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Webster Financial Corporation (WBS)

Q3 2007 Earnings Call

October 23, 2007, 9:00 AM ET

Executives

James C. Smith - Chairman and CEO

Gerald P. Plush - Senior EVP and CFO

William T. Bromage - President and COO; Vice Chairman, President and COO, Webster Bank

Analysts

Mark Fitzgibbon - Sandler O'Neill & Partners

Jared Shaw - Keefe, Bruyette & Woods

James Abbott - Friedman, Billings, Ramsey

Andrea Jao - Lehman Brothers

Gerard Cassidy - RBC Capital Markets

Collyn Gilbert - Stifel Nicolaus

Presentation

Operator

Good morning, ladies and gentlemen, and welcome to the Webster Financial Corporations' Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator instructions]. As a reminder, ladies and gentlemen, this conference is being recorded.

Also, this presentation includes forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, with respect to Webster Financial’s condition, results of operations, and business and financial performance. Webster has based these forward-looking statements on current expectations and projections about future events. These forward-looking statements are subject to risks, uncertainties, and assumptions as described in Webster Financial's public filings with the Securities and Exchange Commission, which could cause future results to differ materially from historical performance or future expectations.

I would now like to introduce your host for today's conference, Mr. James C. Smith, Chairman and CEO.

James C. Smith - Chairman and Chief Executive Officer

Good morning, everyone. Welcome to Webster's third quarter investor call and webcast. Joining me today are Bill Bromage, our President; Gerry Plush, our CFO; and Terry Mangan, Investor Relations. I'll provide some highlights and context for the third quarter results and Gerry will provide details on our financial performance. Our remarks will last for about 30 minutes and then we'll invite your questions.

In our earnings release, we reported $0.64 in diluted earnings per share in the third quarter, which includes the impact of $0.14 a share from an $11 million increase from Q2 to the allowance for credit losses, primarily in connection with home equity loans. This compares to EPS of $0.63 in Q2 and $0.17 a year ago and to adjusted EPS of $0.78 in Q2 and $0.77 a year ago.

I'll speak to trends in business activity in the quarter and then provide a thorough update on our loan loss provisions and on asset quality prior to handing off to Gerry for the financial review. I want to say upfront that we believe we've applied a conservative standard in determining the Q3 provision, attempting to reserve today against the losses we foresee based on a thorough analyses of trends in force.

As we've stated in prior calls, comparison to a year-ago continue to show the benefits of the balance sheet repositioning actions that we implemented late last year and the beginning of this year. While average earning assets in Q3 are $1.2 billion less than a year ago, a 37 basis point increase in the net interest margin to 3.38% contributed to a 4% increase in net interest income.

Securities were 14.9% of assets at September 30 compared to 18.3% a year ago. Borrowings were 13.6% of assets compared to 21.9% a year ago. The benefits of the balance sheet repositioning are now clearly reflected in high-quality earnings from loans and deposits. And our improved capital position has facilitated an aggressive stock repurchase program year-to-date.

Webster continues to show momentum in both commercial and consumer lending. Aside from the NewMil acquisition in the fourth quarter of '06, total commercial loans and consumer loans grew over 4% from a year ago as we continue to place emphasis on building these portfolios. Including the loans received in the NewMil transaction, commercial loans including commercial real state loans totaled $5.5 billion and grew by 6% from a year ago and now comprise 44% of the total loan portfolio compared to 39% a year ago.

Our C&I portfolio was by design about twice the size of our CRE portfolio. The portfolio yielded 7.44% in the quarter, up 6 basis points from a year ago. The C&I portfolio is balanced, diversified, and granular. These characteristics underpin our favorable charge-off experience and overall asset quality. While we saw strong origination activity of $96 million in the third quarter, we also saw significantly higher levels of payoff activity connected to the capital markets. We've seen CLOs, private equity, and the hedge funds aggressively moving into the lower end of the middle market, which has had a dual effect with either taking out bank debt or putting in a loan structure that doesn't meet our credit standards. Payoffs in our C&I portfolio totaled an unusually high $111 million, which explains the relative flatness in the C&I portfolio from June 30 to September 30 despite strong originations.

Our commercial real estate portfolio remained essentially unchanged from the second quarter at $1.9 billion as strong originations were again offset by high prepayment activity. Originations of $56 million in the quarter were offset by payoffs of $60 million. Total CRE portfolio yielded 7.13% in the quarter compared to 7.27% a year ago. As for the C&I portfolio, credit performance has been strong with virtually no CRE charge-offs in the past decade.

The consumer loan portfolio totals $3.3 billion and grew 8% from a year-ago or almost 5% excluding NewMil. Consisting about equally of home equity loans and lines, the portfolio yielded 7.01% in the quarter, up 7 basis points from a year ago. Consistent with the announcement we made upon completing our strategy review, our emphasis is on a direct-to-consumer and branch-oriented strategy. We had branch originated home equity production of $112 million in Q3, or almost 50% of the total compared to $100 million or 28% of the total a year ago.

Retail outstandings in the home equity portfolio increased $28 million at June 30. This increase helped to offset a decline of $11 million in wholesale outstandings during the quarter, which reflects our previously reported decision to limit our wholesale originations to the Northeast compared to nationally, previously. Excluding the $300 million of residential loans received from NewMil, resi loans declined 30% from an year ago, primarily due to the two securitizations that took place in Q4 '06 and Q1 '07 and consistent with our plan, as well as of our decision in July '06 to sell all fixed-rate production. Resi loans currently comprise slightly less than 30% of the loan portfolio compared to 37% a year ago. We expect that further planned attrition in the resi portfolio will be more than offset by ongoing commercial and consumer loan growth.

We want to provide the details around the decision to increase the loan loss reserve by $11 million, primarily in connection with home equity loan non-accruals and higher delinquencies. In total, non-performing assets increased to $104.2 million at September 30 compared to $78.7 million at June 30. We had anticipated that NPAs would rise and we have adjusted our quarterly provision accordingly in recent quarters to $4.25 million in Q3, up from $3 million a year ago. All of the $11 million increase from Q2 levels was applied against emerging trends in Webster's $3.2 billion home equity portfolio, most especially against out-of-market, high combined loan-to-value ratio, no-income verification loans, which meet our definition of higher risk loans. The spike in home equity related non-accruals and delinquencies overall, but most particularly in September coupled with our risk layering approach to analyzing the portfolio caused this us provide the additional $11 million. Of our $3.2 billion home equity portfolio at September 30, $94 million meets our definition of higher risk, out-of-market high CLTV, but none over a 100%, and no income verification. We have been tracking this portfolio closely and as you may've seen including it in our investor presentation, most recently at the Lehman conference in September.

The delinquency rate for these loans rose from 2.38% at June 30 to 3.06% at September 30, and the non-accrual rate rose from 2.70% to 4.83%. Given the trend and the anticipated high loss rate in the event of default, we concluded that the prudent course of action warranted a higher allowance. To complete the home equity picture, we have another $189 million of no-income-verification loans, two-thirds of which are in footprint and only $22 million of which have CLTVs greater than 90%. The delinquency rate on this $189 million bucket rose from 1.84% at June 30 to 2.59%, and the non-accrual rate was reasonably stable rising from 0.56% to 0.71%. The balance of the home equity portfolio or $2.9 billion in outstandings performed within normalize provision levels with the delinquency rate rising from 0.57% to 0.59% and the non-accrual rate from 0.34% to 0.46%.

Overall, consumer non-performing assets were $19.5 million at September 30, $12.3 million at June 30, and $3.6 million a year ago, with the majority of the increase coming from the out-of-market loans I’ve described. The annualized net charge-off ration in the consumer portfolio was 18 basis points in the third quarter, down actually from the 24 basis points in Q2 and up from 2 basis point a year ago.

One other portfolio bears special mention that being national residential construction loans, about which we've commented in the past two earnings calls. The NCLC portfolio as we call it is reported as part of the residential mortgage portfolio. Since last quarter, balances have declined $31 million or 26% to $116 million, while delinquencies have risen as expected by $2.3 million to $11.9 million and non-accrual loans have risen $5.3 million to $18.5 million. We allocated $10 million in reserves against this portfolio in Q1 in anticipation of related credit losses. About $8.5 million of that reserve remains as we work out this portfolio. As a reminder, we announced earlier this year that we discontinued all residential construction lending outside New England market area. We continue to have good experience in retail construction lending in New England where such loans totaled $110 million at September 30 compared to $130 million at June 30.

As loan quality is the focus of our report today, I'd like to provide information on other portfolios as well. Total residential developer outstandings within our commercial real estate portfolio were $241 million across 257 individual loans at September 30. Our portfolio actually has remained flat over the last several quarters. As with our overall CRV portfolio, we've had no net charge-offs in the res dev segment over many years now. We lend only in the Northeast to establish builders who have been in place for a long time and have seen the cycles themselves. Our proven underwriting standards have served us well in the res dev segment over the years. We verify each developers' liquidity upfront as part of our underwriting, complete a global analysis to ensure that their other developers... developments will not negatively impact our project.

Total non-performing assets in the residential mortgage portfolio was $34.3 million at September 30 compared to $27.4 million at June 30 and $7.6 million a year ago, with the majority of the increase representing the residential construction loans that I've described a couple of minutes ago and that where originated by the NCLC unit. NPAs represented 0.43% of the $3.5 billion core portfolio at September 30 compared to 0.38% at June 30. Commercial non-performing assets totaled $31.1 million at September 30 compared to $24.1 million at June 30 and $30.9 million a year ago. The net increase of $7 million from June 30 primarily reflects one middle market credit. Commercial NPAs to total commercial loans where 0.87% at September 30, 0.68% at June 30, and 0.92% a year ago. Non-performing assets in our equipment finance portfolio increased to just over $5 million at September 30 from $2.6 million at June 30. Most of this increase reflects one loan where we are at a strong collateral position and we expect full realization in Q4. Commercial real estate non-performing assets were $14.2 million at September 30, $12.2 million at June 30, and $16.8 million a year ago. CRV non-performing assets to total CRV loans were 0.75% at September 30, 0.63% at June 30, 0.95% a year ago. The $2 million increase from June 30 reflects a single residential developer credit.

Turning now to deposits, total deposits amounted to $12.6 billion, $615 million of which came from the NewMil acquisition that closed in Q4 '06. Excluding NewMil and the planned reduction in broker deposits, deposits grew 2% from a year ago. Growth over the past year has been led by CDs, which reflect the consumer preference across the industry for higher yielding deposit products and to a slightly lesser extent by relatively lower costing savings accounts. Webster’s overall cost of deposits increased 8 basis points from Q2. The Q2 cost of 2.8% was 18 basis points below the median for our peer group, clear proof that our above average market growth rate stems from execution, not price.

Our de novo banking program consists of 27 branches open since 2002 or 15% of our total retail branches that have total deposits of $773 million at September 30 compared to $790 million at June 30 and $701 million a year ago as we have let some of our higher costing deposits run off. Our de Novo branches continue to provide an improving mix of demand now and savings account deposits over time. The de novo program is an essential part of our buy-and-build strategy, enabling us to expand our retail presence and creating opportunities for us to deliver our bank-wide products and services to consumers and businesses in new market areas.

We opened two new locations in Q3; one in New Rochelle, New York and the other in the Springfield, Mass area. We expect to open to locations during Q4, one more in the Springfield area and one in Woodbridge Connecticut. While we have slowed the pace of the de novo openings in the past 18 months, we continue to see de novo branching as integral for our plans for a longer-term organic growth.

Turning to HSA Bank, we now have $384 million in deposits in this division, an increase of $106 million or 39% from a year ago, and we also have $54 million in linked brokerage accounts compared to $34 million a year ago. HSA Bank's average cost of deposits for this fast growing category was 2.97% in the third quarter, about the same as cost of in-market deposits. Strategically, we have expanded our reach for core deposits to fund our above-market loan growth and we’ve kept the deposit market poised for attractive growth over the next several years. In the third quarter, HSA Bank acquired about 11,000 new accounts from enrollments and transfers from other banks, and the more than 181,000 total accounts have an average balance of over $2100 each, which we expect to increase over time given the higher deposit limits allowed by recent legislation. HSA Bank is expanding its sales force as market acceptance for health savings accounts continues to build among employers.

I will now turn the program over to Gerry Plush, so that he can provide full details on the financial performance in the third quarter.

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Good morning. I would like to update everyone on our continued progress in several key areas. First, our tangible capital ratio, inclusive of the impact of repurchasing over 1.1 million shares in the third quarter, now stands in excess of 6%. Our TCE ratio of 6.17% as of September 30, 2007 is a solid improvement over the 5.66% we recorded a year ago at September 30 of 2006. Our tangible capital ratio for the third quarter remains higher than the 6% we’ve stated as our target range, which allows for ongoing capital management flexibility.

Next, our loan-to-deposit ratio was 99% compared to 97% at June 30 of ‘07 and over 106% in September 30 of 2006. The improvement in this ratio over the last year is due to an $860 million increase in core deposits, partially offset by a $610 million reduction in broker deposits and the completion of the balance sheet repositioning actions. Our statement of financial condition show that compared to June 30 of 2007, our deposits decreased $265 million and loans decreased $20 million. Broker deposits declined a $114 million by quarter-end as well as we continue to minimize the use of this source of funds.

Borrowings increased $202 million in the third quarter, but have declined 42% for the third quarter of last year. Our net interest margin of 3.38% in the third quarter compares to 3.47% in the second quarter and 3.01% for the third quarter of '06. The 9 basis point decline from the second quarter to the third quarter is the result of an increase in share repurchase activity, which accounts for 3 basis points, a higher average level of trust preferred securities outstanding during the third quarter which accounts for another 3 basis points, as the second quarter benefited from the retirement of $105 million of trust preferred securities as of 04/02/07 and the issuance of $200 million in new trust notes in late June of 2007. In addition, the effective loan interest reversals on higher non-performers also impacted the NIM as well.

Looking at the provision for credit losses when taking into account the additional $11 million in provision that Jim outlined earlier that was specifically set aside for the home equity portfolio, the provision for credit losses for the third quarter was $15.25 million compared to the second quarter at $4.25 million. Our allowance for credit losses to total loans is now 1.32% as of September 30 in comparison with 1.23% at June 30 and 1.20% a year ago. Charge-offs for the quarter were $3.9 million compared with $4.2 million for the second quarter and $3.1 million for the third quarter of 2006. The $0.64 of diluted earnings per share for this quarter, or $0.78 if you look to be exclusive of the additional provision that I just talked about, reflects the achievement of our return to positive operating leverage. Earlier in the year, we noted that we expected to achieve positive operating leverage by the second half of the year. I'm pleased to state that we've achieved this as adjusted revenues grew by 6.2% from a year ago and adjusted expenses grew by 5.4%. We continue to build our earning asset base with higher yielding commercial and consumer loans that are funded by core deposit growth. The yield on total loans was 6.8% compared to 6.81% for the second quarter and was 15 basis points higher than the 6.65% we reported a year ago. Commercial including commercial real estate and consumer loan categories in aggregate grew by 7% from a year ago or by $566 million and are up $39 million from the second quarter. Commercial and consumer loans now represent 70% of total loans compared to 63% a year ago.

Yield on securities for the third quarter was 5.79% compared to 5.78% for the second quarter and 5.06% a year ago. It reflects the positive effect of the security repositioning steps that we took in the latter part of 2006. On the funding side, our cost of deposits increased 8 basis points to 2.96% over the cost of deposits for the second quarter, and were 20 basis points higher than the 2.76% reported a year ago. Seasonable municipal deposit in-flows were the primary driver of the cost of deposit increase in the quarter. The cost of FHLB advances was 4.58% in the third quarter, down 14 basis points from the prior quarter and down 40 basis points from a year ago. Our total FHLB borrowings are now down by $1.2 billion from a year ago.

If we turn now to non-interest income, we reported $60.2 million for the third quarter compared to second quarter non-interest income of $64 million. Note that the second quarter non-interest income included $2.1 million in gains on the Webster Capital Trust I and Trust II securities. This also compares to a non-interest income of $6.8 million a year ago, which was reduced by the $48.9 million securities portfolio repositioning charge that we took.

Deposit service fees totaled $30 million compared to $28.8 million in the second quarter and $25.3 million a year ago. The increase from a year ago reflects tiered [ph] retail pricing changes and the benefit of no longer charging the uncollected overdraft amounts, just the uncollected fees to deposit service fees. Our insurance revenue was $8.9 million in the third quarter compared to $9.1 million in the second quarter and $9.8 million from a year ago, while loan related fees were $7.7 million in comparison with $7.9 million in the second quarter and $7.8 million from a year ago. Wealth management fees were $7.1 million, down from the $7.6 million we recorded in the second quarter and $6.7 million in the third quarter a year ago, while our another… our non-interest income was $1.6 million for the quarter compared to $1.4 million in the second quarter and $1.7 million a year ago.

Our mortgage banking activities we have reported are $1.9 million for the third quarter compared to $4 million in the second quarter. We have as previously announced scaled back our mortgage banking activities to the Northeast from a nationwide view previously. We recorded $482,000 in net gains from the sale of securities in the third quarter compared to $503,000 recorded in the second quarter and $2.3 million a year ago.

Turning now to our expense, our total non-interest expenses were $121.7 million compared to $138.1 million in the second quarter. The second quarter included one-time items such as $8.9 million of capital trust securities redemption premium and $5.3 million of severance and other one-time charges. Total non-interest expenses were $115.9 million a year ago and do not include the additional expenses of the NewMil acquisition, which occurred in the fourth quarter of 2006. So, excluding severance and other costs and costs from the debt redemption during the second quarter of 2007, non-interest expense declined $2.6 million during the third quarter. Non-interest expenses though for the third quarter of '07 did increase by 5.4 million from the third quarter of 2006.

Looking ahead now to the balance of the year, let's first talk about our capital ratios that will be maintained at a level to provide ongoing capital management flexibility including share repurchases. We will see some continued pressure on the net interest margin fourth quarter based on the recent fed reduction as loans repriced down went more quickly than deposits in the short-term. We would anticipate also going forward that our provision for credit losses could increase from the previous run rate that we reported based on loan growth overall and more specifically based on the mix of that loan growth. This will place increased emphasis on further reductions in expense and growth in higher yielding assets to offset these expected trends. The achievement of positive operating leverage this quarter was a goal we set earlier in the year and we plan to continue this trend in the future periods.

In addition, we continue to be committed to driving down our operating efficiency towards our stated targeted 60% lower by reducing expenses from low contribution businesses identified in our strategic review and realizing efficiencies from the recent completion of our organization review. We continue to make forward progress in the process of centralizing all of shared services functions with the objective on improved effectiveness and efficiency. And we believe that the consolidation of the facilities represents more opportunity in future periods.

With that, I will now turn it back to Jim.

James C. Smith - Chairman and Chief Executive Officer

Thank you, Gerry. Putting the quarter in perspective, we made good progress in strategic focus, commercial loan originations, margin, management, and organizational development. While I'd like to think of the $11 million provision increase as an event and that we’ve isolated and fortified the small portion of our loan portfolio that was under stress, we can only say that we have acted as aggressively as possible under the circumstances given our experience and the trends we see. We have adjusted our reserving model accordingly.

I'd like to reiterate that the higher risk home equities that I described represent a very small portion of our portfolio. There are many areas in which we have excelled; our balance sheet is strong, we have capital management flexibility, we’re growing organically, and we're beginning to show positive operating leverage, we look for strong performance ahead.

Thank you very much for being with us today. We would be happy to respond to your questions.

Question and Answer

Operator

Thank you. [Operator instructions]. Okay, our first question comes from the line of Mark Fitzgibbon with Sandler O'Neill. Please proceed with your question.

Mark Fitzgibbon - Sandler O'Neill & Partners

Hi, good morning. Gentlemen, you guys have had a... some pretty bad luck with your national lending businesses over time, whether it was the shared national credit book or Florida construction and now home equity, does it make sense to just exit those national lending businesses altogether and focus on Connecticut or sort of the footprint lending?

James C. Smith - Chairman and Chief Executive Officer

I would say, in a nutshell, you’ve pretty well summarized our strategic review and our plan. We actually exited the national construction lending program I think eight months ago or so. We indicated in our earnings call after the last quarter that we were de-emphasizing all of our national mortgage lending as well as home equity lending and that we'd be focusing on the New England footprint, and to the extent that we had originations beyond that it would most likely be in the Mid-Atlantic region.

Mark Fitzgibbon - Sandler O'Neill & Partners

Okay. So, we won't see you guys in any other national lending businesses in the future… in the near future anyway?

James C. Smith - Chairman and Chief Executive Officer

You can't say that exactly because the question is national versus regional. We have capabilities such as commercial real estate where we originate within and outside of the market. Our equipment finance direct lending business is on a broader scale as well, and we've our asset based lending business that originates in a border footprint. But I think that that… what we can say is that in our retail business is that in footprint will be the focus and that overall at Webster direct is the key. And I will acknowledge that it has not gone well for us, and we have had some stress both on the construction lending side and on the home equity loan side as well.

Mark Fitzgibbon - Sandler O'Neill & Partners

And then, just to clarify, I think you had said that there was $94 million of out-of-market home equity loans and none of those had greater than 100% loan-to-value. Just, I was curious if I got that right. And also, if you could give us a sense for geographically where those loans are.

James C. Smith - Chairman and Chief Executive Officer

Sure. Actually, $94 million is what we call the higher risk loans, which are out-of-market, no-income-verification, high combined loan-to-value ratio, which we think of as between 90% and 100%. We did not make any loan originations over 100% and we thought that was a point worth noting. Virtually, all of those loans were made in and around the offices that we’ve set up in Chicago and in Arizona and a couple of other places. So, we were actually... we were in those markets around which those loans were originated, and we've made plans to discontinue those offices, which is part of the de-emphasis of the out-of-market lending program.

Mark Fitzgibbon - Sandler O'Neill & Partners

Okay. And I wondered if you could give us a sense for what you're seeing, it looked like aside from the consumer stuff C&I, equipment finance, commercial real estate non-performers were also up linked-quarter by pretty decent percentages. Are you seeing any additional troubling trends, sort of the 30 and 60 day buckets or anything that we should be cognizant of?

James C. Smith - Chairman and Chief Executive Officer

In addition to the increase on the non-accrual side, we've had some increase in delinquencies as well. I stated and I thank you for letting me make this point again that we believe that the ratcheting up of our regular quarterly provision to the $4.25 million that we are at now is the appropriate measure against the rise, both in non-accruals and delinquencies in those portfolios.

Mark Fitzgibbon - Sandler O'Neill & Partners

So, you are seeing some rises in delinquencies in over 30-day bucket and over 60-day buckets?

James C. Smith - Chairman and Chief Executive Officer

Yes, we are. 30 to 90's.

Mark Fitzgibbon - Sandler O'Neill & Partners

Okay. And then last question I have for you, Jim. I wondered if you could update us on your plans for the sale of the insurance business?

James C. Smith - Chairman and Chief Executive Officer

We can't really make much comment about that right now, Mark, except to say that our plans to seek the strategic alliance are moving forward.

Mark Fitzgibbon - Sandler O'Neill & Partners

Okay. Thank you.

James C. Smith - Chairman and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Jared Shaw with KBW. Please proceed with your questions.

Jared Shaw - Keefe, Bruyette & Woods

Hi, good morning.

James C. Smith - Chairman and Chief Executive Officer

Good morning, Jared.

Jared Shaw - Keefe, Bruyette & Woods

Could you… did you update the FIFO scores on that highest risk segment for September 30?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Yes.

Jared Shaw - Keefe, Bruyette & Woods

What has that done?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

The latest that we have is that about 20% of those FICOs now are down to about under 650 I believe. And I believe that that was as of September 30.

Jared Shaw - Keefe, Bruyette & Woods

And is that 20% of the entire portfolio or is that 20% of that highest risk segment?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

It's 20% of that highest risk segment, Jared?

Jared Shaw - Keefe, Bruyette & Woods

Okay. And then, in terms of the follow-up I guess on Mark's question about the geography, where you seeing the greatest geographic weakness as supposed to where you're seeing the most of originations on the national portfolio?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

The two areas where you'd see the most would be around the Chicago area and then in the Arizona area.

Jared Shaw - Keefe, Bruyette & Woods

Okay. And then just looking at the information you had in your presentation from September, you were saying that the state concentrations for Illinois, Washington and Arizona, those added up to about 8% of the non-footprint home equity loans. Where… is there any other large area other than those three?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Those are the primary areas.

Jared Shaw - Keefe, Bruyette & Woods

Okay.

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

I think you said the whole portfolio, that you said not just the footprint portfolio.

Jared Shaw - Keefe, Bruyette & Woods

Pardon me?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Hey, Jared. Could you clarify that?

Jared Shaw - Keefe, Bruyette & Woods

Yes. I am just looking at the... on the--

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Or where you asking on the 90--?

Jared Shaw - Keefe, Bruyette & Woods

I see. Okay, that is under 95 million. Okay.

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Right.

Jared Shaw - Keefe, Bruyette & Woods

Okay. And then are you getting a higher yield on those loans that are out of market?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Very definitely, yes.

Jared Shaw - Keefe, Bruyette & Woods

Okay. And then any change in the way you're looking at the allowance for the non-performing loans, that ratio has slipped, is there a target you have for that?

James C. Smith - Chairman and Chief Executive Officer

I think the allowance for loans, we are really looking at allowance against the need. We focus significantly on the loan loss coverage, and I think that ratio is up right now over 130 although we do expect to use some of that. We talked about wanting to be in a range of 120 or so, say, plus or minus a few basis points as far as that coverage is concerned. We are not overly concerned that the coverage ratio of the non-accruals themselves is under 200%.

Jared Shaw - Keefe, Bruyette & Woods

Okay. And then finally, if you could just comment on your outlook for consolidation in the market and your appetite for future transactions?

James C. Smith - Chairman and Chief Executive Officer

Sure. We believe there is going to be consolidation and that we are going to have an opportunity to expand through making partnerships with like-minded companies and share our vision of being New England's bank primarily. Of course, the fly in the ointment is the valuation of our own currency. And so, to some degree, our ability to acquire is related to that. But our sense is that there will be opportunities over the next 12 months or so, and more so than in the past.

Jared Shaw - Keefe, Bruyette & Woods

Okay, thank you.

Operator

Thank you. Our next question comes from the line of James Abbott with FBR. Please proceed with your question.

James Abbott - Friedman, Billings, Ramsey

Hi, good morning. I just was... see if I could ask or drill down a little bit more on the FICO spectrum, and I'm not talking just about the $94 million loans of concern, but are you seeing... what can you tell us about delinquency trends across the FICO spectrum? We heard on one conference call earlier this quarter that there is... it seemed to be no respecter of FICO scores, one company was seeing delinquencies across the spectrum, but curious to your vantage point on that? And then I have a follow-up.

James C. Smith - Chairman and Chief Executive Officer

I'll just make a broad comment that delinquencies are higher across this spectrum in part because a lot of people were put in a situation where they were able to borrow more perhaps than they should have regardless of what their FICO score was. And so, you'll see that there is a slice all the way through right up in the super prime where people were borrowing more than they would have in the previous environment and the natural result of that will be higher delinquency and potential non-accrual rates, although the higher the credit score the lower the impact. But it will be across the spectrum, and we are seeing that too.

James Abbott - Friedman, Billings, Ramsey

Okay, and... Okay, I appreciate that candor. When you look... you mentioned you are providing as aggressively as possible for your home equity portfolio. Two questions; one is a housekeeping question on the reserve to high loan-to-value out of footprint stuff, $94 million high-risk stuff, do you have the reserve-to-loan ratio on that at this point? And then, a follow-up question is more qualitative, which is, what are the loss assumptions you're using, what are the default assumptions, what is the severity? Have you actually in situations where the loans go bad or… what are you seeing as far as the severity there?

James C. Smith - Chairman and Chief Executive Officer

Bill Bromage?

William T. Bromage - President and Chief Operating Officer; Vice Chairman, President and Chief Operating Officer, Webster Bank

Yes, Bill Bromage. I think we segment our portfolio... I think part of your question, the $94 million gets a little granular for us to get down that far. I'll say that what we do is we have a model, which we run in evaluating every one of our loan segments and every one of our loan categories, and that is based on our experience with respect to delinquency rates and our experience with respect to loss in the event of default. And in this environment, based on what we're seeing, particularly given the newness of this portfolio relative to other more mature portfolios we've had, we've shortened the timeline… look back timeline if you will to estimate what our expected loss might be. So, it is a computer model if you will, it is not driven by the one specific loss assumption, it is driven by a set of experiences over a period of time, and we have a short period of... we’ve shortened that period of time, which has the impact given recent experience of increasing the level of loss potential we see in this portfolio today. So, that is the driver if you will for us pushing… putting that… posting that specific $11 million reserve. And the balance of it, the portfolio, we evaluate all those portfolios and I think if you reflect back on the 120 basis points plus or minus that Jim referred to, to loans, that is an outcome of the risk profile we look to have in the portfolio when you take the various asset categories and expected performance we might have from each one.

James Abbott - Friedman, Billings, Ramsey

Okay. So, is the $11 million the only dollar amount of reserve set aside against that $94 million or is that not the right way to look at it?

James C. Smith - Chairman and Chief Executive Officer

No, that is not the right way to look at it, that the overall reserve is available against the loan portfolio. In this case, we decided that we should allocate additionally against this segment.

James Abbott - Friedman, Billings, Ramsey

Okay. This is… my concern on the overall industry is that we’re… we haven't been here before or at least we haven’t been here in a long time where the look-back periods may not really accurately reflect it and the companies in general are not going to be able to get ahead of this trend and it is going to be continued bad news for two or three quarters in a row because the models are rearview looking. What can you tell us about your ability to get ahead of it and anticipate the losses, even though you may not be seeing any quantifiable situations or numbers, there is no numbers to support that, doesn’t know if there is loss or that you know if there is default in the portfolio. Is there any way to get ahead of that or is it just we have to live with the GAAP accounting rules?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

It is Gerry, I think by significantly shortening the time period that you look back and taking into account with a greater weighting of more recent trends that as you evaluate that then on a monthly and quarterly basis and you are continually updating that, you are making a quantum step toward addressing the very thing that you are looking at, which is making it much more real-time. And I think that that is what really appropriate, particularly with this product when you think about home equity and the potential stress that this product… or the stress that we are seeing in this product right now. I think it is appropriate that we took very aggressive steps to shorten that look-back period. So, you are seeing a much, much greater weighting the way that we are looking at our portfolio and the reserves that we need to establish and maintain for our portfolio as a result, and we think that that is a very prudent step to be doing at this time.

James Abbott - Friedman, Billings, Ramsey

Okay. Thank you. Thank you for your time.

Operator

Thank you. Our next question comes from the line of Andrea Jao with Lehman Brothers. Please proceed with your question.

Andrea Jao - Lehman Brothers

Good morning, gentlemen.

James C. Smith - Chairman and Chief Executive Officer

Andrea, good morning.

Andrea Jao - Lehman Brothers

Just want to follow-up on a couple of comments you made earlier. First, you mentioned that you try to be very aggressive on the credit front. Given delinquency trends at various portfolios, what exactly does this imply for loan loss provision in the fourth quarter and in 2008?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Hey, Andrea, this is Gerry. The comment that I made, specifically in my remarks about the potential for the provision to increase in future periods, is one that if you evaluate the specific comments of thinking about run rate, which is our currently at 4.25 and looking at our charge-off levels, which has been in and around $3.9 million to $4.25 million that as the loan portfolio grows and dependent on the mix that grows and the associated risk in that mix, we are stating very candidly that that will require an increase in the provision assuming the same level of charge-offs on a consistent basis going forward. We think it is important to note that we have been in a period of transition as an organization in terms of when you take into account all the balance sheet restructuring actions that we have taken, the rebuild of our portfolio, the de-emphasis of a larger percentage of residential, which went from 37% of receivables down to 30% and a greater percentage in commercial and consumer, which went from 63% up to 70% as our portfolio mix changes, as the risk associated with that, which by the way there are higher yielding assets, and we believe priced accordingly then for risk, you'll see that the provision then naturally would need to begin to be elevated, again assuming current charge-off levels and that was the specific comment.

Andrea Jao - Lehman Brothers

Okay. So, would it be fair for me interpret that as your loan loss provisioning, let’s say, in coming quarters pulls in from third quarter levels, but remains way above the 4.25?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

I am not sure I would confirm way above. I’d say, we believe that it will be above given current charge-off experience.

Andrea Jao - Lehman Brothers

Okay, fair enough. Then to another comment you made earlier, which is you are focused on generating positive operating leverage and I think you mentioned good expense controls as well as balance sheet growth. With respect to expense controls, how quickly do you think you can drive down your efficiency ratio to your targeted 60%? And with respect to balance sheet growth, what is your propensity to add borrowings and securities to help balance sheet growth?

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Great question. Let me answer first the operating efficiency. We stated at the beginning of the year that the... I think the terms were the next frontier, were positive operating leverage, achieving that and consistently achieving it, and a significant reduction in operating efficiency ratio. That operating efficiency ratio, we believe as we look at the lower contribution lines of business and really basically take a significant look at the expenses that are incurred in those businesses and prudently fill back those expenses, that that is the first step many that we are planning to take and actually that we're taking right now to reduce our overall expenses.

In addition, we believe that a combination of centralization steps of various activities coupled... particularly in the shared services area, coupled with a little bit longer-term horizon looking at centralization of facilities really going from the significant number that we have today to fewer facilities will have a... both an intangible benefit as well as a tangible one, intangible of people being together and the tangible one being much lower expense as you would imagine in all the other line items. You'd really see that showing up in… probably more in our F&E and occupancy lines.

Andrea Jao - Lehman Brothers

Okay.

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Regarding the question on securities and borrowings, I would state that it is not our intent to go back to the days that… where we were much more depended on wholesale. However, we see that there are opportunities for us in the current environment to prudently add to our portfolio, but nowhere near to the extent that we think we've seen in the past. We really believe that we are focused on growing loans and growing deposits and that's our core business, and to the extent that we have some select opportunities on the security side, we will take those opportunities.

Andrea Jao - Lehman Brothers

Perfect. That's very helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Gerard Cassidy with RBC. Please proceed with your question.

Gerard Cassidy - RBC Capital Markets

Thank you. Good morning. Regarding the home equity portfolio, can you guys share with us how you go about working out those delinquent loans, if there is a $100,000 or $150,000 home equity loan that's outstanding that goes delinquent, that is second to a first as $300,000 or $400,000, would you guys take out the first to get to the property, or how do you work out those loans?

William T. Bromage - President and Chief Operating Officer; Vice Chairman, President and Chief Operating Officer, Webster Bank

I'm sure as you can appreciate… this is Bill, I'm sure as you can appreciate that obviously as part of the art of the collection process when you are into… when you are in a second position, and I'll state the obvious that we... it is a case-by-case decision, will we do that? Yes, we'll do that, but we do it based upon our sense of confidence in our understanding of the underlying collateral value and its ability to hold if that collateral was in fact in the hands of a bank as opposed to an individual. Properties tend to trade less when banks or the party is trying to sell them. So, we're very conscious of looking at what can we expect to net realize on a piece of property and make an individual decision if we think that there is coverage for all or a significant portion of our indebtedness.

Gerard Cassidy - RBC Capital Markets

What are you... in the delinquencies that you are seeing in both the out-of-market portfolio as well as the in-market, what are you seeing in terms of the value of the collateral? Is the value of the houses or multi-family units falling in value?

William T. Bromage - President and Chief Operating Officer; Vice Chairman, President and Chief Operating Officer, Webster Bank

I think what we see… I'd say, yes. What we've seen is that the value what we've gone to realize has turned out to be less than the place value when we went into the loan. I want to be careful here and point out that we're looking at a subset of loans here that is relatively small as it turns out were the higher risk elements of the portfolio when we went into their high loan-to-value to begin with. The three prongs that Jim was articulating in terms of the higher risks loan portfolio is a meaning portion of the charge-offs we've shown in that book and they are a relatively high loan-to-value number. Having said that, I'm not sure that is necessarily representative of the entire portfolio. We've a retail book if you will, which is what we’ve mentioned in the footprints that has a very strong loan-to-value ratio, and then we've ratios overall for the portfolios that don't have as much loan-to-value risk in them.

James C. Smith - Chairman and Chief Executive Officer

I just like to add to that. If you get an opportunity to look through the presentation that we did in the third quarter of this year, that is posted out on the website, we've got a specific slide that takes in… and in a pie chart breaks up our home equity portfolio by CLTV. And one of the positives you'd see that we are at 80% or less in about 60% of the portfolio. Another 20% plus is the net 80 to 90 range and another 10% plus in the 90 to 95. So, if you were to think of the potential impact of declining values in that underlying collateral as Bill was stating, we're still in a huge portion of this portfolio and a positive position in collateral. However, that's always of course dependent upon what the prevailing conditions are given where housing prices have... we've continued to see declines, as Bill stated. You need to look at each and every one of these in a case-by-case basis.

Gerard Cassidy - RBC Capital Markets

And how often do you guys update the values of the collateral? When you say loan-to-values are 80% or 90%, are those up-to-date as of the third quarter or second quarter of this year?

William T. Bromage - President and Chief Operating Officer; Vice Chairman, President and Chief Operating Officer, Webster Bank

We don't evaluate the entire portfolio. We are looking at those loans that we have a problem with and we will reorder whether it is a full appraisal or a broker valuation as we go through that process with [inaudible] credits.

Gerard Cassidy - RBC Capital Markets

And then finally, you guys indicated that it is likely that the loan loss provision will be greater than the $4.25 million. What is your outlook that you guys are using for the economy in your footprint? Do you expect... what kind of growth are you guys are looking for in '08?

James C. Smith - Chairman and Chief Executive Officer

We are looking for modest growth in the footprint. I also would say that we think that the real estate value has held up pretty well in the footprint. It didn't get quite as out of hand in the bulk of our primary market as they did in some other areas, so that is a strong point. We do think that there will be economic growth in our markets. They have gone a little bit behind the national average of growth over the past several years. There is no reason than they will exceed the national rate, but we think that they will be close to it.

Gerard Cassidy - RBC Capital Markets

Thank you.

Operator

Thank you. Our next question comes from the line of Collyn Gilbert with Stifel Nicolaus. Please proceed with your question.

Collyn Gilbert - Stifel Nicolaus

Thanks. Good morning, gentlemen.

James C. Smith - Chairman and Chief Executive Officer

Hi, Collyn.

Collyn Gilbert - Stifel Nicolaus

Maybe if we could just swath gears to the commercial side of the business for a minute, Bill, could you just give us a little bit color in terms of what that $7 million commercial credit that [inaudible] non-performance this quarter, what industry that was in? And then, just if you're seeing delinquency trends on the commercial side if they are in any one segment. And then also, in terms of the pipeline, Jim that you spoke to was strong on the C&I side, if you could just talk about what types of credits those are and if you are taking market share away, from whom are you taking it, and just give a little bit more color of those segments?

William T. Bromage - President and Chief Operating Officer; Vice Chairman, President and Chief Operating Officer, Webster Bank

Okay. With the specific credit and to your question [ph], a Connecticut middle market privately owned company is in the retailing business, some of it supplying to the construction industry. But… so it is right and about a classic middle-market company if you will, that’s indicative of a trend.

With respect to pipeline if you will, we've had very strong production this year in terms of our performance. Our commercial origination book is... through nine months is an excess of $750 million in commitments. It’s not [inaudible], it is funded obviously and closing down, but significant production probably 10% to 20% over what we did last year. As Jim was mentioning in his opening remarks, the market earlier in the year had been so strong that we have had a number of prepayments and then frankly a number of middle-market companies that have elected to sell out to private equity firms, which has caused some higher prepayment levels than we had anticipated. So, we have seen a put and take if you will of a greater volume than we might normally see, which has caused our portfolio to grow probably, we estimate for this year more into 5% to 6% range than what we have got used to in terms of the… double-digit range in terms of commercial loan growth over time. It is not, however, as I say reflective of what we have seen in the market and our ability to source good quality transactions in and around our footprint. We see the commercial real estate market, currently we see a flow of transactions there that are better quality transactions at a reasonable rate. Transactions that previously might have got into the conduit market, we now see the opportunity to look at those. So, there is a potential there to see that this rate disruption that has taken place in the market may provide some further opportunity for us as we look into that market. Our asset-based lending operation also has a very strong track record, continues to see good loan demand.

Collyn Gilbert - Stifel Nicolaus

Okay. Just a follow-up to the $7 million middle market credit, and you said that there is some supply there… or there wasn’t supply [inaudible] construction. Have you gone through the portfolio and tried to comb through some of the business credits to assess who does have exposure to construction businesses and maybe where you might see potential weakness? I know you said it's not necessarily a trend, but where there is a slowdown in construction maybe of your borrowers who might be impacted?

William T. Bromage - President and Chief Operating Officer; Vice Chairman, President and Chief Operating Officer, Webster Bank

Collyn, the answer to that is a qualified, yes, we have. I mean, combing through the portfolio implies perhaps a richer exercise, but we have certain buckets, certain segments that went into that industry. Our equipment finance area for example has a construction subset, they have very actively reviewed the entire portfolio and have seen some softness in that portfolio and we are working with our borrowers in monitoring that portfolio closely and our performance in that area continues to be strong but we’re cognizant that there’s potential for weakness. We have done that additionally in the small business area, but I don't want to leave the impression that we’ve sorted every single loan and done a thorough review of that. But we are very cognizant of what is happening in the marketplace, the segments that are potentially negatively impacted, and having the leadership in each one of our loan areas take a good hard look at their portfolio.

Collyn Gilbert - Stifel Nicolaus

Okay, great. That's very helpful. Thank you.

Operator

Thank you. Our next question comes from Andrea Jao with Lehman Brothers. Please proceed with your question. Ms. Jao, please proceed with your question.

Andrea Jao - Lehman Brothers

Sorry about that. Just wanted to step back a little, now that you've finished your strategic review of your business, kind of if you could talk about how over the years the company has taken charges and essentially there charges go against capital to restructure the balance sheet, and then credit costs have been elevated in recent quarters. What do you foresee in terms of managing capital that way or avoiding charges against capital in the coming year because obviously reducing charges against capital would be much better?

James C. Smith - Chairman and Chief Executive Officer

Well, we’ve really… just thought reducing the charges against capital would be better and I think that some of the steps that we have taken particularly with the laser like focus on the direct franchise businesses will be a positive in that regard, we will have less exposure to that out-of-market influence. I think that ultimately the capital is a cushion to some degree against potential loss even though we don't really want to see it or use it that way. We want to be able to use it to invest in our businesses to capitalize our growth, to create flexibility, to have buyback programs or make acquisitions, and of course the stability of the capital base is essential to be able to make that happen. I believe that the focus that we have will make us less vulnerable to the range of issues that can affect us. While we are focused on our core franchise, we also have the limited geographic span. There always is the question of what will happen within the markets where you operate. But I want to say that we don't take our responsibility to protect and increase our capital base slightly and we do our best to avoid any [inaudible] capital such as what we're seeing today.

Andrea Jao - Lehman Brothers

Okay. That's good. Now, separately, I was hoping you could talk more about deposit trends, I know deposits were seasonally strong this quarter. But what else are you seeing in terms of customer migration to higher cost categories, your propensity to… not to compete in terms of pricing or on the other hand to accommodate higher pricing, if you could talk a bit more about that that would be great.

James C. Smith - Chairman and Chief Executive Officer

Well, sure, I will crack at it. In the core market, we have been very successful at increasing our deposits faster than the market, which has been relatively slow growth by the way, while also reducing our cost of deposits as compared to our peer group. And I made the comment that that is clear proof that our execution is strong and we haven't relied on price. In the meantime, as we open our de novo offices, we generally do you some promotional pricing although we have scale that back in recent quarters and that that has had an impact on the growth of the de novo. So, overall, we have what I would call a highly responsible deposit pricing approach and a very aggressive and successful marketing program that has enabled us to continue to grow deposits faster than the market. I think one of the things we benefit from is that we have a very low attrition rate among our customers and we continue to pick up the higher share of churn in the market than is our existing market share. When you combine that with very, very low attrition rates you have the benefit of being able to continue to grow faster than the market.

Andrea Jao - Lehman Brothers

Great. Thank you so much.

James C. Smith - Chairman and Chief Executive Officer

I will just make one other comment too is that in terms of managing deposits by running off some of broker deposits, we expect that will have a positive implication for cost of deposits as well as for the net interest margin.

Andrea Jao - Lehman Brothers

Okay, awesome. Thank you.

Operator

Thank you. Our next question comes from the line of Philip Gutfleish [ph] with Elm Ridge Capital. Please proceed with your question.

Unidentified Analyst - Elm Ridge Capital

Hi. Just really quickly, why was the amortization lower in this quarter? Was there... I don't recall you having actually sold anything during the quarter. Could you just sort of explain that one?

James C. Smith - Chairman and Chief Executive Officer

I think that it is because CDI related to an acquisition made several years ago was complete and that resulted in a lower amortization of CDI.

Unidentified Analyst - Elm Ridge Capital

$1.2 million on the 3.3 base, that seems a bit high. I would have thought that that would have been coming down over time as opposed to just flowing pretty big--?

James C. Smith - Chairman and Chief Executive Officer

Generally, we amortize the CDI over seven years. So, at the end… and we have done ratably over that period of time. So, at the end of seven years, you see this amortizing. Gerry may have more detail.

Gerald P. Plush - Senior Executive Vice President and Chief Financial Officer

Now, this is the CDIs from branch acquisitions in the past and that the periods expired.

James C. Smith - Chairman and Chief Executive Officer

We actually bought Mechanic Savings Bank back in the second quarter of 2000. We had a seven-year amortization, which ended in Q2.

Unidentified Analyst - Elm Ridge Capital

Okay. Thank you very much. Appreciate the color.

Operator

Thank you. Our next question comes from the line of Collyn Gilbert with Stifel Nicolaus. Please proceed with your question.

Collyn Gilbert - Stifel Nicolaus

Hi, guys. Just a quick follow-up. Could you give some color as to the percent of your loan portfolio that reprices with prime?

James C. Smith - Chairman and Chief Executive Officer

Yes, give me a second here. I believe we are about 25%.

Collyn Gilbert - Stifel Nicolaus

Okay, that's great.

James C. Smith - Chairman and Chief Executive Officer

Not so sure [ph].

Collyn Gilbert - Stifel Nicolaus

Okay, thank you.

Operator

Okay, thank you. Our next question comes from the line of James Abbott with FBR. Please proceed with your question.

James Abbott - Friedman, Billings, Ramsey

Yes, also just a quick follow-up on the expenses. Were there any contra expenses or anything unusually low during the quarter? Obviously, there was very good change in expenses on a link-quarter basis, and I'm just wondering if there is... if that is a good run rate to use going forward based on the comments you made in the conference call or if there is anything unusual that might pop back up in the fourth quarter?

James C. Smith - Chairman and Chief Executive Officer

There is nothing unusual in the quarter.

James Abbott - Friedman, Billings, Ramsey

Okay.

James C. Smith - Chairman and Chief Executive Officer

We did record about $700,000 worth of severance, but as we've said before, we actually consider as we go through the process that that could be something that pops in and out of each quarter. So, I would actually tell you to keep that in the run rate.

James Abbott - Friedman, Billings, Ramsey

Okay. Thank you again and congratulations on the expenses.

Operator

Thank you. There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

James C. Smith - Chairman and Chief Executive Officer

Thank you very much for being with us today. Good day.

Operator

Ladies and gentlemen, this does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Webster Financial Corporation Q3 2007 Earnings Call Transcript
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