look at the NPAs, you'd see it will be mathematically impossible for that to have a meaningful effect, there's really no impact on the yield from that. So, it also explains the drop, it's a very competitive market out there particularly for credits that fit within the National City's credit parameters. We grew almost 3% quarter-to-quarter in the commercial books. The new volume was coming on at lower volumes than the existing volumes, there is also pressure to sustain the existing names and we will match that ... we will match that market on pricing.

Jill Hennessey - Investor Relations

Thank you, Jim. A question for Tom. Valuations of certain Florida banking franchises have decreased 35% to 45% this year, should National City investors expect a goodwill right down associated with your two Florida purchases based on what is happening in the Florida market. If not, why?

Thomas A. Richlovsky - Treasurer

I'd say, categorically, the answer to that question is "no." And there is two reasons for that, one, sort of the accounting reason is that we measure impairment at the business segment level or one level below business segment, not with Florida as a separate entity. The economic reason would relate to the underlying cash flows and profitability of the franchise which don't even remotely approach the point at which we would need to consider an impairment.

Jill Hennessey - Investor Relations

Another question for you, Tom, what is the $25 million disallowed valuation adjustment that ran through the loan sale revenue line item. It has been running at a rate of less than $1 million per quarter over the last eight quarters and then spike in the second quarter of 2007?

Thomas A. Richlovsky - Treasurer

Well, I would just say that there is no such thing as a run rate for that item, because it's ... it is fundamentally a series of accounting timing differences that relate to the fact that we hedge the economic risk in loans held for sale. We actually hedge the economic risk of mortgage loans from the point of lock through the point of sale; we do that through a variety of derivatives. Under the accounting rules, the derivatives are fully marked to fair value constantly. Under the accounting rules, the loans are held either lower of cost or market or fair value, if the qualify under FAS 133. Frequently or from time-to-time, the accounting and the economics miss match, so there'll be a timing difference between when income is recognized and that's the fundamental reason and that's why it's not a run rate. If the questioner would like a more detailed explanation, feel free to give me a call or send me an e-mail, and we'll be happy to discuss it in even more agonizing level of detail.

Jill Hennessey - Investor Relations

Jeff, turning back to you. Can you provide more color on why gain on sale margins declined so much, linked quarter? It appears to fall more than peers, what is your outlook for Q3?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

I can't really comment on how it stacks up versus pierce. I'd say though when I am thinking about the mortgage market generally, I don't usually tend toward hyperbole but the secondary markets in the mortgage market really is in something of a meltdown right now. And I'd say that ... I get the sense from talking to our mortgage desk that most market participants are stepping, in many cases, completely out of the market until it stabilizes, so there is a just a tremendous lack of liquidity. My understanding is that there have been several failed auctions of prime first and second mortgages, where there are literally no buyers today for some of those products.

So, up to this point we have continued to sell in our home equity business, we have continued to sell into the market despite falling prices which is clearly impacted our gain on sale. At this point, we are pricing to sell at what we expect to be profitable levels when we can sell. But yesterday we too put a small portfolio of closed down seconds out for sale and really didn't have a bid. So, we will retain some of these loans and held-for-sale until we can conclude the secondary market can accommodate a sale, in which case we'd be probably likely to change that to a portfolio designation. But I think at this time, it's ... with the instability in the market it's probably foolish to guess when things will stabilize. So, I think gain on sale looking forward is going to continue to be anemic, as I said earlier in my comments. And it's hard to see right now when that's going to turn around.

Jill Hennessey - Investor Relations

Please discuss the loss reported on HELOC sales and your exposure to retain interest from home equity sales? And given the current market conditions what does that mean for the originate-and-sale model?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Well I think I've spoken to the latter part of the question already. I'd say there was a loss reported on some HELOC sales. And I ... when we look at the economics around a sale transaction, we look at it as a total rate of return. So, that would include the net interest income that we earn on the loans while they are in the warehouse. In this particular instance, the net interest income earned on those HELOCs while they were in the warehouse more than offset the decline in gain on sale or the negative gain on sale, and actually hit our targets, at that time at least. As it relates to the question about retained interest, we don't do any securitizations. So, we don't have any residuals to value in that instance. I think if the question goes to more of a recourse question, particularly as it relates to home equity loans, I think given the extend of due diligence that we've seen by buyers in that market, we really haven't seen any need to increase our recourse reserves materially.

Jill Hennessey - Investor Relations

Jim, can you give us an update on the portfolio quality trends of the Florida Bank?

James R. Bell, III - Chief Risk Officer

Sure. The Florida Bank, in aggregate on the commercial side, would be roughly $1.5 billion in size, that is, principally real estate and small business related. The portfolio is fairly stable with what our estimate was. We estimated during the acquisition that someone grades will [ph] modestly more generous than we would provide ... hasn't been much movement in long grade, but now having our own Chief Credit Officer in place on the ground and having gone through in detail, confirmed our numbers. I would say that there's a little ... there is maybe $25 million to $30 million of MPAs in that portfolio, approximately 15% of the portfolio might be in our areas of additional management attention. Both of those would be on the order of half, again as high as, say, commercial real estate portfolio and the balance of the corporation, but no discernible ... no material deterioration in trend.

Jill Hennessey - Investor Relations

Based on your previous comments on construction lending, were not allowing further draws, how is the project finished, doesn't this just accelerate losses.

James R. Bell, III - Chief Risk Officer

I must not have been clear enough in my comments. Let me walk through, just a second, there is an interest reserve associated with each construction loan and if nothing is happening on the project than the interest reserve is being drawn down to pay the interest on the project. You can have a stalled project for a long time, not being recognized as a problem and it won't be non-accrual or otherwise dealt with until the interest reserve runs out. We have stopped the draws on the interest reserves in order to precipitate the discussions with clients about what their intent is with the project.

Projects stall for many reasons: people change their mind about building; they loose a builder and have to get someone else to complete the project. We will work with each of our borrowers in these situations individually; it's like 1,000 individual workouts. Or the borrower just decides well it's going to be a land loan I am going to hold on to it or it's going to be a land investment and they would pay off the loan, which is probably by far the most common single endpoint we've seen so far. But it precipitates the recognition of a problem, but we are not in here trying to cause losses.

Jill Hennessey - Investor Relations

Thank you, Jim. Peter, returning to you. Can you give us an update on the cost based status in Florida and also the de novo strategy?

Peter E. Raskind - President and Chief Executive Officer

Sure thanks. When we announced the two Florida transactions ... on the Harbor Federal transaction, I believe, we announced 15% cost saves and on Fidelity Federal 25% cost saves. At this point, as I said, both banks are fully integrated and converted to our systems. And we fully expect to achieve both costs save targets. And moving forward from here, we should be pretty much in a state where we are realizing those costs sales now, since we have completed the conversions.

With respect to de novo, we announced at the time of both transactions that we expected ... I think, between the two ... to contemplate something like 30 or so de novo branches to fill out that coastal footprint over the next several years. And at this stage our intent is to do exactly that. Now that will be very dependant on the availability of the right real estate. Our de novo philosophy has always been, and continues to be, that if can't find exactly the right real estate to site a de novo, we would prefer not to do it at all than to compromise with a grade B site.

Jill Hennessey - Investor Relations

Peter, second question for you. When should we expect to hear more about plans for appointment of a Chairman? And is the interpretation of NCC being open to an MOE reasonable?

Peter E. Raskind - President and Chief Executive Officer

Thanks for that question. As we announced earlier this week, Dave Daberko, will be serving as Chairman of the National City Board thorough the end of the year and then retiring from the Board and from National City. A couple of points, I would make about that. First, that process, and that structure, has been long planned by our Board as part of a very well planned and well crafted succession effort. I'd further add that that structure. The one that we have in place at this very moment is, I think, actually quite similar to a number of other banks who have had CEO transitions over the last couple of years. And finally, it would be, we think, extremely inappropriate governance to preordain who will be Chairman of the Board after Dave, that is the Board's decision to make at the appropriate time. So, my encouragement here would be not to over-interpret the structure. It is exactly what it appears to be on its face.

Jill Hennessey - Investor Relations

Thank you, Peter. I will direct this question to Dan Frate. With regards to deposit competition, rate seems to be picking up and growth slowing in non-escrow and non-interest bearing deposit. While deposit fees are up nicely and strong year-over-year. Are these results inline with your expectations?

Daniel J. Frate - Retail Banking

Yes, they are. The deposit growth year-over-year, organic growths year-over-year, is nearly 6%. The mix of that deposit growth has improved less in the way of CDs, more in the way of money market savings. That was our plan and expectation moving into 2007. So, those expectations are being realized. The year-over-year growth in fee come ... that's specifically overdraft, NSS income is tied completely to the increase in the number of the active accounts. The seasonal, linked-quarter increase that you see is seasonal. You've seen that over the last couple of years as well. And the year-over-year increase, as I said, is due to the increase in accounts, not due to an increase in price or in spin rate.

Jill Hennessey - Investor Relations

Thank you, Dan. Jeff, I will direct this question to you. Can you provide an update on the efficiency program, how far are we through the program? How much do the program impact second quarter results? And how many more quarters of incremental improvement do you anticipate?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Okay. Thanks Jill. Well in terms of how far through the program we are? The program when we set it out back in 2005 had goals, pretax net income improvement in '06, '07 and '08. In '06 we anticipated, and got, $160 million in improvement. I think we've consistently said, and still believe, we're on track to realize about $400 million worth of improvement in calendar year 2007, ramping up to about $700 million in 2008. Virtually all of those projects, some 36 or 37 today, are pushed down into the business lines, goals and objectives and financial ... indeed in their financial results. So, it's a little difficult, I would say, to say how much that contributed in the second quarter itself. So, I think from the numbers I gave that you can see there is a pretty steep ramp up in what we expect to get at least through the end of 2008 and I certainly wouldn't expect those ... that improvement. I would expect to really be ... continue to be an annuity going forward.

Obviously, when we set these objectives we were hoping they would fall directly to the bottom-line, be purely additive to what we were earning when we set those goals, but we undertook best-in-class as an initiative because we anticipated a very tightening credit in a competitive environment, I should say. And unfortunately, that part of the predictions come true and so as a result some of the competitive environments that were resulting in contractions of spreads and so forth is beginning to offset some of those benefits, but in terms of the benefits and the projects themselves, we expect to hit the goals that we set for ourselves.

Jill Hennessey - Investor Relations

With regard to the mortgage company, why is the absolute number of personnel moving up with regards to loan originations and commission staff?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

Okay. The reason for that is ... relates purely to the addition of the two Florida banks. Those ... when we first integrated those banks, the folks in the mortgage lending business at those two companies were integrated directly into the mortgage company, and their origination staffs then showed up as FTE additions to that business.

Jill Hennessey - Investor Relations

Thank you, Jeff. I'll direct this question to Phil Rice, Head of our Regional Commercial Bank. Phil, what are you seeing in terms of new originations on the construction side?

Philip L. Rice - President and Chief Executive Officer, National City Bank

Okay. Thanks Jill. Originations of commercial real estate construction are down this year versus last year and prior years, and this is due primarily to the slowing in the residential real estate activity.

Jill Hennessey - Investor Relations

Thank you, Phil. Jim, a question for you. We are seeing a large up-tick in OREO in the First Franklin loans. Can you speak specifically to which markets?

James R. Bell, III - Chief Risk Officer

Thanks Jill. No, there is not specifically a market concentration there, though the Midwestern markets were disproportionate, but they are a small proportion of the First Franklin loans. So, I would say the characteristics would match the First Franklin portfolio as a whole.

Jill Hennessey - Investor Relations

Thank you, Jim. What amount of the $263 million in the 90 day past due category in National City Mortgage are construction loans?

James R. Bell, III - Chief Risk Officer

Virtually all of that, that's a portfolio statistic. There may have been some standing loans that were reclassified in there on the Florida acquisitions but virtually all of that is construction loans.

Jill Hennessey - Investor Relations

Thank you, Jim. And our last question for Peter. What is the breakup fee on the MAF transaction? It appears that the MAF fundamentals are materially worse than when you signed the agreement. Have you or would you think about changing the terms in the agreement or backing away from the deal completely?

Peter E. Raskind - President and Chief Executive Officer

Well, thanks Jill. The specifics of the breakup fee in the MAF transaction are publicly disclosed in the S4 that we filed associated with the transaction, but I think more to the spirit of the question, are we still fully committed to the MAFB transaction? And the answer is absolutely yes. MAFB is exactly the right franchise, exactly the right distribution network to bring us to threshold scale in Chicago, hence our continuing interest in it over the last seven to ten years. And as I said a couple of times earlier now this morning, that is a very long term view on our part. And while near term changes in the balance sheet of MAFB or in the overall operating environment may make it easier or more difficult to move through integration and to realize growth there. In the very near term, it doesn't change our long term interest in the franchise. We have every intention of proceeding.

Thomas A. Richlovsky - Treasurer

Actually we do have a couple of more questions that have come in, and they will go to Jim Bell and to Jeff Kelly.

Jill Hennessey - Investor Relations

Jim, do you have any exposure to the big publicly-traded home builders? If so, what type of loans do you have outstanding, and what is the total dollar amount?

James R. Bell, III - Chief Risk Officer

We have a number of relationships with the large home builders, none of them of any individual significance in terms of size. In aggregate it might be $200 million to $250 million and those are general corporate revolving facilities.

Jill Hennessey - Investor Relations

And can you please give us the total dollar amount of the total construction loan portfolio that is tied to residential condo and land development business?

James R. Bell, III - Chief Risk Officer

Sure, the aggregate number for the corporation is about $5 billion. To fill in on some things we've commented on before, about $2 billion of that is in Florida, call it half ... $500 million in old National City transactions, and the $1.5 billion which were discussed previously on Harbor, And ... only other issue area would be South Eastern Michigan which is ... that's a grand total of $250 million, but that's modestly down absent the acquisition effects from the beginning of the year.

Jill Hennessey - Investor Relations

Thank you, Jim. Jeff, a final question for you. Long term interest rates have declined to approximately 4.82% from about 5.03% at the end of the second quarter. Where would the ten-year government yield need to be at the end of the third quarter for your MSR value to turn negative?

Jeffrey D. Kelly - Vice Chairman and Chief Financial Officer

I'm assuming that the question relates more to the net MSR hedging results than the MSR itself. And actually, we have very little exposure to the absolute level of rates changing. Our exposure really relates to changes in the mortgage swap basis ... so, that spread ... and into the absolute level of implied volatility in the options market. So, when the mortgage basis widens that tends to improve hedge results and when it narrows it tends to be a negative for results. And when relativity goes up that tends to be a positive and similarly when it falls it tends to be a negative. More recently, what we've been seeing is an increase both in the basis and an increase in volatility. So, as I said earlier, as long as that seems to hang in there at that kind of a trend, I'd anticipate that hedging results would probably continue to ... it would continue to be a reasonably favorable hedging environment for us.

Thomas A. Richlovsky - Treasurer

Thanks Jeff. Looks like we've cleaned out the question tray. So, operator would you give the closing instructions, please.


Certainly. It would be my pleasure. And ladies and gentlemen, this conference will be available for replay starting today, Thursday, July 26th, at 2:30 PM Eastern Time and it will be available through next Thursday, Aug 2nd, at Midnight Eastern Time.

And you may access the AT&T Executive Playback Service by dialing 1-800-475-6701, and then enter the access code of 866914. Those numbers once again are 1-800-475-6701, and again, enter the access code of 866914.

And that does conclude our conference for today. Thanks for your participation, and for using AT&T's Executive Teleconference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!