Fifth Third Bancorp Q3 2007 Earnings Call Transcript

Fifth Third Bancorp (FITB)

Q3 2007 Earnings call

October 19, 2007 8:30 am ET

Executives

Jeff Richardson - SVP and Director, IR

Kevin Kabat - President and CEO

Chris Marshall - CFO

Analysts

Mike Mayo - Deutsche Bank

Matthew O'Connor - UBS

John McDonald - Banc of America Securities

Ed Najarian - Merrill Lynch

Presentation

Operator

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

Mr. Richardson, you may begin your conference.

Jeff Richardson

Thanks, Filis. Hello everybody and thanks for joining us this morning. We'll be talking with you this morning about our third quarter 2007 results, as well as our outlook for the remainder of 2007.

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

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

Kevin Kabat

Thanks, Jeff. Good morning and thanks for joining us everyone. I have few comments and then I will turn things over to Chris, who will review our financial statements, our credit trends and also our outlook for the rest of 2007. I would like to start off saying that this was a solid quarter for us and we are pleased with the results, particularly given the macro environment that we are operating in.

We showed strong revenue growth and expenses were well controlled. Fee growth was outstanding and NII growth was also quite good and we hope we'll continue to benefit from wider, more rational spreads. We do expect some further deterioration of credit as we manage our way through the cycle. However, we've been able to generate core performance that's allowed us to earn through a higher provision and still grow EPS. That will stand us in good stead when the cycle turns in the next year or so.

Our payments business had another strong quarter, up 16% year-over-year. Last quarter we mentioned the signing of Walgreen's credit card processing business. They were converted to our system during latter part of this quarter.

U.S. Treasury business is about half way converted and that will becoming on through the first quarter of 2008. Additionally, we just won the rest of the EFT business for our largest financial institution client. We continue to feel very good about this business as we significantly outpaced all of our peers in organic growth and expect to maintain our strong mid-teens growth rate.

Results continue to exceed our expectations in the credit card business. We really focused our management team and resources from lot of areas of the bank into this and that demonstrates the power of that focus. Credit card account originations were up 83% and balances were up 57% year-over-year, despite having sold 89 million of non-strategic receivables last quarter.

We have an enormous opportunity here that we've just began to tap into. We've grown to $1.5 billion in an outstandings even after selling over 100 million in balances the last 15 months and we think we have $2 billion or $3 billion of runway ahead of us, just in penetrating our own retail customer base beyond the current 14% to 15%. As one of our strategic growth initiatives that we promised to deliver on, we are pleased about the early success we've had here.

In Commercial, C&I growth remains solid at 7% over last year, commercial mortgage and construction continued to slow driven by lower activity in the marketplace. We had another very good quarter in corporate banking fees and we are really seeing success from the build out of our capital markets capabilities in loan syndications, asset backed products and better execution and increased sales in international foreign exchange and interest rate derivatives.

Our Investment Advisors business grew 7% year-over-year with continued strong results in private banking and continued improving results in brokerage. The addition of new management and our focus on improving the quality, productivity and number of our brokers is beginning to pay off here.

In retail banking, we saw another strong quarter for deposit service charges with double-digit year-over-year growth. Retail DDA production was really good in a fairly tough environment, up 6% from a year ago with 7% DDA account growth. In fact, recent industry studies we've seen indicate that we are in the top quartile in retail core deposit growth and stake up very well in key deposit performance categories.

In our Consumer Lending business, auto loan production was strong with balances up 14% year-over-year. From mortgage, I am sure you are well aware of the challenges in that sector during the quarter, and as you can see from our results we are not immune to that. Chris will give you more detail on this in a moment.

The home equity balances continue to come down a bit due to our tightening of our underwriting standards over the course of the last 12 months.

Let me turn to credit. Charge-offs came in at 60 bps for the third quarter, in line with expectations, and up from 55 bps in the second quarter. NPAs were higher than expected with the majority of the increase coming from Eastern Michigan, Northeastern Ohio and Southern Florida. About $22 million of the increase in consumer NPAs this quarter came from debt restructuring for our consumer borrowers. Like all banks we have seen customers struggle to service their debt, particularly in more difficult geographic areas.

We are being very proactive in approaching them to address potential problems before they miss payments or go into foreclosure. It's good for our customers and its good business for us. We do think charge-offs will be up in the fourth quarter and Chris will walk through this in more detail in just a moment.

We feel very good about our de novo activity. During the quarter we added 14 net new branches and remain on track to add a net 59 branches to our network in 2007. De novo deposit growth remains on track to exceed our target deposit levels. I also like to mention that we are on pace with our acquisitions of R-G Crown Bank, First Charter, and the First Horizon branches we purchased in Atlanta. We are still targeting a fourth quarter close for the R-G Crown conversion and first quarter 2008 closed on the First Charter and First Horizon branch acquisitions.

Finally, let me say that I have been CEO for six months now and while we were in a very difficult environment, I am excited about lot of the actions we are taking as a new management team they are bearing fruit and we will continue to do so for years to come. We are delivering on our commitments. We said we were going to diversify our footprint into faster growing areas and over a relatively short period of time we've made huge strides. We really transformed the demographic profile of Fifth Third.

We'll have a third of our branches in growth markets, specifically the Southeast and Chicago at the end of the first quarter of 2008, as double the proportion of just three years ago. Most of that change is been through de novo activity and I am part of the activities here, investing in our future, the analytical and site selection work is gone into enabling our success, and the fact that we've been able to absorb the initial impact in the earnings.

Expected population growth and household income growth in our pro forma footprint weighted for deposits is now roughly the national average, that's the significant improvement and opportunity and we probably surprised a lot of folks.

We told you, we would fix our balance sheet issue last year and we did. We made commitments to deliver on our growth initiatives, like our card initiative and healthcare industry vertical and we are doing that. We've also been completely transparent about our opportunities and our problems. For example, we've been very clear for a year that we expected home equity to be the most likely source of higher losses, not only for us but for the industry.

The management team, we've been very focused on addressing our issues, particularly as it relates to our credit quality. For example, we've consolidated consumer and home equity underwriting and approval in to two regional credit centers. We've reduced exceptions to guidelines and eliminated channels that were producing home equity loans and poor credit performance. We are now delivering all Alt-A production under an agency flow arrangement, and we are proactively addressing problem loans in the making.

We can't eliminate the effects of the market and the cycle, I know they have increased, charges-off are in line with our forecast at the beginning of the year, they were higher than we would liked. Steps we're taking will take time to cycle through, but we'll produce better results in the future. We can expect that as a team, we'll remain focus on executing our strategic plan, meeting our commitments and building a stronger institution going forward even as we work through a fairly challenging time.

With that I'll turn things over to Chris, to talk about third quarter results and the outlook for the remainder of the year. Chris?

Chris Marshall

Thanks, Kevin. Good morning everyone. Well I'd agree with Kevin that it had been a pretty tough quarter for the industry. Our financial results were pretty solid and hopefully that is beginning to demonstrate to all of you that while we continue to suffer from the same issues as the rest of the industry. We also continue to make significant progress in improving productivity and the profitability of our businesses.

Now, before I get to the details of the financial statements in our outlook, let me try to say you some trouble digging through our release by recapping the major drivers of our EPS. As you've seen earnings per share was $0.71, which we feel reasonably good about. Our results were characterized by strong growth in revenue and pre-tax income before provision, which was up 3% sequentially and 9% versus a year ago.

Now, growth in provision obviously offset a good bit of the bottom-line benefit, but we continue to show respectable EPS despite that. So while credit costs are masking some of the growth we're experiencing we feel good about where we are because as Kevin said the credit cycle will turn and when it does we will retain the benefit of having raised our earnings capacity.

I'm going to discuss each of these items more fully in my remarks later, but in terms of the major items; third quarter results included a number of offsetting issues including, starting with our fee income.

In fee income we had about $0.03 total benefit from securities gains which total about $13 million. We also had $15 million in gains from the sale of FDIC deposit insurance credits. And those gains offset losses of almost a $0.01 were $6 million on auto loans held for sale that we were planning to securitize this quarter. As well as significantly lower our mortgage banking income.

Our mortgage banking income was down $15 million or $0.02 for the quarter -- from second quarter. In terms of NII and expense items, we had a benefit in NII of about $6 million for dividend adjustments related to the repurchase of our re-preferred securities. Well that benefit offsets the $6 million in expenses we incurred in the quarter related to pension settlement expense, neither of these items are going to reoccur in the fourth quarter.

And then in terms of tax items we had a net benefit from a variety of items, which totaled about $8 million after tax and they were the result of finalization of exams, expiration of Statutes of Limitations and stating context law changes specifically in Illinois, which I mentioned to you last quarter.

Our effective tax-rate ended up at 28% which was right in the line with our expectations and that's right in line with our full year outlook. So net-net we benefited to the tune of about $0.015 to $0.02, largely in the tax line from the items I just outlined and then provisioned exceeding charge-offs by $24 million which raised the reserve to loans to 108 from 106 while it cost us about $0.03 in the quarter.

Now as a reminder in terms of comparing results to prior periods, second quarter results were $0.69, and they included $16 million in gains on the sale of single product credit card accounts as well as $7 million in one-time costs associated with our expense reduction initiative.

So we netted about a $0.01 of benefit there and then third quarter results a year go which were $0.68 included net securities gains of $19 million and $11 million charge related to debt termination an $8 million pension settlement charge and finally $10.5 million in gains on the sale of branches and out-of-footprint credit cards. So all-in-all we had about a $0.01 in net benefit there as well.

Let me move on to the details starting with credit. It was obviously difficult quarter from a credit standpoint as no getting around that. Charge-offs were 60 basis points for the quarter, which is largely in line with our expectations.

Though NPA growth of 34% was higher than we were projecting and we had some upward pressure in the quarter and that market conditions were very poor for NPA and charge-off loans sales and that obviously raised our NPAs and lowers our recoveries.

Now, we continue to evaluate opportunities to sell NPAs at the right pricing and we'd expect to do so going forward. Additionally, as Kevin noted, we did restructure consumer borrowings this quarter and that increased NPAs by $22 million.

Turning to charge-offs; gross charge-offs were 66 bps for the quarter, largely in line with the second quarter. However, lower recoveries resulted in a net charge-off ratio of 60 basis points, which was a 5 basis points sequential increase and that puts us at 51 basis points year-to-date.

Now, consumer charge-offs were $79 million or 93 bps versus 68 bps in the second quarter, which was $24 million increase. Lower recoveries accounted for 7 basis points of the increase. The largest quarterly increase in net charge-offs occurred in auto lending, which was up about $10 million and then home equity was also up about $7 million.

The increase in auto losses largely reflected the impact of higher than normal originations in the latter part of 2005. Those vintages are now lowering in their peak charge-off period, and we are finding that the 2005 vintage, as well as some of the 2006 vintage, are defaulting a little early and therefore we are seeing a little higher LTV. So, the severity of loss on collections is a little bit higher than it has been. And then as you probably know, the used car auction market is seasonally weak in the third and fourth quarter, so that's also been a factor on our losses.

The 2007 vintage, on the other hand, is performing better at this point in the life cycle than 2005 and 2006. So, in terms of new originations, we feel pretty good.

In home equity, we are seeing most of the losses coming in the higher LTV broker products, and I have been talking about that for the past years or so, so no surprise there.

And of course distressed geographies you are all aware of continue to be a big factor, as an example almost 40% of our year-to-date home equity charge-offs have been realized in Michigan, which represents just about 20% of our home equity outstandings. And then mortgage and credit card losses were relatively stable throughout the quarter.

Our commercial net-charge offs were $36 million and 33 basis points versus 44 basis points in the second quarter. The 11-point declined was driven by 16 basis points drop in gross commercial charge-offs, partially offset by 5 basis points and lower recoveries.

Most of the improvement came in lower commercial real estate and the absence of high dollar write-offs. In fact, unlike the past few quarters, we had no charge-offs recorded this quarter greater than $2 million.

Moving on to provision; provision expenses are $139 million and exceeded net charge-offs by $24 million, which, as I said earlier, increased the allowance ratio to 1.08. We'd expect to see provision continue to exceed charge-offs in the near future, given our expected loan growth and the expectation from continued growth in NPAs and criticized assets in the near term.

Let me mentioned just a few more points on NPAs to make sure I covered everything. Let's see NPA is totaled $706 million or 92 basis points of loans, up 22 basis points from last quarter. That totals $178 million increase or 34% as I just said.

Commercial NPAs were $446 million. We had a $106 million increase in NPAs in commercial. Most of the increase came from commercial mortgage and construction, particularly in Eastern Michigan, Northeastern Ohio, and Southern Florida.

Home builders and developers accounted for about $50 million of the total, which is up about $5 million from the second quarter. Consumer NPAs of $276 million were up $61 million, and they were driven by an increase in residential mortgage and home equity loans primarily in Florida and Michigan.

And as Kevin mentioned, that increase $22 million related to proactively restructuring borrowers debt to better enable and to service their loans. And we'd expect to do more of that in next few quarters.

Now again, credit is problematic, but we've made a lot of changes that Kevin said. Since the new team has been in place over the past 12 months in terms of identifying areas of potential and developing stress in the portfolio.

Tightening terms and guidelines ensure the credit problems are mitigated and it's going to take a while as you would expect for these changes to fully take hold. So you are seeing higher levels of issues currently than we'd expect longer term.

Based on our analysis of the portfolio and credit conditions in the fourth quarter, we expect to see NPAs increased by similar amount to the third and we'd expect charges-offs to be up probably in the 10 basis points range or so.

Let's say, let me turn to the balance sheet. Let me start with loans; loan growth remained solid this quarter, was up 2% sequentially and 6% year-over-year. The breaking thing is down a lit bit. Average consumer loans also grew 2% sequentially and 6% versus the third quarter.

C&I loans were up 4% sequentially and 7% compared with last year. A commercial mortgage loans were up about $90 million and that just reflects perming out of construction loans, which were down by about the same amount. Other than that, there was very little deal activity going in the CRE sector as you would expect.

Average consumer loans were up 1% sequentially and 6% year-over-year. As Kevin said, we continue to see strong growth in all our loans, up 3% sequentially and 14% from last year.

And as you know, we plan to do an auto securitization about a $1 billion in the third quarter, but market conditions made that transaction very unattractive from a return perspective, so we pushed that out until pricing improves.

Retail credit card balance growth was also very strong, was up 9% sequentially and 57% year-over-year. Now that would have been 18% sequentially and 75% versus last year, excluding the sale of $89 million of non-strategic credit card accounts last quarter. And that's really a pretty remarkable given that our card growth initiative has only been in place since January.

As Kevin said, originations were up 83% year-over-year. That translates into an increase in monthly card originations from just under 14 cards per month per store last year to more than 28 for banking center this year, and new sales continue to increase. We were actually at monthly rate of 32 cards per store last week and we're confident that Charles Drucker and John Grock, our credit card executive are going to have production at best-in-class levels by year end.

Moving on to deposits; average core deposits were down a little less than a 1% sequentially and up 2% from a year ago. Transaction deposits excluding CDs were up 3% year-over-year, driven by 5% retail growth and 1% commercial growth.

Looking at the key deposit lines, DDA balances were down 2% sequentially and 4% year-over-year. The decline continues to relate to lower commercial DDA balances, that's consistent with the last few quarters.

Commercial accounts have grown. They are up about a 1%, so we are holding on our customers, they just carrying lower balances.

The Retail DDA balances are up 6% from a year ago on 7% account growth offset by about a 2% reduction in average balance.

Interest checking balances declined 5% sequentially, and are down 12% versus year ago, also consistent with the last few quarters. Most of the runoff from this product relates to our customers moving balances into savings and money market products, as we brought our pricing and IBT in line with the market over the last couple of years.

Now as a result of this shift, and also very good management of CD pricing, savings balances grew 5% sequentially and are up 25% versus a year ago.

And then finally, retail CDs are down 5% year-over-year and 5% sequentially, which is right in line with our expectations.

We have been very vigilant about our pricing on CDs as well as our pricing on Pub funds. A law that has caused some balance erosion.

Our average weighted rate paid for interest-bearing core deposits was 3.36% and that's down from 3.42% in the second quarter. So our everyday great rates pricing strategy is really doing a very good job of managing the trade-off between volume and rates, and still providing the right value for our customers.

Let's move onto revenue, starting with NII. NII was up 2% from last quarter and 6% from the same quarter last year. Earning assets were up about 2% from last quarter, but NIM was down 3 basis points to 3.34%.

And our year-to-date NIMs now stands at 3.38, which is right in line with our full year forecast of 3.35% to 3.40%.

Last quarter, we told you we expect that the NIM to be down a few basis points this quarter, due to a full quarter effect of our hybrid issuance and our share repurchases. And as I just said, we ended up down 3 bps. Now, of course, a lot change in the quarter.

Compared to our forecast, the repurchase of our REIT preferred stock helped the NIM this quarter and the behavior of rates obviously helped the origination Sprint's spreads in wholesale funding costs, but those benefits were offset by the impact of higher non-performing loans and the decision to postpone our auto securitization.

But at the end of the day, we ended up right where we expected to be, but we didn't necessarily get there the way we expected to.

I'm going to talk a little bit more about margin and the outlook, but we'd expect fourth quarter NIM to be fairly stable with where we are right now.

Now moving on to non-interest income; fee income growth was very strong, driven by payments processing revenue, service charges on deposits and corporate banking revenue.

Our payments processing results continued to be exceptional, processing fees were up 4% sequentially and 16% versus a year ago. As Kevin mentioned, we are substantially outpacing all of the large processing companies in organic growth, and we have an incredible strong competitive position in this business. And we see nothing on horizon that would cause us to change our mid-teens growth expectation in the foreseeable future and that's particularly true given the disruption in the competitive marketplace.

Now looking at the payments business in a little more detail; revenue from the merchant segment was up 8% sequentially and 23% from a year ago, which is really fantastic. Financial institutions revenue was up 2% sequentially and 7% from a year ago. And finally, a card related revenue was flat sequentially from a seasonally strong quarter for debit card usage and up 15% from a year ago.

Now as we have mentioned in the past, we believe our segment reporting makes it difficult for you to determine the real contribution from our processing business. And so, we are really focused on adjusting our reporting and I hope that we will have that done in time for our 10-Q. I think it's really important that you all get a better look at FTPS as though it was a standalone business and so we hardly work on that.

Now switching to deposit service charges; we had another strong quarter, up 6% sequentially and 13% from a year ago. Consumer service charges drove the increase growing -- they are up 11% sequentially and 19% year-over-year. This increase reflects the higher levels of customer activity as well as an increase in a numbers of consumer DDA accounts, which, as I just mentioned, are up 7% from the third quarter last year.

Commercial service charges grew much more modestly at 1% sequentially and were up 5% year-over-year. Investment and advisory revenue decreased 3% sequentially, largely due to seasonality in the brokerage and private banking areas so it's related to business, that's typically driven by second quarter tax planning.

Private banking revenue was up 3% sequentially and 10% year-over-year. NHS reflects continued strong performance across the business as well as some nice new customer additions.

Retail brokerage fees were seasonally down 9% sequentially but up 7% versus last year, reflect increased broker productivity as well as success we are having in terms of broker hiring during the last few quarters.

Corporate banking revenue was up 3% sequentially and 15% year-over-year. Now Bruce Lee and our affiliate teams deserve a lot of credit for the consistent strong growth we've seen across the business, particularly in syndications, asset backed, customer derivatives activities as well as improving letter of credit fees. Now, this is still an undersized business for us. As Kevin mentioned, we are seeing real results from our investments and upgrading the talent here and this still remains a great opportunity for future growth.

Our mortgage banking revenue was $26 million for the quarter, down from $41 million in the second quarter. Now, this was a very disappointing quarter for us in mortgage, and we missed our forecast by a very wide margin.

The good news is that we didn't have any huge write-downs. We don't have a whole lot of capital market exposure given our business model. But, execution of profitable transactions was especially difficult this quarter. We've got new leadership in our mortgage business, and they are very focused on identifying opportunities to earn our way through these conditions, because we think it's going to remain tight for the next few quarters.

The decline in mortgage revenue was largely due to significantly lower gain on sale margins, which as you know was caused by widening credit spreads in the mortgage market. And I am hopeful that gain on sale margins will start to return to more normal levels in the fourth quarter, but that hasn't happen yet, and so it's a pretty mature to start to count on that.

As we note in the release, originations were down modestly from the second quarter, but they were still fairly strong. A big driver of the drop in originations is our elimination of a number of products and channels, as Kevin mentioned. We shutdown our national brokered home equity origination channel due to the poor performance of that channel. And we're also or we also have eliminated all of our Alt-A production except that which were able to deliver under agency or forward flow agreements.

During the quarter, we also incurred $3 million in mark-to-market losses stemming from the transfer of $470 million of jumbo mortgages and $110 million of Alt-A mortgages that were held for sale, and we moved those loans to the portfolio. Now, we have been originating jumbos for sale, but we'll be holding them in the portfolio going forward if they meet all of our criteria for portfolio and product and they're really one of the best relationship products. So, that's the right decision for us.

The loans we moved during the quarter had a weighted average cycle of 740 and an LTV of 72%. In Alt-A, as we've told you, we've moved very aggressively to try to stay ahead in changing market conditions. We wanted to develop this product without risk of holding it.

Now, one of our hand full of banks that in the last quarter has been able to arrange for future Alt-A production to be delivered within flow sale agreements and so we feel good about that and we don't think you should expect any future warehouse risk from this product. Of the $110 million of loans we moved to the portfolio had a weighted average cycle of 700 and LTV of 72%.

All right, other non-interest income decreased 3% sequentially, and was up 6% year-over-year. As I said earlier, in this quarter's result we had a $15 million gain on the sale of FDIC deposit insurance credits, partially offset by a $6 million loss on auto loans that were held for securitization. The last quarter results included the $16 million gain on the sale of the credit card accounts. And third quarter of 2006 results included gains on the sale of branches and card accounts, which I mentioned was kind of $10.5 million.

Moving on to expenses, we had another quarter of well managed expenses. Our reported expense growth was 2% sequentially, driven by higher payments processing activity and 6% growth compared to last year, also due to higher payment processing activity, as well as higher de novo related expenses and technology investments. Now, excluding payments processing expense, growth was flat sequentially and up 4% year-over-year.

Compensation expense, salaries, incentives and benefits of $377 million was flat sequentially and up 4% year-over-year. Benefits included $6 million of pension settlement expense this quarter compared to $8 million last year. Now, this tends to hit us in the third quarter each year and we would expect to see similar smaller number in the third quarter next year.

Second quarter salaries expense included $6 million of severance and again that was related to the expense initiative reduction we announced at the end of the first quarter. Otherwise incentives on strong fee growth and merit increase drove the year-over-year increase.

Our payments processing expense was 9% sequentially and 25% year-over-year. This expense line is being driven by 22% growth in transaction volumes. As we mentioned last quarter, growth in this line will be a couple of percentage points higher this quarter and in fourth quarter due to the conversion of national merchants, as well as the effect of makeshift and the merchant business is our largest one and continues to grow the fastest of the three segments and it also has the highest efficiency ratio of the three.

I just note here that other expense in the third quarter '06 included the $11 million charge of early termination of debt.

Right, in terms of capital, our tangible equity ratio was 688, down four basis points, but still very strong. As we told you we expect the PCE ratio to be about 6.5 at year end, in line with our target due to the impact of R-G Crown which will reduce the PCE ratio by about 40 basis points.

Regulatory ratios were up about 40 basis points sequentially and that reflects the retail hybrid issuance that we did in August. As we noted last month, the repurchase of our REIT preferred stock will reduce fourth quarter regulatory capital ratios by about 65 bps, however we would expect to do further capital securities issuance in the coming quarter to further bolster those capital ratios.

Okay. Let me turn to the full year outlook, and you'll find that on page 9 at the earnings release. And as we've told you in that past we are going to update this each quarter, and again we've highlighted the line items where we've made an adjustment to the July outlook to save you some time.

I do want to point out that these expectations are excluded in the acquisition of R-G Crown, which we've planned to close sometime in the quarter. With three quarters in the book though, at this point I would sound fairly confident in our ability to meet these expectations, and while there have been a couple of adjustments, I don't think there is any significant change overall.

Starting with NII, our NII growth outlook remains unchanged and its still on the mid single-digits and this reflects the couple of things. Our share repurchase activities and debt issuance, as you would know I have been replacing free funding with debt and that's lowering NII, obviously though the offset there is in EPS.

Our commercial loan growth is still expected to be fairly sluggish given the uncertainty in the overall economy and specifically in Midwest part of our footprint. C&I growth remains good, but we see very little CRE demand and in this environment we continue to feel very strongly that slower growth is a better option for us right now and I think you would agree with that.

Consumer growth has been solid in the 6% range and that feels relatively sustainable. In terms of core deposit growth we expect it to be in line with expectations. Retail core deposits held up pretty well, but we still haven't seen any strengthening in commercial side, and so I don't want to just start to bet on those result at this points. But, we are hopeful we will start to see that turn.

Turning to net interest margin, in July I told you that we expected the third quarter margin to be down a few basis points and it ended up down 3, as I said. And for the year we still expect the margin to be in the 3.35% to 3.40% range and that's been our forecast all the year. Fourth quarter should be stable. However, the addition of R-G Crown is going to reduce the number about 3 bps, given the composition of their balance sheet. So, we'd expect to be around 3.34%, 3.35% for full year, including Crown.

Let's see turning to non-interest income, again no change to the fee outlook. The payments business continues to do very well and we remain very, very confident with our mid-teens growth expectation there. We expect the deposit service charge in corporate banking revenue growth to be consistent with the third quarter results. So, we feel very good about that. Now, while we expect at the mortgage business where we are down somewhat from the lows of the third quarter, we still see a lot of uncertainty there. Although, we would expect the originations to be consistent with where they were in the third quarter.

You'll see an increase in our outlook for expense growth to the mid to high single-digits. As I said earlier, if revenue expectations developed as planned we thought that expense growth would likely to be in the 7% range. Our revenue growth is continued to be good and was very good this quarter. Our merchant processing revenue growth, in particular, has been exceptional, though, that business has an average efficiency ratio over 70% and that's big driver pushing us into the high end of our range. Now with Crown, we will probably end up at about 8% for the year.

I remind you that about half of our expense growth is in processing in de novo expense. Underlying expense growth -- we'd expect -- we forecasted to be in the 3.5% to 4% range and I still feel very good with that expectation.

We've raised our net charge-off outlook from the low 50s to the mid-50s to reflect third quarter results and fourth quarter expectations. Now that's more in line with our expectation at the beginning of the year, but it's a little bit higher than we told you last quarter. As I mentioned, we expect fourth quarter charges-offs to be upwards in the 70 basis points range.

As I've already noted, we still expect NPAs and delinquencies to continue to trend upwards a little bit.

Our effective tax rate outlook remains between 28% and 29% for the full year, probably towards the high end of that range for the fourth quarter. And then one final thing, we'd expect R-G Crown to produce about a penny of dilution in the fourth quarter and an additional penny in one-time charges in the quarter.

Okay. To wrap things up, I know the results have some noise in them, but we feel pretty good about our underlying businesses, especially in light of the difficulties that we experienced in the third quarter.

There is a lot going on and it's a very, very tough environment as you all know. But our 21,000 employees, we really feel are doing an incredible job in terms of implementing a lot of very, very positive change here in Fifth Third while at the same time building on our strength.

From my perspective, morale is as high as it's been, and it continues to grow. Everyone is very focused on executing their strategic plans. And we've got a lot of confidence in them and we are very committed delivering value to U.S. shareholders.

So with that, I'd like to thank you for your attention this morning and we'd be happy to answer any questions you have.

Question-and-Answer Session

Operator

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

Kevin Kabat

Good morning, Mike.

Mike Mayo - Deutsche Bank

Good morning.

Chris Marshall

Good morning, Mike.

Mike Mayo - Deutsche Bank

First, just on kind of your vision here, I mean you highlighted that your footprint is kind of one-third in growth market and you said that was doubled what it was, not that long ago. Where do you want to take that fraction and how do you define growth market?

Kevin Kabat

Yeah, Mike, we have defined the growth markets really relation to the demographic and population growth, exceeding the rest of the footprint and exceeding national averages. So that's kind of a rough approximation of how we define it.

Our expectation and our orientation is really kind of getting a mix to more of a 50-50 split, if you will, a growth rate, if you will. That's what we would expect to try and drive to through our growth and through the opportunities that we see before us, and probably not in the two distant future, in a relatively short term.

The progress that we've made in the last two to three years, we think we can continue that same type of expected progress. And as we mentioned as well, most of that has been through our de novo expansion and we also believe that strategically, we've said that up to continue to be able to invest in those high growth markets again through organic expansion and the de novo strategy very well. So hope that helps in terms of some of our perspective.

Mike Mayo - Deutsche Bank

And in addition to the Southeast and Chicago, any other growth markets that are on your radar screen?

Kevin Kabat

Obviously, we do spill and look into the Mid-Atlantic arenas, but again we are going to be opportunistic as it evolves over the next few years. But there is a lot of work to be done in terms of where our platform is today, and we feel good about the positioning that we have the company really ready to take on so.

Mike Mayo - Deutsche Bank

And so additional acquisitions possibly?

Kevin Kabat

Yeah, as I mentioned, obviously, Mike, it's a challenging environment out there. Pricing hasn't changed a heck of a lot from that perspective, but I think if you look at it overall, the combination of what we've done organically, specifically through the de novo strategy been very effective approach for us.

And so while we are open to that, we'll consider that and will continue to be opportunistic in that route. We have a good organic platform to drive off of that growth as well. So that's what you could expect us to continue to execute on.

Mike Mayo - Deutsche Bank

And then one unrelated question over to credit quality. So NPAs were up one-third and they should go up another one-third in the fourth quarter. Now, I guess your NPAs loans are kind of a above peer average at least what I'm looking at, and I guess it will go up higher still. And Fifth Third has a long history of having a good credit culture. How are you thinking about credit quality today versus history?

And also if you can just give a little more detail on the auto loans, you said some of the severe losses worse than you expected, and at the same time, you are kind of growing it 14% year-over-year?

Chris Marshall

Mike, this is Chris. Let see, the first, the long terms NPA growth, I can't give you an exact number, but I think 34% is what we saw this quarter. I think that was -- if you look at it in two pieces, the biggest piece obviously credit deterioration is probably about 25% and 9% to 10% was due to the troubled debt restructuring and the lack of an NPA sale.

I can't tell you what we are going to do in the fourth quarter, but I would expect that not having an NPA sale is going to be unusual for us. We would love to do those each quarter. So that would offset some of the NPA growth and then the trouble debt restructuring. While it's a little too early to tell how those credits are going to perform once they are restructured. I put those in a slightly different category. So I might look at the underlying NPA growth as a little bit lower than the 34%, more than 25% range.

In terms of autos, I think the bigger while there was an increase in severity of loss just given the earlier charge-offs in the '05 vintages and I think you'd see some of that occurring in some of our competitors across the country for some reason. There is higher charge-offs in that vintage.

Mike Mayo - Deutsche Bank

Why you think that is, I guess the quick question is the consumer problems in mortgage going over to other areas and now we have auto to add to that list or not?

Chris Marshall

It's a good question, but it's one I really couldn't give you a great answer on yet, but somewhat very focused on trying to figure out exactly what happened in 2005 that we drive that. By comparison if it was just as borrow for consumer, you'd expect that the 2007 vintage would continue to deteriorate even at this point in its maturity, and in fact the opposite is happened is performed a little bit better.

And then when we look at other consumer lending, like credit card, we said balances were up, but, in fact, we don't see any stressing on credit card at all. In fact that's performing very, very well.

So, I am not sure if there was change in standards or something else in 2005. We are very focused on trying to figure out why that's occurring. The bigger issue in the quarter is due to seasonality and the market is always very weak in the third quarter and it's been even weaker this quarter because of the influx of inventory.

So, I think that's the bigger driver. So if you look at the 2007, vintage is performing well. The growth is we feel good about the stuff we are originating right now.

Mike Mayo - Deutsche Bank

How long does it for an auto loan usually to go back, I mean '07?

Chris Marshall

They begin charging off, I mean you see the charge-offs even at very well levels from the time you write the loans, so you see 90 days out. Loans are already starting to be delinquent and starting to fail.

We don't see that as badly in this new vintage as we did in '05 and '06 toward a lower level.

Kevin Kabat

Your questions are very good question and you are right on the right point, it's just -- I would not assume that just because '05 and '06 are poor vintages, that that's going to continue through this year.

Mike Mayo - Deutsche Bank

All right. Thank you.

Kevin Kabat

Thanks Mike.

Operator

Your next question comes from the line of Matthew O'Connor with UBS.

Matthew O'Connor - UBS

Hi, Kevin and Chris.

Kevin Kabat

Good morning Matt.

Chris Marshall

Good morning, Matt.

Matthew O'Connor - UBS

Chris, when we met in September, you had mentioned that if mortgage spreads remained wide, which they have, you might add some securities in the fourth quarter. Are you buying securities, and if so, what types?

Chris Marshall

Well, if they remain wide up mortgages, the mortgage pools have actually come down little bit. Securities are probably now where we would want them to be before we stated to add. If we saw our spreads, maybe, widened by about another 30, 40 basis points than I think they would at or about the point where we would to start to add things. Right now, the returns will still be a little tight for us.

Matthew O'Connor - UBS

Okay. And is it dependent on your view on what the Feds could do, so if you thought the feds was going to cut one or two more times, you would look to add now or is it risk premium?

Chris Marshall

No. Exactly, is it that, that the outlook for the Fed gets a little clear than things would look a little more advertising.

Matthew O'Connor - UBS

Okay. And just separately you've talked about securitizing or selling some lower spreads out that's the thing from the auto book in the past, obviously this I think I had done in 3Q. What are the plans going forward there as you think about '08 and what you intend to do to free that capital?

Chris Marshall

Well. First of all, it's not a tremendous amount of capital, and I am not sure we have this specific use for that capital other than staying at our 6.5% target given the three purchases we are going have to make. So, this first securitization is already factored into completing those transactions and still staying at 6.5%.

Long-term and that is opposed to the next quarter or two, we are going to build out an auto securitization platform. We're very committed to that. We think that's the right way to run the business and so we will do that. In the short-term, though, the timing of the transaction is going to be entirely dependent on market pricing.

Matthew O'Connor - UBS

And over time would you like to bring down your auto exposure relative to all of loans?

Chris Marshall

Yes.

Matthew O'Connor - UBS

Do you have any target in mind?

Chris Marshall

Yes. I'd said, while we don't talk a whole lot about of the specific target, we would start it maybe half the size of what the book is today.

Matthew O'Connor - UBS

Okay. And then just lastly, I am sorry if I missed it, but what percentage of your home equity is brokered?

Chris Marshall

Hang on, let's see. I am going to say it's about -- I don't have the exact number, but it's about somewhere between 20% in the quarter, maybe low 20s.

Matthew O'Connor - UBS

Okay. Thanks very much.

Jeff Richardson

Thanks Matt.

Operator

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

John McDonald - Banc of America Securities

Hi, good morning guys.

Jeff Richardson

Good morning, John.

Chris Marshall

Good morning, John.

John McDonald - Banc of America Securities

Chris, I was wondering if you could give us a little bit of color on kind of what the drivers are of the level of the reserve build. I guess with NPAs and charge-off ratio going up, why don't we see a growth in the ratio of reserved loans?

Chris Marshall

Well, I would give you a general answer to that John. I mean, there is not a linear relationship, as you know, between NPAs and reserves. It really has to do with the expected loss from those loans that are moving into NPA status. And in our case the vast majority of them are commercial loans and our loss expectation on those loans are all factored into the calculation.

In fact, we not only look at what our loss experience has been, over the last couple of quarter we've really tightened that up to make sure we are looking at what our loss experience has been in the immediately proceeding quarter as opposed to looking over the average of a year or two. So, I think we're looking very accurately at credit-by-credit or pool-by-pool what's flowing into NPA or what deteriorates have been and what the expected losses are and that's how the allowance is built.

John McDonald - Banc of America Securities

Okay. I guess I just figured with the charge-offs forecast going up, is this for everyone, you would see more in terms of reserve building. But, are you just saying it's a bottoms up and that's what [fits out].

Chris Marshall

Yes. It is very much a bottoms up.

John McDonald - Banc of America Securities

And just to clarify one of your other answers, did you say that the NPA sale market has gotten a little better from virtually staying down over the summer?

Chris Marshall

I really don't know. You really can't tell until you put a portfolio out to market what pricing is. It turned out that when we waited just happened to be the way it happened, and so we put a portfolio out it was at the end of the quarter.

We expected to sell it and I think everybody in a broader came to market in the same week and so pricing was poor and we pulled it. I think pricing could have improved by now, maybe it hasn't, I don't know. But, we have to hold those loans, we will hold them, if we can sell them at the right price, we will. But, we are not going to give them away.

John McDonald - Banc of America Securities

Okay. Thanks, Chris.

Chris Marshall

Terrific, John.

Operator

Your next question comes from the line of Ed Najarian with Merrill Lynch.

Ed Najarian - Merrill Lynch

Hello. Good morning.

Jeff Richardson

Good morning, Ed.

Chris Marshall

Good morning, Ed.

Ed Najarian - Merrill Lynch

First question has to do with credit quality and with respect to commercial mortgage loans and commercial construction loans. We saw that that was one of the biggest drivers of the increase in NPAs this quarter. Yet when we look at the charge-off ratios, commercials mortgage loans charge-offs 26 basis points down from 56 basis points in the second quarter and commercial, construction 35 basis points down from 48.

So, it would have appear like potentially you are deferring some of the loss recognition of I these NPAs and commercial mortgages and commercial construction? Can you just speak to the very low charge-off ratios that you recorded this quarter in those two categories?

Chris Marshall

Well, I guess I could talk to it, but Ed, I guess I respond initially, you can't differ loss recognition and we are certainly not in anyway doing that.

So if you specifically, if you want me to reconcile the amount of NPA inflow to the charge-off ratio, I don't think I can do that right at this moment. I'm gladly trying to get you some more data off-line. But I think the loss recognition we had in the quarter is accurate and our charge-off ratios in the rest of our lines had moved around quite a bit and I don't think you can try to reconcile them one to one.

Ed Najarian - Merrill Lynch

But I guess when we should think about it is that a lot of the migration to NPA that we saw this quarter was not written down materially. Would that be correct, because if it would have been, we would have seen higher loss ratios in those categories?

Chris Marshall

The one thing I would say is had we done a charge-off sale, which we expect to, we would have seen higher charge-off, I mean I'm sorry in NPA sale. We expected to do NPA sale of about $60 million and that was the sale that didn't happen. If I had to guess, the loss might have been 10% of that. And so we would have seen higher losses to a tune of $10 million on that stuff that we would have sold. The rest of the step that flowed in, I couldn't reconcile what that would have done to charge-offs in the quarter.

Ed Najarian - Merrill Lynch

Okay. And then secondarily you've spoken a lot about the de novo branch expansion in a way. I think you talked previously about opening 50 branches in Chicago next year and then some other de novo expansion in some other markets. Could you just put some color on how you expect that to impact the growth in your operating expenses outside of sort of the typical growth and the core franchise?

Chris Marshall

Yeah, well, I'll give you some top level numbers. As Kevin said, we are going to bring on 59 stores this year. Next year, our current planning would say, we bring on about 80, so about 20 additional stores.

In terms of the numbers, there won't be 15 in Chicago. They're probably be about 50% of those stores in Florida and Southeast now. There is probably going to be 20 or so in Chicago and then 20 stores are probably be spread through out other parts of franchise like Tennessee and other areas. So, there is probably a couple cents of dilution, maybe an extra penny from the extra 20 stores may be $0.02.

Ed Najarian - Merrill Lynch

So, I mean could you give us a sense of those 80 stores, what kind of operating cost that entails opening those 80 stores on a year-over-year basis, or on a percentage basis, how much (inaudible)?

Chris Marshall

On a percentage basis, well, I am telling you that assuming that we have already got roughly 60 stores opening this year. So that's in our run rate. We will have about 20 more next year and that will cost us about $0.02 in incremental dilution next year from the expense drag from bringing those stores on.

Ed Najarian - Merrill Lynch

Okay. And then last question in terms of the First Charter acquisition, do you have the percentage of their loan portfolio, there is any construction or residential and commercial construction on land development lending?

Chris Marshall

We do have, but I don't have it with me yet. But I would gladly ask them to follow up with you after the call.

Ed Najarian - Merrill Lynch

Okay. Thank you.

Chris Marshall

Sure. One more.

Jeff Richardson

Operator?

Operator

Your next question comes from the line of [Andy Walker with New Age Capital].

Kevin Kabat

Good morning Andy. Is Andy still with us?

Operator

Andy Walker your line is open.

Kevin Kabat

Any other questions?

Operator

At this time sir, there are no further questions.

Kevin Kabat

Hi, let me just close it down, then thanking everybody for joining us. As we've said at the beginning of the call, there are lot of really positive developments and a very tough quarter for the industry and particularly in terms of the credit challenges before us. But we feel that really good about the improvements we are making in the business are going to stay with us. So, we thanks for your attention and we'll talk to you next quarter.

Operator

This concludes today's Fifth Third Bancorp third quarter 2007 earnings conference call. You may now disconnect.

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