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U.S. Bancorp (NYSE:USB)

Q3 2007 Earnings Call

October 16, 2007 8:30 am ET

Executives

Judy Murphy - Sr. VP and Directorof IR

Richard Davis - President and CEO

Andrew Cecere - Vice Chairman andCFO

Bill Parker - Chief CreditOfficer

Analysts

Mike Mayo - Deutsche Bank

John McDonald - Banc of America Securities

Nancy Bush - NAB Research, LLC

Gary Townsend - FBR Capital Market

Matt O'Connor - UBS

Manuel Ramirez - KBW

Todd Hagerman - Credit Suisse

Lori Appelbaum - Goldman Sachs

Operator

Good morning and welcome to theU.S. Bancorp's Third Quarter 2007 Earnings Conference Call. Following a reviewof the results by Richard Davis, President and Chief Executive Officer, andAndy Cecere, U.S. Bancorp's Vice Chairman and Chief Financial Officer, therewill be a formal question-and-answer session. (Operator Instructions). Thiscall will be recorded and is available for replay, beginning today atapproximately 11:30 AM Eastern Time, through Tuesday October 23rd, at 12O'clock midnight Eastern Time.

I will now turn the conferencecall over to Judy Murphy, Senior Vice President.

Judy Murphy

Thank you for joining us thismorning. This is Judy Murphy, Director of Investor Relations at U.S. Bancorp.Today, Richard Davis and Andy Cecere are here with me to review U.S. Bancorp'sthird quarter 2007 results. If you have not received a copy of our earningsrelease and supplemental analyst schedules, they are available on our websiteat www.usbank.com.

I would like to remind you thatany forward-looking statements made during today's call are subject to risk anduncertainty. Factors that could materially change our current forward-lookingassumptions are detailed in our press release and in our Form 10K report onfile with the SEC.

I will now turn the call over toRichard.

Richard Davis

Thank you Judy, and good morningto all of you for joining us today. As you know, during the third quarter of2007 issues, events in general terms are all surfaced in the financial markets andhave significant impact on our industry. These issues seemed to accelerate andexpand as the quarter progressed, and at the forefront our concerns surrounded sub-primelending, liquidity and credit quality. Despite having this environment as abackdrop to the third quarter, I’m actually pleased to be here with you todayto review the results of our third quarter.

As we discussed in earlySeptember at our Industrial Conference, this company is not immune to theseissues and uncertainty in the current market. But given our prudent riskmanagement and credit culture, the impacts on our results have been and we willexpect it to be limited and manageable.

At this point, I’d like to take afew minutes to give you an overview of our third quarter results. I will thenturn the call over to Andy, who will provide you with additional comments aboutthe earnings.

As we've completed our briefformal remarks, we will open the line-up for questions from our audience.

Our company reported a net incomeof $1,176 million for the third quarter of 2007. Earnings per diluted commonshare for the third quarter were $0.67 or $0.01 higher than the earnings pershare in the same period of 2006, and $0.02 higher than the second quarter of2007. We achieved a return on average assets of 2.09% and a return on averagecommon equity of 23.3% in the third quarter. Both of these profitabilitymetrics continue to be among the best in our industry.

Our third quarter net interestmargin of 3.44% was 12 basis-points lower than the net interest margin wereported in the third quarter of 2006, but equal to the prior quarter of 2007.The result of this stabilization in the margin was a modest increase in netinterest income on both a year-over-year and a linked quarter basis.

Earlier this year, we'd indicatedthat the net interest margin will continue to decline from the first quartermargin of 3.51% and then stabilize at 3.40%. We continue to believe that giventhe current rate environment yield curve and balance sheet mix, this assumptionstill holds true. Importantly, for our company, a stable margin is a keycomponent to our future and long-term revenue growth assumptions.

Once again, our fee-basedbusinesses exhibited excellent momentum. Payments and trust related revenuewere particularly strong this quarter. Year-over-year, our Payments Related Feesgrew by over 11%, while Trust and Investment Management Fees increased by 8.5%.In addition, the Treasury Management Fees, Commercial Products Revenue and MortgageBanking revenue all increased over the prior year.

You may recall that the Treasury Managementand commercial product revenue fees are targeted for improvement through anumber of our revenue growth initiatives, and we expect to see those categoriescontinue to expand.

Mortgage banking revenue has beenone category that has actually benefited from recent market conditions, what Iwould call a flight to quality. Our mortgage products are first-rate and ourcustomers and business partners know that we will be there to fund the loan atclosing.

Non-interest expense in thecurrent quarter was 5.9% higher than the third quarter of last year, butslightly lower than the previous quarter. A portion of the increase and expenseyear-over-year was related to investments in our fee-based businesses and ourbanking franchise. Personnel, marketing and business development were associatedwith a number of our growth initiatives, which includes PowerBank, financialinstitution services, and the expansion of our FAF Advisors' third-partydistribution.

On a linked-quarter basis,non-interest expense was lower as the cost of these investments made their wayinto the run rate. This reduction in expense along with the increase in netrevenue resulted in an expected positive operating leverage for the company ona linked quarter basis.

Our tangible efficiency ratio ofthird quarter of 2007 was 43.6%, making us one of the most efficient financialinstitutions in the industry. A disciplined approach to expense control willcontinue to be a focus for this company. It is our efficiency that allows us tocontinue to invest, while still maintaining our industry leading profitabilitymetrics.

Turning to the balance sheet:Total average loans grew by 4.3% year-over-year led by solid growth in averagetotal retail loans of over 8%. Credit card loans, once again drove the retailnumbers with a 26.9% increase in average balances year-over-year. And our branch based co-branded,affinity and financial institution partnerships all contributed to the increaseof this prime-only based portfolio.

Although not yet fully reflectedin the average balances, the company did see a pick-up in commercial loangrowth, during the latter part of the third quarter. In fact, total loans grew$3.3 billion or over 9% on an annualized basis between June 30th and September30th of this year.

Going forward however, wecontinue to expect that our company's growth in both commercial and commercialreal estate loans will be slightly lower than the industry average, as wecontinue to concentrate on originating principally higher quality credits andcompete on price for the best customers.

Once again, our credit qualitymetrics were strong. Net charge-offs were 54 basis points of average loans forthe third quarter 2007, slightly above the 53 basis-points in the second quarterof 2007, and higher than the 38 basis-points of average loans in the thirdquarter of 2006. These ratios represented an $8 million increase in netcharge-offs on a linked quarter basis and a $64 million increaseyear-over-year.

The increases over both the priorperiods, prior quarter and third quarter of 2006 were expected and were a consequenceof the current stress in the homebuilding and mortgage industry, as well as thenormalization of consumer net charge-offs after the late 2005 bankruptcy reformmeasures.

The most significant increase inyear-over-year was in credit card loan net charge-offs. The growth inoutstandings, and a slow return to a normalized net charge-off ratio, led tothis increase. The credit card net charge-off ratio of 3.09% this quarter wasseasonally lower and well below our expected long-term run rate for thiscategory. As we have previously communicated, this ratio will continue to climbover time to its pre-bankruptcy reform rate of slightly over 4%, still very lowby industry standards.

Residential real estate related charge-offs, includingconsumer first and second liens also grew modestly year-over-year on a linkedquarter basis as stress in the housing markets filtered through the portfolios.Going forward, we expect that both commercial and retail net charge-offs willincrease moderately as well as they can through the cycle. Given our risk and rewardprofile, we expect our credit quality toremain favorable when compared to our peers, and any increase in net charge-offsto be very manageable. As expected non performing assets increased to $641million at September 30, from $565 million at June 30, this 13% increase wasconsistent with the expectations that we discussed at our recent investorconference. Given the current economic environment, we anticipate that our nonperforming assets will edge higher, but that increase will be modest.

Our capital position remains strong. We repurchasedapproximately 6 million shares of stock in the third quarter of 2007. This combinedwith our quarterly dividend resulted in a 74% return as earnings to ourshareholders in the third quarter, and 117% year-to-date, which were well aboveour goal of 80%. We remained well capitalized at quarter-end with a Tier 1capital ratio of 8.6% and a total capital ratio of 12.8%.

I will now turn the call over to Andy, who will make a fewmore comments about our quarter.

Andrew Cecere

Thanks Richard. For the first time in eight quarters, netinterest income was higher on both the year-over-year and in linked quarterbasis. The $12 million increase in net interest income over the third quarterof 2006 was the result of a $7.7 billion increase in average earnings assets,which was enough to offset the 12 basis-point drop in the margin. The $35 millionincrease in net interest income on a linked quarter basis, was the net resultof a stable margin and $2.6 billion increase in average earning assets.

The margin contraction year-over-year could be attributed totighter credit spreads primarily due to competitive loan pricing. Additionally,the cost of funding of the company has risen over the past year as rates oninterest-bearing deposits have gone up and the mix of liabilities continues toshift towards higher cost deposits and other funding sources. An increase inloan fees partially offset these negative factors. We are still comfortablewith the assumption that our net interest margin will be relatively stablethrough the end of the year for a number of reasons. During the past severalmonths credit spreads appear to have stabilized for both commercial and retailloans. As many of you know however, our company strategy has been to focus onhigh quality credits, which by their very nature carry lower margins.

There continues to be aggressive competition for thesecredits and we are just beginning to see risk price back in the market.Consequently, although we don't see credit spread deteriorating further, wefeel it'll take some time before these spreads have meaningful upside potentialfor the margin.

In addition, the growth in our own portfolio in recentquarters has come from higher spread products including credit card and otherretail loans. And finally, the Fed actions in September will have a positiveimpact on the margin due to our slightly liability-sensitive position.

Total non-interest income was higher in the current quarterthan the same quarter of 2006, by $96 million. Year-over-year the growth wassomewhat muted by a $32 million gain from the sale of equity interests in acard association, recognized last year in the third quarter of 2006. Alsoincluded in other income category in the third quarter were two specificvaluation losses totaling $21 million. The first was related to amark-to-market of certain trading account assets, while the second resultedfrom a mark-to-market of loans held by a commercial real estate joint venture.

Non-interest income in the current quarter was lower thanthe prior quarter. Seasonal variances in trust and investment management andtreasury management fees contributed to the decline on a linked-quarter basis,both of which were affected by strong tax related activity in the priorquarter. The reduction in deposit service charges on a linked-quarter basis wasthe result of one less processing day in the quarter as well as fewertransaction related fees.

Non-interest expenses in the third quarter of 2007 were $90million higher than the same quarter of 2006. The year-over-year increasescontinue to reflect recent investment in our business lines and franchises. Theremaining increase in expenses was driven by general business growth includingoperating expenses related to tax credit investments and merchant processingexpenses related to new customer and transaction growth. Also we haveORE-related expense.

Non-interest expenses declined on a linked quarter basis by$12 million. The positive change can be attributed to favorable variancesacross many categories. At our recent Investor Conference I noted that ourmoney market funds may be impacted by exposure to liquidity and credit issuesin the asset-backed commercial paper market. Our third quarter results were notimpacted by this issue. The situation for the money market funds, including ourFirst American Funds, remains fluid. We still believe that the future EPS, infact, had a range from zero to a couple of pennies over the next couple ofquarters.

Although recent market events had a minimal impact on ourincome statement, the rapid loss of liquidity in the mortgage securitizationmarket led to an increase in our non-performing loans on a linked quarterbasis. We identified this potential increase in September, as two mortgagebanking customers declared bankruptcy earlier in the third quarter. Bothcommercial loans have been placed in non-accrual as of September 30. Althoughthe loans are not performing, they are well collateralized and we do not expectany material losses.

In addition, the slow-down in the real estate constructionmarket resulted in an increase in non-performing commercial real estate loans,as one large project was placed on a non-accrual status.

Finally, an update on our exposure to sub-prime lending. Ourexposure to sub-prime residential loans is minimum and very little has changedfrom the end of the second quarter of 2007. As of the end of this quarter wehave $3.2 billion of residential real estate loans and $900 million of homeequity and second mortgage loans outstanding to customers that could beconsidered sub-prime. Those two portfolios represent 2.8% of total loansoutstanding as of September 30th.

I would now like to turn the call back to Richard for hisclosing remarks.

Richard Davis

Thanks Andy. I am sure many of you in the audience todayhave had the chance to read our recent press release announcing that BillParker has been promoted to Chief Credit Officer of U.S. Bancorp. Bill has beenwith the company since 1984 and has been very involved in the establishment andimplementation of our current credit policies, procedures and culture. I amvery pleased that Bill has agreed to assume this very important role for ourcompany, a role that is even more important today than it was just a quarter ortwo ago. Bill is joining Andy and I today to answer any specific credit-relatedquestions you may have about our third quarter results or the current creditenvironment as a whole.

In conclusion, as a company, we will continue to capitalizeon our core financial strengths including our profitability, efficiency,prudent credit culture, capital management and customer service; whileselectively investing in the growth of our businesses and our people, bothorganically and via small strategic acquisitions.

Our long-term goals have not changed. We believe that we canmeet the challenges presented by this environment and do so without taking therisks that could jeopardize our future.

We are not immune to thechallenges, and our third quarter and year-to-date results support my beliefthat this company is well-positioned to produce the consistent, predictable andrepeatable earnings stream going forward, for the benefit of our customers,communities, employees, and shareholders. Andy, Bill, and I will now be happyto answer any questions from our audience. Operator we are ready.

Question-And-AnswerSession

Operator

Thank you, sir. (Operator Instructions). Okay the firstquestion is from Mike Mayo with Deutsche Bank.

Mike Mayo - DeutscheBank

Good morning.

Richard Davis

Good morning, Mike.

Andy Cecere

Good morning, Mike.

Mike Mayo - DeutscheBank

Could you just say something simple, it sounds like thereare a couple items that might have either hurt earnings, and I'm not sure thismight have helped earnings. You mentioned in other income $21 million ofvaluation losses, I guess that's probably not likely to repeat and you mentionedsomething else in other incomes that seemed to depress this quarter's results?

Andy Cecere

Right Mike, this is Andy. Two items; first of all last yearin the third quarter, we recognized a $32 million gain from a card associationtransaction, and there was a 2006 event in the third quarter of $32 million inother income. This quarter in 2007 we have $21 million mark-to-market relatedto our trading activity, and I would not expect that to be a repeatable event,but it was an unusual event.

Mike Mayo - DeutscheBank

Negative $21 million?

Andy Cecere

That is correct.

Mike Mayo - DeutscheBank

You also said the credit card losses are well below typical?

Richard Davis

Right.

Mike Mayo - DeutscheBank

And why is that? Is just credit quality expected to staygood for a while or…?

Richard Davis

You know Mike, if you look at our long-term history, lastquarter and third quarter, we were 285 and are quarterly and seasonally low forthe year. Quarter three is based on the timing of people's receivables and theyare working themselves up to the fourth quarter spending for the holidayseason, and are always in our portfolio because it's only prime, and it behavesin that manner. So while we'd love the 3.09% we didn't want the market to thinkthis was our new run-rate. As much as Iwould celebrate that, it's really much more in the [mid-3.50s] right now on acore basis without seasonality and we want to remind the folks that before thebankruptcy reform, we were right around 4% and that's where we expect thisthing to level out over the next future quarters.

Mike Mayo - DeutscheBank

And I guess the question is a stay of the U.S. consumer then. Do you stillfeel good with that 4% range? Is the consumer good in your markets?

Richard Davis

We do. We have a high propensity of prime customerco-branded credit card clients. By virtue of saying that these are people whouse their card for not essentials as much as they do some of the morediscretionary purchases continue to perform quite well. I would be the firstperson in the third quarter earnings cycle to say, with a bit of surprise, thatthe consumer holds are very strong and in categories that are more than justrequired spending, they continue to do quite well and seem to be quite robust.We are holding to those forecasts and expecting that there will really be nomajor change in consumer behavior for spending patterns.

Mike Mayo - DeutscheBank

And then last question, I think we have core deposits inlinked quarter down a little bit, I know that's been a focus. Any color?

Richard Davis

Say it again, Mike.

Mike Mayo - DeutscheBank

Core deposits?

Richard Davis

Yeah.

Mike Mayo - DeutscheBank

I mean when we look at it we are down a little bit,excluding jumbos.

Richard Davis

That's right.

Andy Cecere

Right. A little bit of that is seasonal. Our second quarteris heavy in our government activity and that does cause our deposit categoriesto increase a bit. So part of the decline is seasonal and if you strip thatout, we do continue to see a bit of a shift to the higher earning deposits from a customer standpoint, but notdissimilar from prior quarters.

Mike Mayo - DeutscheBanc Securities Inc.

All right. Thank you.

Richard Davis

Thanks, Mike.

Operator

Your next question is from John McDonald of Bank of AmericaSecurities.

John McDonald - Bancof AmericaSecurities

Hi, good morning, Guys.

Andy Cecere

Good morning.

John McDonald - Bancof AmericaSecurities

Andy, wondering if you could give a little bit of color onwhat drove your mortgage revenues this quarter, and what kind of outlook youhave for the mortgage business?

Andy Cecere

Sure, first of all John, the hedging component, both of ouron-the-book overall, is fairly neutral on a linked quarter basis. What we haveseen is, as Richard mentioned in his comments, a bit of a flight to quality. Sothere has been increased production and activity in our mortgage group,relative to prior quarters. In fact, they are having a very solid year. So, itreally is core production increase seen across the board.

Richard Davis

And John, given our size, last I saw we were 23rd ranked inproduction and 14th in servicing. We just really like that space. I mean we arevery good at this. We have a great deal of client relationships that we benefitfrom, both in the broker community and directly to the branches.

It’s just for us a core operating stream that's been, ifanything, slightly benefited, but as you all know it's not big enough to movethe needle except for the fact that it could be harmful to us if we were tostart to fail in this quality.

John McDonald - Bancof AmericaSecurities

You said the vast majority is agency business If youquantify that, how big?

Andy Cecere

The very vast majority of agency we have.

John McDonald - Bancof AmericaSecurities

Okay.

Andy Cecere

It's a bit on the jumbo side and some of that is REITportfolio, but the great majority is agency.

John McDonald - Bancof AmericaSecurities

Okay, great. And then a credit question. I don't know if yousaid, Bill is on the line today, If you guys can handle this.

Bill Parker

Yeah. I am here.

John McDonald - Bancof AmericaSecurities

Okay. Hi. Congratulations, Bill.

Bill Parker

Thank you.

John McDonald - Bancof AmericaSecurities

What's your remaining exposure to mortgage companies, andthen also if you could just walk through exposure to homebuilders as well?

Bill Parker

Yeah. The mortgage lending unit that we have has $1.4billion of loans outstanding. They're all secured either by warehouse firstmortgages or by mortgage servicing rights. So, we've had the two that Andymentioned that did file. The good news on the other ones is that they seem tobe getting through this liquidity crisis.

Most of them have returned to issuing only conformingmortgages. On the homebuilding side, we do have a $4 billion of residentialconstruction. $1 billion of that is condominium construction and that is aportfolio that I am sure you are all aware is under stress, but it's regionallybased. Some markets are better than others but…

Richard Davis

I'll add to it. And John, you know we've have a lot ofsub-categorical limits for different kinds of lending. And condos would havebeen one of those and our diversity of geography would also prove that we'renot concentrated in any one market, good or bad necessarily. But I think in the real estate market, you'regoing to see our diversification across all size, types, levels andgeographies. They are going to serve us well during this next phase, as commercial real estate and the downstreameffects of homebuilders might start to affect other things.

John McDonald - Bancof AmericaSecurities

Okay. And then one quick follow-up for Andy. In terms of themargin, what would need to happen in the rate environment to see some benefitsfrom the rate cuts? If you could just comment on that.

Andrew Cecere

We did have a bit of a benefit, John. As we talked about itin our investor day, we are slightly liability sensitive. Late in the quarteras rates went down, that helped us a bit. But our outlook continues to be forus this year sort of at a stable margin. We talked about credit spreads. We arepursuing high quality credits and that would be a key factor in terms of themargin improving, but our expectation again is relatively stable.

John McDonald - Bancof AmericaSecurities

Okay. Thanks.

Andrew Cecere

You bet.

Richard Davis

Thanks, John.

Operator

Your next question is from Nancy Bush with NAB Research,LLC.

Richard Davis

Good morning, Nancy.

Nancy Bush - NABResearch, LLC

Good morning.

Andy Cecere

Good morning.

Bill Parker

Good morning.

Nancy Bush - NABResearch, LLC

I guess this is a question mostly for Bill. Bill could youjust speak a little bit, about the one large CRE project that went onnon-performing.

Bill Parker

Right.

Nancy Bush - NABResearch, LLC

If you could give us any color on that, I would appreciateit. And also, we are pretty well aware that, Florida is a troubled market, but could youjust speak to sort of the regional trends that you are seeing in terms of CRE,credit quality and whether they are any changes in the last few months?

Bill Parker

Sure. As I said, we have $4 billion overall residentialconstructions. $1 billion is for condominiums. The one project is a condominiumproject in a good suburb of Las Vegas.However, unlike many condo projects which have experienced fallenpre-sales, it is fully guaranteed, andwe're working with the guarantors to re-margin the project. We do anticipateadditional stress in that market in the residential construction. We do haveprojects and these are homebuilding projects, they are not condo projects inthe San Diego, Sacramento area that's a soft market. Nowagain those are guaranteed projects which we work together with ourrelationship lender, and work with our borrowers to re-margin the loans.

In Florida we have ourcondo exposure in Floridais now about $100 million and the three remaining projects we have there areall on schedule and performing fine.

Nancy Bush - NABResearch, LLC

Bill, could you just speak to the rest of the South East. Imean are you seeing any….What's your exposure in sort to the Atlanta market and if you are seeing anyadditional [places]?

Bill Parker

Yeah, we don't have -- we have very little in South East.The only place we really have is in the South East is Florida.

Nancy Bush - NABResearch, LLC

Great.

Bill Parker

That's a $100 million. Yep.

Nancy Bush - NABResearch, LLC

Thank you.

Richard Davis

Thanks Nancy.

Andrew Cecere

Thank you.

Operator

The next question is from Gary Townsend with FBR CapitalMarket.

Gary Townsend - FBRCapital Market

Good morning. My questions have been asked and answered.Thank you.

Richard Davis

Thanks Gary.

Andrew Cecere

Thank you.

Operator

The next question is from Matt O'Connor with UBS

Matt O'Connor - UBS

Good morning.

Richard Davis

Hi Matt.

Andrew Cecere

Hi Matt.

Matt O'Connor - UBS

The margin was stable despite higher deposit costs, a littlebit of mixed shift over non-interest-bearings and I am just trying toreconcile, it seems like the offset might have been higher yields in retailloans?

Richard Davis

Matt that is certainly a factor, as I talked about it anddiscussed in my comments. The growth that we're seeing is in principally thehigher yielding assets, loans, credit cards and installments. That certainlyhelped our liability sensitive position a little bit, and the stabilizationacross the board in credit spreads also helped. So, all those factorscontributed to the stable margin.

Mat O'Connor - UBS

Okay. And then separately loan growth picked up like we areseeing in a lot of places. In September your period-end growth was about doublethe average driven by commercial. Is that better spreads that you are gettingso you are more open for lending? Is business coming back to the bank?

Richard Davis

Yes.

Matt O'Connor - UBS

Driving down a [household family], what do you think thatwill be?

Richard Davis

Matt its Richard. Thespreads are not getting better yet. The hope is that they will, and we arewatching for risk premiums to come back as the yield curve starts to move. Thatdoes help a bit. But by and large, let's just say the banks aren't giving backthe benefit shot to the banks; they are giving it to the customers. So we arestill thinking to be very intensively competitive for the best customers, andbecause we really don't dabble in the markets with structured credits orcustomers who may not be as strong, I am not sure whether or not there is moreflexibility in the pricing downstream, but we simply [aren't] playing in thatcategory.

So for us the answer is that the spreads are just as tightas they were before. The volume is a good sign. I do think it indicates that particularly the middle market is startingto use their clout a bit and as I think we talked in last two quarterly calls,there is a cycle in banking, and it's a real long one. But in the best of ourworlds, our customers are doing well and they are using the bank's balancesheet to grow their companies. Then they get strong and they start to stopusing loans, they start to build up cash and they are good depositors for useven if they are not using their loans.

Then they go back to the cycle, they use up their cash andthey start to use our loans again and we are in that inflection point, wherethe cash is coming down, the use of the bank's balance sheet for the benefit oftheir growth is starting to happen. I think that portends quite frankly to goodthings for the economy and that's why banks typically see these things first,and we are seeing it now.

Matt O'Connor - UBS

Okay, and I guess that the concern might be that the banksare picking up some of this loan growth, and at the end of a cycle. What does that mean in terms of creditquality looking out a year or two?

Richard Davis

Good question. I can't answer that for us. We are simply notdoing anything structurally that we haven't done for the last five years, whichat the peril of some optics where we have been at a slower growth, it’s paid ushandsomely. At this point of the cycleand we are as a company not going to take any changes at this point. As yousay, we are at the end of the cycle, where the risk could be much greater than the reward, so, we are notdoing that.

Matt O'Connor - UBS

Okay. Thanks a lot.

Richard Davis

Thanks Matt.

Operator

Your next question is from Manuel Ramirez with KBW.

Richard Davis

We call him Manny.

Manuel Ramirez - KBW

Will get it at the fourth try.

Andy Cecere

Good morning.

Manuel Ramirez - KBW

Good morning guys. On the reserves, just in thinking aboutwhere you are versus the industry, your reserve to loan ratio continued todrift down a little bit, although I would readily admit that you are prettywell reserved at this point. But if I think about the mix shift in loanportfolio from commercial to retail, your retail charge-offs are normalizingand your NPAs are rising albeit at a more modest pace in the industry overall.When should reserves to loans start to fund out and perhaps even start to riseto, unless there are changes in the balance sheet, what are we are seeing at this point?

Richard Davis

Manny, this is Richard and I'll have Bill be more specific.We don't see that point yet in our current view, in terms of looking out a yearand forward, trying to get an inflection point. For a couple of reasons. One iswe do -- our growth in our balance sheet is expected to be high quality. So, weare not looking to change the mix of our portfolio as we grow it in the future.It has performed quite well, and I think the combination of the mix won'tchange measurably. It's a pretty big portfolio, so, it won't change veryquickly. Having said that we have a fair amount of unallocated reserves, whichwe threw up especially once a year, but they are well in the range of no actionrequired and no action even contemplated, because we have, as you said, a verystrong kind of a fortress balance sheet at this point in the cycle.

So, while I do expect it to continue to be used as it'ssupposed to, I don't see in the near-term [or call it out] in the next year, aconsequential event that would cause us the need to take any actions on the provision that itwould be greater than the charge-offs at that same point in time. Now Bill, youmight add to that some more details.

Bill Parker

Yeah, well Manny, I think you have cited some of the keythings we look at of course, which is our NPA coverage and we compare veryfavorably there to the peers. As Richard said, we look at this every quarter.We have models that we evaluate and we adjust those to what we believe as themoderately increasing loss forecast we have in our retail portfolios, and wewere adequately reserved.

Manuel Ramirez - KBW

And one kind of technical follow-up question on yourunfunded construction commitments as well as your unfunded home equitycommitments. Do you hold reserves against those at some particular ratio tounfunded amounts?

Bill Parker

Yeah effectively we do, because we look at any kind ofdrawings that would result in a loss during a certain forecast period.

Manuel Ramirez - KBW

Okay.

Bill Parker

So the answer is yes.

Manuel Ramirez - KBW

All right. Thank you.

Richard Davis

Thanks Manny

Andy Cecere

Thank you.

Operator

The next question is from Todd Hagerman with Credit Suisse.

Richard Davis

Good morning, Todd.

Andy Cecere

Good morning, Todd.

Todd Hagerman -Credit Suisse

Good morning everybody. Most of my questions have beenanswered, but Bill just a follow-up in terms of the real-estate, could you justcomment. You have mentioned before, theone project that came on non-performing this quarter, just the re-marginingprocess with that borrower.

Bill Parker

Yes.

Todd Hagerman -Credit Suisse

Could you just give us a sense, as the industry goes throughthe cycle, of the kind of appetite thereon or the willingness on the borrowers' part of what the dialogueis like with some of these borrowers as you look to strengthen your [lateral]position?

Bill Parker

Sure, I mean this is a pretty typical case, where because weare relationship lenders, this is a developer. This is our third project withhim. The first two went extremely well and the third one would be changingmarket conditions so obviously the sale stalled out. These folks have anincentive to work with us. If they have any liquidity they will put it in. Inthis particular case he has other properties of which we are seeking to take anequity position. Ourfirst lender in other projects backed it and was able to shore up this project.So, in all cases, these folks are willing to continue to work with us, becausethey are long-term developers, they've been through the cycles; they want tomaintain a good relationship with the bank.

Todd Hagerman -Credit Suisse

That's helpful. And then just secondly, how often or can youtalk a little bit just in terms of kind of the reappraisal process in some ofthese markets. What are you doing there,in the process?

Bill Parker

Yep. And probably the area where that comes up most rightnow is Californiaand there are projects that we have to get reappraised, as often as every sixmonths and get re-margined every six months.

Todd Hagerman -Credit Suisse

And I am assuming you've re-graded as appropriate?

Bill Parker

Oh yeah. Yeah.

Todd Hagerman -Credit Suisse

Great, thank you.

Richard Davis

Thanks, Todd.

Operator

The next question is from Lori Appelbaum with Goldman Sachs.

Richard Davis

Good morning.

Lori Appelbaum -Goldman Sachs

My question is….hi Richard.

Andy Cecere

Good morning.

Lori Appelbaum -Goldman Sachs

And Andy. My question relates to the loan loss reserve. Myrecollection was as of the last $10,000, the unallocated reserve was about $700million plus, and I was curious what the current unallocated position is?

Andy Cecere

It is…

Richard Davis

We are calculating it for you.

Lori Appelbaum -Goldman Sachs

Oh, thank you.

Bill Parker

It's about 600 to 625.

Lori Appelbaum -Goldman Sachs

600 to 625 and some of that has been eaten up by the realestate issues that you have mentioned?

Andy Cecere

I left that in the outlook on retail credit mortgages there.

Lori Appelbaum -Goldman Sachs

Okay.

Andy Cecere

Yeah. And credit cards and the increasing return tonormalization on cards.

Lori Appelbaum -Goldman Sachs

Okay. And then the normalization on cards, I can see thedelinquency deterioration, but the loss rate actually improved?

Bill Parker

Right.

Andy Cecere

Correct.

Lori Appelbaum -Goldman Sachs

So, what actually is happening within the card portfoliothat seems to be a disconnect between loss trends and delinquencies?

Andy Cecere

Well, again, as Richard said, third quarter is usually aseasonally good quarter for collections for us. Now we will see the increase indelinquencies that will occur from now through basically second quarter of nextyear.

Richard Davis

Yeah. I know it's a bit of anomaly in a one year view, butif you do go back at least two more years you will see third quarter performslike clockwork for us, which is why as much as I want to celebrate the number.I actually didn't want you all, to mistakenly think that was our new run rate,because that would be unsustainable.

On the other hand, when we talk about long-term we are likea lot of our peers. I actually don't know why the pre-bankruptcy levels haven'treturned yet. We don't see them coming even in the next couple of quarters. So,we are saying that we think we will be at the 4% level, because we know we haveto believe that, but we actually don't have all the evidence that it will bethere at this point in time. We just believe it's going to have to get back tothat point.

Lori Appelbaum -Goldman Sachs

Okay. And if you can also update us on credit performance inyour sub-prime portfolio, delinquencies and losses?

Bill Parker

Sure. On the residential mortgage side, while thedelinquencies are up, obviously in both home equity and residential mortgagesand the sub-prime, the loss rate we had in the third quarter on our firstmortgages was 1.29% and the loss rate on the home equity was 4.09%.

Richard Davis

That's sub-prime.

Bill Parker

That's all sub-prime rate now.

Richard Davis

Which is 2.8% of the total portfolio?

Bill Parker

Right. Yeah.

Richard Davis

There is some point to note to that our prime home equitylends and loans are stable and that to us is good news. I know there is a newconcern in the marketplace that seconds or the next to have impairment and I dobelieve that sub-prime will and are. Butbased on the percentages that we don't have in sub-prime we will have to reportthat loans and lines are both performing steady in the prime portfolio and insome cases, I think there is a worry that, lines will perform more poorly thanloans and we're not seeing that in our case right now. But you know we didn'tgrow this portfolio in the double-digits for the last couple of years either.So I would expect our performance to be handsomely better than our peers, giventhat we were both through the loan to value and through the cycle ofunderwriting to our prime portfolio.

Lori Appelbaum -Goldman Sachs

And in the pace of delinquency deterioration that was more noticeable in the quarter, I am assuming that the delinquencydeterioration of residential mortgage. Was all of this sub-prime portfolio?

Richard Davis

A good chunk of it was prime majority it was.

Lori Appelbaum -Goldman Sachs

Okay. We didn't think expect that. These loss rates that you just mentioned, arethey going to continue to move a bit higher in terms of share?

Richard Davis

[In loans also], yeah, but I think they will move a bithigher. That's correct, we agree.

Lori Appelbaum -Goldman Sachs

Thanks.

Operator

(Operator Instructions) And at this time I am showing nofurther questions.

Richard Davis

Great. Operator, thank you and everyone thank you forjoining us and thanks for your continued interest. Judi?

Judy Murphy

Thank you for listening to our third quarter review. If youhave any follow-up questions or need hard copies of our press release andsupplement of schedule, please feel free to contact me at 612-303-0783.

Richard Davis

Thank you.

Andrew Cecere

Thank you.

Operator

Thank you for participating in today's conference call. Youmay now disconnect.

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