South Financial Group Q3 2007 Earnings Call Transcript

Oct.19.07 | About: South Financial (TSFG)

The South Financial Group Inc. (TSFG) Q3 2007 Earnings Call October 19, 2007 10:00 AM ET

Executives

Mary Gentry - EVP of IR

Mack Whittle - Chairman, President and CEO

James Gordon - CFO

Lynn Harton - Chief Risk and Credit Officer

Analysts

Kevin Fitzsimmons - Sandler O'Neill

Christopher Marinac - FIG Partners

John Pandtle - Raymond James

Andy Stapp- B. Riley

Andrea Jao- Lehman Brothers

John Pandtle - Raymond James

Bill Young - Oppenheimer &Co.

Andy Stapp - B. Riley

Operator

Good morning, and welcome to The South Financial GroupEarnings Conference Call. All participants will be placed on listen-only modeuntil the question-and-answer session of this conference. This conference isbeing recorded. If you have any objections, you may disconnect at this time. Iwould like to introduce Ms. Mary Gentry, Executive Vice President of InvestorRelations. Ms. Gentry, you may begin.

Mary Gentry

Good morning. Thank you for joining The South FinancialGroup's third quarter earnings conference call and webcast. Presenting todayare Mack Whittle, Chairman, President and Chief Executive Officer; JamesGordon, Chief Financial Officer and Lynn Harton, Chief Risk and Credit Officer.We also have with us other members of our management team. We'll follow theprepared remarks on earnings with an update on our strategic plans. We'll thenfinish up with an analyst question-and-answer session. In addition to our newsrelease, we have a supplemental financial package, which is available on theInvestor Relations portion of our website.

Before we begin, I want to remind you that today'sdiscussion, including the Q&A period contains forward-looking statementsand is subject to risks and uncertainties, which may cause actual results todiffer materially. We assume no obligation to update such statements. Pleaserefer to our reports filed with the SEC for a discussion of factors that maycause such differences to occur.

In addition, I would point out that our presentation todayincludes reference to non-GAAP financial information. We've providedreconciliations of these measures to GAAP measures in the financial highlightsof our news release and the supplemental financial package on our website.

Now, I'd like to turn the presentation over to Mack.

Mack Whittle

Thanks, Mary, and good morning everyone, and thank you forjoining us. This quarter brought steady progress in some areas we haveemphasized throughout the year. We stabilized our net interest margin whilemaintaining at 3.12% for the third quarter in level with the fourth quarter2006 margin.

Last year, we began talking about improved tools and astronger team to analyze and manage the margin. We delivered a stable margin inface of continued declines in the industry. Going forward, we are continuing towork hard to improve our net interest margin by focusing on low-cost depositgathering. We continue to produce balanced loan growth. Average loans increased3.2 linked-quarter annualized, on period basis, we had 5.7 annualized loangrowth. We lowered our non-interest expense for the third consecutive quarter.

In January, you may remember, we set an expense savingstarget of $20 million annualized from our fourth quarter operating non-interestexpense run rate. In the second quarter, we reached our targeted level ofsavings. This quarter, we continue to execute on our expense control measures.As a result, we've had positive operating leverage for three quarters in rowand improved the cash operating efficiency ratio to 59.3%.

Expense control remains to be a primary focus for thecompany and it also has helped us offset some of the increased credit costswe've seen in this quarter.

We have ongoing emphasis on managing capital position aswell. During the quarter we repurchased shares, called preferred securitiesthat had above market spreads, and issued new trust preferred securities atlower spreads.

We've ended the quarter with a 6.47 tangible equity to assetratio, due in part to positive changes in the mark-to-market on our securitiesat the end of the quarter. This progress has come despite the challenges thatface the entire industry and our company as well.

I'd like to spend a few minutes and focus on a couple ofareas, revenue growth, credit and the competitive deposit environment. First,revenue growth, while total operating revenue was flat for the quarter, weimproved our earning asset mix by shifting from investment securities to loans.For the third quarter, average loans as a percentage of average assets exceeded80%, a substantial improvement from 76% a year ago and 68% two years ago. Byquarter end, securities to total assets declined below 17% from 27% two yearsago. We've come a long way and now are more in line with our peer group inthese metrics.

We're fortunate that while the real estate related lendingin general had slowed from last year, we're still seeing good real estateactivity in substantially all of our markets. In this environment we are beingprudent and selective, while still looking for good opportunities to pick upthe right relationships. Additionally we're seeing pricing of loans becomingmore rational.

Credit, first of all we are seeing the same signs thateveryone else did, this toughening credit cycle which is affecting the entireindustry. Past dues have moved higher in North Carolinaand Florida.We are doing an extra analysis and portfolio review in preemptive areas on manyloans in all areas of the company. We are also taking a good hard look at our Florida portfolio giventhe weakening residential market. Later in the call, Lynn Harton will providean update on credit and what we are seeing in our markets.

Next is funding. Improving our funding base and lowering ourfunding cost remains a key challenge for us. Our net interest margin was stablefor the quarter. Our long term outlook for the net interest margin depends to alarge degree on our ability to grow core deposits.

When we measure ourselves against the market opportunity andour peer group; we under perform on our cost, on our volume and on the mix ofour deposits. We are well aware of theses issues and aggressively working oneach component. While we'd like to improve all three we've started withimproving our deposit cost since its the area where we can have and show themost immediate results.

We are measuring our success by margin than by growth. Wekept our customer funding cost flat in the second quarter and up one basispoint in the third quarter. Our funds transfer pricing has become an importanttool in fostering this pricing discipline.

Our strategic plan is built around being a bank of choicefor customers starting with deposit-based relationships. A central component ofour plan centers on improving deposit volume and mix while maintaining pricingdiscipline that we've used to move our pricing down on a relative basis overthe last three quarters.

We have simplified our customer checking account offeringsthis quarter going to three, down from 25 checking accounts earlier in theyear. We feel that this will enhance the customer experience and the relationshipwith the customer. To further support this strategy over the last six months,we have limited special campaigns and promotions. You can see the impact in ourresults; lower deposit balances, lower advertising expense, but better depositpricing.

This has forced us to compete on customer value versusprice. This has also given us the opportunity to assess our competitivenesswithout any pricing advantages and make changes in our sales and marketingprocesses. That being said, we are now ready to support the retail efforts withadvertising and began advertising system wide on October 14th, supporting inparticular the rollout of our new checking account products.

One of the successes in this funding to date has been the steadyincrease in the balances of our customer sweeps for our treasury customers.This has been effective in growing this business and attracting the coreoperating accounts from our commercial customers. In the third quarter 2007,average customer sweeps increased to $560 million, up 51% from $370 million ayear ago.

Now, I would like to turn the call over to James Gordon toreview our third quarter results in more detail.

James Gordon

Thanks, Mack. I will add some details about our third quarterresults and expand on the few items we covered in our release. In the third quarterwe earned $0.35 per GAAP earnings per share and $0.36 per operating earningsper share. This follows second quarter 2007 operating earnings of $0.27 or$0.36 after adding back the $10.5 million additional provision for creditlosses related to the well publicized loan fraud at Spruce Pine, North Carolinareal estate development.

Non-operating items for the quarter included $287,000 netpre-tax gain on securities and $1.3 million pre-tax loss on early extinguishmentdebt related to calling the trust preferred securities. The gain on securitiesincluded a gain from the sale of certain community bank equity holdingspartially offset by the $300,000 additional loss from the sale of the corporatebond portfolios previously disclosed, and the write-down of an equityinvestment.

Third quarter 2007 operating revenue remained essentiallyunchanged versus the prior quarter at $128.8 million. The third quarter netinterest margin remains stable at 3.12%; average loans increased 3.2% linked-quarterannualized led by growth in commercial loans including shared national credits,primarily through our corporate banking group, which increased to $604 millionat September 30th.

We have indicated that we intend to reduce our investmentsecurities portfolio to around $2 million. This runoff slightly is beneficialto both the net interest margin and overall earnings due to the negative spreadbetween the portfolio and wholesale funding costs, but does limit overallgrowth in the earnings. Our projected time for reaching this level depends onthe interest rate environment, which impacts the level of prepayments of calls.

In November, we have $120 million treasury securities that'sscheduled to mature and will not now be replaced. In addition depending oninterest rates we may be in a position to reach the intended goal in the nearterm. We anticipate average earning assets to decline in the fourth quarterwith modest growth thereafter until securities reach the $2 billion level.

Consistent with what we've said previously, we worked hardto neutralize our interest rate position and based on our interest rate risks andsensitivities we believe that the reason and potential changes in the Federal fundsrates will have no significant impact on the near-term loans. However, thecontinued spread differential between Fed funds and LIBOR continues to putpressure on our overall funding cost and net interest margin.

Our average customer funding balances declined this quarterwith average customer funding down 4.2% linked quarter annualized. Our pricing disciplineand focus on profitability contributed to this decline. As you can see we'vekept our overall customer funding cost under control up one basis point thisquarter to 3.46% after remaining unchanged at 3.45% for the second quarter.

During the quarter we called approximately $70 million ofpreferred securities at an average spread of 364 basis points over LIBORrealizing $1.3 million loss on the early extinguishment of debt. We were ableto replace approximately $50 million with new trust preferred securities thatpreviously anticipated spreads for a savings of over 200 basis points. We planto call approximately $25 million more in the fourth quarter and ran upapproximately $600,000 in unamortized issuance cost.

Operating non-interest income decreased $259,000 to $30.5million for the third quarter of 2007, principally from $1 million decline inmortgage banking revenue. Our mortgage origination volumes slowed to $108 millionfor the third quarter versus a $148 million for second quarter reflected by thecurrent market conditions.

We had $1.7 million positive swing in the valuationsassociated with certain derivative activities, which offset a $1.5 milliondecline in bank-owned life insurance income from insurance proceeds we receivedduring the second quarter of 2007.

Our treasury services analysis fees increased to $2 millionfor the third quarter, while our merchant processing revenues continued to showstrong growth, although this is reflected by the seasonal nature of those inour coastal markets.

Next to efficiency, for the third consecutive quarteroperating non-interest expenses declined down $1.9 million or 2.4% linkedquarter. For the third quarter of 2007, FTE declined by 10 to 2,457 and aredown by 106 persons a year ago. This is the lowest FTE count since 2005.

We will continue to monitor and review our expense base andlook for operating non-interest expenses in the $79 million to $80 millionrange for the fourth quarter of 2007, which includes an increased FDICinsurance premiums of approximately $1.1 million from the fourth quarter alongwith the net costs associated with implementing the strategic plan.

The cash operating efficiency ratio totaled 59.3%, ameaningful improvement from 60.6% for the second quarter of 2007. The decreasein cash operating non-interest expenses led to positive operating leverage forthe third quarter of 2007, a third quarter in a row of positive operatingleverage.

Our income tax effective rate for the third quarter 2007 waslower at 31% based on the mix and expected level of taxable income. We expectincome taxes in the 32% range for the fourth quarter of 2007 and similar levelsheading into 2008, part due to a recent $100 million allocation for loans whichwe are eligible to receive new market tax credits.

Lastly to capital. During the third quarter we repurchased850,000 shares of common stock at an average cost of $21.93. In August, theBoard of Directors amended and restated the South Financial Group's stockrepurchase authorization to be an aggregate of $100 million which expires withfund used on or before June 30th 2008. With this authorization we continue tohave the flexibility to repurchase additional shares depending on capitallevels, market conditions and growth prospects.

We ended the second quarter with a tangible equity totangible assets ratio of 6.47% within our 6% to 6.5% targeted range. Howevergiven the turbulence in the credit and capital markets, we may allow the tangibleequity ratio to move above the 6.5% level in the near term.

We had a positive mark-to-market on the securities portfolioas we reduced our annualized loss on securities net of taxes by $21 millionduring the quarter. This improvement caused a 14 basis point favorable increasein the September 30th tangible equity ratio.

Just a couple of comments on credit quality in advance of Lynn's remarks. Theprovision for credit losses for third quarter 2007 totaled $10.5 million, that's$3.9 million increase over second quarter of 2007, excluding the $10.5 millionadditional provision for the North Carolina development loans in the second quarter.

I'll now turn it over to Lynn for further comments on credit.

Lynn Harton

Thanks James. I'll start with a few comments on netcharge-offs, which totaled $16.8 million to the $11.6 million increase over thesecond quarter. Third quarter net loan charge-offs included 7.7 million for theNorth Carolinadevelopment loans, excluding the 7.7 million net loan charge-offs at 36 basispoints. Year-to-date charge-offs excluding North Carolina development loans were 27basis points, slightly less than the 28 basis points we experienced in 2006.

In the third quarter we had been anticipating a potentialrecovery, which would have reduced net charge-offs by about 10 basis points,due to market conditions our borrower was unable to complete the transaction,and at this point we are uncertain whether the transaction will occur with amagnitude of any potential recovery.

Additionally third quarter charge-offs included $2 million [C&R]relationship in our South Carolinamarket. This credit has been in our nonperforming assets for some time;previously it was fully reserved in our allowance.

Our nonperforming asset ratio increased to 58 basis points,excluding North Carolinadevelopment loans, which had a 6 basis points impact. Nonperforming assetsincreased by 7 basis points to 49 basis points primarily from two credits. Onewas a South Carolinabased textile company that we have been monitoring as a problem one for sometime, which also contributed 750,000 to charge-offs this quarter. Secondly, a Florida based mortgagelender that I'll discuss in more detail later.

Next, I would like to touch on several topics, I am sure areof interest to everyone. First, the North Carolina development loans, with $7.7 million incharges-offs I mentioned earlier, we have recorded a significant portion of thecharge-offs that we provided for last quarter. At this point, we have had nomaterial changes in the situation, either positive or negative.

We continue to negotiate with several borrowers and haveinstituted collection activities on several others. Borrowers wereapproximately $1.8 million, continued to honor the terms of their notes. Wecontinually evaluate our position; we'll make adjustments if the situationmoves to a resolution.

Secondly housing, including Florida. Like most of the industry we'reseeing weakening fundamentals and sectors impacted by the housing market and Iwould like take each one of those in turn, our mortgage warehouse lendingfirst. We have a small portfolio of a limited number of mortgage lendingcompanies in Florida.These are customers we bank for some time. Three of these customers haveexperienced some stress during the market disruption. This quarter, we addedone of these to nonperforming assets. This is the [Florence] based mortgage lenders I mentionedearlier with a balance of approximately $4 million. We are secured by notesreceivable and we are evaluating our collateral position there.

The second one is TransLand, which has been made public andcontinues to perform. We have had a third party evaluate each of our individualnotes in that relationship and the result of that report was very favorable.The final one continues to perform although they have temporarily ceased theirorigination business and are focusing on the services side of their business.Our loans are continuing to be serviced and we are monitoring that situationclosely as well.

Residential, construction and development. We have notexperienced increased nonperforming assets or net charge-offs in ourresidential construction, and development portfolios, but we are seeingincreasing stress on developers particularly in the Florida market.

We are continuing to tighten the underwriting standards fornew loans, renewals. Where appropriate we are obtaining additional collateralor otherwise improving our risk positions on existing loans and we continue toclosely monitor all of our projects.

Condos. Condo projects are experiencing high levels ofcontract fallout than we had anticipated. In the South Carolina coast we are seeing levels up to approximately 30%,slightly higher in the Floridamarket. Even at these higher levels of fallouts we believe that any remainingbalance on our loans will be well secured after all closings are complete onthe new construction Condo projects. We are fortunate to have little exposureto the conversion market as that product is under more stress than the newconstruction is.

Home equity. Our home equity portfolio is all bank customerrelated. We don't book any brokered or sub-prime home equity loans. Ourcharges-offs in this portfolio are stable at a very low level. We have seen aslight increase in our past dues, our 90 day past due ratio in the HELOCportfolio has moved from 20 basis points in June to 33 in September.

Our mortgage portfolio is also bank-customer related with nobrokered loans or sub-prime exposure. Our 90 day past dues and mortgaged assetsbilled this quarter as did our net charge-offs.

In summary, our net loan charge-offs excluding the North Carolinadevelopment loans were higher this quarter but continue to be consistent with pastresults on a year-to-date basis, even in a more difficult environment.

The environment for residential construction and developmentcustomers is more difficult and we're staying very close to these relationshipsduring this period. The diversity in our markets is a positive, our South Carolina market isactually improving credit metrics. South Carolinareal estate markets had not been as severally affected by the downturn in the Florida markets. Thedirection of the housing market over the next several quarters will influenceour results, but we believe we've got a solid plan and right action steps inplace to manage through the environment.

I should now turn it back to over to Mack.

Mack Whittle

Thanks, Lynn.This quarter we continued to stabilize our net interest margin and postedsteady progress in quality loan growth, earning asset mix improvement, expensereduction and capital management.

We've improved these areas quarter-by-quarter throughout2007. A couple of areas remain challenging, particularly funding and credit,but provide an opportunity to improve our overall profitability and returns toshareholders.

As we have previously discussed we've been working on ourstrategic plan during the last several months. Our objective of this plan is toguide improvement of our long-term financial performance with step-by-stepimprovements in certain critical areas. The plan puts initiatives and actionplans around key performance drivers that will certainly move us toward peerlevel profitability. To reach this level we intend to grow our earnings fasterthan our peer group.

Given the current market conditions, it's not an opportunetime for us to disclose long-term performance targets. Instead we're measuringour progress quarter-by-quarter and improving performance in six key areas;funding, loan growth, credit quality, non-interest income, expense control andcapital management.

We engaged First Manhattan Consulting Group to support ourplanning process and provide an outsiders perspective. The planning processincluded the development of strategic plans for each of our business lines;commercial, retail, wealth management areas, fee income areas, corporatebanking and indirect lending.

We developed specific action plans and set priorities toaddress the needs identified in each of these business plans. This process involvedunderstanding the positioning of each business line relative to the industry,and in terms of overall profitability.

The work we've done on our new profitability system was animportant tool in this process. As we further develop the analytical tools thatare part of this profitability system, our decision capabilities at thebusiness line, product and customer levels will continue to improve.

Our plan in First Manhattan ultimately converged on some keyareas; lowering our funding cost by improving the level, the mix, and the costof deposits; maintaining balanced loan growth; maintaining credit qualitylong-term; growing non-interest income from increased levels of deposits andexpansion of private banking; controlling non-interest expense; and number six,actively managing capital levels and mix.

Also, our planning process has highlighted the challengefacing the organization. Funding; specifically generating core deposits.Through our work with First Manhattan, we deepened our understanding of ourdeposit challenges and focused our efforts on three high-impact areas,improving our retail focus, leveraging our existing commercial base and fullydeveloping our private banking resources.

Our plan is tactical and detailed. While we've numerousaction plans, I'd like to walk you through three examples of actions that arealready underway.

First is retail banking. We've developed a power ratio foreach market and each branch. This power ratio is a measure of the fair share ofdeposits versus competitors. The power ratio compares the share of deposits tothe share of branches for each branch using a defined market area thatapproximates a 2 mile radius around the branch. Branches with low ratios aregoing to attack the market with product offerings, enhanced marketing, prospectlist and aggressive goals. Branches with higher power ratios are focused onservice levels, retention and cross selling. This is a much more logical andgranular approach to uncovering deposit opportunities that we've previously used.

Our commercial plan. We developed a methodical approach toleveraging our strong commercial lending relationships to attract new andexpanded deposit relationships. Approximately, half of our lendingrelationships do not have their primary depository relationship with us, eventhough we may be their primary lender. We have implemented procedures tosystematically review each existing commercial relationship to identifyopportunities with the focus on attracting and expanding operating accounts aswell as introducing our treasury services.

Third is private banking. Our plans include expandingprivate banking services to our more affluent customers. We plan to adddedicated private bankers in non-markets in 2008 to build on the resourcesalready around the four markets that we are in. Private bankers will seekopportunities to capture entire relationships, deposits, lending, and wealthmanagement services. To support private banking initiatives we'll look foradditional deposits, credit and investment products to be introduced.

Over the last several months the senior management team hasvisited every market to discuss this plan. It's important to our future and thespecifics on the changes created by these initiatives. We are excited about theplan. We are excited about the initial progress that we are seeing and we lookforward to sharing the future updates with you.

We are also focused more than ever throughout theorganization on improving returns to shareholders. We built our franchise inhigh-growth markets and we have a great team of employees and customers.

These strengths make our plan achievable even in thischallenging environment, where opportunities will present themselves. All of usat the South Financial Group appreciate your support and I would like to openit up for questions.

Mary Gentry

This is Mary. We ask that you limit your questions to oneprimary question plus one follow-up. If you have additional questions feel freeto re-enter the queue. We are ready for the question-and-answer session tobegin.

Question-and-AnswerSession

Operator

We invite analyst to participate in the question and answersession. (Operator Instructions). Our first question comes from KevinFitzsimmons of Sandler O'Neill.

Kevin Fitzsimmons -Sandler O'Neill

Good morning everyone.

Mack Whittle

Morning, Kevin.

Kevin Fitzsimmons -Sandler O'Neill

Just one question on credit, I know the allowance ratio camedown really, probably due to the timing difference with Spruce Pine, but givenLynn's commentary on the market and it just seem like -- we are hearing it fromlot of banks these days and I am sure its no different in your franchise, butthat things are deteriorating and customers are under more pressure, eventhough maybe the losses aren't emerging at the current time. And just want toget a sense to how comfortable you are with the allowance, where it is and howyou're going to look going forward provisioning relative to net charge-offs andthen I just have one follow-up as well. Thanks?

Lynn Harton

Sure Kevin. No there is no single individual ratio that drivesreserve levels. So there is not anything that I would be particularly focusedon. We look at several different data points. It's a fairly mathematicalprocess that looks at that. This isn't a prediction or anything else but if youlook back in the past for example coverage of nonperforming assets. We've been exposedto [non] which was much higher than that today. I would make a couple of pointsin thinking about the reserve, we tend to take charge-offs early and thatnonperforming assets would not have a significant loss built into them.

So as we put them in nonperforming, we try to take the lossat that point and we also tend to put on our loans on non-accrual earlier, putthem in nonperforming. If you look at us relative to other banks and our 90 daysis still accruing for example you will see that we are much more conservativewhen we put things on nonperforming. So [let me commit it], the summary is weare very comfortable with our reserve ratios now and we are going to continueto look at all those data points and make the right adjustments going forward.

Kevin Fitzsimmons -Sandler O'Neill

Okay great. Mack, just one question on the follow up on theFirst Manhattan study, I recognized that they are providing an outsider a newway to look at things, but just listening to some of the areas they arefocusing on and some of the things they might do, the thing that strikes me isthese are things and these are areas that you all have been talking about andfocusing on for quite a while, with retail for example, Chris has been, youknow, that's been his mandate to get core deposits up and to focus on thebranch level, and I am just wondering what kind of new revelations really stoodout for you from bringing them in? Was it just a formalization of the thingsyou already knew or was there really any really light bulbs that when off interms of that you really all had not thought of before? Thanks.

Mack Whittle

There were really no light bulbs that went off, I mean it'sreally pretty simple, it was more of a affirmation of where we knew we were, itdealt primarily with funding. And they did give us more granularity on funding.They did help us come up with some specific methods of execution, and gave us somescience around that that we didn't have before. They allowed us to use some oftheir modeling they've used for other companies before to look at in ways thatwe really had not looked at it before. So, not only did we identify the upsidesand the opportunity to normalizing our funding to our peers, but we came upwith some specific action points and the three that I presented earlier arejust three. And three that we now have started there will be many, many ofthese as we move forward with this.

Kevin Fitzsimmons -Sandler O'Neill

Okay, great. Thank you very much.

Operator

Our next question is from Christopher Marinac of FIGPartners.

Christopher Marinac -FIG Partners

Thanks, Hi. Good morning

Mack Whittle

Good morning.

Christopher Marinac -FIG Partners

Mack. I just wanted to get a sense of kind of what you seein terms of pipeline of future problems or how -- just kind what the loss list lookslike and in either colors, and then maybe you could kind of talk about that bymarket?

Mack Whittle

As I mentioned in terms of bond market, I personally stepback in terms of pipeline, we don't really keep, what you would call a pipelineof losses or problems where actually managing the portfolio risk rating andetcetera. I'd say in general. It's the residential real estate related businessesthat we are most concerned about and relatively we're more concerned about Florida than we are of North Carolina and South Carolina. Ask me another question I'll give a littlemore detail.

Christopher Marinac -FIG Partners

Sure. If we'll drill down the residential, so if we talkabout Florida, the issue is primarily in Tampa, in Orlando, or areyou seeing in Jacksonville, in Miami to what extent do you think you haverecognized most of the issues now?

Mack Whittle

Of course in terms of recognizing we think we've got a greathandle on all the projects and customers. We've been doing a pretty deepportfolio (inaudible) over the last six months, and so A) we think we've beenidentified all the problems. B) If you look at Florida, in general, it is the worst marketsin the state or the most difficult market in the state and once where we don'thave a big presence, we're not in the Panhandle. We really don't have a bigpresence at all, even though one loan I think in the Sarasota area.

We're not in the Fort Myers,we're not in Naples;those areas have been really heavily hit. Our smallest market in Florida is Miami, Fort Lauderdale. So, in terms of Florida, in general, we're not overlyexposed to the weakest market. In my mind the weakest market that we are in is Tampa. We're spending alot of time looking at that. And you step back and say what's our customerprofile, we deal with local developers that we know, local projects, and it'svery locally focused. We're comfortable with our process. We're comfortablewith how we're managing through it. It's the environment that has changed andwe are trying to go to the right people and move the other customers out.

Christopher Marinac -FIG Partners

Got you okay, and then just the final question. This has todo with just your general use of interest reserves and any loan modification.How often is that coming into play if you did not have of the Asian level?

Lynn Harton

Come into play in terms of not have an NPA show up. If youlook at interest reserves when we underwrite a credit on the front end,interest is a normal ongoing part of a project and so rather than ask thedeveloper to come up with the interest over time, what we prefer is toessentially get him prepay the interest and always get the right amount ofequity on the front end of the deal and then we control the advance of theinterest overtime with the project. Now if the project does not work asanticipated and the interest reserves run out in that situation we arerecognizing that as a potential problem and to the extent we extend additionalinterest carry, it would be in return for additional collateral or additionalconcessions from the developer that improved positions. We would not justincrease interest reserves without and do a [fully] a nonperforming asset.

Christopher Marinac -FIG Partners

That makes sense. Okay, great. Thank you for the color. Iappreciate it.

Operator

Our next question is from John Pandtle from Raymond James.

John Pandtle - RaymondJames

Thank you and good morning.

Mack Whittle

Good morning.

Lynn Harton

Good morning.

John Pandtle -Raymond James

Had couple of questions, first relates to employee expense.On a sequential quarter basis it looks like the incremental decline subsided abit. Should we expect the line item to be flat from here or is there anopportunity to get further reductions in that employee expense line?

Mack Whittle

It will continue to hold relatively in that line. A big partof that is, some of the employee benefit things and so that is relativelyvariable when the insurance calls them and things of that nature. So that goesup and down over the course of time but then we would think it would say evenat relatively same level. We continue to manage the headcount, new additions inreplacing those positions over the course of time to manage it within thatrelative level.

John Pandtle -Raymond James

Okay. And then separately could you share the size of yourresidential construction portfolio in terms of funding and commitments and thenalso the total amount of non-accrual loans in that portfolio?

Lynn Harton

Yeah. In terms of the total residential development,construction etcetera portfolio, it would be approximately 15% of the totalapproximately $1.5 billion.

John Pandtle -Raymond James

Okay.

Lynn Harton

Of that about 20% of that is Condo related, about $300million and about 25 % of that is residential construction, sticks and bricksmajority of them, reminder of that would be acquisition and development. Interms of nonperforming loans they, I don't have that number right in front ofme but it is relatively low, it would be lower than the overall number. Thoseare handled by individual categories in terms of their total, it would be lowerthan the overall.

John Pandtle -Raymond James

Okay, great.

Operator

Our next question is from Andy Stapp of B. Riley.

AndyStapp - B. Riley

Good morning.

Mack Whittle

Good morning.

James Gordon

Good morning.

AndyStapp - B. Riley

May be I missed this, but the Florida Mortgage company,could you provide the amount that you charged off on that relationship?

Mack Whittle

We haven't charged off anything at this point.

AndyStapp - B. Riley

Okay. But in your press release, did you mention two C&Iloans that you did charge off loans, I guess, to South Carolina textile, what was the otherrelationship and could you tell me the amount you charged off there?

Mack Whittle

Sure. The total -- they we're both in South Carolina, the one was about $1.750million and the textile company was $750,000. So the total of two was $2.5 million.

James Gordon

Good potential.

Mack Whittle

Both are textile related. They have been on the watch loan for5 or 6 years.

AndyStapp - B. Riley

Okay, great. Thanks.

Operator

Our next question is from Andrea Jao of Lehman Brothers.

AndreaJao - Lehman Brothers

Good morning, everyone.

Mack Whittle

Good morning.

James Gordon

Good morning.

AndreaJao - Lehman Brothers

It's clearly a challenging environment to grow revenues foreveryone. And everyone is also facing higher credit costs. Just wanted to checkin with respect to your propensity to lever up the balance sheet to kind ofcompensate for weak revenue growth, given that you have levered down the balancesheet a lot already over the past few years?

James Gordon

Our first time, we have been there and done that, and we don'tintend to do that because to do that profitable or to have profits in the nearterm, you will have to take a significant amount, most likely, of interest raterisk to make that profitable. And given that we are trying to manage our interestrate risks more in the neutral category, you could then achieve bothprofitability and neutral interest rate risk. So, we don't have that in theplans.

We won't keep in heading down to around that 15, 16 typepercent range, that's $2 billion. As the balance sheet grows then it wouldgrow, it would grow back to somewhere at the same those relative levels toreally become just a tool for our interest rate risk management and overallliquidity needs for pledging and things of that nature, but not as a profittool.

AndreaJao - Lehman Brothers

Great, that's awesome. And I assume you're continuouslywilling to let the very high cost for the irrationally priced customer fundstrying to leave the portfolio?

Chris Holmes

Yes, Andrea this is Chris. That's a good point. We arereally focused on margin and profitability and we installed a pretty highdegree of discipline around our pricing of deposits.

And so especially this quarter, we're seeing some irrationalpricing, and we are not chasing balances in this environment, that hurts ourgrowth near term, but you saw that we've been improving on our pricing.

So we're only up one basis point in the customer funds, onebasis point in the cost of our customer funds over the last six months. So,you're exactly right.

AndreaJao - Lehman Brothers

Perfect. Thank you so much.

Chris Holmes

All right. Thanks.

Operator

Our next question is from John Pandtle of Raymond James.

John Pandtle -Raymond James

I had a quick follow-up question. I was wondering if youcould walk through the rationale of allowing the total deposits. It looks likethey were down ending period almost $600 million. And you have replaced thatwith short-term borrowings. Is there an actual financial pickup there, and thenhow do you think about that in terms of franchise value?

Lynn Harton

Yeah. James, now I'm about address that, as I had just saidespecially in the last quarter we saw some irrational pricing. And we made aconscious decision not to chase some balances in that environment and so wecould get it. We could get the funding cheaper in some other places and so wechoose to do that and to address what you were talking about, just sort of yourcore franchise and what that will do for us is creating a more stable coredeposit base is what its doing and that's really what we're focused on. It'screating that stable core deposit base and so yet we're not chasing balances.

Mack Whittle

Chris, this is Mack. The one thing I would to add to that,the 600 million number that you cited includes a decline of about 300 millionof broker deposits. So our customer funding actually declined about half ofthat.

John Pandtle -Raymond James

Okay. I mean, have you guys done any internal work andtrying to identify what is the dollar amount of core deposits that you thinkits kinds of the trough or a stable level? How much hard money is left?

Mack Whittle

We've done a little bit of that and as you compare where weare from the pricing standpoint to the market, we're still on the high end. Wewere -- you looked at compare to we were at, we were the highest actually. Andwe've come down especially in our core, in our interest checking, in our moneymarkets. So we've come down, we have seen I guess the rate of decline slowsome, as we moved prices now. So we've seen slow some over the last month orso.

We've seen some money move from non-interest bearing intoour customer sweeps. So you'll see that's up pretty dramatically and we havebeen working with customers on this and when that's the best thing forcustomer, we certainly allow that to happen.

James Gordon

I think John too its based on managing and gettingrelationship whether it's the sweep account or the DDA accounts and then if youlook at what we saw particularly later in the quarter particularly after theFed cut, several -- particularly on the time deposits, in one case of offering 20to 25 basis points over the brokered CDs. So from a financial perspective it'sstill better to get the brokered CDs than it was to try to compete on thatlevel and then we saw some 5% money markets after the 50 basis point rate cutstill out there. So its in this competitive environment the trade off is thereand then we are trying to build the base for the longer term obviously flat, buton the short term it might be better sometimes to do those, but over the longerterm we don't feel that it is.

John Pandtle -Raymond James

Okay and if I could just a quick follow up on a separatetopic. If you look at the plan that First Manhattan has given you should we --are there any expense implications from an execution standpoint and I guess I'mthinking about I mean do you need to upgrade talent level at the branch,implementation costs, those sorts of things?

Mack Whittle

I would make two comments relative to that. I want to first emphasizejust to make sure everyone is clear. It our plan First Manhattan helped us withdeveloping that and second is that as far as that cost our goal and what we arestriving is to absorb any of those costs? Yes, a lot of things you talkedabout, we need to do, but we are committed to absorb those without increasingour expense base.

John Pandtle -Raymond James

Okay. Very good. Thank you.

James Gordon

We will pull off all those levers to control going forward.

John Pandtle -Raymond James

Great, thanks.

Operator

Our next question is from [Bill Young] of Oppenheimer.

Bill Young -Oppenheimer &Co.

Hi. Good Morning.

Mack Whittle

Good morning.

Lynn Harton

Good morning.

Bill Young - Oppenheimer&Co.

I have a question relating to the North Carolina development loans. Given thatyou provided a special reserve of $10.5 million last quarter, and this quarteryou charged-off I mean for portion of that. Do you still feel comfortable withyour reserve levels for those specific NPAs?

Mack Whittle

Yes we do. If the fluid situation could change, but at thispoint we continue to be comfortable with the level we provide.

Bill Young - Oppenheimer&Co.

Okay. I mean since the remainder of the non-NPA status, andif there was no further reserve built for these loans, the loss content that weestimate is about 10% to 11%. Do you think that's appropriate?

Mack Whittle

Well, again we think where we are today is appropriate andas we get into negotiations and those things with the borrowers. If thingschange we would change it, but today we think it is a right loan.

Bill Young - Oppenheimer&Co.

Okay. Great. Thank you.

Operator

Our final question comes from Andy Stapp of B. Riley.

Andy Stapp - B. Riley

If we exclude the Spruce Pine loans and the two C&Irelationships, you mentioned, net charge-offs were up about $6.6 millionsequentially. Could you provide some color on that $6.6 million please?

James Gordon

They would actually roughly flat quarter-to-quarter, if youback out those two. They were about $16 million and $7.7 related to (inaudible)and then those two loans were roughly $3 million. I mean, they would have beenup slightly. It would have been up slightly from last quarter from about 13 basispoints to about 26 in [respect] but not up.

Andy Stapp - B. Riley

Okay. And looking at your page 5 sheet, excluding the North Carolina development,it looks like net charge-offs were $9.1 million and in prior quarter it was 3.7?

James Gordon

But from that 9.7 you are not excluding those two loans thatwe mentioned, which was about [5] million, which is about --

Andy Stapp - B. Riley

So you back [it] and those were $2.5 million, right?

James Gordon

Yeah, it's 2.5 roughly. So that's was about $3 millionincrease.

Andy Stapp - B. Riley

Okay.

Mack Whittle

Well, and as we said last quarter, last quarter wasn'tabnormally low for us.

Andy Stapp - B. Riley

Okay.

Mack Whittle

15 basis points, given the environment which at that time wedidn't think that would hold up. I would say a better comparison would be to goback and compare to the first quarter or fourth quarter or third quarter, wehave been pretty consistent in that 27-28 basis point range. And so, comparingit to the 15 is -- we would love to be able to do it.

Andy Stapp - B. Riley

Okay. Fair enough.

Operator

I will now turn the call back to Mr. Mack Whittle forclosing comments.

Mack Whittle

Good. Thank you again to everyone for joining us. Weappreciate that and look forward to hearing from you later. Thanks.

Operator

This concludes today's conference call. Thank you forparticipating in today's call.

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