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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

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

Operator

Good morning, and welcome to The South Financial Group Earnings Conference Call. All participants will be placed on listen-only mode until the question-and-answer session of this conference. This conference is being recorded. If you have any objections, you may disconnect at this time. I would like to introduce Ms. Mary Gentry, Executive Vice President of Investor Relations. Ms. Gentry, you may begin.

Mary Gentry

Good morning. Thank you for joining The South Financial Group's third quarter earnings conference call and webcast. Presenting today are Mack Whittle, Chairman, President and Chief Executive Officer; James Gordon, 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 the prepared remarks on earnings with an update on our strategic plans. We'll then finish up with an analyst question-and-answer session. In addition to our news release, we have a supplemental financial package, which is available on the Investor Relations portion of our website.

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

In addition, I would point out that our presentation today includes reference to non-GAAP financial information. We've provided reconciliations of these measures to GAAP measures in the financial highlights of 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 for joining us. This quarter brought steady progress in some areas we have emphasized throughout the year. We stabilized our net interest margin while maintaining at 3.12% for the third quarter in level with the fourth quarter 2006 margin.

Last year, we began talking about improved tools and a stronger team to analyze and manage the margin. We delivered a stable margin in face of continued declines in the industry. Going forward, we are continuing to work hard to improve our net interest margin by focusing on low-cost deposit gathering. We continue to produce balanced loan growth. Average loans increased 3.2 linked-quarter annualized, on period basis, we had 5.7 annualized loan growth. We lowered our non-interest expense for the third consecutive quarter.

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

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

We have ongoing emphasis on managing capital position as well. During the quarter we repurchased shares, called preferred securities that had above market spreads, and issued new trust preferred securities at lower spreads.

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

I'd like to spend a few minutes and focus on a couple of areas, revenue growth, credit and the competitive deposit environment. First, revenue growth, while total operating revenue was flat for the quarter, we improved our earning asset mix by shifting from investment securities to loans. For the third quarter, average loans as a percentage of average assets exceeded 80%, a substantial improvement from 76% a year ago and 68% two years ago. By quarter end, securities to total assets declined below 17% from 27% two years ago. We've come a long way and now are more in line with our peer group in these metrics.

We're fortunate that while the real estate related lending in general had slowed from last year, we're still seeing good real estate activity in substantially all of our markets. In this environment we are being prudent and selective, while still looking for good opportunities to pick up the right relationships. Additionally we're seeing pricing of loans becoming more rational.

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

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

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

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

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

We have simplified our customer checking account offerings this quarter going to three, down from 25 checking accounts earlier in the year. We feel that this will enhance the customer experience and the relationship with 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 our results; lower deposit balances, lower advertising expense, but better deposit pricing.

This has forced us to compete on customer value versus price. This has also given us the opportunity to assess our competitiveness without any pricing advantages and make changes in our sales and marketing processes. That being said, we are now ready to support the retail efforts with advertising and began advertising system wide on October 14th, supporting in particular the rollout of our new checking account products.

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

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

James Gordon

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

Non-operating items for the quarter included $287,000 net pre-tax gain on securities and $1.3 million pre-tax loss on early extinguishment debt related to calling the trust preferred securities. The gain on securities included a gain from the sale of certain community bank equity holdings partially offset by the $300,000 additional loss from the sale of the corporate bond portfolios previously disclosed, and the write-down of an equity investment.

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

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

In November, we have $120 million treasury securities that's scheduled to mature and will not now be replaced. In addition depending on interest rates we may be in a position to reach the intended goal in the near term. We anticipate average earning assets to decline in the fourth quarter with modest growth thereafter until securities reach the $2 billion level.

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

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

During the quarter we called approximately $70 million of preferred securities at an average spread of 364 basis points over LIBOR realizing $1.3 million loss on the early extinguishment of debt. We were able to replace approximately $50 million with new trust preferred securities that previously anticipated spreads for a savings of over 200 basis points. We plan to call approximately $25 million more in the fourth quarter and ran up approximately $600,000 in unamortized issuance cost.

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

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

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

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

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

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

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

Lastly to capital. During the third quarter we repurchased 850,000 shares of common stock at an average cost of $21.93. In August, the Board of Directors amended and restated the South Financial Group's stock repurchase authorization to be an aggregate of $100 million which expires with fund used on or before June 30th 2008. With this authorization we continue to have the flexibility to repurchase additional shares depending on capital levels, market conditions and growth prospects.

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

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

Just a couple of comments on credit quality in advance of Lynn's remarks. The provision 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 million additional 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 net charge-offs, which totaled $16.8 million to the $11.6 million increase over the second quarter. Third quarter net loan charge-offs included 7.7 million for the North Carolina development loans, excluding the 7.7 million net loan charge-offs at 36 basis points. Year-to-date charge-offs excluding North Carolina development loans were 27 basis points, slightly less than the 28 basis points we experienced in 2006.

In the third quarter we had been anticipating a potential recovery, 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 a magnitude of any potential recovery.

Additionally third quarter charge-offs included $2 million [C&R] relationship in our South Carolina market. 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 Carolina development loans, which had a 6 basis points impact. Nonperforming assets increased by 7 basis points to 49 basis points primarily from two credits. One was a South Carolina based textile company that we have been monitoring as a problem one for some time, which also contributed 750,000 to charge-offs this quarter. Secondly, a Florida based mortgage lender that I'll discuss in more detail later.

Next, I would like to touch on several topics, I am sure are of interest to everyone. First, the North Carolina development loans, with $7.7 million in charges-offs I mentioned earlier, we have recorded a significant portion of the charge-offs that we provided for last quarter. At this point, we have had no material changes in the situation, either positive or negative.

We continue to negotiate with several borrowers and have instituted collection activities on several others. Borrowers were approximately $1.8 million, continued to honor the terms of their notes. We continually evaluate our position; we'll make adjustments if the situation moves to a resolution.

Secondly housing, including Florida. Like most of the industry we're seeing weakening fundamentals and sectors impacted by the housing market and I would like take each one of those in turn, our mortgage warehouse lending first. We have a small portfolio of a limited number of mortgage lending companies in Florida. These are customers we bank for some time. Three of these customers have experienced some stress during the market disruption. This quarter, we added one of these to nonperforming assets. This is the [Florence] based mortgage lenders I mentioned earlier with a balance of approximately $4 million. We are secured by notes receivable and we are evaluating our collateral position there.

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

Residential, construction and development. We have not experienced increased nonperforming assets or net charge-offs in our residential construction, and development portfolios, but we are seeing increasing stress on developers particularly in the Florida market.

We are continuing to tighten the underwriting standards for new loans, renewals. Where appropriate we are obtaining additional collateral or otherwise improving our risk positions on existing loans and we continue to closely monitor all of our projects.

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

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

Our mortgage portfolio is also bank-customer related with no brokered loans or sub-prime exposure. Our 90 day past dues and mortgaged assets billed this quarter as did our net charge-offs.

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

The environment for residential construction and development customers is more difficult and we're staying very close to these relationships during this period. The diversity in our markets is a positive, our South Carolina market is actually improving credit metrics. South Carolina real estate markets had not been as severally affected by the downturn in the Florida markets. The direction of the housing market over the next several quarters will influence our results, but we believe we've got a solid plan and right action steps in place 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 posted steady progress in quality loan growth, earning asset mix improvement, expense reduction and capital management.

We've improved these areas quarter-by-quarter throughout 2007. A couple of areas remain challenging, particularly funding and credit, but provide an opportunity to improve our overall profitability and returns to shareholders.

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

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

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

We developed specific action plans and set priorities to address the needs identified in each of these business plans. This process involved understanding 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 an important tool in this process. As we further develop the analytical tools that are part of this profitability system, our decision capabilities at the business line, product and customer levels will continue to improve.

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

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

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

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

Our commercial plan. We developed a methodical approach to leveraging our strong commercial lending relationships to attract new and expanded deposit relationships. Approximately, half of our lending relationships do not have their primary depository relationship with us, even though we may be their primary lender. We have implemented procedures to systematically review each existing commercial relationship to identify opportunities with the focus on attracting and expanding operating accounts as well as introducing our treasury services.

Third is private banking. Our plans include expanding private banking services to our more affluent customers. We plan to add dedicated private bankers in non-markets in 2008 to build on the resources already around the four markets that we are in. Private bankers will seek opportunities to capture entire relationships, deposits, lending, and wealth management services. To support private banking initiatives we'll look for additional deposits, credit and investment products to be introduced.

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

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

These strengths make our plan achievable even in this challenging environment, where opportunities will present themselves. All of us at the South Financial Group appreciate your support and I would like to open it up for questions.

Mary Gentry

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

Question-and-Answer Session

Operator

We invite analyst to participate in the question and answer session. (Operator Instructions). Our first question comes from Kevin Fitzsimmons 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 came down really, probably due to the timing difference with Spruce Pine, but given Lynn's commentary on the market and it just seem like -- we are hearing it from lot of banks these days and I am sure its no different in your franchise, but that things are deteriorating and customers are under more pressure, even though maybe the losses aren't emerging at the current time. And just want to get a sense to how comfortable you are with the allowance, where it is and how you're going to look going forward provisioning relative to net charge-offs and then I just have one follow-up as well. Thanks?

Lynn Harton

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

So as we put them in nonperforming, we try to take the loss at that point and we also tend to put on our loans on non-accrual earlier, put them in nonperforming. If you look at us relative to other banks and our 90 days is still accruing for example you will see that we are much more conservative when we put things on nonperforming. So [let me commit it], the summary is we are very comfortable with our reserve ratios now and we are going to continue to 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 the First Manhattan study, I recognized that they are providing an outsider a new way to look at things, but just listening to some of the areas they are focusing on and some of the things they might do, the thing that strikes me is these are things and these are areas that you all have been talking about and focusing on for quite a while, with retail for example, Chris has been, you know, that's been his mandate to get core deposits up and to focus on the branch level, and I am just wondering what kind of new revelations really stood out for you from bringing them in? Was it just a formalization of the things you already knew or was there really any really light bulbs that when off in terms 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's really pretty simple, it was more of a affirmation of where we knew we were, it dealt 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 some science around that that we didn't have before. They allowed us to use some of their modeling they've used for other companies before to look at in ways that we really had not looked at it before. So, not only did we identify the upsides and the opportunity to normalizing our funding to our peers, but we came up with some specific action points and the three that I presented earlier are just three. And three that we now have started there will be many, many of these 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 FIG Partners.

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 see in terms of pipeline of future problems or how -- just kind what the loss list looks like and in either colors, and then maybe you could kind of talk about that by market?

Mack Whittle

As I mentioned in terms of bond market, I personally step back in terms of pipeline, we don't really keep, what you would call a pipeline of losses or problems where actually managing the portfolio risk rating and etcetera. I'd say in general. It's the residential real estate related businesses that 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 little more detail.

Christopher Marinac - FIG Partners

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

Mack Whittle

Of course in terms of recognizing we think we've got a great handle on all the projects and customers. We've been doing a pretty deep portfolio (inaudible) over the last six months, and so A) we think we've been identified all the problems. B) If you look at Florida, in general, it is the worst markets in the state or the most difficult market in the state and once where we don't have a big presence, we're not in the Panhandle. We really don't have a big presence 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 overly exposed to the weakest market. In my mind the weakest market that we are in is Tampa. We're spending a lot of time looking at that. And you step back and say what's our customer profile, we deal with local developers that we know, local projects, and it's very locally focused. We're comfortable with our process. We're comfortable with how we're managing through it. It's the environment that has changed and we 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 to do 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 you look 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 the developer to come up with the interest over time, what we prefer is to essentially get him prepay the interest and always get the right amount of equity on the front end of the deal and then we control the advance of the interest overtime with the project. Now if the project does not work as anticipated and the interest reserves run out in that situation we are recognizing that as a potential problem and to the extent we extend additional interest carry, it would be in return for additional collateral or additional concessions from the developer that improved positions. We would not just increase interest reserves without and do a [fully] a nonperforming asset.

Christopher Marinac - FIG Partners

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

Operator

Our next question is from John Pandtle from Raymond James.

John Pandtle - Raymond James

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 a bit. Should we expect the line item to be flat from here or is there an opportunity to get further reductions in that employee expense line?

Mack Whittle

It will continue to hold relatively in that line. A big part of that is, some of the employee benefit things and so that is relatively variable when the insurance calls them and things of that nature. So that goes up and down over the course of time but then we would think it would say even at relatively same level. We continue to manage the headcount, new additions in replacing those positions over the course of time to manage it within that relative level.

John Pandtle - Raymond James

Okay. And then separately could you share the size of your residential construction portfolio in terms of funding and commitments and then also 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 total approximately $1.5 billion.

John Pandtle - Raymond James

Okay.

Lynn Harton

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

John Pandtle - Raymond James

Okay, great.

Operator

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

Andy Stapp - B. Riley

Good morning.

Mack Whittle

Good morning.

James Gordon

Good morning.

Andy Stapp - 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.

Andy Stapp - B. Riley

Okay. But in your press release, did you mention two C&I loans that you did charge off loans, I guess, to South Carolina textile, what was the other relationship 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 $1.750 million 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 for 5 or 6 years.

Andy Stapp - B. Riley

Okay, great. Thanks.

Operator

Our next question is from Andrea Jao of Lehman Brothers.

Andrea Jao - Lehman Brothers

Good morning, everyone.

Mack Whittle

Good morning.

James Gordon

Good morning.

Andrea Jao - Lehman Brothers

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

James Gordon

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

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

Andrea Jao - Lehman Brothers

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

Chris Holmes

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

And so especially this quarter, we're seeing some irrational pricing, and we are not chasing balances in this environment, that hurts our growth 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, one basis point in the cost of our customer funds over the last six months. So, you're exactly right.

Andrea Jao - 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 you could walk through the rationale of allowing the total deposits. It looks like they were down ending period almost $600 million. And you have replaced that with short-term borrowings. Is there an actual financial pickup there, and then how do you think about that in terms of franchise value?

Lynn Harton

Yeah. James, now I'm about address that, as I had just said especially in the last quarter we saw some irrational pricing. And we made a conscious decision not to chase some balances in that environment and so we could get it. We could get the funding cheaper in some other places and so we choose to do that and to address what you were talking about, just sort of your core franchise and what that will do for us is creating a more stable core deposit base is what its doing and that's really what we're focused on. It's creating 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 million of broker deposits. So our customer funding actually declined about half of that.

John Pandtle - Raymond James

Okay. I mean, have you guys done any internal work and trying to identify what is the dollar amount of core deposits that you think its 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 we are from the pricing standpoint to the market, we're still on the high end. We were -- you looked at compare to we were at, we were the highest actually. And we've come down especially in our core, in our interest checking, in our money markets. So we've come down, we have seen I guess the rate of decline slow some, as we moved prices now. So we've seen slow some over the last month or so.

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

James Gordon

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

John Pandtle - Raymond James

Okay and if I could just a quick follow up on a separate topic. 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'm thinking 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 emphasize just to make sure everyone is clear. It our plan First Manhattan helped us with developing that and second is that as far as that cost our goal and what we are striving is to absorb any of those costs? Yes, a lot of things you talked about, we need to do, but we are committed to absorb those without increasing our 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 that you provided a special reserve of $10.5 million last quarter, and this quarter you charged-off I mean for portion of that. Do you still feel comfortable with your reserve levels for those specific NPAs?

Mack Whittle

Yes we do. If the fluid situation could change, but at this point 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, and if there was no further reserve built for these loans, the loss content that we estimate is about 10% to 11%. Do you think that's appropriate?

Mack Whittle

Well, again we think where we are today is appropriate and as we get into negotiations and those things with the borrowers. If things change 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&I relationships, you mentioned, net charge-offs were up about $6.6 million sequentially. Could you provide some color on that $6.6 million please?

James Gordon

They would actually roughly flat quarter-to-quarter, if you back 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 been up slightly. It would have been up slightly from last quarter from about 13 basis points 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 that we 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 million increase.

Andy Stapp - B. Riley

Okay.

Mack Whittle

Well, and as we said last quarter, last quarter wasn't abnormally low for us.

Andy Stapp - B. Riley

Okay.

Mack Whittle

15 basis points, given the environment which at that time we didn't think that would hold up. I would say a better comparison would be to go back and compare to the first quarter or fourth quarter or third quarter, we have been pretty consistent in that 27-28 basis point range. And so, comparing it 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 for closing comments.

Mack Whittle

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

Operator

This concludes today's conference call. Thank you for participating in today's call.

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