National City Corporation (NCC) Q3 2007 Earnings Call October 24, 0000 11:00 AM ET
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
Welcome to the National Citythird quarter 2007 earnings conference call. (Operator Instructions) I wouldlike 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 CityCorporation's third quarter earnings conference call.
Let me remind you that the presentation and commentary thatyou are about to hear will contain forward-looking statements. Such statementsare based on presently available information and on management's currentexpectations. We believe these statements to be reasonable, but they aresubject to numerous risks and uncertainties as described in our Form 10-K andother 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-lookingstatements at some future point; however, we specifically disclaim anyobligation to do so.
We have several members of the management team on hand thismorning including Peter Raskind, President and CEO; Jeff Kelly, Vice Chairmanand CFO; Jim Bell, Chief Risk Officer; Rob Rowe, Chief Credit Officer; and JillHennessy, Investor Relations Manager. Jeff, Rob and Peter will each have someremarks on the results and the outlook followed by a question-and-answersession which, per our usual practice, will be conducted by email.
To ask a question, simply send us an email at any timeduring the conference to email@example.com. We'll take asmany questions as time permits.
Before I turn the program over to Jeff, I want to make youaware of a couple of items relative to our financial disclosures. In additionto the news release and our regular quarterly financial supplement, thismorning we also published a separate slide deck containing details on loansheld for sale and a variety of loan and credit statistics. Both Jeff Kelly andRob Rowe will be referring to this document during their remarks so you'll wantto be sure that you have it handy. It's available on NationalCity.com in theinvestor relations section.
Secondly, as you know, for the last several years we havebeen publishing a mid quarter update during the third month of each quarter. Anumber of other banks have been following a similar practice, but have sincestopped, such that today I believe that we are the only bank still providing aregularly scheduled mid-quarter update. In light of that circumstance, andconsidering the time and effort involved in producing the update, we conductedan informal poll among analysts and investors relative to its ongoing usefulness.While nearly everyone found it useful, a number of respondents noted that itseemed to encourage short-term speculation in the stock; certainly not ourintent or expectation when we started issuing the update.
Taking all of the feedback and the various pros and consinto consideration, we have decided to finish out this year and then eliminatethe mid quarter update beginning in 2008. So the one published this comingDecember will be our last one. We will continue to provide monthly financialdata 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. Infact, we expect to continue to expand and enhance the quarterly supplementbased 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 ouranalyst conference last month and again in our mid-quarter update, the third quarterresults included some significant mortgage-related charges and lossesreflective 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 quarterinclude the following:
We suspended origination of broker-sourced home equityloans. We moved non-salable warehouse inventory into our loan portfolio,narrowed the product set of the mortgage company to agency-eligible firstmortgages and high quality jumbos; and took steps to reduce the mortgagebanking and supporting workforce by about 1,600 FTE, most of which will comeout by year end.
As a result of those actions and the general deteriorationin the mortgage markets, the mortgage banking unit posted a net loss of $152million for the third quarter, including all of the charges discussed lastmonth, and also including approximately $40 million in after-tax net MSRhedging gains. Mark-to-market adjustments and scratch-and-dent losses turnedout to be lower than we had projected.
Severance and asset impairment charges were somewhat higherthan forecast, and credit provisions were meaningfully higher than weanticipated back around the analyst conference. Rob Rowe will cover that pointin a few minutes in his prepared remarks.
At quarter end, we have loans in our mortgage warehousetotaling about $11.5 billion, detailed on page 2 of the supplemental handoutthat Tom referenced earlier. Other than agency-eligible mortgages, thevaluation of loans held for sale was a challenging exercise last quarter, dueto the dearth of market trading or even bids in the market.
In valuing non-agency loans, seconds and HELOCs, weincorporated estimates of trade fallout for loans under contract to sell wherewe had reason to believe that a counterparty will ultimately fail to settlesome or all of the loans they had contracted to buy, or that some loans will bekicked out prior to the settlement of those trades for documentation reasons.
Absent some recovery in the market, it is likely that suchkickouts will be moved into the portfolio as they occur. We also incorporatedan estimate of the likely scratch-and-dent loss content of the remaining loansnot under contract to sell. Because the majority of the loans held for sale butnot under contract are agency eligible, we expect the trade fallout -- andthus, scratch-and-dent losses -- will bematerially lower going forward.
Obviously though, because we are dealing with estimates andbecause the state of the market is so uncertain, we probably have a greaterthan 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 beoff the mark, they are subject to true up in the fourth quarter which couldresult in either additional charges or gains, depending on the direction of themarket from this point.
Beyond the third quarter restructuring actions notedpreviously, we initiated further restructuring of the mortgage business in October.We are closing our correspondent lending business and making some othermanagement changes in our mortgage business. Approximately 100 additional staff cuts willoccur, bringing the cumulative employment reduction in mortgage banking andrelated support functions to 1,700 or so in the second half of this year. As aresult, the fourth quarter will include some additional severance andassociated charges.
As we discussed at our analyst conference in earlySeptember, our intent is to resize and reshape the mortgage company to be morefocused on retail and agency-eligible mortgage lending and to be profitable inan environment likely to witness a much lower level of volume than has existedbroadly in the market, and for us in particular. Given the changes that I notedearlier, our best guess today is that we'll see originations of about $30billion in 2008.
The disruptions in the market in the third quarter alsoaffected our capital plans. At the beginning of this year, the declining levelof mortgage risk on our balance sheet prompted the deployment of excess capitalthrough stock repurchase to move our capital ratios to the bottom of theirtarget ranges. The abrupt changes in the mortgage and credit markets in thethird 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 andthus, necessitated a rethinking of our capital plans.
In our view -- and I have mentioned this at our analystconference -- it now seems appropriate to allow our capital ratios to migratetowards the top of their respective target ranges and in the case of our tier 1capital 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-basedcapital ratio. As I said, we did implement an increase in this target range ofabout 0.5%.
In the absence of issuing capital securities of some type,the increases I described in those ratios will occur naturally over the nextseveral quarters as the balance sheet shrinks from here and retained earningsaccumulate. During the third quarter, we did issue some tier 1 hybrid capitalsecurities and we would consider the issuance of some additional tier 1 hybridcapital, should the opportunity present itself.
In sum, the quarterly results were dominated bymortgage-related issues which obviously hurt our financial performance. We havetaken fairly aggressive steps in repositioning the mortgage business, butconditions will probably require continued vigilance for some time to come.
In the interest of time, I have not covered the more routineaspects of the quarter this morning, but would be happy to do so during theQ&A, to the extent there's interest in that.
With that, I'll turn the floor over to Rob Rowe to discusscredit issues.
Thanks, Jeff. Goodmorning, everyone. We have provided to all of you supplemental data which wewill utilize as a tool to describe the third quarter credit performance. Beforewe move to the deck, note that National Cityhas significantly increased its loan loss reserve during the quarter. The extraprovisioning is somewhat above the top end of reserves estimated during theinvestor presentation in September.
We believe that the contraction of capital in the realestate sector has obviously led to a very different and difficult environment. Althoughit is not easy to simulate the new reality, we have attempted to do so in ourreserving approach.
With that preface, please turn to slide 3 in the handout which summarizes theloan portfolio per our consolidated balance sheet. Broadly speaking, there arefour major categories to address, as depicted on the chart: commercial,commercial real estate, residential real estate and consumer. Most of ourcomments will focus on the real estate categories but first, let's address thecommercial and consumer books.
The commercial loan portfolio totaling $34 billion includingleases, is as we have said in the past, very granular, diverse and hasperformed well. The same statement could be made today. All credit metrics inthe commercial portfolio -- non-performing assets, net charge-offs and pastdues -- are very low and representative of the very high operating margins thatmuch of our commercial base is performing at.
The consumer portfolio, just over $8 billion is, likewisevery stable and has also performed well. In particular, note that the creditcard and other unsecured line of credit portfolio which totals approximately $3.5billion which was repositioned a couple of years ago to serve as relationshipproduct, has exhibited low and stable delinquency trends.
The middle of the chart depicts real estate; $23 billioncommercial and $47 billion residential. The $23 billion of commercial realestate exposure is laid out on the next slide, page 4, showing a breakdown bygeography and loan type. Again, you can see the diversity and relative lack ofconcentration by product type in this portfolio. From a credit qualityperspective, please focus on the first two rows depicted in both boldface whichrepresents direct exposure to the U.S.housing market.
The performance of the residential development and landdevelopment portfolio has varied by location. For your reference, thenon-performing asset percentage of Michigan,Florida, and the national groupis more than double that of the rest of the National Cityfootprint. The traditional Midwestern footprint did not have significant priceappreciation and thus, was less susceptible to speculative activity.
The primary point is that at the current time, the stress weare having is primarily emanating from the residential development activity of Michigan,Florida and the nationalbusiness. 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 ourstringent 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 intovarious sub-segments. The starting point is slide 5, summarizing the majorcategories of residential real estate and home equity. The top half of the pagedepicts the portfolios associated with our core businesses, low-risk customerportfolios that are performing well. The bottom half of the slide representsour run-off portfolios whose sub-segments are exhibiting varying degrees ofrisk and loss development.
Please turn now to slide 6 which reflect the direct homeequity portfolio originated through our branch network and consisting of bothlines and loans. At the bottom of the chart, we have provided you a trend lineof charge-offs and 90 days past due. For the first three quarters ourannualized charge-off rate is 23 basis points, which is very low. The top ofthe chart stratifies the portfolio by FICO score and loan to value. The averageFICO is 733, the weighted average loan to value is 72.5%. For the loans withloan to value greater than 90%, we have mortgage insurance. We believe theperformance 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 theprime first mortgage we want to discuss this morning, and that is theresidential construction book, approximately $3.1 billion consisting of loansto individuals to finance home construction. The bulk of the portfolio is to individualsto build their primary home. I spoke last month about a particular subset ofthis portfolio, approximately $400 million, representing financing extended toindividuals to build speculative properties, primarily in Florida.
With the downdraft in real estate prices, the economicincentive to do the deal has gone away and many of the borrowers have decidednot to build and have stopped making payments or are expected to. In essence, National City has a portfolio of lot development loans toindividuals at high loan to values because the equity in the deal was notrequired until construction of the home began. We have decided to set asideapproximately $50 million of reserves for this specific portfolio, given ourcurrent 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 Fidelitylending book.
That brings us to the run-off portfolios, which account forthe lion’s share of delinquencies and non-performing assets, as well as a goodportion of our reserve build this quarter. These consist of the former FirstFranklin book of first lien sub-prime and second lien sub-prime loans and theNational Home Equity portfolio, including loans transferred from held-for-salein early August.
We will start with the non-prime portfolio on page 8. Lossesfor the non-prime first liens and second liens have been broken out. In themiddle of the chart, loan losses for the first liens have been averaging $6million per quarter, less than 50 basis points on an annualized basis for thefirst nine months. We would not expect that the future level of charge-offs forthe first lien book to materially deviate from the current run rate.
As we have described in the past, the action is in theperformance of the second lien portfolio which totals $1.7 billion. During thethird 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 themonth of September. It appears that the rate resetting of the first liens infront of those second liens is leading to increased delinquency. With littleliquidity 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 oflender-paid mortgage insurance that have been exhibiting different claimspayment performance; one paying essentially all valid claims and the otherrejecting an inappropriately large number. While we would comment that therescission rate on the insurance claims with the second insurer declined duringthe last quarter, payment of claims continues to be below expectations.Therefore, we have not made changes to the underlying assumptions establishedin 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 billionof national home equity loans and lines that were declared to be no longersaleable. Thus, the total national home equity run-off portfolio now totals$10.7 billion. Note that both the original held-for-investment book andheld-for-sale book share similar characteristics in terms of loan to value andFICO and purpose, except that the held-for-sale book held higher percentage ofstated income, roughly 40% versus the original 10%.
The time series at the bottom of the chart shows charge-offsfor the $10.7 billion portfolio for the third quarter. Given that the original held-for-investmentbook is performing consistent with prior periods, it is apparent that therecently transferred held-for-sale book is exhibiting higher delinquency andpotentially higher loss content than was assumed 45 days ago.
Because of the worsening trends, we have placed additionalloan loss reserve against the portfolio that was moved from held-for-sale. Thisreflects the current level of loss development and delinquency as well assignificantly 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 ofthe provision applied to each of these portfolios for the third quarter. Insummary, we conducted a thorough review of all the loan portfolios, rigorouslyevaluated the trends and current environment and increased our reserves to alevel that we believe is appropriate. While we cannot predict what will happenin the market in the coming months or quarters, reserve actions taken in thethird quarter represent our view of the expected loss inherent in the loanportfolio. 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 viewof the quarter.
Thank you, Rob. While mortgage and the related credit issuesare understandably dominating the agenda this morning, I do want to brieflytouch on the performance in the rest of the company. Core deposit and loangrowth were reasonably good in both the corporate and retail bankingbusinesses. Excluding acquisitions and escrow deposits, average core depositswere 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 thoseassociated with residential real estate were stable.
The net interest margin declined in the quarter due to a morecostly funding mix resulting from a larger balance sheet. At the same time,corporate loan spreads continue to be narrower than planned in the previousyear. While it's a tough operating environment, the core retail, corporate andwealth management businesses are competing well. These businesses have clear,coherent operating plans and we are executing well against them.
While our Floridaacquisitions are certainly facing some initial headwinds due to the slowed realestate environment there, the conversion events are behind us and we are makingsteady progress. All that said, I think we can and should do better in each ofour businesses and overall.
At our investor conference last month, I spoke about sixareas that we are particularly focused on in the near term, all of which are ultimatelydirected to the same outcome, and that is to significantly improve thefinancial performance of National Cityfrom this point forward. Briefly, those six areas of focus are:
First, continuing to improve our share of wallet amongbusinesses 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 thisone in a moment.
Fourth, restructure and improve our mortgage business, asJeff spoke about earlier.
Fifth, integrate our recent acquisitions -- Florida,Chicago, Wisconsin-- to bring them up to the performance levels commensurate with the potentialidentified at the time of purchase. The Florida banks are fully converted andintegrated from a systems and branding perspective. MAS closed in September andwill convert in the first quarter of 2008.
Sixth and finally, instill a heightened sense ofaccountability across our entire organization.
While we have identified these as near-term objectives, mostof them are processes that take place over some period of time. However, two ofthem have particular immediacy and they are the restructuring of our mortgagebusiness, and cost management generally throughout the company. We are in themortgage business because the home mortgage is an essential consumer product.Implicit in our goal of becoming the best retail bank is also to be afirst-rate mortgage provider. The mortgage unit, as it was configured earlierthis year, was not in a position to do well in the mortgage environment that wenow foresee over the next couple of years. As Jeff discussed in his remarks, weare narrowing the focus of the business and adjusting its capacity to therealities of the mortgage market going forward.
Beyond the immediate effect of the problems in the mortgageunit, it seems clear that the weak housing market portends a weaker economygenerally in the year ahead. Revenue growth will be harder to come by foreveryone, which means that cost management is crucial to achieve theperformance to which we aspire.
To that end, we began this month to initiate some fairlystrenuous cost cuts throughout the company, primarily in support functions, inorder to configure ourselves for a better 2008 and beyond. As of today, we havenearly all of the cuts completed, and hardwired into every business unit's planfor next year. Combined with the mortgage cutbacks, which Jeff describedearlier, they represent a headcount reduction of approximately 2,500 positionsfrom September 30 levels with an associated expense impact of approximately$125 million. As a result, we will be incurring some additional charges in thefourth quarter of around $40 million, mainly severance.
Getting from where we started earlier this year to where weneed to be by year end is not pleasant or fun, to be sure. But, inaction is simplynot an option. Our current level of overall performance is unacceptable.Restoring an acceptable level of profitability is job one and we will do whatneeds 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 bridgeloans and underwriting commitments?
Well, at the current time, we have one transaction that wehave described previously, which is a corporate to corporate LBO, where we havea $20 million exposure to a senior subordinated bridge loan.
Please comment onwhether National City has exposureto Newman Brothers, the Chicagobuilder that is expected to file bankruptcy shortly?
We currently do nothave any exposure to Newman Brothers or any project financing that NewmanBrothers has undertaken.
Can you please discuss the issue of severity versusfrequency of losses in home equity loans and lines?
Right now, I would say that for us or for anybody in theindustry, we would pretty much be modeling that severity as 100% write-off of ahome equity loan. So, the decision point would really be what is the frequencyor what is the default probability of the home equities? But at the currenttime, I believe we pretty much have only have a 5% recovery rate on the homeequity loans that do default.
Jeff, there have been a number of questions related tomargin 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 themargin decline that we saw in the quarter was certainly more than we hadanticipated on our last call where we discussed this, and I bucket the changesin the margin on a quarter-over-quarter basis into five areas.
The first would be the acquisition of MAF. MAF, theirbusiness model, their balance sheet had a much narrower margin than National City's prior to its acquisition and it's merecombination with the company had the effect of reducing our margin for thequarter by about 4 basis points.
The second area that I would talk about would relate to ourdeposits both in terms of mix and rate because both were unfavorable comparedwith the second quarter. So, from a mix standpoint, we saw fewer escrowdeposits due to slower mortgage prepays and we also saw a higher component ofour deposit book in CDs.
In terms of rates, rates on checking and money marketsavings were slightly higher in the third quarter and I would attribute thatgenerally to money market conditions as well as competitive conditions.
The third area that I described relates to those moneymarket conditions and that's really what I refer to as the prime LIBOR basissqueeze from both a rate and a mix standpoint. Normally, when short-term ratesdecline, such as occurred during the third quarter at least in terms of the Fedfund rate, you see prime decline but you generally see one and three month andsix month LIBOR lead that decline.
We are a net receiver of prime and a net payer of LIBOR andwhat actually happened was even though prime went down in the quarter followingthe Fed funds decline, LIBOR actually spiked up in some instances duringquarter and that change in the basis negatively impacted our margin as well. Iwould say that the impact there probably cost us about 2 basis points, and Iwould say that the overall mix and rate change on core deposits was about 7basis points.
Also, just in terms of our purchase funding, we did do ahybrid debt issuance during the quarter and that cost us about 1 basis pointduring the quarter.
The final bucket was probably related just to the generalincrease that we have seen in higher, non-accrual loans on the books and thatprobably contributed a couple of basis points.
So I think that pretty much covers the change from thesecond quarter to the third quarter. So let me spend just a couple of minuteson what we would think would be trends going forward in the margin. I'd prefacethat 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 themargin caused by the addition of MAF to our books should ease going forward andthe margin, I would think on that balance sheet would expand as it becomes morebank-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. Thesqueeze that we have seen in the third quarter should dissipate over time andcatch up, particularly in an environment where short-term rates are stable forsome period of time.
How that occurs, how quickly market rates decline or how farthey decline and where they generally shake out will determine the pace of thatlessening of the core deposit squeeze but we do expect to see a lessening ofthat going forward.
The LIBOR prime basis pressure could remain for a while. We'llclearly benefit when this normalizes, but that would really be contingent uponeasing of the liquidity concerns in the market.
I would just say the loan related issues as it relates tonon-performing, non-accrual at least, will depend on the credit outlookgenerally. I would say in looking at themargin overall, we'd expect the next quarter or two probably to see a modestdecline and then our guess would be that we would begin to see some recovery inthe margin in the second half of 2008.
How did the Fed ratecut affect the bank in the third quarter and what is the likely effect goingforward?
Well, I describedsome of that in my previous comments, but as you can see if you look at ourinterest rate risk position on page 14 of the supplement, we do have a positiveduration of equity so generally, a favorable exposure to declining interestrates. Although not extreme by any measure, that risk position or favorableexposure to declining interest rates is higher than it has been in severalyears.
So generally, as I said, we'd expect the Fed rate cut tohave a positive effect on net interest income and our net interest margin butas I said, some of the money market anomalies that occurred in the thirdquarter dampened that to some degree. I'd expect, as those rate cuts aresustained or even continue, I'd expect it to have a positive impact on ourmargin.
Tom, a question foryou. What's behind the very low effective tax rate for the third quarter?
Thanks, Jill. Forreference, you may have noticed that the rates in the third quarter wassomewhere in the low 20s and typically the tax rate would be somewhere in thelow to mid-30s. There are actually no one-time adjustments to tax that affectedthe quarter. In fact, the one-time adjustments were unfavorable to the taxrate.
The main reason and really the reason for the low rate isthe lower level of taxable income for the year. We have fixed dollar amounts ofcredits that are part of our tax-based calculation and at a lower level oftaxable income, those benefits have a higher percentage effect.
So, as taxable income resumes or is restored to levels morein tune with historical patterns, that rate will naturally gravitate up towhere it has typically been, which would be in the low 30s.
I will address thisquestion 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 onecontingent funding arrangement with approximate $400 million exposure to aconduit through which it is securitized, sub-prime automotive paper. As amatter of business practice, we don't have any other relationships, any creditextensions 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 ofRepresentatives, Alfonso Jackson, the Secretary of Housing and UrbanDevelopment, suggested that one-quarter of homeowners with sub-prime mortgagesscheduled to have resets over the next 18 months were likely to lose theirhouses. Applying this 25% ratio to the total sub-prime mortgage exposure ofNational City, both to sub-prime mortgages owned and owned derivatively throughcollateralized debt obligations or where National City has exposure, if thebank had to foreclose on the collateral for these mortgages and sell theunderlying property for an extreme hypothetical of one-half the face value ofeach mortgage, given the bank's level of loan loss reserves and capital, whatwould be the effect on the bank's operations?
Well, when you lookat the non-prime book at National City,it's made up of both first liens and second liens. The ultimate outcome, aswe'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 firstlien 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 weonly have a $600 million book of business that will be subjected to rate resetswhere 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 lossseverity 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 thatwould be half of that. So that's a $75 million nut.
What I would highlight for you is that we have been trackingsince October of last year what exactly does rate reset activity mean? The lastdata point we have is the month of August, which was around 12% to 14%delinquency generated from rate reset activity. So the assumptions that areunderlying the question are extreme and far more severe than we have seen yetto date.
On the second lien part folio, we have approximately $600million of content that will have rate reset in front of it over the next 18months. 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 $150million, we are insured, as you know, and given the current payment rate of oneof the two insurers, we would expect that they would pay their $50 millionclaim. We'd really be left with a $100 million nut of which, at the currentrate of payment, which I don't want to fully describe, we would expect we'd besomewhere in the middle of that range from a loss content.
What I would assure you in our calculations when we aresimulating the current environment, we have assumed delinquencies that aregenerated from rate resets and we have also assumed loss severities that arehigher than we have seen traditionally. So, it is my view that at the currenttime, although it's a great question and certainly the assumptions underlyingit might be reached at some point, we believe that we are appropriatelyreserved for the potential outcomes.
Strong growth in thethird quarter in commercial construction and commercial real estate portfolios.Where are you getting this in the current environment?
Well, I believe theMAF book is included in the third quarter and is not included in the secondquarter and MAF now has around a $600 million to $800 million multi-familyportfolio 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 retailas well.
So if you factor those in, I believe the increase on alinked-quarter basis would look more normalized, plus with the lack ofliquidity in the marketplace, there's probably some deals that have workedthat's now stabilized, gone from construction to stabilization and cannot goout to the CMVS market, so that probably also provided some lift for thequarter.
In general, should weexpect additional reserve build going forward?
Well, I would stateright up front that the current level of reserves today is driven by ourexpectations of the performance of the portfolio going forward. It's not drivenby 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, thisis a difficult environment to simulate and we just have to keep it at that. Webelieve we are appropriately reserved today.
Jeff, how much is theresidential mortgage non-performing loans and 90-day past due increase is fromalt-A loans transferring back to portfolio.
I will take that one,Jill. There's zero content for that transfer back.
Jeff, can you pleasetalk about capital strength in the context of what would cause the currentdividend to be at risk? What would make you reevaluate your dividend policy?
Well, let me say thatI think given both our current capital position and our intention to allowcapital to rise over the next several quarters within the target ranges that Idescribed and in the context of those target ranges that we see no need to andhave no intention of reducing the dividend. We have always believed this is avery important component of our total return to shareholders and have alwayssought not only to pay it every year but frankly to increase it every year.
While I would certainly admit that our dividend payout ratiois clearly above our long-term target of 45%, I remind all that this is along-term target and there have certainly been time periods in the past whenour actual payout ratio has exceeded that level. So I think many of thefactors, at least recently, that have contributed to that actual payout ratiobeing somewhat above our target, we consider to be short-term and indeed, inmany cases, one-time in nature.
As Peter mentioned in his comments, we're focused onimproving the financial performance of the company and we believe that'sachievable and therefore, we see no need to or have no intention of cutting thedividend.
Peter, how much doyou plan to cut in non-personnel expenses and in what types of categories?
Thanks, Jill. As Imentioned earlier in my comments, we have nearly completed our 2008 budgetprocess. 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 inemployment will have some follow-on effects, in terms of other expensecategories related to things like travel, entertainment and so on, and justother areas where expense arises from positions that won't be there in thefuture.
But I think furthermore and probably more important, as wego through the budget process, we are scrutinizing every category of the incomestatement, whether it be revenue or expense as we head into planning for andthen achieving a better 2008. So a very natural outgrowth of our budget processand 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 ofexpenses. I think that will occur very naturally as an outgrowth of the budgetprocess, and I might add much better procurement processes that we now have inplace as a result of our best-in-class initiative.
In the Visaperspective, National City ishighlighted 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 youexpect to recognize that value?
As a result of our issuance activity and our formerownership with MPC we do have an unusually large stake in the newlyrestructured Visa. As I suspect many of you are aware, Visa restructured inearly October into an independent for-profit company with the ultimate intentof taking that company public. As a result of our approximately 8% share inVisa USA, weend up with a share in the new Visa, the new worldwide Visa, somewhere between4.5% and 5% of a good-sized entity.
There's quite a bit of discussion going on right now betweenthe various banks involved and the SEC as to exactly how the accounting shouldoccur for this transaction. That is not yet fully resolved. So therestructuring has already occurred. There will be, we hope, resolution withinthe next several weeks by way of the SEC as to whether that restructuringcreates an accounting event or not.
But even if it does not, there is an expectation that thecompany will go public some time next year and therefore, presumably at thattime a gain would be realized. I would not at all engage in speculation as towhat the size of that gain is going to be yet today, but given the size of Visaand our stake in Visa, there's reason to believe that it will be sizable.
What level of mortgage and home equity loan originations areyou comfortable originating on a quarterly basis, assuming that capital marketsdo not open up any further?
Our best guess is at this time, given the product set thatwe're originating, which I referred to earlier in my comments, we think thelikely monthly originations are in the vicinity of $2.5 billion, so on aquarterly basis that's obviously times three, so about $7.5 billion. I wouldsay there is an extremely small amount -- effectively none -- of home equity froma National standpoint within that just because we do not see the markets forhome equity product opening up in any material fashion.
My level of comfort with our level of originations is more afunction 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 thecapital markets to open up and sell and avail ourselves of more product that wecould sell. We would be comfortable in expanding some of the product offeringsinto the non-agency area, including home equity.
Another question pertaining to mortgage banking. When do youexpect 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 thequestion. The first part of the question, I would answer the same way weanswered at the analyst's conference call. I think given what I consider to benon-heroic assumptions about both margins and volumes and again, at theanalyst's conference call we thought or were expected that we could getagency-related executions based on an expectation of roughly 50 basis pointgain on sale roughly $2.5 billion per month in originations. We think thatgiven the restructuring we've done in the mortgage business, that it can be inthe black on an operating basis, and we'd expect that to occur in the fourthquarter of this year.
I don't see any reason should that continue that we'dcontinue to earn operating profit in that business going forward.
Rob, with regards to the growing delinquent loans, how areyou handling borrower negotiations and do you handle requests to renegotiateand how do you decide to renegotiate when you do?
Well, our practicesare consistent with what we've done in the past, which is it's always our goalto work with our customers for a beneficial outcome for both them and for thebank. I would say that as it relates to the Legacy First Franklin book, we haveinstituted a calling tree, calling 90 days ahead of time to any customer thatis going to have a rate reset. We think that's an important thing to do so wecan actually work with that person in front of the rate reset to kind of goover the math and determine what is their ability to handle that type ofincrease or not.
We have changed our behavior as it relates to thatparticular portfolio.
How are you managing foreclosures?
Well, we are managingforeclosures no differently than we have in the past. What I would tell you isthat to-date the turnover in the foreclosure activity is pretty consistent withwhere it's been, which is a little bit of a surprise to me. I thought it wouldhave lengthened out at this point. We are still managing through those as wealways have.
How much of the increase in MPAs was due to loans that werepreviously held for sale and were subsequently transferred into the portfolio.
Well, none because those are home equity loans and thosewouldn't be hitting in MPA anyway. So there's nothing there.
What percent of second lien home equity loans on the run-offportfolio are you behind your owned first?
How much of the provision in the quarter was related tonon-reoccurring items such as the transfer of loans held for sale to held forinvestment, and how much pertained to fundamental trends?
Well, I guessprobably the easiest way to handle that would be to look at slide 10 and lookat the different buckets. Obviously the national home equity run-off book iscomprised of stuff that was coming back from homes held for sale as well as thevintage portfolio. A fair amount of that provision was due to stuff coming backfrom held for sale. So I would describe that as nonrecurring.
The residential construction book I would also describe asan action that we took that is not really due to fundamental trends but is dueto that particular portfolio as we have talked in the past, with some issuesabout not having the equity upfront on the deal. The rest of it is morefundamental trends going on in the market place today.
How much innon-performing loan increases were from Harbor and Fidelity?
I think about $16 millionto $20 million was from Harbor and Fidelity.
Do you expect to have to over provide by a similar amount inthe fourth quarter?
No I don't. But what I'm getting to is if we knew that todayand that would be the basis for having already taken that type of reserveaction. So the reserve actions we have taken today are consistent with what wethink of the future. That's what we are talking about today.
We are through with the questions. Thanks, everyone, fortheir participation and we'll go through the closing comments now. Thank you.
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