First Horizon National Q3 2007 Earnings Call Transcript

First Horizon National Corp. (FHN)

Q3 2007 Earnings Call

October 18, 2007 9:00 am ET

Executives

Dave Miller - Director of IR

Jerry Baker - CEO

Bryan Jordan - CFO

Analysts

Tony Davis - Stifel Nicolaus

Christopher Marinac - Fig Partner

Eric Wasserstrom - UBS

Heather Wolf - Merrill Lynch

Fred Cannon - Keefe, Bruyette & Woods

Bob Patten - Morgan Keegan

Chris Sideman - OT Capital

Presentation

Operator

Good day, everyone and welcome to First Horizon National Corporation's Third Quarter Earnings Call. Today's call is being recorded. In addition, you can listen to this conference simultaneously at www.fhnc.com. Again, that is www.fhnc.com at the Investor Relations link.

Hosting the call today from First Horizon National Corporation are Jerry Baker, Chief Executive Officer, and Bryan Jordan, Chief Financial Officer. They are joined by Dave Miller, Director of Investor Relations for First Horizon.

At this time, all participants have been placed in a listen-only mode. But later, the floor will be opened for your questions.

Mr. Miller, you may begin, sir.

Dave Miller

Thank you, Operator. Before we begin, we need to inform you that this conference call contains forward-looking statements involving significant risks and uncertainties. A number of factors could cause actual results to differ materially from those in forward-looking information. Those factors are outlined in the recent earnings press release, and more details are provided in the most current 10-Q and 10-K. First Horizon National Corporation disclaims any obligation to update any forward-looking statements that are made from time to time to reflect future events or developments. Also, please remember that this audio webcast on our website at www.fhnc.com is the only authorized record of this call.

Now, I would like to turn it over to our CEO, Jerry Baker.

Gerry Baker

Good morning and thank you for joining the call. Let me start by saying that we faced market pressures this quarter, some large and many other financial services companies. We also did some solid work in further establishing our foundation for profitable growth. Our reported loss of $0.11 per share this quarter includes approximately $30 million or $0.20 per share and charges for restructuring, repositioning and efficiency initiatives. We also had roughly $65 billion of unusual impacts, from credit market disruptions to our businesses.

Bryan will go through the details with you shortly. Since I believe it will be helpful for us to spend some time revealing this quarter's market impacts.

In response to market conditions, we have adjusted pricing of mortgage originations and concentrated on conforming products. We have managed down inventories and commitments in capital markets and positioned the balance sheet well. I believe these challenges are temporary and we continue to take actions that will have a long-term positive impact on the profitability of First Horizon.

We are making investments in our Tennessee banking franchise. We are committed to building new financial centers in the high-growth markets in the state and expect to open ten or so a year for the next several years. We are focused on gathering deposits and adding top-talent and we have increased our emphasis on sales and marketing to expand our already leading market share in the state. We are already experiencing a near-term lift from this effort. But the long-term goal to move our Tennessee market share above 30%.

Our banking success in Tennessee is being recognized externally as well. First Tennessee's business banking was recently given the Overall Banking Services award for excellence in serving small business customers by Greenwich Associates. First Tennessee was one of only 22 banks recognized with this top honor and one of only 15 banks have repeated as a winner this year.

Additionally, we are continuing our careful review of all aspects of our business to identifying areas for improvement. This ongoing review has already led to a series of meaningful actions that will improve near-term results and long-term return on capital.

First, we announced recently that we have agreements to sell our First Horizon Bank branches. These transactions include all 34 full service locations and we expect that to be concluded by early next year. We were pleased with the outcome and believe that it is a testament for the quality of our people and operations in those markets.

Second, as we announced in September, we are reducing our dependency on real estate related businesses, by significantly cutting our national sales forces and related support costs. These actions should reduce earnings volatility and free up capital for higher return businesses or share repurchase, as we shrink our homebuilder one-time close and home equity national portfolios by over $2 billion over the next year.

We will also look for opportunities to sell mortgage servicing rights, when market conditions improve. Explore other avenues to further reduce our exposure to the mortgage business.

Third, we are taking other steps to adjust our business operations to improve profitability. These include shutting down our small business program out of Tennessee. We are focusing on our national deposit gathering on remote delivery via the internet and exiting the fore planned lending business in our traditional markets. We will realize other opportunities to improve our businesses as we continue our systematic review.

Finally, we are still on track to achieve our targeted $175 billion in annual efficiency and productivity benefits by first quarter of 2008. That means, permanently reducing our headcount and expense run rate. Once we reach our goal, we will continue review other expenses. I believe there is more we can do.

The impact of these actions I just outlined is significant. Our total FTE employees are now about 11,000, down more than a 1,000 from a year ago. We expect that number to decline further in 2008 probably to around 10,000 or less. Our objective has been to retain our top sales people for consolidating back office functions resulting in a substantial improvement in productivity. With this approach, we believe we can sustain and actually enhance our competitive advantage to our people.

Financial benefit of these efforts is also substantial. As I said, we are on track to execute a $175 billion of productivity in efficiency improvements. As of the end of the third quarter, we would estimate that roughly a $115 million of that annual benefit is in our run rate.

Additionally, the sale of the First Horizon Bank branches will improve pre-tax income by $30 million to $40 million annually and the restructure of mortgage on our national specialty businesses will improve profitability by another $30 million to $40 million.

Our real estate businesses are changing and we remain focused on the management and quality of our current portfolios. In today's environment, we're directing additional resources to manage problem loans which remain a relatively small portion of our total portfolio. As the economy slows and the housing market weakens further, we are seeing excepted deterioration in real estate loans. And so, we added to reserves again in third quarter as provision for loan losses exceeded charge offs. I am sure there will be some unpredictability going forward. But we expect asset quality cost to remain manageable as we move into next year.

Let me recap. We are committed to the process of evaluating all opportunities to make our company better and to taking swift action when these opportunities present themselves. We expect there will be some further efficiency and restructuring charges in the fourth quarter and first quarter of 2008. But there should also be gains associated with the sale of the First Horizon Bank branches. I believe the changes I have outlined today will significantly improve return on equity and the book value and we will reward shareholders accordingly.

In the meantime, we are comfortable that our capital position will support us as we make the necessary improvements to our business.

On another note, our Board of Directors have recently authorized the repurchase of up to 7.5 million shares over the next three years, giving us flexibility to redeploy the excess capital that will be freed up over the course of our business restructuring efforts. They also approved the quarterly dividend of $0.45.

Over the past few months, we have been asked several times about the sustainability of our current dividend. Our recommendation to the Board regarding dividends each quarter takes into account many factors. We believe that our current capital position for operating results and initiatives to improve efficiency and rebalance our business mix along with capital freed up as we reduce national lending portfolios, provide sufficient capital to sustain our current dividend and enable us to make investments in the near term.

As these factors change, we will factor them into our recommendations to the Board. But our efforts are focused on improving earnings and as a result, reducing our dividend payout ratio below the current level.

Now, I will turn it over to Bryan for his comments and later, we will take your questions.

Bryan Jordan

Thanks, Jerry. Good morning, everyone. Our reported results this quarter were a loss of $14 million or $0.11 per share, reflecting several unusual items, including disruptions in the credit markets.

We incurred charges of $33 million dollars this quarter from restructuring, repositioning and efficiency initiatives. These charges are related to our efficiency efforts, First Horizon Bank divestitures, restructuring of our mortgage business and the downsizing of national specialty business.

All charges are recorded in our corporate segment and we have again provided a detailed schedule in our financial supplement to explain which line items these charges impact on a consolidated income segment.

My detailed comments this morning will be divided into three main parts. First, the impact of the credit markets we had during the quarter and how we responded. Next, I will the review the progress being made with our restructuring, repositioning and efficiency efforts and then, the highlights from each of our business.

Based on the number of details, Dave and I will be glad to follow up with you after the call to review the specifics. As you know, we are in a number of businesses that are subject to inherent market related risks. In the third quarter, we experienced approximately $65 million of aggregate negative pre-tax impact to our Mortgage; Capital Markets and Consumer Lending businesses as a result of widening credit spreads and associated market illiquidity.

First, in Mortgage Banking, interim mortgage spread widened out substantially during the third quarter. Although, the majority of our production has always been GSE eligible for governments, the value of prime non-conforming loans in our warehouse and locked pipelines are managed significantly.

The widening of mortgage swaps spreads help to improve MSR hedging results and servicing run-off has also slowed providing additional offsetting benefit. In total, the negative mark-to- market and lower cost of market or LOCOM impacts in the net hedging and run off benefits, reduced profitability in our Mortgage business by approximately $45 million during the quarter.

Second, in Capital Markets, disruptions in the CDO market significantly decreased demand for pooled trust preferred securities in the third quarter. Accordingly, we completed a smaller issuance of $330 million this quarter in the disrupted environment. The impact of this disruption on our pooled trust preferred product reduced Capital Markets' profitability by approximately $15 million in the third quarter.

While our structured finance business will remain with quarterly fluctuations, we believe the market will come back as it is an important source of capital for smaller banks.

In National Consumer Lending, our quarterly sales of consume loans was also disrupted in the third quarter as investor demand for even high quality home equity product dried out. As a result, we incurred approximately $5 million of increased LOCOM in our retail/commercial banking segment this quarter and have significantly diminished revenue from loan sales.

We are not certain when or if the secondary market for consumer home equity loans will come back and have adjusted our operations to reflect this outlook.

We responded to these market conditions throughout our businesses. In Mortgage, we significantly adjusted pricing and product mix and sold rather than balance sheeting $1.3 billion of our prime non-conforming production, leveraging our capital markets distribution system. We did retain $19 million of subordinated bonds at the end of the quarter, since they have attractive yields and solid credit metrics.

In Capital Markets, we reduced our total average earning assets by approximately $900 million in the third quarter compared to second quarter, primarily due to a reduction in average fixed income trading inventory from $ 2.5 billion in the second quarter to $1.8 billion in the third quarter.

During the third quarter, we also designated a small amount of trust preferred loans with good underlying credit characteristics as held to maturity. We also managed our trust preferred warehouse to mitigate risk in the current market environment. While, the overall deal size of the pooled trust preferred transactions we have completed over the past two years has ranged from approximately $600 million to $1.6 billion, typically less than 50% of the underlying collateral, mixed transaction has been pre-funded on our balance sheet.

Additionally, as market condition has changed this quarter, we slowed the rate of pre-funding commitments and adjusted our price in our funding that we did make. As a result, we incurred only a minimal LOCOM adjustment on our trust preferred warehouse quarter end.

In our National Consumer Lending business, we have eliminated originations of standalone products. We held $300 million of consumer loans that would otherwise have been sold or considered held for sale in prior quarters. These consumer loans have good yields and strong underlying credit risk with an average FICO score of nearly 740 and average CLTV of 86%.

Our overall liquidity position is solid. We have adjusted our funding strategies throughout the quarter according to market conditions. As a result, we have reduced liquidity and higher borrowing costs in the consumer CD market. We shifted $2 billion in wholesale funding from short-term CDs to lower cost Federal home loan bank advances.

During the quarter, we sold substantially all our current mortgage, HELOC and other productions to maximize future balance sheet flexibility. Our loans to core deposit ratio was 163% at the end of the third quarter, nearly in line with the second quarter at 157%.

As we continue to implement changes in our national real estate construction and national home equity lending businesses, we expect this ratio to improve going forward.

As we have seen market conditions stabilize somewhat since mid-September, while we do not see the market for non-conforming mortgage product improving significantly in the near term.

We don't expect the great deal of further spread widening and this production has been priced accordingly. And although, it's difficult to predict, the pooled trust preferred markets should begin to stabilize over the next few months.

Now move on to our repositioning, restructuring and efficiency initiatives. We are focused on improving returns on capital, despite a challenging market, by moving to further reduce costs and restructure certain businesses. We should see substantial annual pre-tax benefits from theses efforts across four broad areas.

First, with our enterprise wide efficiency initiatives, we continue to execute on our efficiencies and productivity improvements. Combined with 2006 initiatives, the 2007 efforts are expected to produce about $175 million of annual benefit by the first quarter of 2008. We are currently tracking over 75 individual projects to make up these efficiency initiatives. We do not expect these cost reduction efforts to have a meaningful adverse impact on revenues or customer service.

You will note that our operating expenses decreased $36 million from second to third quarter driven by the realization of lower variable costs and roughly $12 million in additional efficiencies related to these initiatives. As Jerry pointed out, our third quarter run rate reflects approximately $115 million of annualized benefit of our targeted $175 million of annualized cost reductions.

Second, the sale of the First Horizon Bank should improve pre-tax income by approximately $30 million to $40 million annually. Some benefit will be realized late in the fourth quarter of this year, but the majority will be late in the first quarter 2008, as we complete the divestitures.

Please not that since we have signed definitive agreement in September for the sale of First Horizon Bank branches, we moved $511 million of deposits and $165 million of loans into held for sale categories as of the end of the third quarter. We have broken these out for you on a consolidated balance sheet in our financial supplement.

Third, we are restructuring our mortgage business. We are eliminating the lower 50% of our retail sales force, reducing wholesale account executives and management, closing 50 to 60 offices, decreasing wage support staff and cutting other back office costs such as technology. We expect to have the majority of savings in place by the middle of the fourth quarter.

Fourth, we are downsizing our national specialty businesses. We will reduce our sales forces in construction lending and consumer lending as we pair back originations and focus on current relationships. We will also eliminate our national small business program and are significantly downsizing our network of national FSMs. We expect to have many of these savings accomplished by year end, although some will be faced in over 2008 as we manage down existing construction commitments.

The net impact of restructuring our mortgage and national specialty business should add an additional $30 million to $40 million to our annualized pre-tax run rate over the next several quarters. Over the next two quarters, we would expect to incur additional charges associated with this efficiency and restructuring initiatives. In addition, we currently expect up to $40 million in gains from divestitures.

We have again provided a detailed schedule in the financial supplement to explain these restructuring initiatives as clearly as possible including charges and their impact on the consolidated income statement, estimated benefits by segment and an estimated benefit realization table.

Now, I will move on to highlights from each of our business lines. In the Retail/Commercial Bank, we are focusing on improving profitability and growing market share in our Tennessee full-service banking operation. We have adjusted our deposit pricing to competitive levels and we have also increased marketing spending as we launched a major statewide campaign to engage our sales force to bring in new customers, especially in light of ongoing competitive consolidation.

Our activities are particularly focused on bringing in deposits as well as primary consumer and business relationship. The results of these efforts appear to be paying off. During the third quarter, net consumer checking account increase by 9,000 accounts, up 35% from last quarter and more than doubled the net growth experienced in third quarter of 2006.

Business customer growth has been encouraging as well. As a result of these actions, direct contribution from First Tennessee Bank increased 4% sequentially. We expect growth to continue in the quarters ahead, as we reap the benefits of our investments and the opening of new financial centers in Tennessee.

The pre-tax income for the total Retail/Commercial Bank segment declined 4% sequentially to $78 million in the third quarter. This decline was driven mainly by increased provision expenses for our national construction businesses and reduced consumer loan sales in our national consumer lending business.

Deposits in the Retail/Commercial Bank grew slightly over second quarter and 2% year-over-year. And deposit fees increased 4% sequentially, driven by primary account growth and higher transaction fees. Loans declined 1% sequentially over second quarter and increased 2% year-over-year. As we've mentioned, we expect tighter underwriting and sales force reductions to shrink our real estate loans by $2 billion over the next year.

The net interest margin in the Retail/Commercial Bank was relatively flat compared to the second quarter at 3.88% in the third quarter, driven largely by improved spreads in Tennessee, offsetting continued pricing pressure on consumer and construction loans in our national markets.

Expenses declined 6% sequentially and the efficiency ratio improved by over 200 basis points, as we had lower variable compensation costs and we continue to realize the benefit of our ongoing restructuring, repositioning and efficiency efforts.

In the mortgage business, pre-tax income for the third quarter was a loss of $46 million, $30 million below the second quarter levels. Originations declined 8% over second quarter to $6.7 billion in the third quarter. 72% of volume was from conventional or government product up from 66% last quarter.

However, based on changes made in midway through the quarter, we would expect 85% of new production going forward to be GSE eligible as non-conforming origination volumes decline. Gain on sale margins declined from 76 basis points in the second quarter to negative 33 basis points in the third quarter driven by the market impacts already discussed.

MSR run-off declined to $49 million in the third quarter from $63 million in the second quarter driven primarily by increased coupon rates on non-conforming loans and disruptions in the mortgage market. MSR net hedging performance improved significantly to a positive $22 million in the third quarter, $37 million better than the $15 million loss last quarter. As spreads between mortgage and swap rates widened, option volatility increased and seasonality moved in our favor. We do not expect to sustain this level of positive hedge performance going forward.

Expenses in mortgage banking decreased $7 million from second to third quarter, primarily driven by the impact of efficiency and restructuring initiatives and lower legal expenses, which will partially offset by the timing of origination costs. Going forward, we expect volume to slow and pricing to remain challenging in the mortgage business. Absent further incremental disruptions to the mortgage market, we believe that our product and cost structure changes should enable the mortgage segment to return to around breakeven in the fourth quarter.

In the capital markets segment, pre-tax income declined sequentially from $13 million in the second quarter to a loss of $8 million in third quarter. Fixed income revenues were $46 million this quarter as compared to $48 million in the second quarter. As Fed fund rates and the yield curve steepened, we did see a pick up late in the fourth quarter.

Other product revenues declined significantly from $42 million in the second quarter to $16 million in the third quarter. As our structured finance business was significantly impacted by credit market disruptions, namely, pooled trust preferred issuances. Going forward, we expect continued demand from our institutional client based to raise capital through trust preferred issuances. While we believe that investor demand for these securities will return, it is difficult to predict when this might occur.

Capital markets expenses declined $7 million from second quarter to third quarter, as lower revenues drove lower variable compensation costs and we remain focused on expense control in a challenging environment.

Turning to our consolidated financials, the tax benefit of $9 million this quarter primarily reflects a normal statutory Federal and state rights, and permanent tax benefits of $7 million, offset by 7 $million of increased taxes of non-deductible goodwill included in our restructuring charges.

Corporate net interest margin increased from 2.79% last quarter to 2.87% in the third quarter, primarily driven by lower trading assets in capital markets, a smaller mortgage warehouse and a decrease in wholesale funding costs from a lower effective Fed funds rate.

Going forward, we expect the margin to improve somewhat, would steep the yield curve and the reduction of lower margin businesses, including the First Horizon Bank branches and national consumer lending.

Given the slowing economy and the weakening housing market, we are particularly focused on managing asset quality. We have committed additional resources to managing problem loans. Overall, our C&I and consumer lending portfolios remain healthy and our greatest detention remains focused on our national construction businesses.

Charge-offs in the third quarter increased to 57 basis points versus 41 basis points experienced in the second quarter. Deterioration of problem construction loans were a key driver in the charge-off increase. And we also addressed a few individual C&I loans in our full-service bank markets.

NPAs increased from 81 basis points last quarter to 113 basis points in the third quarter, primarily reflecting the downward migration of home builder and condominium construction loans. One-time close loans also contributed to the increase.

Our allowance to loan ratio increased from 103 basis points last quarter to 108 basis points in the third quarter, as we provisioned in excess of charge-offs again this quarter. Provision expenses were relatively flat sequentially at $43 million, but rose excluding the $8 million of additional provision last quarter associated with the divestiture of some national loans.

In the OTC portfolio, we are aggressively managing weakening credits. Issues were magnified in specific markets, like Florida, or home loan buyers have declined and where real estate speculation was wide spread. We have made significant changes to the way we approach this business, including equity requirements, product channels and process management. And we are confident in the quality of current production.

However, problem asset levels and resulting in charge-offs, this portfolio is likely to increase somewhat throughout 2008. Inflow to non-performing is expected to remain near current levels while outflow with remediation and disposition will continue to be a slower process. Problem loans and our home builder finance portfolio increased in third quarter as well.

Our pressure was evident across several markets, other markets and specific segments remain largely unaffected. We are focused on portfolio management and are leveraging the experience of our bankers' prior cycles to manage us both. We continue to have confidence in our approach to this business. But we expect pressure on portfolio metrics going forward.

Our home equity portfolio performance remains steady, favorable to the industry and better than expected. We except some deterioration of this portfolio overtime due to market conditions, but continue to expect our performance to be favorable relative to peers. We attribute this to high quality borrowers, predominantly retail originations and underwriters.

While, we expect continued challenges within our construction portfolios and may experience some bleed over to home equity and C&I for credit cost are expected to remain manageable as we move into 2008. Of course, we may continue to see quarterly variations caused by lumpiness from individual credits.

In summary, given the difficult markets of the third quarter, we are pleased with the progress we are making to rebalance our business mix, realize efficiencies and build a more predictable earnings space. We still have additional work to do, but our core franchise is strong and we are executing on the steps necessary to drive long-term shareholder value creation.

With that, I will turn it back over to Jerry for his closing comments.

Jerry Baker

Thanks Bryan. That was a lot to cover. In conclusion, we expect the operating environment to continue to have its challenge, although, we should see some improvement over the turbulent events of the third quarter. We expect continued weakening of the housing market as some inventories decline, prices soften and some buyers are removed from the marketplace by less availability of credit.

However, conditions will clearly vary by market and price point and we have seen many of pressurized end-markets remaining stable. Credit markets appear to be returning towards more rational behavior. The Fed rate cuts and modernization of Federal loan programs should help some borrowers. The yield curve has steepened somewhat, although, the spread between LIBOR and Fed Funds remains elevated.

I do no want to use the market as an excuse for performance. We must continue to make changes to improve our ability to perform well in many different environments. To that end, we remain focused on investing on our Tennessee banking franchise, while completing the divestiture of our First Horizon banks, downsizing our national mortgage and specialty banking businesses, executing many efficiency initiatives we previously outlined, maintaining asset quality and reviewing all business areas for further opportunities to improve returns.

We have more work to do and more opportunities to improve our profitability. We will substantially increase shareholder value by reducing our real estate exposure, borrowing, earnings volatility and paying up capital that can be redeployed for higher return activities or use for share repurchases. We believe the decisions we are making will reward our shareholders over the long term.

Now, let me turn it back over to the operator and open it up for your questions.

Question-and-Answer Session

Thank you, sir. (Operator Instructions). For our first question, we go to Tony Davis with Stifel Nicolaus.

Tony Davis - Stifel Nicolaus

Jerry, Bryan, good morning.

Jerry Baker

Hi, Tony.

Bryan Jordan

Good morning, Tony.

Tony Davis - Stifel Nicolaus

It is a difficult time out there. The last time I remember you caught with disclosing this I think was probably back in March. And I think the number at that point was around 4%. But I wonder if you could give us some idea of what the watch list looks like right now relative to total loans? And, could you give us a little more color on the risk classification migrations you have seen outside of residential and construction?

Jerry Baker

I think that watch list percentage is down about 3.5%. Our detailed red and yellow and green are still the same. Suspects that you have seen the past, it's Florida, around Georgia, Atlanta marketplace, Washington DC, a little bit in California. Bryan, I want you to add to that.

Bryan Jordan

All right, the thing I would add is that in terms of our risk rating, we have seen a little bit pressure on downward migration. We would expect that to continue in this part of the cycle. In some sense, the depth and severity of what we are seeing in the markets will continue to pull it down, if this persists. And so, we are very actively monitoring it. And we have got a tremendous amount of resources dedicated to managing problem assets. But at this point in the cycle, although, watch list is down a little bit, we think credit risk ratings will probably have more of a negative bias in the near term than a positive bias.

Tony Davis - Stifel Nicolaus

And Bryan, what's the average LTV on the commercial real estate right now?

Bryan Jordan

Commercial real estate, I am not sure you are going to express it that way, because you have got so much on a spread across so many different categories. I would suggest that in average, it's going to be, I don't know, Jerry, we might get back to him on this.

Jerry Baker

Yeah. We can follow up with you Tony. Probably, it's going to be very clear where you are going to have -- what we do in LTVs on land and LTV on vertical constructions might go up to an 80% level. But we'll follow up with you, Tony.

Bryan Jordan

That portfolio has been performing very well. And we feel very comfortable with what we are seeing there. It's more in the residential construction side that we have bigger concern.

Tony Davis - Stifel Nicolaus

Right, yes, I was speaking about the construction side.

Jerry Baker

And Tony, I would add one other thing. It might be a good point. It would be of interest to others as well that I see some discussion in the news that the housing crunch might last a quarter or so. I think our review is that it goes well into 2008. I don't think it's going to be short term. And in many ways, the residential marketplace is driven by the lack of the availability of financing for home buyers. On both ends of the spectrum, there's a fair amount of availability for conforming product, but not for nonconforming, even for good creditworthy borrowers. And so, until that eases some, I think it's going to have continued pressures on the absorption of already build or soon to be build homes.

Operator

We go next to Christopher Marinac with FIG Partner.

Jerry Baker

Hey, Chris.

Christopher Marinac - Fig Partner

Hi. Good morning. Jerry, I just want to clarify. On the dividend review, is that done monthly, quarterly, and when was the last time the Board visited that?

Jerry Baker

We review that every quarter and present it to the Board quarterly. And that was done several days ago as we went through our Board meeting.

Christopher Marinac - Fig Partner

Okay. So the next time when that's up on the agenda, will be January.

Jerry Baker

That's correct.

Christopher Marinac - Fig Partner

Okay. And then the follow-up question, I guess is in general. What would be your goals for the deposit franchise in 2008, just focused on Tennessee and kind of back to basics there?

Bryan Jordan

Chris, this is Bryan. Good morning. As we focus on the Tennessee market over the next year, we are really expecting very attractive growth rate. We think that the advertising and marketing we put in to the market, the steps we have taken around competitive pricing and segments to the market, coupled with our ["power of can"] campaign, which is designed to engage our sales force in growing both the consumer and the business, commercial type deposits in our footprint. We see significant transactions starting to build.

So, we would expect something in the low-to-mid single digits in terms of the deposit growth next year in the State of Tennessee. From a quarter perspective that will be masked by the sale of the deposits which we have talked about in the First Horizon branches. But we expect pretty attractive growth in the state of Tennessee next year.

Jerry Baker

I might add too. We typically have experienced about 50 basis points in market share growth in Tennessee, a little better in the last year. And we would expect it to be strong above 50 basis points, may be as much as 100 basis points improvement, the consolidations in the state as well as what Bryan said, our focus on marketing and communications in the state on, what we call, "the power of can" and the engagement of our, not just our ground staff, but all of our relationship management and wealth management teams are focused together on growing deposits and increasing new customers.

Operator

We go on next to Eric Wasserstrom with UBS

Eric Wasserstrom - UBS

Thanks. Good morning, gentlemen.

Bryan Jordan

Hey, Eric.

Eric Wasserstrom - UBS

I was wondering if you could help me and sort of prioritize your usage of capital. There seems like there's a lot of conflicting pressures on capital, on the one hand, obviously, a very high dividend on compressed earnings. You also made the announcement about the share repurchase authorization. It seems like there could be some benefits from cost savings conversely, credit pressures are also mounting. Can you just help me understand where you prioritize the use of capitals right now?

Bryan Jordan

Eric, this is Bryan. In terms of priorities right now, we feel like we have adequate capital to support the growth that we see in the balance sheet and what we need to invest in the business over the near term. As we shrink the portfolios that Jerry enumerated in the comments and I touched on as well, we should free up a significant amount of capital over the next year. That coupled with our improvement initiatives around efficiency, restructuring the mortgage business and driving greater profitability there, we think drives the payout ratio on the dividend down by increased earnings.

And so, in the near term, we wouldn't expect to be active in share repurchase. We do think it’s important, given the shrinking that we expect in certain portfolios in the balance sheet, to have the flexibility over the next two or three years to purchase the stock when it is attractive. So, in the near term, I think we have adequate capital. It's designed to support the dividend, to drive, to enhance earnings and drive that payout ratio down.

Eric Wasserstrom - UBS

Thanks very much.

Bryan Jordan

Sure.

Operator

And for our next question we go to Heather Wolf with Merrill Lynch.

Bryan Jordan

Hi, Heather.

Heather Wolf - Merrill Lynch

Hi. Good morning. I was just taking a look at the charge-offs that you have taken in the two construction portfolios, relative to the non-performing loans, and it doesn't appear that you are expecting material loss severity. I was wondering if I have interpreted that correctly and if you can put any numbers behind it?

Bryan Jordan

Hi. Heather, this is Bryan. I would say material is a term of art rather than science. Again we have seen those losses tick up substantially all of the growth in our losses or in the one time close and the homebuilder finance product. We expect that they should remain elevated for a period of time. I think in the one time close product we had about well over $6 million in losses, and about $5 million or so in the homebuilder finance. So, on an annualized basis that's higher than we would hope for run rate. But as we said, until we get clarity about the depths in the severity of what goes on in housing, we feel like they are sustained at these levels, and maybe a little bit upper pressure, but we think its manageable.

Heather Wolf - Merrill Lynch

Okay and just a quick follow-up to that, does your capital plan assume that there isn't a substantial pressure to your credit cost over the next year?

Bryan Jordan

As we look at the capital plan, we factor in credit cost, and as I said, we assume that credit costs will be elevated, and maybe up somewhat from here. But in terms of severity we've not put clearly, we haven't elevated it significantly because we think at this level, we think it's manageable, and we can work through it.

Operator

We go next to Fred Cannon with Keefe, Bruyette & Woods.

Fred Cannon - Keefe, Bruyette & Woods

Thanks and good morning. And this question is really for Jerry. Really the question is, what is the national "Outside of Tennessee" strategy for the company at this point in time, I mean after over a decade, I believe kind of expanding based on following mortgage up with branch banking. It would appear you are scaling back significantly in branch levels in mortgage, and in national asset gathering strategies. I was wondering, are we evolving back to a Tennessee bank, away from the national strategy or what exactly are you planning on in nationally moving forward?

Jerry Baker

Fred, I would say that we are a bank that is community focused and that focus is primarily in markets that are in and around Tennessee and in the Southeast. Yes, we have a national business in our middle market lending, and asset based lending, of course, our capital market's activity in mortgage, and in many markets around the country. But in terms of banking, I think that our best focus for certainly the short-term and over the next year or two is around and in Tennessee and in the markets adjacent to Tennessee.

Fred Cannon - Keefe, Bruyette & Woods

Okay. And then are those national businesses that you also mentioned, credit quality, your strategy moving forward or are you essentially re-evaluating?

Jerry Baker

Well, I think there are positive compliments to our strategy. In many ways these businesses intersect and intertwined together, certainly capital markets with our banking activity, and with mortgage and vice-versa. And I think we're getting better at having our various specialty businesses work together. But I think it's clear with the size of our organization that we'll do best, focused on a broader regional basis, not just in Tennessee but on a broader regional basis, then national.

Operator

We go next to Bob Patten with Morgan Keegan.

Bob Patten - Morgan Keegan

Good morning guys.

Jerry Baker

Hey Bob.

Bob Patten - Morgan Keegan

Most of my questions have been asked. I guess just on a bigger picture, Bryan and Jerry, where are you in the overall business review. I would assume you have completed at this point, and then if you have completed, and when it's about execution, what is left or what else can you do in terms of business rationalization here that you don't think you've done? What stones are left unturned?

Jerry Baker

I think Bob, one of the things that we're focused on heavily is how do we maximize the businesses that we are in today? Are we in the right segments in terms of our customer activity, are we maximizing it between different segments of customer relationships and business relationships? How de we fine tune, both our pricing in those different aspects of what we do, and we are going through that.

And so there is a little more work to do in that area. There are few businesses that we are watching to see if they perform as we expect, I expect that they will, but we still want to continue to watch those, because our game is to make sure that we are delivering as much value from the businesses we're in. So, we're getting to the point as certainly as we enter 2008, its execution.

Bob Patten - Morgan Keegan

Can you give us a sense of the moving parts over the next two quarters, because now we are talking about charges going in to '08 in terms of gains and charges left and where they are attributed to?

Bryan Jordan

Yeah, Bob, this is Bryan. I think the bulk of the charges will be realized in the fourth quarter, and we are still within the original framework that we said, some where between $90 million and $100 million, so, probably another $20 million maybe $30 million in charges. That will be offset by the premiums on the sale of the First Horizon branches. The bulk of that will be in the first quarter, because that's when those divestitures close. We'll have a little bit in November that offsets the charges. But we expect up to $40 million of net premium, they are offset by a little bit of severance and costs, whether we have yet to accrue it.

Bob Patten - Morgan Keegan

Alright, thanks Bryan. And then last question, obviously with your dividend payout ratio, peaking and your yield now at 7.5%, people are getting very uncomfortable in terms of how this Company can sustain this dividend. Obviously with still the capital markets and mortgage businesses under stress, what is the dialogue that you go through with your Board in terms of justifying that dividend?

Bryan Jordan

Yeah, in Jerry's comments, and then I guess in mine, Bob, listen we are very attuned to the need to drive that payout ratio down by increasing our earnings level. We think the initiatives that we have in place will do that, if you remove the market dislocations and the one-time costs from this quarter, we think our core earnings rate is approaching the level of this dividend. And you take into the account, the additional efficiency initiatives we have, the opportunities, we think we realize from the actions in the mortgage, in the national business as well as, the divestiture of First Horizon banks.

We think we can get to a place where we reduce that payout ratio below a 100%. As we talk to the Board, we make that as a very clear point. And we also really talk about the issues that Jerry has enumerated. Can we support the growth and the investments that we need to make in the business? And make the right kind of investments for long-term? So, as Jerry said, it's a quarter-to-quarter evaluation and we are getting ample of it, stay very focused on it.

Operator

And we go next to [Chris Sidemen] with [OT] Capital.

Chris Sideman - OT Capital

Hi, good morning, not to beat a dead horse here, but with respect to the dividends, could you maybe walk us through the constraints on the parent's ability to upstream cash from the bank and also from the non-bank subsidiaries, which apparently turned in losses this quarter. And maybe could you also comment as to whether or not the regulators have sort of blessed your calculations in terms of the sustainability of that dividend. Let's say going into next year?

Bryan Jordan

Chris, this is Bryan again. In broad terms, it's not quiet this simple, but in broad terms you have available earnings from the two previous years, plus earnings from the current year available in the regulatory calculation. There is also a provision to make a request from the regulators. It's not a computation that the regulators would bless, they are mindful of our need for capital in the bank. And as we look at the capital ratios in the banking organization, we want to maintain very strong capital levels there. But the big limitation on cash flow to pay dividend for the holding company does come out of the banking franchise that's because that's where the bulk of the earnings exist.

Now, we feel like we have adequate liquidity as a holding company, and we have adequate dividend availability as we move into 2008 to sustain the dividend. If we can deliver on these things that we have said, which are the improved earnings initiatives and the gains we expect to get out of First Horizon divestures, and the mortgage in national markets activity. So, at the end of the day, the calculation is going to be greatly influenced by our ability to do the things that we have said we are doing to improve that earnings right from. No matter how you define the third quarter in terms of a core rate, but to get that up above the 45 and greater level to drive that payout ratio down.

Operator

And with a follow-up question, we return to Bob Patt with Morgan Keegan

Bob Patten - Morgan Keegan

Hi, I got to ask a question. I am looking at the capital markets business and I am looking at, the trust preferred business which was a great business of yours for a long time, but that's a CDO business and that market is closed. And I think everybody is optimistic that it’s going to get better, but how do you sort of weigh the value of capital markets in this environment, if we are sitting here a year from now and we could be, with a market that's locked up and versus the cost and the carry?

Bryan Jordon

Bob, this is Bryan. Again, the CDO market has been slow. We did get a small issue. It has done about $330 million in the quarter. There is still a very strong demand from issuers to issue products, it's an important part of the capital structure for the relative financial services industry. And ultimately we think that that market will comeback. We think it's an important part of the capital structure. So, we're not sure whether it's the fourth quarter or the first quarter. We're encouraged Bob, that it moved a little bit in the third quarter. And we hope that it will start to move in the fourth quarter.

We think capital markets as a business is an important part of our business, its important that we integrate it further into the banking business over the next year or so. And we have taken steps to do that in the past, it's been an important part of our distribution network for product. It was originated in other channels, it has evolved in our banking businesses, and so it's an important business. We think that the CDO, the pool trust preferred business will comeback.

And we think the actions that we've got in place to further integrate that into our customer service model to enable us to be effective and serving broad customer needs. It's very important. Including continued improvement in fixed income business that we have [stopped this] last two or three months that we have seen in a long time, besides continued activity in the other aspects of what it really had balanced broker dealing.

Jerry Baker

In two or three weeks.

Bob Patten - Morgan Keegan

Okay. Thanks.

Jerry Baker

Thanks Bob.

Operator

And with that ladies and gentlemen we have no further questions on our roster. Therefore, Mr. Baker I will turn the conference back over to you for any closing remarks.

Jerry Baker

Thank you very much. We had good questions. We appreciate the opportunity to have dialogue with you. We feel like we're making the changes that need to be made, we are confident in actions we're taking, and what we're doing as we go forward here. And we will be anxious to be back with you in January and share with you the progress we've made over the intervening several months here. So, thank you very much and have a great rest of the day.

Operator

And ladies and gentlemen this does conclude the First Horizon National Corporation conference call. We do appreciate your participation, and you may disconnect at this time.

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