John A. Allison, IV - Chairman and Chief Executive Officer
Christopher L. Henson - Senior Executive Vice President and Chief Financial Officer
Steven Alexopoulos - J.P. Morgan
Nancy Busch - NAB Research
Betsy Graseck - Morgan Stanley
Todd Hagerman - Credit Suisse
Jefferson Harralson - Keefe, Bruyette, & Woods
Christopher Marinac - Fig Partners
Chris Mutascio - Stifel Nicolaus
Matthew O’Conner - UBS
David Pringle - Fells Point Research
Gary Tenner - Suntrust Robinson Humphrey
Gary Townsend - FBR Capital Markets
BB&T Corp. (BBT) Q3 2007 Earnings Call October 18, 2007 11:00 AM ET
Greetings ladies and gentleman, and welcome to the BB&T Corporation Q3 of
2007 earnings conference call. At this time all participants are in a
listen-only mode. A brief question and answer session will follow a formal presentation. If anyone should require operator assistance during the conference, please *0 on your telephone keypad. As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Ms. Tamera Gjesdal, Investor Relations manager for BB&T. Thank you, you may begin.
Thank you Diego and thanks to all of our listeners for joining us today. This call is being broadcast on the Internet from our website at bbt.com/investors. Whether you are joining us this morning by webcast or by dialing in directly, we are very pleased to have you with us.
As is our normal practice, we have with us today John Allison, our Chairman and Chief Executive Officer, and Chris Henson, Chief Financial Officer. We will review the financial results for this third quarter of 2007, as well as provide a look ahead. After John and Chris have made their remarks, we will pause to have Diego come back on the line and explain to those who have dialed into the call how to participate in the question and answer session.
Before we begin, let me make a few preliminary comments. BB&T does not make predictions or forecasts, however there may be statements made during the course of this call that express management's intentions, beliefs or expectations. BB&T actual results may differ matierally from those contemplated by these forward-looking statements. Additional information concerning factors that could cause actual results to be materially different is contained in the company's SEC filings, including but not limited to the company's report of Form 10K for the year-end of December 31, 2006. Copies of this document may be obtained by contacting the company or the SEC.
And now it is my pleasure to introduce our chairman and CEO, John Allison.
John A. Allison IV, Chairman and Chief Executive Officer
Good morning Tamera, and thank all of you for joining us. We'll try to give you some insight into our third quarter financial results along with the year-do-date results, focusing primarily on asset quality and non-interest income. We'll share with you a few thoughts about merger and acquisitions, and then some thoughts about the future financial performance. Chris is going to give you some deeper insights on what's happening to our margin non-interest expenses, taxes on a capital position, and then of course we'll have time for questions.
Our GAAP net income for Q3 was $444 million, up 6.5%. Operating earnings were $448 million, up 5.7%. GAAP-diluted EPS for the Q3 was $0.80, up 3.9% and operating-diluted EPS was $0.81, up 3.8%. The $0.81 was $0.03 less than the consensus estimate, by fault of the primary reason we missed the consensus with the impact of market disruption on our capital markets and other businesses, which we think was in the $25 or $26 million range, about $0.03 a share. I'll talk a little bit more about that.
If you look at our returns, they remained very good. Our cash ROA was $1.50, cash ROE was 26.86. Our cash base in EPS was $0.84, up 3.7%. Year-to-date we had similar kind of results. GAAP net income $1.323 billion, up 3.6%, operating earnings $1.334 billion, up 5.5%. GAAP EPS 240, up 2.1%, operating EPS 242, up 3.9%. Cash EPS 251, up 3.3%, and similar kinds of returns which are still pretty healthy. Cash ROE 27.83.
If you look at the financial results, margin continues to be a big challenge for us, although we plan there's going to be some improvement in that regard, as Chris will discuss, but our margin continued to decline to 354 in Q3 from 355 in the second, down ten basis points and down from 368 back in Q3 of 2006. As I said, Chris will give you some good insights there.
Our interest income was a challenge, and kind of counter to the trends we've been having. If you look at non-interest income and take out purchase acquisitions and the MSR impairment, annualized second to third was actually down 34%, third to third was basically flat up .6%, year-to-date is up 6%. Again looking at each one of these areas excluding non-recurring and purchases, in shares commissions we had a fairly challenging quarter. It was down from Q2, which is partly seasonality, but we're also experiencing very intense price pressure in the insurance commission business. If you look at third to third, we were up, were essentially flat in terms of insurance revenues taken out of purchase acquisitions, etc. which actually is very good compared to the industry. We haven't seen the Q3 report, but I know looking at the numbers we've seen from our peer group in the insurance business, most are experiencing anywhere from 5-10% reduction in revenue because of really soft pricing markets, so we're actually moving market shares simply to keep our revenues flat in insurance.
Service charges was good news, our service charges annualized link, we're up 15.8%. Third over third up 11.3%, we added 30,000 net new transaction accounts, we've added 91,000 year-to-date so we continue to do well in terms of creating new client relationships and service charge revenues.
Our non-deposit fees and commission, which are primarily our debit card and bank card fees, annualized link up 3.1%, third to third up 11.2%, pretty healthy growth there. Investment banking down 4.5% on a link basis, up 6% third to third. Obviously that market has slowed with what's going on in the overall capital markets. Trust revenues were flat, mortgage banking income was down slightly in the third from $31 million in the second down to $27 million in the third quarter, up a little bit from $24 million in the third of last year.
Despite the fact that we had a very good production quarter, our production was $3.225 billion, one of the best quarters we've had in terms of production, the commotion in the mortgage market impacted the short-term profitability of our mortgage banking business. As you know, we practically don't do any sub-prime lending, and we're almost, we're very largely a portfolio lender, with Freddie Mac and Fannie Mae being our large production is focused to that marketplace. We did have a small amount of our production that went into the capital markets and we did take some small losses in that regard that one time in nature. It won't affect our business going forward, in fact going forward we're very optimistic because there's a flight to quality, and you can see with our production volumes, despite a very soft mortgage origination business, we're clearly moving share. So our very traditional business, while we had some losses in the third quarter as the market went through the disruption, should benefit in the fourth quarter and going forward from what's actually happened in the mortgage marketplace, because we're a very traditional mortgage originator.
Other income was down significantly in the third quarter compared to the second, and down 60% third to third. This decline in other income was mostly market related activities in our capital markets business and also in our Scott & Stringfellow business and hedge-related activity. As I mentioned earlier, if you look at all of our market-related losses, we think they've totaled about $26 million, about $0.03 a share. The good news is that they shouldn't happen again in the future unless we have the same kind of market disruption, and none of the losses are critical to revenues going forward, they were just because of the disruption in the marketplace.
The other item that's important is our non-interest expenses, which is a very good story. Non-interest expenses analyzed second to third, we're down 19.7%, third to third down 4.7%, and year-to-date are down .8%, so that is good news and Chris is going to give you some insight into how that happened.
Looking at growth, actually pretty good results on the loan growth side, from a GAAP perspective, annualized second to third, our total loan growth was 9.8%. If you take out purchase acquisitions, securitizations and leveraged leases, average growth second to third, we were pretty pleased with. Commercial was 6.5%, direct retail 1.6%, sales finance 12.5%, revolving credit 19%, mortgage 13%, specialized lending 16.4%, total 8.2%. Have a look at those and compare them to the third to third numbers and see what the direction is. Commercial was 6.5%, direct retail 2%, sales finance 10%, revolving credit 11%, mortgage 11%, specialty lending, if you take out AFCO/CAFO fluctuation was 19.2%, and total 7.4%.
And the year-to-date numbers are similar but different. You can see what's happening in the portfolio. Commercial 6.4%, direct retail 3.1%, sales finance 10. 4%, revolving credit 8.1%, mortgage 11.3%, specialized lending without the AFCO/CAFO acquisition 22.4%, and in the total 7.7%.
If you look through the portfolios then what you see is commercial has actually been fairly stable at around a 6.5% growth rate. What's happening in that portfolio, we're having a pretty significant slowdown in residential related construction lending, as you would expect. But we're having pretty healthy growth in our C&I portfolio, both in the small business market and in the corporate market, so that's offsetting the slowdown in the residential related construction lending. The only negative is that residential related construction lending as some of the best margins because of pricing in it.
Direct retail continues to slow, and that is a challenge for us. Our sales finance business is actually fairly strong, we continue, we believe, to move market share. In the automobile finance business, we were ranked again as the number one prime lender to automobile dealers in America in terms of service quality. Also we've entered both the RV and the boat market and are having pretty good success in those marketplaces. Revolving credit business, momentum is building, and that's really an internal push to sell more credit cards, and particularly commercial credit cards into the small business marketplace. I think that's more largely an internal effort. Mortgage, as I mentioned is pretty solid, and we're pretty optimistic about where that goes. One good thing about the mortgages in our portfolio now, and particularly in the jumbo market, we have much better spreads in them. There's much more rationality in the jumbo marketplace. We are seeing some slowing in our specialized lending, specifically in our sub-prime automobile finance business, reflecting what's going on in the marketplace.
Overall, though, loan growth looks very solid, and we've got some pretty good momentum going into the fourth quarter. Deposit growth is a little bit of a mixed bag, we continue to struggle with non-interest bearing deposits. Again if you take out purchase acquisitions, annualized link and non-interest bearing, we're down 5%, third over third down 3.6%. Most of the decline is on the commercial side and I think it reflects our clients using their liquidity and also the fact that they can get higher returns, and many people are coming at them. DDA into cash management accounts, you get higher interest. Client deposits annualized link 4.1%, if you take out purchases in both cases, up third to third at 5.6%, year-to-date 7.4%. Total deposits annualized link 9.3% and third to third up 4.8%. So solid deposit growth, just the mix is not like we'd like it to be. We'd like it to have a faster non-interest bearing deposit growth, obviously.
We did have some very good news with the FDIC market share numbers. We either maintained or gained market share in every state we operate in. As you may remember last year, we moved market share in every state we operate in, with the exception of West Virginia, where we maintained the number one market share position. So we've had two years in a row where we've either been maintaining or gaining market share in every state we operate in, which is, I doubt there's any other commercial bank in our size category that can manage that kind of deposits momentum.
Okay, the big issue that I'm sure everyone is focused on is asset quality. We did have a rise in our non-performers, and in our charge-offs. Our non-performers increased from 423 million in the second quarter to 547 million at the end of the third quarter, from .33 to .42. Our charge-offs increased from 76 million in the second quarter to 90 million, and the loss ratio increased from .35 to .40. Looking at our loss ratio excluding our specialized lending, in Q2 was .20, in Q3 was .23. Interestingly enough, that .23 is a very good loss ratio, so one of the interesting things that's happening is we're having a rising level of both non-performers and charge-offs, but it's on a very low base. And the actual level of non-performers and charge-offs is not very high, by historical standards.
Year-to-date, our losses are $227 million, .35%, excluding specialized lending, .19%. Again, a very good number. In terms of provisioning, we provisioned $105 million and charged off $90 million, so we added $15 million. Here today we provisioned $264 million and charged off $227 million so we added $37 million to the provision. Our coverage of non-accruals did decline to from $283 at the end of the second quarter to $223 at the end of the Q3, but that is still very good coverage of non-accrual lines.
Our reserve remained flat, $104 at the end of the second and $104 at the end of the third, so we maintained the reserve. If you look at the numbers it is a fairly significant deterioration in credit quality but again, off a very low base of non performers and charge-offs. The deterioration was in practically all of our portfolios but within the portfolios it was primarily driven by challenges in the residential real estate market. In addition we did have some increase in regional acceptance.
Our sub-prime automobile lender and that is coming from two categories. We are having a slightly higher default rate but mostly we are having entire losses on repo because repo causes softness in the used car market. In addition we did an acquisition in Texas last year and we had some problems around that acquisition that fortunately we think we have worked through. So we are optimistic we are going to have a little better results in regional going forward, but we have had some deterioration there.
If you look into the markets where we’ve had the biggest challenge, the largest concentration is in Atlanta and a lot of the problems we’ve had in Atlanta are related to an acquisition we did there of Main Street last year. We have also had some problems in the greater metro D.C., not so much in the interior D.C., but in the outlying areas around D.C. and proportionately some problems in Florida although we are not a very big Florida lender, but relative to our exposure we have had some deterioration in Florida.
We don’t know exactly where we are going from here. I’ll tell you what our guesses are. We do expect non performers to continue to rise, but we are a very secured lender. We deal with people that have been in the market a long time. We only make loans in markets where we operate essentially with well known builders and we think that we won’t have a huge rise in losses even though we will continue to have rises in non performers.
Our guess, and it is a guess, is that our total losses will probably continue to be in the .40% to .50% range, similar to the Q3, maybe a little higher than the Q3. With implied losses in our core portfolios, while excluding our specialized lending business in the .25% to .30% range, and again I would say that is a guess. We expect a rising level of non performers but we don’t expect huge losses because we are basically a secured lender.
With that said let me change direction a little bit and talk a little bit about merger and acquisitions before I share with you a few thoughts about the future. I just want to reiterate some comments that we made at a recent investor conference regarding our acquisition strategy. We are for all practical purposes out of the community bank acquisition business for two basic businesses. We think the prices are way too high, that we think several recent deals were not rational, and also we are very concerned that from our direct experience that the community banks are the residential real estate lenders last resort and it would be very hard to do due diligence on a number of their portfolios in the kind of market we are in today, so I won’t say that it’s not possible that we would do a community bank deal but we are pretty much out of that market for the time being. We also mentioned that the conference that we have explored our merger of equals opportunities and we can’t find a partner that fits culturally and economically. While we are still interested in theory, conceptually in that concept we don’t see anything happening in the immediate future because of the issues of cultural and economic fit.
We will continue to pursue relatively small non bank acquisitions especially in insurance. You saw we announce two agency acquisitions and in consumer and commercial finance related areas we did announce the acquisition of collateral real estate which will be integrated with lawyer capital our commercial mortgage originator.
The companies together will have combined origination of capacity of around 10 billion and combined servicing portfolio of about 20 billion. We think they are great synergy, they add capacity in both products and markets to each other and there are some significant long term efficiencies. On the surface not a great time to make an acquisition in the commercial real estate market although the commercial side continues to do well we do a lot into the life insurance market and also with this acquisition we’ll have greater position for both Fanny and Freddie in the multi family programs which are really booming. We think it’s a pretty good time to make that kind of acquisition.
Now let me share with you a few thoughts about the future, as Tamera said we certainly don’t make future earnings estimates and this is a particularly difficult time to say what’s going to happen to the future and obviously it depends a lot of the economic environment.
For us the most significant question is what’s going to happen in the residential real estate markets. We did practically a very small amount of sub-prime, we didn’t do negative amortization mortgages. So as I’ve said earlier we think our mortgage origination business will benefit in both revenues and profitability. In the flight, the quality, we are a Freddie Mac, Fanny Mae, FHA portfolio lender and our spreads and volumes are improving so we are optimistic about that.
The bigger effect we are having of course is on our residential development and construction lending, which we are, is a big business with us. We operate with well established local builders ,we don’t practically do very little with national track builders however the local builders are being impacted by the mortgage market disruption, the foreclosure rates, and sub-prime and significant discounting by the national track builders so they are having some liquidity problems.
Even where market prices haven’t declined, and frankly in a lot of our core markets the prices haven’t fallen materially, volumes haven’t fallen. There are simply not that many buyers. Also, when you do get foreclosed assets it takes you a little longer to liquidate them. We think, and again this is the guess category, that it’ll be another year to eighteen months to get through the cycle but I would expect to see some improvement in the spring.
The big thing right now is consumer psychology. People that probably want to buy homes wait to figure out when the bottom is and they think prices are going to keep falling and when the bottom gets here we think that the activity will return. The good news in our markets, generically speaking, that we have a migration of population, people will need houses and the market will correct.
We’ve been through a number of real estate cycles, I’ve certainly been through them in my career and they always do correct and while this one may be a little bit deeper than people originally anticipated the fundamental demographics and economics in most of our markets are pretty good. One thing that’s nice, let’s say we’re having more problems in Atlanta, the affordability of housing in Atlanta is still very positive and people are moving into the market so that is a self correcting phenomenon and that’s true for most of the markets that we operate in.
Based on that we expect non performers to continue to rise, as I mentioned earlier but we think charge will also go up some but we don’t think that they will go out of what I’d call long term normal range if .40% to .50% for the total portfolio with your core portfolio .25% to .30%, obviously we could be wrong about that but that’s what we expect.
As Chris will discuss we are liability sensitive by design. This is a hedge against real estate risk as the Fed has always cut rates when faced with a real estate recession as they should. How much of this liability positioning will turn into net interest income obviously depends on loan volumes and asset and liability mixes etc, but we are better positioned for the current environment than many financial institutions. We are positioned as an intentional hedge against our real estate exposure to have a liability sensitive position.
I do also think that there is long term good news for us in this environment. Much of the irrationality both n risk taking and in pricing has gone, risk spreads are returning to more normal, more appropriate levels. In addition BB&T is primarily an origination and hold business .With the exception of what we do for Freddie and Fanny, we are pretty much origination and hold.
The origination and sell business is what’s really been impacted by what’s happening in the markets. It had become pretty irrational, particularly in 2005, 2006, early 2007. We will not lose much business from the market situation long term but we‘ve seemed to gain as the market returns to a more rational level so while you hate to have disruptions like this and there certainly have been negative impact in the short term I’m fairly optimistic that the trends of what’s going on are good for us in the long term.
With that said let me turn it over to Chris for some deeper insights into a number of key performance factors.
Mr. Christopher L. Henson, Chief Financial Officer
Thanks John. I’d also like to welcome you all.
I’ll speak to you briefly about net interest income, net interest margin, noninterest expenses, taxes, and capital.
First, looking at net interest income based on operating earnings. If you look at link quarter, we had average earning asset growth very healthy up 10.3% adjusted for purchases that produced $992 million. In net interest income, which was a 1.2% annualized increase over link quarter adjusted for purchases. Common quarters average earning assets were up 7% adjusted for purchase accounting produced again $992 million in net interested income which is a 1.4% decrease over the prior year quarter after adjusting for purchases. Year to date had a like amount of earning asset growth at 6.5% adjusted for purchases which reduced $2.94 billion in net interest income which is a 1.1% decline over prior year adjusted for purchases.
John commented the margin in link core perspective was down 10 basis points, 355 in the second to 345 in the third. Common quarter was down 23 from 368 Q3 of 06 to 345, and then for the year to date basis down 21 basis points down from 375 to 354.
John just mentioned during the Q3 we remained liability sensitive operating in a very difficult market condition, actually which negatively impacted both the asset and liability side of the balance sheet. We did experience an increase in non accruals, changing asset mix and a slight increase in our total interfering liability cost. In fact, total interest bearing deposit cost increased during the quarter while the cost of long term debt also edged up a bit when comparing to the second quarter.
Also our deposit mix shifted somewhat toward higher cost deposits, on link quarter basis and I’ll speak more about that in a moment. So when you look at the yields and rates you can see link quarter total earning assets were actually down 3 basis points and total interest bearing liabilities is up 5 causing spread compression of about 8 basis points.
Kind of looking at detail of that you see the core securities portfolio once again performed well overall while loan yields actually declined this quarter primarily as result of the 12 basis point reduction in commercial loans and leases which in part was because of the fed funds cut which drove prime rate down which a large number of our commercial loans are indexed to, the non-accrual increase that I mentioned.
After decreasing last quarter, our interest rate deposit cost actually increase seven basis points in the Q3, and we saw that really two primary places, three basis point increase, interest checking, and then a non basis point increase in other client deposits.
Common quarter total earning assets were up 12, interest rate and liability costs were up 29 so we had about 17 basis points of compression and common quarter comparison and really driven by other client deposits and CDs which increased 33 and 31 basis points respectively.
If you look at the main drivers of the 10 basis point decline in the link quarter comparison, really three reasons for that. First was the effect of ht changing asset mix, for example we are now putting a declining percentage of higher yielding assets such as commercial real estate loans and to a lesser extent direct retail loans on the books on our balance sheet while simultaneously putting an increased percentage of lower yielding loans on the books such as mortgage loans, so changing asset mix is certainly one driver.
Secondly, increased level of non accruals and thirdly increased liability cost with really a result of general shift toward higher cost deposits.
In the quarter we saw interest checking, retail checking product, and also non-interest bearing DDA balances move away from us as clients use a liquidity, potentially the result of the market disruption that we experience. So it really felt like that was the primary driver of the liability cost issue.
Looking forward, just wanted to point out again our outcome model based on blue chip consensus forecast. In the model today, we are assuming the fed funds rate will decline 25 basis points at the end of October. And remain relatively flat with a balance of 2007 and end of 2008, or real flat for a balance of 2007 into 2008. And as for our forecast, we expect our margin to remain relatively flat during the fourth quarter and then improving slightly as we move into 2008.
Looking at non-interest expenses we were very pleased with our expense control results year-to-date. As I said, in the past versus our stated growth goal for 2007 of 4% adjusted for purchase acquisitions, we're really pleased with the year-to-date performance.
We continue to focus a lot of energy towards productivity and improvements across the entire company and as a result, I think expect strong expense control for the balance of 2007 and into 2008.
During the third quarter, non-interest expenses declined on a link, common in year-to-date basis, and as a result achieved positive operating leverage and improved operating efficiency as measured by cash basis efficiency ratio for the fourth consecutive quarter. I am very pleased with that.
Also, important to point out that excluding one interest acquisition, it closed in the quarter we reduced FDE’s by 118, during the third quarter.
So, if we scroll down expenses just a bit more, you can see that again non-interest expenses, year-to-date, were down 0.8% over the prior year quarter, we were only ahead of our 4% target, and the drivers, the drivers that really was in other operating expenses which was down about $26 million. If you kind of look at that detail, it was decreases in advertising, and also software expense. Small level charge and also decline in phone expense.
Look at common quarter; we were down 4.7% over the prior year quarter, adjusted for purchases. And that 4.7% equates to a decline of $44 million after purchases and it really in two areas, personnel and other operating expense. First looking at personnel, we saw decreases in the pension plan, due to a change in estimated amounts. With actuary, we saw declines in the value of [ravi] trusts, and also, declines in incentives for insurance, and executive incentive comp plans. As well as the third comp plans. And in other operating expenses, we saw declines in advertising and public relations and then again some in charge-offs.
If you look in link quarter, we were down 19.7%, adjusted for purchases, which was appropriate given the non-interest income decline. And that equated to being down about $46 million, after purchases, again in two areas, personnel, and other operating.
Some similar items, personnel, for link quarter, was driven by a decline in market value [revi] trusts, pension expense, and incentives in executive comp plan, insurance, and investment incentives.
In the other expense category, again some similar items, advertising and public relations, retail and bankcard expense, donations, and operating charge-off.
But overall, I would say that I am very pleased for the entire year, and I think we have done a very good job in controlling FDE's and sort of pleased with where we are and where we are headed.
Looking at just a quick update on our expense savings for recent acquisitions. Main Street, First Citizens and Coastal Financial. Main Street, you might recall, we had targeted savings, at $27.7 million and we have achieved all of those to date, in $3 million in this past quarter, and you might remember that conversion was a year ago, in September of 2006. So we will not be reporting on Main Street going forward.
For Citizens, we targeted $7.5 million, and we have achieved $5.7 year-to-date. You might remember that we converted them in November of 2006, and $1.9 of that came this quarter for Citizens.
In Coastal Financial, we had targeted $19 million, and we have achieved $5.3 year-to-date. That conversion was in August of this year and $4.8 million of that came in the third quarter.
Move attention to taxes, want to comment just on the effective tax rate you kind of want to expect. You can see the effective tax rate actually declines slightly from 33.09% in the second quarter to 32.83% in the third. Nothing unusual there. Going forward, we expect the tax rate to be fairly stable in the 32.5% and 33.5% range, so not a lot of volatility in the tax rate.
And then, looking at capital, again, not any significant changes in our capital’s strategy during the quarter, and our targets remain the same. Leverage capital is targeted at 7%. Tangible equities is targeted at a minimum of 5.5%. I want to point out that equities and total assets at the end-of-period was at 9.5%. Tier one, at the end of period was at 9.3, total capital end of period total risk space at the end of period was at 14.6. And then leverage capital end-of-period was 7.33%. Well above our target of seven.
We did repurchase 3.1 million shares for $123 million year-to-date with all that coming in the third quarter. And we plan to repurchase in the range of 3-4 million shares during the fourth quarter. And, also as a reminder, just point out our dividend is projected $0.46 for the fourth quarter, which represents a 9.5% increase over the prior year quarter. That concludes my comments. Thank you.
Thank you Chris. Before we move to the question and answer segment of this conference call, I will ask that we use the same process that we have in the past, to give fair access to all participants. Please limit your questions to one primary inquiry and one follow-up. Then, if you have further questions, please re-enter the queue, so that others may have an opportunity to participate. Now I will ask Diego, our operator, to come back on the line, and explain how to submit your question.
Thank you, ladies and gentleman, we will now be conducting a questions and answers session. (Operators Instructions).
Our first question comes from Gary Townsend, with FBR Capital Markets.
Good morning gentlemen, could you talk about your homebuilders exposures, and just provide any color. I got on the call late, I am sorry if you covered it already.
Gary, our residential construction development lending is the area we were most conscious of following what is going on in the marketplace. We lend to people who have been in the market a long time, that are established builders, and we are a secured lender. We take the real estate as collateral. We generally don’t do national track builders, and we don’t generally do out of market builders. We do people that are part of the market place. What we are seeing is our builders are facing more liquidity problems. They're being impacted, of course, by the lack of availability of mortgages for certain market segments, the foreclosures coming out of the sub-prime and all markets. And, to some degree I think, at least particularly in the short term, the fact that the large national builders have been doing gigantic discounts on houses in order to move inventory, which created a perception among potential buyers, that they all be gettin' whoppin' discounts, and that slowed activity. We haven’t had any really large subdivisions get in trouble. Yet, we are a pretty diversified lender, but we have had a number of projects that the builders have basically given to us. We don’t think that we have, you know, material losses in what we're seeing, but it's going to be a year or so until we get through the real estate cycle.
And I think the biggest thing is the psyhology when potential buyers are interested, or believe the floor's been achieved in the market. And also just the anxiety around the availability of financing, whether or not its true, has impacted, I think, consumer activity. Our single biggest concentration of problems is in Atlanta and a lot of those frankly came out of our Main Street acquisition, in fact the vast majority of them come out of our Main Street acquisition. We’re having some more problems in the what I’d call the extended Metro D.C. market area, not right around D.C. but around the areas that were growing that have fairly long commutes and percentage wise we’re having more problems in Florida, although fortunately we’re a fairly small Florida lender and I would say Florida’s the toughest market we’re in now, but fortunately it’s not a big market for us. Your guess is as good as mine but having been through several of these cycles I would think we’re another year to 18 months till we get through it, but I wouldn’t be surprised to see some improvement starting in the spring and by this time next year it’ll be really clear that the market has turned.
Price declines pretty significant in Florida, some in Metro D.C and lot of our core markets like Charlotte and Raleigh, places like that we’re not seeing any material price line declines but activity has slowed even where the prices haven’t fallen that much. That’s kind of an overview of where we think we are in that regard.
And have you commented at all on home equity exposures and trends there? I’m sure you did and I missed it and I apologize again.
Well we’re actually not having, and I guess I don’t want to knock on wood because I’ve seen some other people have been having problems in the home equity market. We’re not having any material problems in our home equity loan portfolio. We were a, I’d call us a grade a+ lender. We didn’t do the kind of odd stuff that was done in the home equity business, very high credit scores for our home equity borrowers. And I really don’t see material losses in our home equity business, the biggest problem we’re having is lack of volume. There’s just no demand and that’s one, that and our other direct retail lending of some of our highest margin products, but we’re not having credit problems and I don’t think we’re going to have credit problems. We’re on very low loss rations, we might go up a little bit but I don’t see us having big credit problems either in home equity or in our traditional direct lending portfolio because the credit scores that we have on our client base in that portfolio.
Gary, to that point, the credit scores in equity loans are about 724, first mortgages is about 78% and equity lines credit scores are 757, and on the home builder you might be interested, our average loan size is 262 and we’ve got about 40 45 million in exposure to our top 25 relationships.
And the jump in commercial loans and leases, that will, it seems by default be your focus going forward just keeping that under control?
I said we have two categories of problems, one is residential real estate related that goes through a number of portfolios and the other I mentioned earlier is our regional acceptance our subprime automobile dealer did have a spike which we think will move back a, as used car prices correct and also we had some problems on an acquisition we did in Texas. That’s really were the challenges have been.
Thank you for your comment.
Thank you. Our next question comes from Nancy Busch with NAB Research, please state your question.
Good morning guys.
I have to ask kind of a blunt question here and I hope you’ll forgive me in advance but the question is, I mean, you’ve just not had a great record this year in sort of predicting where you’re net interest margin was headed. I wanted to get your thoughts about sort of what the major variables have been that have been so difficult to predict and do you sort of feel you’re getting a handle on telling us where it’s going?
Yeah, I’d be happy John, to take a shot at that. You know, we did see some compression this quarter. I think what we did not know were the level of non-accruals, so the non-accruals might have been a little more than we would have anticipated but I also think volume plays a great deal in kind of what occurs from quarter to quarter and the change in asset mix that we experienced I commented on would also be a variable. With the slowdown in single families that John just explained those are really our higher yielding and more fee intense kind of credit that we’re really have been flat from quarter to quarter and so in part replacing that with mortgage loans, etc. is really kind of a driver.
And I would say liability sensitive, you know I think it played out like we, to some extent like we thought, except the fallen rates we hadn't got much benefit what occurred the 18th of September but in fact our liability, or our deposit costs actually decreased first to second quarter but we saw that increase this quarter. So for liability sensitive that was a little more punitive to us than a down rate cycle would have been. And some of those rate increases on the liability side, Nancy, were driven in part by the market disruption. I mean, early on, we invested in some other interest-bearing deposits and what we saw during this quarter that I think we didn't anticipate, I don't think we could have anticipated, was more movement away from EDA and interest tracking where people were just using their liquidity.
And we saw the same side on the borrowing side. Utilizations were up on our loan clients. So I don't think we could have anticipated that and I think it was a little bit deeper than maybe we had seen.
Do you think you'll, Chris, you'll continue to have the same kind of variability that you've had, or just kind of the Q3, Q2 to Q3 decline. Is that sort of the worst?
I think, yeah, it's a fair question. I think the variability from Q2 to Q3 was greater and I think it was greater because of the market disruption. When I say market disruption not just liquidity but we really saw, John has commented on the increase in non-accruals. I think the variability should be somewhat less as we move forward and again declining rates are good for us. We're clearly liability sensitive and you know to the extent deposit rates behave accordingly then we sort of win. But without the market disruption I think some of the variability goes away.
My follow-up would be this. I mean, given that CRE is proving to be a challenge for you guys and a number of your peers. Are you seeing a sort of heightened regulatory attention to that and is there any sense that they're going to be targeted exams going forward on your CRE portfolio. And if you could just comment on the regulatory environment right now, I'd appreciate it.
Nancy, we just had a targeted exam and fortunately while they always have issues, it came out very well in terms of how well we were managing that portfolio. So I'm definitely confident the regulators will be focusing on that portfolio. And we did just finish an exam with favorable results. I think it would be, this is one man's guess, I think you'll see a bigger effect maybe on some of the community banks that don't have all the systems that maybe they need in the kind of environment we're in.
Right. I mean is there, John…I'm hearing that there's kind of a heightened communication with the regulators now at the largest banks. That there are, you know, a lot more phone calls than there used to be, you know, a few quarters ago. Is that sort of your experience as well?
Well, actually no. It's funny because we weren't doing the things that have got the regulators excited. We weren't (inaudible) prime business. We didn't do negative integration mortgages, we weren't into the private equity market, we didn't have liquidity problems. So they're actually talking to us less, but they must be, maybe they're spending more time talking to other people, so I'm not saying they might not change their mind but we seem to be getting less regulatory attention in a broad context and maybe rightly so, because we weren't doing a lot of this stuff.
Every cloud has a silver lining.
All right. Thank you very much.
Thank you, Nancy.
Our next question comes from Christopher Marinac, with Fig Partners. Please state your question.
Hi John, How are you?
I want to ask you about your sense of commercial real estate relative to residential and we talked about the negatives on the donors. But what are you seeing on some of the traditional commercial stuff whether it's office or shopping centers, or the other various types that you lend on?
The irony there Chris, is that those markets are continuing to do well. The occupancy rates remain high in the office market. If anything, apartments are picking up. I don't know, people being forced out of homes, you know they can't get mortgages for a house so apartment construction is actually doing, and apartment occupancy rates are good, so it certainly could be that commercial real estate will follow residential. Traditionally it has, but traditionally what's created the corrections in residential is high interest rates, and we don't have a high interest rate environment and the cap rates make a big difference in the commercial end of the real estate market. One thing that has happened is that a lot of the commercial conduits have closed down. And that has had a big impact, I think on refinances. One thing that was going on pretty big in the commercial real estate market, was that people were able to refinance at a lower cap rate. Cap rates have moved up some, the conduits aren't available so there's maybe less activity in the refinancing end of the market, which then may slow the other end, because I mean if you can refinance the lower rate and also sell and a new buyer can get a new tax deduction, that does spur commercial real estate, so my own instincts will see some slowing in commercial real estate, but commercial real estate shouldn't have big problems unless the economy itself gets in trouble.
Okay, great. And then my follow-up just has to do with deposit pricing and do you think it's going to be hard to pass along any further fed cuts, let alone this fed cut that we've just experienced on the deposit side.
I think it's going to be mixed. The biggest practical problem we have today is that Wachovia has been more aggressive on deposit pricing than traditionally and my guess is they're trying to move out of the deposits they got and go west, which would be very expensive, I don't know. I mean I'm obviously outside of that and they usually have been pretty willing to cut. They're not usually a big price competitor over deposits and they've been more price competitive than usual. That may just be a temporary phenomenon. But the community banks have actually backed down more than usual, I think because they don't have the loan demand and they got other challenges. And for us, our big competition over the long term on pricing has been on the community bank side. So, I tend to think that over the next 90 days, deposit pricing at least on the CD side, will reflect the decline in the fed funds raise.
Great John, thanks very much.
Our next question comes from Steven Alexopoulos with J.P. Morgan. Please state your question.
Hi, good morning everyone. John, I'm curious. If you expect non-performers and charge-offs to both increase over the next couple of quarters, does that mean that you also expect reserve coverage to increase?
I don't know where we'll rate, there's a pretty mathematical formula and we try to, as we go through this process, we try to take our losses on the front end, by the time we get something to other real estate, we traditionally, in fact through September we made gains when we liquidated that portfolio so I don't know, you know, it depends on how material the change is, but I don't know whether that will cause a rise in reserves or not, because that phenomenon now under the gap rules is pretty much a mathematically driven kind of formula process.
And just to follow up on the margins, so I understand this right. I know you're saying you expect the margin to be flat in Q4 and then up in '08, but if we look at your funding or your loan rowth with wholesale funds, I would imagine that security to be put in a portfolio, about 1 billion was probably at a 2% margin on that. Why won't the margin stand the pressure here?
It's basically relatively flat. In some of the wholesale funding that you saw this quarter was kind of related to the market disruptions I'd commented on to Nancy's questions, so you know we ought to be able to return to hopefully a little better core funding like we had seen in Q1 to Q2 when you actually saw the deposit call decline. So you would have some of that and I think you know over time, we're going to continue to try to affect the asset mix as best we can as well. And you begin to get a full quarter of the benefit too of the rate drop that occurred. You know, it happened the 18th of September and we really hadn't gotten much of any of the benefit of that. It's a mathematical phenomenon based on the fact that we're very liability sensitive. And of course the assumption on the improving margin is that we'll have another 1/4% point drop in the fed funds rate. So, the mathematical fact that we're liability sensitive. It has to offset the changes, the negative changes in the asset mix, assuming the volumes are in the right places and kind of what we projected in the model.
Yeah. If you factor in the competitive environment, that you just said Wachovia is doing, do you think it's realistic you'll be able to drop deposit rates?
I do, I do, because I think everybody's under margin pressure. I mean, you just saw everybody's results. At some point we all have to get rational, including all forms of competitors, so I think there's going to be a lot of motivation for people to bring down deposit rates.
Our next question comes from Todd Hagerman with Credit Suisse. Please state your question.
Good morning everybody. John, I was wondering if I could just follow up, just in terms of your outlook. You reiterated expectations with the loss rates and the portfolio 40 to 50 basis points. We're now kind of at the low end of that range. I guess what I'm having trouble with is reconciling your outlook that, you know, the housing market, it could take anywhere from a year to 18 months or so to kind of work its way through, if you will. I'm just trying to gauge what gives you that, you know, greater degree of confidence that the loss severity will remain relatively low.
Well, as I said earlier, it was a guess and the reason is I don't think we have big losses and a lot of stuff we'll end up foreclosing on. Because we are a secured lender and typically we can, a lot of the builders really face either liquidity problems or they just don't want to do it and they don't want to go through that process and I think that we will work through a lot of those kind of projects without big losses. Now obviously if the market goes deep enough and it lasts long enough then we'll have more problems than we expected at this point in time. And that's partly mitigated on the assumption that the economy itself doesn't tank and if the economy itself doesn't tank, people are going to want to buy houses. And so that the price declines will start stopping and then it'll be a cycle of actually holding the real estate and selling it. So, that's the guess why we don't expect our losses to be a lot higher.
Todd, I might add two items too. I mean our objective would be to throw more resources at the non-performers and work through them as John pointed out, but if you kind of look back at the last sort of 10 years how we've behaved, you've got to decide for yourself whether this one, this downturn or the single family downturns worse than the past, but we kind of, at the low point we're 27, 28 bases point range in losses and the high point back in, I guess '02 and the 48 bases point range (peers) were at 70 conversely. So, we tend to have sort of the, we tend to work through them as John said, if I can just kind of give you that historic perspective.
Okay and maybe just as a follow-up, you know, as a secured lender if you will, and granted the industry really hasn't seen losses in close to 20 years in real estate, but with respect to your home builder portfolio, what specifically have you done in terms of, you know, enhancing your security position on that portfolio and how are you working through that?
Well, you really have to do that before the cycle starts, A. by not being greedy in your lending practices and B. by servicing your portfolio very closely. You know, we require equity in the projects, we deal with people we've known that are in the marketplace. We control a number of spec houses, we do a really good job of making sure that on construction loans that we don't advance until the work is done. So, you run the risk, of course, that the house ends up being worth less because the market has deteriorated, but usually there's a profit margin on houses and most losses in construction lending come because people advance too much money on the house or they've done unsecured loans to the builder and he's used it for working capital in the short run, or they hadn't gone out and inspected the sub-division and made sure that the power got put in, the roads got put in, those kind of things. Or allow the builder to have way too many spec houses and he's sitting on a great big inventory of unsold houses.
And while I'm sure we've made some of those kind of mistakes, we haven't made a lot of those kind of mistakes, because we were very traditional residential construction development lenders, kind of a core business for us. We tend to deal with, we don't have the very big subdivisions where you have the biggest problems. You know, you got a smaller subdivision, you tend to work through it easier, we got a very graniality, we got it all the way across our footprint, we're not overly concentrated in any particular market.
So while we're kind of what I call the ABC basics of residential construction development lending matter in times like this. Also we're not an outer market lender, we lend in markets where we know the markets and we understand the markets. We didn't get in the condo market. If you look at the big issues, I think the big loss is going to be in the condo lending business, and we are a very small condo lender and the reason condos have had such more volatility is you tend to get more speculators. If you’re dealing in the traditional single family residential market you’re less likely to get speculators in that marketplace and that is so you’re less likely to have price volatility, or less likely to have fall outs from people not actually buying the condos.
So I think that the fact that we’ve had a core business for us, Ken Chalk our senior credit officer has been through several real estate cycles as I’ve been. I did a lot of residential construction lending and we haven’t changed our standards. That doesn’t mean that we’re immune from the cycle, it just means that we didn’t do the excess stuff at the margin which is usually where you get the biggest losses in correction like this.
Thanks very much for your comments. I appreciate it.
Our next question comes from Matthew O’Conner with UBS, please state your question.
John, Chris, Good morning. You guys have done a good job managing expenses this year and you talked about, I think, targeting 4% growth next year in your budget. If revenue comes in a little bit weaker than expected or there’s a little more pressure on credit, is there more flexibility there and how low do you think that 4% can go?
I think when we talked earlier in the first, second quarters we got those questions and whether we had additional flexibility and I think we said the potential was there to continue to reap some benefit and I think we’ve been able to demonstrate that. I have to say though year to date we have gone down about 800 FDE’s and I think added probably net 24, 25 branches in the process. We are good kind of where we are. I do not know if we have a lot of upside flexibility in terms of additional percentage gains but I feel very good about expense control across the country as good as I’ve ever felt and I feel very good about being able to kind of hold what we have and you know, might be the potential to add back some revenue producers in certain places but overall I feel very good about where we are.
Ok. And then separately, assuming the M&A environment does not improve we think about your excess capital generation 08 should we assume that it’s going to go towards buy backs or how do you feel about adding securities given wider spreads and probably a steeping yield curve
Probably buy backs.
Okay. Thank you.
Thank you, our next question comes from David Pringle with Fells Point Research, please state your question.
Good Morning. You and the construction lending for the single family, you do loan the interest reserves, right?
That would be atypical for us. We generally, we may have interest reserves in a project if we have extra collateral in the project, but generally we expect the borrower to carry the interest. That is generally our pattern.
You mentioned the increase in non-accruals affected the margin in the 3Q, how many basis points did that cost you?
I’m sorry, I didn’t hear the question
The impact of the non accruals on the margin’s basis points
You know, my guess is it would probably be in the sort of the four to five range
Four to five basis points
Yeah, I don’t have an exact number
I would have guessed a little less than that Chris, you might want to think about that. I would guess about two basis points.
Let me see if I have that
Have you been renegotiating any single family exposures?
We obviously might be making some more loans to people that use another collateral so they can have cash flow to hold their houses, that kind of thing. I wouldn’t say we do many what we technically call renegotiations. We work with our borrowers; most of them have been clients of ours a long time. We try to help them through tough times. That’s a long term strategy for us, provided they’re cooperative and they’re doing what they’re supposed to do. They’re willing to put up their personal assets to help us lend them some more money, that kind of thing. But in terms of formally renegotiating because a project is in problems we would do very little of that and I wouldn’t say a lot of that’s going on.
If you do a rate reset then we are unlikely to see it as a renegotiated loan.
We would do very few rate resets. Atypically if we were in that circumstance the rate would go up instead of down. We don’t normally do that kind of stuff.
And then on the DDA’s do you know how much of the decline or flows in the non interest earning deposits are being affected by consumers or commercial
It’s almost all commercial. Our consumer DDA is rising, commercial DDA is falling and I think it’s two basic reasons. One, the people that have excess liquidity are going to cash management where they would just leave it in a DDA because it didn’t have return. And two, I think our client base has less liquidity. A lot of our builders had huge liquidity. One thing that’s important to remember , people that have been in the building business that had a long positive run and now they’re using their liquidity to keep their projects viable and then you have things like title insurance companies that have less liquidity and I think there is generally less liquidity in the business community. So you’ve got two factors, less commercial liquidity and then people going into cash management for prior returns.
Yeah you saw that in California bout a year ago. And how much are your DDAs were builder related?
I would not know off the top of my head. It wouldn’t be a huge percentage; builders don’t typically keep a lot of extra DDA.
Definitely cash forward
And I did have that and it was closer to two basis points. You were exactly right John.
Ok. Well thank you very much.
Our next question comes from Betsy Graseck with Morgan Stanley. Please state your question.
Good morning Betsy
Just on the home equity business, I would be useful to understand how you are managing that in this environment where home prices are deteriorating. How frequently do you refresh things like FICO and LTV and do you ever take any action on limiting the lines that you have extended that might not be utilized at this stage?
In generally we do have periodic reviews of all home equity lines looking at FICOs, looking at collateral values. It would be atypical for us to cut somebody’s line because of declining appraisals if their performance had been very good and if they had extra leeway in their line. As I said maybe earlier we are just not having material problems in our home equity business and I think it’s because a large percentage of our borrowers have great credit scores and unless you have something happen in terms of the economy and they’re losing their jobs or something like that they would be unlikely to fall on their home equity lines, the 750 kind of score. We just didn’t get into the home equity business that was really used to help people buy homes that they shouldn’t be buying. We didn’t do much of that kind of lending.
Can you remind us of the channels that you use to originate the home equity?
It’s all direct. We don’t do anything but direct home equity.
Ok. And then just a little nitty question but other noninterest income and you might have mentioned this earlier in the call and if I didn’t hear it I apologize, but other noninterest income had a noticeable drop quarter on quarter. What was the driver of that?
It was primarily market related activities, some losses we had in our capital markets business and losses we had in our brokerage operations. Most of the fall in non interest income was related to market disruptions.
Thank you, your next question comes from Chris Mutascio with Stifel Nicolaus, please state your question.
Good afternoon John and Chris. I missed a good bit of the call earlier during your comments so forgive me if you’ve addressed this. John can you talk a little bit about the insurance commissions more because I hear a lot of comments on the margin during the Q and A, when I look at my motto the insurance commissions were probably the bigger miss that I had. I know you talked in the release about competitive pressure but is the 4Q a good run rate to go forward with, are competitive pressures that difficult to see the drop from second to third?
That’s a good question. Two phenomenons’ we had in the insurance business. Number one was there is seasonality between second and third and it’s traditionally been that, but secondly we had intense pricing pressure more than we had expected. It had intensified during the quarter. I would say typically prices have fallen anywhere from ten to 15 percent, and enough to be noticeable in terms of people even refinancing their insurance midstream on the commercial end of the marketplace. Our insurance commissions third to third was were essentially flat if you take out parts of acquisitions and that actually represented a fairly material market sheer move in order just to keep the commission flat. We should have a stronger 4Q than the 3Q but the internal growth rate is slowed, taking away the seasonality. 4Q is strong seasonally but the internal growth rate is going to be fairly modest.
Thank you and again forgive me if you went over it earlier. Thank you.
Our next question comes from Gary Tenner with Suntrust Robinson Humphrey, please state your questions.
Thanks. Good morning. Chris, I think when we last spoke and last quarter you had talked about a buy back in the second half of the year I think between 7 and 9 million shares.
I think you bought back about 2 million shares this quarter?
3.1, ok go ahead I’m sorry.
I was just going to say in the Q4 we just kind of targeted a 3 to 4 million range.
Ok. Perfect thank you very much
Thank you. Our next question comes from Jefferson Harralson with Keefe, Bruyette, & Woods, please state your question.
I wanted to ask about you had mentioned the absence of conduits in the kind of leveraged most aggressive buyers of commercial real estate going away and do you think that is what impact do you think that has on the bank, I am assuming would translate into higher CAP rates and maybe lower collateral but maybe lower pay downs as the conduits were taking away business from you out the other side?
I think that’s a great point, it might actually be net positive. It goes to the general issue, we’ve been a huge transition model wise from origination and hold to origination and sell which is part of what blew up in the markets because a lot of the buyers weren’t able to get back to the real underlying credit. We are basically an origination and hold business although we do some commercial mortgage; we do some Fanny Mae and Freddie Mac. The general movement back to origination and hold probably will help us. One thing that will help us, I think we do a fair amount of commercial real estate non residential that was getting paid off really fast, even before construction loans got finished, there was such a ready conduit market. I think some of those construction loans will now sit on the books for two or three years which is what we like because they are good projects before they go to the secondary market and I think that will help our outstanding some in that arena. And we’re having great experience right now in the commercial real estate, the non residential commercial real estate market, and while I think it will soften some I don’t think we’re going to have problems in the type of properties we finance. So I think net it actually will probably be a benefit for us.
Thanks a lot.
Thank you for all of your questions today. We appreciate your participation in this teleconference. If you need clarification on any of the information presented during this call please calls BB&T’s investor relations department. Thanks and have a great day.
Ladies and gentlemen this does conclude today’s conference you may disconnect your lines at this time thank you all for your participation.
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