Peter Raskind - President and CEO
Jeff Kelly - Vice Chairman and CFO
Jim Bell - Chief Risk Officer
Rob Rowe - Chief Credit Officer
Jill Hennessy - Investor Relations Manager
Tom Richlovsky - Treasurer
National City Corporation (NCC) Q3 2007 Earnings Call October 24, 2007 11:00 AM ET
Welcome to the National City third quarter 2007 earnings conference call. (Operator Instructions) I would like to turn the conference over to the Treasurer of National City Corporation, Mr. Tom Richlovsky. Please go ahead, sir.
Good morning, everyone. Welcome to National City Corporation's third quarter earnings conference call.
Let me remind you that the presentation and commentary that you are about to hear will contain forward-looking statements. Such statements are based on presently available information and on management's current expectations. We believe these statements to be reasonable, but they are subject to numerous risks and uncertainties as described in our Form 10-K and other filings with the Securities and Exchange Commission. As a consequence, actual outcomes could differ materially from the views expressed today. We may elect to update forward-looking statements at some future point; however, we specifically disclaim any obligation to do so.
We have several members of the management team on hand this morning including Peter Raskind, President and CEO; Jeff Kelly, Vice Chairman and CFO; Jim Bell, Chief Risk Officer; Rob Rowe, Chief Credit Officer; and Jill Hennessy, Investor Relations Manager. Jeff, Rob and Peter will each have some remarks on the results and the outlook followed by a question-and-answer session which, per our usual practice, will be conducted by email.
To ask a question, simply send us an email at any time during the conference to firstname.lastname@example.org. We'll take as many questions as time permits.
Before I turn the program over to Jeff, I want to make you aware of a couple of items relative to our financial disclosures. In addition to the news release and our regular quarterly financial supplement, this morning we also published a separate slide deck containing details on loans held for sale and a variety of loan and credit statistics. Both Jeff Kelly and Rob Rowe will be referring to this document during their remarks so you'll want to be sure that you have it handy. It's available on NationalCity.com in the investor relations section.
Secondly, as you know, for the last several years we have been publishing a mid quarter update during the third month of each quarter. A number of other banks have been following a similar practice, but have since stopped, such that today I believe that we are the only bank still providing a regularly scheduled mid-quarter update. In light of that circumstance, and considering the time and effort involved in producing the update, we conducted an informal poll among analysts and investors relative to its ongoing usefulness. While nearly everyone found it useful, a number of respondents noted that it seemed to encourage short-term speculation in the stock; certainly not our intent or expectation when we started issuing the update.
Taking all of the feedback and the various pros and cons into consideration, we have decided to finish out this year and then eliminate the mid quarter update beginning in 2008. So the one published this coming December will be our last one. We will continue to provide monthly financial data in our regular quarterly and financial supplement, as we did this morning, so the total amount of information disclosed to the market will not change. In fact, we expect to continue to expand and enhance the quarterly supplement based on your ongoing feedback and suggestions.
With that, let me turn the call over to Jeff Kelly.
Thanks, Tom and good morning, everyone. As we said at our analyst conference last month and again in our mid-quarter update, the third quarter results included some significant mortgage-related charges and losses reflective of the rapid and significant deterioration in the mortgage markets, as well as actions we've taken to restructure our mortgage business.
A brief synopsis of some of the actions taken in the quarter include the following:
We suspended origination of broker-sourced home equity loans. We moved non-salable warehouse inventory into our loan portfolio, narrowed the product set of the mortgage company to agency-eligible first mortgages and high quality jumbos; and took steps to reduce the mortgage banking and supporting workforce by about 1,600 FTE, most of which will come out by year end.
As a result of those actions and the general deterioration in the mortgage markets, the mortgage banking unit posted a net loss of $152 million for the third quarter, including all of the charges discussed last month, and also including approximately $40 million in after-tax net MSR hedging gains. Mark-to-market adjustments and scratch-and-dent losses turned out to be lower than we had projected.
Severance and asset impairment charges were somewhat higher than forecast, and credit provisions were meaningfully higher than we anticipated back around the analyst conference. Rob Rowe will cover that point in a few minutes in his prepared remarks.
At quarter end, we have loans in our mortgage warehouse totaling about $11.5 billion, detailed on page 2 of the supplemental handout that Tom referenced earlier. Other than agency-eligible mortgages, the valuation of loans held for sale was a challenging exercise last quarter, due to the dearth of market trading or even bids in the market.
In valuing non-agency loans, seconds and HELOCs, we incorporated estimates of trade fallout for loans under contract to sell where we had reason to believe that a counterparty will ultimately fail to settle some or all of the loans they had contracted to buy, or that some loans will be kicked out prior to the settlement of those trades for documentation reasons.
Absent some recovery in the market, it is likely that such kickouts will be moved into the portfolio as they occur. We also incorporated an estimate of the likely scratch-and-dent loss content of the remaining loans not under contract to sell. Because the majority of the loans held for sale but not under contract are agency eligible, we expect the trade fallout -- and thus, scratch-and-dent losses -- will be materially lower going forward.
Obviously though, because we are dealing with estimates and because the state of the market is so uncertain, we probably have a greater than usual chance of being wrong in some of the valuations placed on non-agency, held-for-sale loans.
To the extent that our September 30 estimates prove to be off the mark, they are subject to true up in the fourth quarter which could result in either additional charges or gains, depending on the direction of the market from this point.
Beyond the third quarter restructuring actions noted previously, we initiated further restructuring of the mortgage business in October. We are closing our correspondent lending business and making some other management changes in our mortgage business. Approximately 100 additional staff cuts will occur, bringing the cumulative employment reduction in mortgage banking and related support functions to 1,700 or so in the second half of this year. As a result, the fourth quarter will include some additional severance and associated charges.
As we discussed at our analyst conference in early September, our intent is to resize and reshape the mortgage company to be more focused on retail and agency-eligible mortgage lending and to be profitable in an environment likely to witness a much lower level of volume than has existed broadly in the market, and for us in particular. Given the changes that I noted earlier, our best guess today is that we'll see originations of about $30 billion in 2008.
The disruptions in the market in the third quarter also affected our capital plans. At the beginning of this year, the declining level of mortgage risk on our balance sheet prompted the deployment of excess capital through stock repurchase to move our capital ratios to the bottom of their target ranges. The abrupt changes in the mortgage and credit markets in the third quarter impacted not only our view of the assets on our balance sheet, but a reassessment of the risks inherent in the macro-economic environment and thus, necessitated a rethinking of our capital plans.
In our view -- and I have mentioned this at our analyst conference -- it now seems appropriate to allow our capital ratios to migrate towards the top of their respective target ranges and in the case of our tier 1 capital ratio, to move the entire target range upward. Our target ranges are 5% to 6% for the tangible common equity ratio, and 7% to 8% for the tier 1 risk-based capital ratio. As I said, we did implement an increase in this target range of about 0.5%.
In the absence of issuing capital securities of some type, the increases I described in those ratios will occur naturally over the next several quarters as the balance sheet shrinks from here and retained earnings accumulate. During the third quarter, we did issue some tier 1 hybrid capital securities and we would consider the issuance of some additional tier 1 hybrid capital, should the opportunity present itself.
In sum, the quarterly results were dominated by mortgage-related issues which obviously hurt our financial performance. We have taken fairly aggressive steps in repositioning the mortgage business, but conditions will probably require continued vigilance for some time to come.
In the interest of time, I have not covered the more routine aspects of the quarter this morning, but would be happy to do so during the Q&A, to the extent there's interest in that.
With that, I'll turn the floor over to Rob Rowe to discuss credit issues.
Thanks, Jeff. Good morning, everyone. We have provided to all of you supplemental data which we will utilize as a tool to describe the third quarter credit performance. Before we move to the deck, note that National City has significantly increased its loan loss reserve during the quarter. The extra provisioning is somewhat above the top end of reserves estimated during the investor presentation in September.
We believe that the contraction of capital in the real estate sector has obviously led to a very different and difficult environment. Although it is not easy to simulate the new reality, we have attempted to do so in our reserving approach.
With that preface, please turn to slide 3 in the handout which summarizes the loan portfolio per our consolidated balance sheet. Broadly speaking, there are four major categories to address, as depicted on the chart: commercial, commercial real estate, residential real estate and consumer. Most of our comments will focus on the real estate categories but first, let's address the commercial and consumer books.
The commercial loan portfolio totaling $34 billion including leases, is as we have said in the past, very granular, diverse and has performed well. The same statement could be made today. All credit metrics in the commercial portfolio -- non-performing assets, net charge-offs and past dues -- are very low and representative of the very high operating margins that much of our commercial base is performing at.
The consumer portfolio, just over $8 billion is, likewise very stable and has also performed well. In particular, note that the credit card and other unsecured line of credit portfolio which totals approximately $3.5 billion which was repositioned a couple of years ago to serve as relationship product, has exhibited low and stable delinquency trends.
The middle of the chart depicts real estate; $23 billion commercial and $47 billion residential. The $23 billion of commercial real estate exposure is laid out on the next slide, page 4, showing a breakdown by geography and loan type. Again, you can see the diversity and relative lack of concentration by product type in this portfolio. From a credit quality perspective, please focus on the first two rows depicted in both boldface which represents direct exposure to the U.S. housing market.
The performance of the residential development and land development portfolio has varied by location. For your reference, the non-performing asset percentage of Michigan, Florida, and the national group is more than double that of the rest of the National City footprint. The traditional Midwestern footprint did not have significant price appreciation and thus, was less susceptible to speculative activity.
The primary point is that at the current time, the stress we are having is primarily emanating from the residential development activity of Michigan, Florida and the national business. This sub-segment totals $2.6 billion or roughly 11% of National City's commercial real estate portfolio. To be sure, non-performing assets in the third quarter rose considerably in this segment, but we believe that content will ultimately be relatively low due to our stringent underwriting.
Now, let's turn to the residential real estate portfolio. The risk levels within this book vary widely, so we'll need to drill down into various sub-segments. The starting point is slide 5, summarizing the major categories of residential real estate and home equity. The top half of the page depicts the portfolios associated with our core businesses, low-risk customer portfolios that are performing well. The bottom half of the slide represents our run-off portfolios whose sub-segments are exhibiting varying degrees of risk and loss development.
Please turn now to slide 6 which reflect the direct home equity portfolio originated through our branch network and consisting of both lines and loans. At the bottom of the chart, we have provided you a trend line of charge-offs and 90 days past due. For the first three quarters our annualized charge-off rate is 23 basis points, which is very low. The top of the chart stratifies the portfolio by FICO score and loan to value. The average FICO is 733, the weighted average loan to value is 72.5%. For the loans with loan to value greater than 90%, we have mortgage insurance. We believe the performance of this portfolio validates our direct to customer strategy, certainly no need to increase reserves on this portfolio.
Please now turn to page 7. There's only one area of the prime first mortgage we want to discuss this morning, and that is the residential construction book, approximately $3.1 billion consisting of loans to individuals to finance home construction. The bulk of the portfolio is to individuals to build their primary home. I spoke last month about a particular subset of this portfolio, approximately $400 million, representing financing extended to individuals to build speculative properties, primarily in Florida.
With the downdraft in real estate prices, the economic incentive to do the deal has gone away and many of the borrowers have decided not to build and have stopped making payments or are expected to. In essence, National City has a portfolio of lot development loans to individuals at high loan to values because the equity in the deal was not required until construction of the home began. We have decided to set aside approximately $50 million of reserves for this specific portfolio, given our current estimate of defaults and loss severities. Before we move to slide 8, one final note on this portfolio. The activity was not part of the Harbor or Fidelity lending book.
That brings us to the run-off portfolios, which account for the lion’s share of delinquencies and non-performing assets, as well as a good portion of our reserve build this quarter. These consist of the former First Franklin book of first lien sub-prime and second lien sub-prime loans and the National Home Equity portfolio, including loans transferred from held-for-sale in early August.
We will start with the non-prime portfolio on page 8. Losses for the non-prime first liens and second liens have been broken out. In the middle of the chart, loan losses for the first liens have been averaging $6 million per quarter, less than 50 basis points on an annualized basis for the first nine months. We would not expect that the future level of charge-offs for the first lien book to materially deviate from the current run rate.
As we have described in the past, the action is in the performance of the second lien portfolio which totals $1.7 billion. During the third quarter, delinquencies rose on the total non-prime book by $115 million, $25 million of that relates to the second liens. All of that occurred in the month of September. It appears that the rate resetting of the first liens in front of those second liens is leading to increased delinquency. With little liquidity left in the non-prime market, we believe this trend will continue. Therefore, we increased loan reserves in this portfolio in the third quarter.
As you know, the second lien portfolio has two providers of lender-paid mortgage insurance that have been exhibiting different claims payment performance; one paying essentially all valid claims and the other rejecting an inappropriately large number. While we would comment that the rescission rate on the insurance claims with the second insurer declined during the last quarter, payment of claims continues to be below expectations. Therefore, we have not made changes to the underlying assumptions established in the first quarter relative to expected insurance recoveries.
Turning to page 9, during the third quarter, National City placed in the loan portfolio just over $4 billion of national home equity loans and lines that were declared to be no longer saleable. Thus, the total national home equity run-off portfolio now totals $10.7 billion. Note that both the original held-for-investment book and held-for-sale book share similar characteristics in terms of loan to value and FICO and purpose, except that the held-for-sale book held higher percentage of stated income, roughly 40% versus the original 10%.
The time series at the bottom of the chart shows charge-offs for the $10.7 billion portfolio for the third quarter. Given that the original held-for-investment book is performing consistent with prior periods, it is apparent that the recently transferred held-for-sale book is exhibiting higher delinquency and potentially higher loss content than was assumed 45 days ago.
Because of the worsening trends, we have placed additional loan loss reserve against the portfolio that was moved from held-for-sale. This reflects the current level of loss development and delinquency as well as significantly changed economic environment with much lower levels of liquidity. This portfolio will bear watching going forward.
By way of wrap-up, on page 10 we have provided a summary of the provision applied to each of these portfolios for the third quarter. In summary, we conducted a thorough review of all the loan portfolios, rigorously evaluated the trends and current environment and increased our reserves to a level that we believe is appropriate. While we cannot predict what will happen in the market in the coming months or quarters, reserve actions taken in the third quarter represent our view of the expected loss inherent in the loan portfolio. That said, the mortgage and housing markets have not yet stabilized, so continued vigilance is required.
With that, I will it turn over to Peter for a broader view of the quarter.
Thank you, Rob. While mortgage and the related credit issues are understandably dominating the agenda this morning, I do want to briefly touch on the performance in the rest of the company. Core deposit and loan growth were reasonably good in both the corporate and retail banking businesses. Excluding acquisitions and escrow deposits, average core deposits were up 2% on a linked-quarter basis and 8% over the prior year.
Total loans, excluding acquisitions and run-off portfolios, were up 1% linked-quarter and 11% year over year. Credit costs other than those associated with residential real estate were stable.
The net interest margin declined in the quarter due to a more costly funding mix resulting from a larger balance sheet. At the same time, corporate loan spreads continue to be narrower than planned in the previous year. While it's a tough operating environment, the core retail, corporate and wealth management businesses are competing well. These businesses have clear, coherent operating plans and we are executing well against them.
While our Florida acquisitions are certainly facing some initial headwinds due to the slowed real estate environment there, the conversion events are behind us and we are making steady progress. All that said, I think we can and should do better in each of our businesses and overall.
At our investor conference last month, I spoke about six areas that we are particularly focused on in the near term, all of which are ultimately directed to the same outcome, and that is to significantly improve the financial performance of National City from this point forward. Briefly, those six areas of focus are:
First, continuing to improve our share of wallet among businesses and consumers.
Secondly, continue to execute our market sales process, which means improving our ability to bring the whole bank to all customers. Said another way, we want to present ourselves to the market as a seamless, integrated, coherent bank, not a collection of business lines.
Third, enhanced cost management. I will come back to this one in a moment.
Fourth, restructure and improve our mortgage business, as Jeff spoke about earlier.
Fifth, integrate our recent acquisitions -- Florida, Chicago, Wisconsin -- to bring them up to the performance levels commensurate with the potential identified at the time of purchase. The Florida banks are fully converted and integrated from a systems and branding perspective. MAS closed in September and will convert in the first quarter of 2008.
Sixth and finally, instill a heightened sense of accountability across our entire organization.
While we have identified these as near-term objectives, most of them are processes that take place over some period of time. However, two of them have particular immediacy and they are the restructuring of our mortgage business, and cost management generally throughout the company. We are in the mortgage business because the home mortgage is an essential consumer product. Implicit in our goal of becoming the best retail bank is also to be a first-rate mortgage provider. The mortgage unit, as it was configured earlier this year, was not in a position to do well in the mortgage environment that we now foresee over the next couple of years. As Jeff discussed in his remarks, we are narrowing the focus of the business and adjusting its capacity to the realities of the mortgage market going forward.
Beyond the immediate effect of the problems in the mortgage unit, it seems clear that the weak housing market portends a weaker economy generally in the year ahead. Revenue growth will be harder to come by for everyone, which means that cost management is crucial to achieve the performance to which we aspire.
To that end, we began this month to initiate some fairly strenuous cost cuts throughout the company, primarily in support functions, in order to configure ourselves for a better 2008 and beyond. As of today, we have nearly all of the cuts completed, and hardwired into every business unit's plan for next year. Combined with the mortgage cutbacks, which Jeff described earlier, they represent a headcount reduction of approximately 2,500 positions from September 30 levels with an associated expense impact of approximately $125 million. As a result, we will be incurring some additional charges in the fourth quarter of around $40 million, mainly severance.
Getting from where we started earlier this year to where we need to be by year end is not pleasant or fun, to be sure. But, inaction is simply not an option. Our current level of overall performance is unacceptable. Restoring an acceptable level of profitability is job one and we will do what needs to be done to get us there.
With that, let's move to the question and answer session.
Rob, could you please comment on your exposure to bridge loans and underwriting commitments?
Well, at the current time, we have one transaction that we have described previously, which is a corporate to corporate LBO, where we have a $20 million exposure to a senior subordinated bridge loan.
Please comment on whether National City has exposure to Newman Brothers, the Chicago builder that is expected to file bankruptcy shortly?
We currently do not have any exposure to Newman Brothers or any project financing that Newman Brothers has undertaken.
Can you please discuss the issue of severity versus frequency of losses in home equity loans and lines?
Right now, I would say that for us or for anybody in the industry, we would pretty much be modeling that severity as 100% write-off of a home equity loan. So, the decision point would really be what is the frequency or what is the default probability of the home equities? But at the current time, I believe we pretty much have only have a 5% recovery rate on the home equity loans that do default.
Jeff, there have been a number of questions related to margin contraction in the third quarter and the outlook for the fourth quarter. Can you elaborate on both?
Thanks, Jill. I think I would start by saying that the margin decline that we saw in the quarter was certainly more than we had anticipated on our last call where we discussed this, and I bucket the changes in the margin on a quarter-over-quarter basis into five areas.
The first would be the acquisition of MAF. MAF, their business model, their balance sheet had a much narrower margin than National City's prior to its acquisition and it's mere combination with the company had the effect of reducing our margin for the quarter by about 4 basis points.
The second area that I would talk about would relate to our deposits both in terms of mix and rate because both were unfavorable compared with the second quarter. So, from a mix standpoint, we saw fewer escrow deposits due to slower mortgage prepays and we also saw a higher component of our deposit book in CDs.
In terms of rates, rates on checking and money market savings were slightly higher in the third quarter and I would attribute that generally to money market conditions as well as competitive conditions.
The third area that I described relates to those money market conditions and that's really what I refer to as the prime LIBOR basis squeeze from both a rate and a mix standpoint. Normally, when short-term rates decline, such as occurred during the third quarter at least in terms of the Fed fund rate, you see prime decline but you generally see one and three month and six month LIBOR lead that decline.
We are a net receiver of prime and a net payer of LIBOR and what actually happened was even though prime went down in the quarter following the Fed funds decline, LIBOR actually spiked up in some instances during quarter and that change in the basis negatively impacted our margin as well. I would say that the impact there probably cost us about 2 basis points, and I would say that the overall mix and rate change on core deposits was about 7 basis points.
Also, just in terms of our purchase funding, we did do a hybrid debt issuance during the quarter and that cost us about 1 basis point during the quarter.
The final bucket was probably related just to the general increase that we have seen in higher, non-accrual loans on the books and that probably contributed a couple of basis points.
So I think that pretty much covers the change from the second quarter to the third quarter. So let me spend just a couple of minutes on what we would think would be trends going forward in the margin. I'd preface that by saying there's probably an unusually large risk, given the environment, around the outlook potentially in either direction, I would say.
I would say going forward that the MAF, the dilution in the margin caused by the addition of MAF to our books should ease going forward and the margin, I would think on that balance sheet would expand as it becomes more bank-like than it did previously.
The second component related to the deposit pricing. Typically what we see is our core deposit rates lag falling market rates. The squeeze that we have seen in the third quarter should dissipate over time and catch up, particularly in an environment where short-term rates are stable for some period of time.
How that occurs, how quickly market rates decline or how far they decline and where they generally shake out will determine the pace of that lessening of the core deposit squeeze but we do expect to see a lessening of that going forward.
The LIBOR prime basis pressure could remain for a while. We'll clearly benefit when this normalizes, but that would really be contingent upon easing of the liquidity concerns in the market.
I would just say the loan related issues as it relates to non-performing, non-accrual at least, will depend on the credit outlook generally. I would say in looking at the margin overall, we'd expect the next quarter or two probably to see a modest decline and then our guess would be that we would begin to see some recovery in the margin in the second half of 2008.
How did the Fed rate cut affect the bank in the third quarter and what is the likely effect going forward?
Well, I described some of that in my previous comments, but as you can see if you look at our interest rate risk position on page 14 of the supplement, we do have a positive duration of equity so generally, a favorable exposure to declining interest rates. Although not extreme by any measure, that risk position or favorable exposure to declining interest rates is higher than it has been in several years.
So generally, as I said, we'd expect the Fed rate cut to have a positive effect on net interest income and our net interest margin but as I said, some of the money market anomalies that occurred in the third quarter dampened that to some degree. I'd expect, as those rate cuts are sustained or even continue, I'd expect it to have a positive impact on our margin.
Tom, a question for you. What's behind the very low effective tax rate for the third quarter?
Thanks, Jill. For reference, you may have noticed that the rates in the third quarter was somewhere in the low 20s and typically the tax rate would be somewhere in the low to mid-30s. There are actually no one-time adjustments to tax that affected the quarter. In fact, the one-time adjustments were unfavorable to the tax rate.
The main reason and really the reason for the low rate is the lower level of taxable income for the year. We have fixed dollar amounts of credits that are part of our tax-based calculation and at a lower level of taxable income, those benefits have a higher percentage effect.
So, as taxable income resumes or is restored to levels more in tune with historical patterns, that rate will naturally gravitate up to where it has typically been, which would be in the low 30s.
I will address this question to Jim Bell. What are your exposures to conduits and/or SIVs?
As we've disclosed in the 10-Q in the past, we have one contingent funding arrangement with approximate $400 million exposure to a conduit through which it is securitized, sub-prime automotive paper. As a matter of business practice, we don't have any other relationships, any credit extensions to anything that is unrelated.
I would point out we are not responsible for that conduit. It's another financial institution that is the sponsor of that conduit.
Rob, in his testimony on September 20 before the House of Representatives, Alfonso Jackson, the Secretary of Housing and Urban Development, suggested that one-quarter of homeowners with sub-prime mortgages scheduled to have resets over the next 18 months were likely to lose their houses. Applying this 25% ratio to the total sub-prime mortgage exposure of National City, both to sub-prime mortgages owned and owned derivatively through collateralized debt obligations or where National City has exposure, if the bank had to foreclose on the collateral for these mortgages and sell the underlying property for an extreme hypothetical of one-half the face value of each mortgage, given the bank's level of loan loss reserves and capital, what would be the effect on the bank's operations?
Well, when you look at the non-prime book at National City, it's made up of both first liens and second liens. The ultimate outcome, as we've described in the past, would be different between first and second liens. Let me walk you through that a little bit.
The rate reset activity over the next 18 months on the first lien portfolio will be approximately $1.6 billion. Of that $1.6 billion, somewhat close to $1 billion are first liens that are insured. So really we only have a $600 million book of business that will be subjected to rate resets where we could be on the hook for loss content.
In that $600 million, assuming that type of draconian situation, which is both on the default probability suggested and certainly on loss severity far in excess of what we've seen to today, if you were to do the math, you'd probably come up with $150 million of default and loss severities that would be half of that. So that's a $75 million nut.
What I would highlight for you is that we have been tracking since October of last year what exactly does rate reset activity mean? The last data point we have is the month of August, which was around 12% to 14% delinquency generated from rate reset activity. So the assumptions that are underlying the question are extreme and far more severe than we have seen yet to date.
On the second lien part folio, we have approximately $600 million of content that will have rate reset in front of it over the next 18 months. Of that $600 million, if you were to make that same type of assumption, you are talking about $150 million of defaults and as we described in the past, home equity loans don't have a very high recovery rate. However, of that $150 million, we are insured, as you know, and given the current payment rate of one of the two insurers, we would expect that they would pay their $50 million claim. We'd really be left with a $100 million nut of which, at the current rate of payment, which I don't want to fully describe, we would expect we'd be somewhere in the middle of that range from a loss content.
What I would assure you in our calculations when we are simulating the current environment, we have assumed delinquencies that are generated from rate resets and we have also assumed loss severities that are higher than we have seen traditionally. So, it is my view that at the current time, although it's a great question and certainly the assumptions underlying it might be reached at some point, we believe that we are appropriately reserved for the potential outcomes.
Strong growth in the third quarter in commercial construction and commercial real estate portfolios. Where are you getting this in the current environment?
Well, I believe the MAF book is included in the third quarter and is not included in the second quarter and MAF now has around a $600 million to $800 million multi-family portfolio which is included in commercial real estate. So those are apartments, but it's in the commercial real estate book. Likewise, I think we now have a $300 million increase due to MAF for some office construction and some retail as well.
So if you factor those in, I believe the increase on a linked-quarter basis would look more normalized, plus with the lack of liquidity in the marketplace, there's probably some deals that have worked that's now stabilized, gone from construction to stabilization and cannot go out to the CMVS market, so that probably also provided some lift for the quarter.
In general, should we expect additional reserve build going forward?
Well, I would state right up front that the current level of reserves today is driven by our expectations of the performance of the portfolio going forward. It's not driven by net charge-offs at the current time, but it's really a look to the future. So, we believe we are appropriately reserved. As we said right up front, this is a difficult environment to simulate and we just have to keep it at that. We believe we are appropriately reserved today.
Jeff, how much is the residential mortgage non-performing loans and 90-day past due increase is from alt-A loans transferring back to portfolio.
I will take that one, Jill. There's zero content for that transfer back.
Jeff, can you please talk about capital strength in the context of what would cause the current dividend to be at risk? What would make you reevaluate your dividend policy?
Well, let me say that I think given both our current capital position and our intention to allow capital to rise over the next several quarters within the target ranges that I described and in the context of those target ranges that we see no need to and have no intention of reducing the dividend. We have always believed this is a very important component of our total return to shareholders and have always sought not only to pay it every year but frankly to increase it every year.
While I would certainly admit that our dividend payout ratio is clearly above our long-term target of 45%, I remind all that this is a long-term target and there have certainly been time periods in the past when our actual payout ratio has exceeded that level. So I think many of the factors, at least recently, that have contributed to that actual payout ratio being somewhat above our target, we consider to be short-term and indeed, in many cases, one-time in nature.
As Peter mentioned in his comments, we're focused on improving the financial performance of the company and we believe that's achievable and therefore, we see no need to or have no intention of cutting the dividend.
Peter, how much do you plan to cut in non-personnel expenses and in what types of categories?
Thanks, Jill. As I mentioned earlier in my comments, we have nearly completed our 2008 budget process. As an outgrowth of that process, there were, as I mentioned, substantial cuts in employment around the company. A couple of points I'd make.
First of all, by themselves, the cuts that occurred in employment will have some follow-on effects, in terms of other expense categories related to things like travel, entertainment and so on, and just other areas where expense arises from positions that won't be there in the future.
But I think furthermore and probably more important, as we go through the budget process, we are scrutinizing every category of the income statement, whether it be revenue or expense as we head into planning for and then achieving a better 2008. So a very natural outgrowth of our budget process and the accountability that creates will be a very tight focus on our expenses. Therefore, I'm not expecting any special initiatives to cut other types of expenses. I think that will occur very naturally as an outgrowth of the budget process, and I might add much better procurement processes that we now have in place as a result of our best-in-class initiative.
In the Visa perspective, National City is highlighted as having an 8% stake in Visa USA. How large of a gain do you expect to take on the Visa IPO and when do you expect to recognize that value?
As a result of our issuance activity and our former ownership with MPC we do have an unusually large stake in the newly restructured Visa. As I suspect many of you are aware, Visa restructured in early October into an independent for-profit company with the ultimate intent of taking that company public. As a result of our approximately 8% share in Visa USA, we end up with a share in the new Visa, the new worldwide Visa, somewhere between 4.5% and 5% of a good-sized entity.
There's quite a bit of discussion going on right now between the various banks involved and the SEC as to exactly how the accounting should occur for this transaction. That is not yet fully resolved. So the restructuring has already occurred. There will be, we hope, resolution within the next several weeks by way of the SEC as to whether that restructuring creates an accounting event or not.
But even if it does not, there is an expectation that the company will go public some time next year and therefore, presumably at that time a gain would be realized. I would not at all engage in speculation as to what the size of that gain is going to be yet today, but given the size of Visa and our stake in Visa, there's reason to believe that it will be sizable.
What level of mortgage and home equity loan originations are you comfortable originating on a quarterly basis, assuming that capital markets do not open up any further?
Our best guess is at this time, given the product set that we're originating, which I referred to earlier in my comments, we think the likely monthly originations are in the vicinity of $2.5 billion, so on a quarterly basis that's obviously times three, so about $7.5 billion. I would say there is an extremely small amount -- effectively none -- of home equity from a National standpoint within that just because we do not see the markets for home equity product opening up in any material fashion.
My level of comfort with our level of originations is more a function of the ability to sell product going forward. So in today's market, I'm pretty comfortable, $7.5 billion to $8 billion on a quarterly basis for the capital markets to open up and sell and avail ourselves of more product that we could sell. We would be comfortable in expanding some of the product offerings into the non-agency area, including home equity.
Another question pertaining to mortgage banking. When do you expect mortgage banking to return to profitability and given the restructuring, how much can it contribute to your earnings?
I would probably not comment on the second part of the question. The first part of the question, I would answer the same way we answered at the analyst's conference call. I think given what I consider to be non-heroic assumptions about both margins and volumes and again, at the analyst's conference call we thought or were expected that we could get agency-related executions based on an expectation of roughly 50 basis point gain on sale roughly $2.5 billion per month in originations. We think that given the restructuring we've done in the mortgage business, that it can be in the black on an operating basis, and we'd expect that to occur in the fourth quarter of this year.
I don't see any reason should that continue that we'd continue to earn operating profit in that business going forward.
Rob, with regards to the growing delinquent loans, how are you handling borrower negotiations and do you handle requests to renegotiate and how do you decide to renegotiate when you do?
Well, our practices are consistent with what we've done in the past, which is it's always our goal to work with our customers for a beneficial outcome for both them and for the bank. I would say that as it relates to the Legacy First Franklin book, we have instituted a calling tree, calling 90 days ahead of time to any customer that is going to have a rate reset. We think that's an important thing to do so we can actually work with that person in front of the rate reset to kind of go over the math and determine what is their ability to handle that type of increase or not.
We have changed our behavior as it relates to that particular portfolio.
How are you managing foreclosures?
Well, we are managing foreclosures no differently than we have in the past. What I would tell you is that to-date the turnover in the foreclosure activity is pretty consistent with where it's been, which is a little bit of a surprise to me. I thought it would have lengthened out at this point. We are still managing through those as we always have.
How much of the increase in MPAs was due to loans that were previously held for sale and were subsequently transferred into the portfolio.
Well, none because those are home equity loans and those wouldn't be hitting in MPA anyway. So there's nothing there.
What percent of second lien home equity loans on the run-off portfolio are you behind your owned first?
How much of the provision in the quarter was related to non-reoccurring items such as the transfer of loans held for sale to held for investment, and how much pertained to fundamental trends?
Well, I guess probably the easiest way to handle that would be to look at slide 10 and look at the different buckets. Obviously the national home equity run-off book is comprised of stuff that was coming back from homes held for sale as well as the vintage portfolio. A fair amount of that provision was due to stuff coming back from held for sale. So I would describe that as nonrecurring.
The residential construction book I would also describe as an action that we took that is not really due to fundamental trends but is due to that particular portfolio as we have talked in the past, with some issues about not having the equity upfront on the deal. The rest of it is more fundamental trends going on in the market place today.
How much in non-performing loan increases were from Harbor and Fidelity?
I think about $16 million to $20 million was from Harbor and Fidelity.
Do you expect to have to over provide by a similar amount in the fourth quarter?
No I don't. But what I'm getting to is if we knew that today and that would be the basis for having already taken that type of reserve action. So the reserve actions we have taken today are consistent with what we think of the future. That's what we are talking about today.
Jill, anymore questions.
We are through with the questions. Thanks, everyone, for their participation and we'll go through the closing comments now. Thank you.
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