Marshall & Ilsley Q4 2007 Earnings Call Transcript

Marshall & Ilsley Corporation (MI)

Q4 2007 Earnings Call

January 15, 2008 12:00 pm ET

Executives

David L. Urban - Director, Investor Relations

Mark F. Furlong - President, Chief Executive Officer, Director

Gregory A. Smith - Chief Financial Officer, Senior Vice President

Analysts

Terry Mcevoy - Oppenheimer

Steven Alexopoulos - J.P. Morgan

Tony Davis - Stifel Nicolaus

Kevin St. Pierre - Sanford C. Bernstein

Eric Wasserstrom - UBS

David George - Robert Baird

Kenneth Usdin - Banc of America Securities

Heather Wolf - Merrill Lynch

Robert Rutschow - Deutsche Bank

Brad Vander Ploeg - Raymond James

Presentation

Operator

Welcome to M&I’s fourth quarter 2007 earnings conference call. My name is Luanne and I’ll be your conference operator today. (Operator Instructions) It is now my pleasure to introduce Dave Urban, Director of Investor Relations for M&I. Sir, you may begin your conference.

David L. Urban

Welcome to M&I's fourth quarter 2007 earnings conference call. The presenters for today’s call will be Mark Furlong, CEO and President, and Greg Smith, Chief Financial Officer. Mark will provide some introductory comments regarding the year and our strategy while Greg will review the fourth quarter financial results.

Before we begin, let me make a few preliminary comments. If you have not read our earnings release, you may access it along with supplemental financial information from the investor relations section of our website at www.micorp.com. Also before we start, I would like to mention that comments made during this call contain forward-looking statements concerning M&I's future operations and financial results. Such statements are subject to important factors which could cause M&I's actual results to differ materially from those anticipated by the forward-looking statements.

These factors are described in M&I's most recent Form 10-K and M&I's other SEC filings. Such factors are incorporated herein by reference.

For a reconciliation of the non-GAAP financial measures mentioned in this presentation to the most comparable financial measures calculated in accordance with GAAP, please refer to M&I's website at www.micorp.com.

And now I will turn the call over to our CEO and President, Mark Furlong.

Mark F. Furlong

Thank you, Dave. I have a few comments about 2007 and some thoughts about what’s ahead in 2008. After Greg has reviewed our financials, we’ll both be available for questions.

2007 was marked by several successes but we ended the year in unfamiliar territory. Historically, we have benefited from solid credit quality even during weak economic cycles, but that is not the case in this cycle. There are two key matters worth discussing.

The first is the well-reported relationship with Franklin through our correspondent relationship with Sky Bank, which is now part of Huntington Bank. We worked closely with Huntington Bank in finding a resolution to this matter. We took a conservative approach to arriving at a $48 million charge-off, of which $28 million has no chance of recovery but of which the remaining $20 million has some chance of recovery, possibly as soon as in three years.

We do not expect further losses as we wind down this relationship.

The second matter is our involvement with smaller, locally owned developers in our construction and development business. These issues reside in three places -- the largest is the former gold franchise on the West Coast of Florida. Each of these troubled developer relationships were originated prior to our acquisition and were not evident in the fall of 2005 when we performed due diligence prior to our acquisition announcement.

The second largest is in our Arizona business and relates to long-time relationships where our customers had multiple successful developments and got caught when the real estate market slowed. We have a solid group of bankers and a very good market which will recover over time and we will participate as that market recovers.

And the final aspect of charge-offs came from our correspondent business, which had experienced no charge-offs in 10 years. This underlying customer base experienced a similar fate as our Arizona business.

Our analysis of all aspects of our construction and development business was a detailed loan-by-loan, ground up review. There remains a good chance additional loans will move into non-performing status in the next few quarters as the real estate market continues to shake out.

We believe our assessment of loss is conservative though it is difficult to predict the exact length and depth of this real estate cycle slowdown and the ultimate manner in which we will dispose of these assets. However, we will deal with these matters and return M&I to a level of solid credit quality.

On the positive side, performing well this year were the growth in credit quality of our CNI and non-housing commercial real estate businesses. The credit quality of the smaller loan relationships developed in our business banking segment and our other consumer portfolios, including our home equity portfolio, and the continued success of our wealth management businesses. Greg will share more with you shortly.

We also added a strong group of bankers in Orlando and Minneapolis this year. In their short time with M&I, they have proven to be very good executives and their customer relationships are of sound credit quality. The wealth management business added North Star in the second quarter and this team, specializing in tax deferred exchanges, land trust, and ESOPs, has integrated very well into the company.

On January 1st, we added a new team in Indianapolis with a solid management team already in place. In a couple of weeks, we will complete the systems conversion. We fully expect the Indianapolis team to fit well in our company.

As 2008 progresses, though there are some headwinds in the economy, there are many aspects completely in our control. We are confident we will make progress on the non-performing loans from the construction and development business and in growing our remaining businesses in each market.

For a well capitalized bank like M&I, we will find opportunities, even in today’s market, to continue to grow as a successful regional bank. At this point, let me turn the call over to Greg.

Gregory A. Smith

Thanks, Mark. By now you’ve had an opportunity to see our press release and supplemental financial information. In addition, we have included more detailed credit quality slides on our website, as we did last quarter.

As Mark noted, our fourth quarter results reflect a challenging operating environment that confronts banks, though we continue to view our core businesses as having a good growth profile over time.

Clearly our financial results this quarter reflect a number of one-time events. As these are discussed in our press release, we won’t go through them in detail but they do include the following items on an after-tax basis: the Visa related reserves totaling $17 million; discontinued operations, which includes the Metavante gain and transaction costs totaling over $500 million; a one-time charitable contribution to the M&I foundation of $16 million; the termination cost of an unfavorable funding arrangement of $48 million; and the Tulsa branch sale gain of $17 million.

Now turning to our results; as highlighted in our press release, we reported $1.83 per share earnings for the fourth quarter. From the perspective of continuing operations, we are reporting a loss of $0.09 per share. In the same quarter last year, we reported $0.62 per share from continuing operations.

For the full year 2007, we reported earnings of $4.34 per share. This compares to $3.17 per share for 2006. From the perspective of continuing operations, we are reporting earnings of $1.87 per share, which compares to $2.54 per share last year.

In light of the credit comments that I’ll make shortly, and while it is certainly debatable what a normalized loan loss provision should be, we view our current earnings per share run-rate as being in the range of $0.58 to $0.60 per share.

As I discuss aspects of growth in our banking business from this point on, I will highlight organic growth for the combined franchise in an effort to give as clear a picture as possible of the underlying trends. Any balance sheet discussion comparing fourth quarter of 2007 with fourth quarter of 2006 will be adjusted for the United Heritage and Excel acquisitions. As you’ll recall, these acquisitions closed in April and July respectively.

Now for some additional insights into the quarter -- first, the net interest margin; our net interest margin increased by six basis points on a linked quarter basis to 3.13%. During the fourth quarter, our margin was positively impacted for two months by the cash realized in the Metavante separation, but was negatively impacted by non-accrual loans. We continue to expect that the net interest margin will experience modest compression. Like the industry in general, we expect to be challenged by competitive loan and deposit pricing, the movement of new and existing deposits into lower spread, higher yielding products, higher wholesale funding spreads, and of course the yield curve.

Any buy-back activity will further pressure the margin. There continue to be many variables that impact the margin, making it difficult to project this one data point with a high degree of accuracy.

Now moving on to our wealth management segment. Wealth management revenue increased 21% in the fourth quarter compared to the same quarter last year. Continued strong sales activities across our trust, asset management, and brokerage businesses contributed to the increase. Assets under management finished the year at $25.7 billion and assets under administration ended at $106 billion.

We had mentioned on the prior earnings call that we had been awarded mandates on two large short-term asset management opportunities. A portion of these assets was distributed during the quarter. However, because of strong in-flows, we partially offset these amounts.

Our sales activities for the quarter continued to provide strong revenue lift, especially in our institutional trust business lines. Our continued investments in the not-for-profit services and employee benefit segments are fueling strong growth in these areas. Our regional integration of trust, asset management, private banking, and brokerage is gaining significant traction and producing new relationships and expanding existing customer opportunities.

We continue to add new financial advisors to our retail platform and expect additional revenue lift in 2008. Brokerage customer assets were $9.3 billion at the end of the quarter. Given the strength in our pipelines, we expect to see continuation of our revenue expansion at high single to low double-digit percentage rates subject to market volatility and direction.

Moving on to other fee income components, service charges on deposits for the fourth quarter were $32 million, up 4% on a linked quarter basis and 14% from the same quarter of 2006. This increase is in both our commercial and community divisions.

Mortgage loan closings for the fourth quarter were $1.1 billion, which was down approximately 13% from the third quarter. As we have shown in previous mortgage cycles, our focus on the production side of the business reduces the volatility of our mortgage revenue stream.

A comment on capital management; during the fourth quarter, we repurchased approximately 4.5 million shares. This was accomplished both through accelerated share repurchase and open market activity.

As we noted earlier, we hope to continue our buy-back activity in 2008, depending on market conditions.

The bank continues to be focused on the redeployment of the capital generated through the Metavante separation. As we have previously indicated, we will prudently invest in our franchise as our top priority. These investments are expected to include new systems, sales people, and de novo branches in our expansion markets.

From an expense standpoint, total non-interest expense amounted to $446 million in the fourth quarter. This is a $153 million increase from the third quarter. Included in this increase are the charitable contribution expenses, the debt termination loss, and the Visa accrual, which in total amount to approximately $125 million.

Our efficiency ratio, when adjusted for the unusual expenses and the Tulsa branch gain, is 53.7% in comparison to 49.9% in the prior quarter. Looking prospectively, the bank efficiency ratio is expected to be in the area of 51% to 53% for 2008.

As we have noted before, we are updating many of our internal systems and expanding our de novos this year in a disciplined manner, particularly in the current operating environment. M&I will continue to be very focused on maintaining our historical expense discipline.

Now moving on to our credit quality trends, like other banks we noted continued deterioration in national residential real estate markets throughout the second half of 2007. But specifically at M&I, the construction and development portfolio has shown the most dramatic signs of stress. For the quarter, we realized total net charge-offs of $192 million, or 1.67%. For the year, we recognized net charge-offs of $256 million, or 59 basis points.

For the fourth quarter, we provided $235 million for loan losses, which is approximately $43 million in excess of net charge-offs. This excess provision has resulted in our quarter end allowance for loan losses being 1.07% of total loans.

For the year, we provided $320 million for loan losses, which is approximately $64 million in excess of net charge-offs.

For this discussion, we will discuss non-accrual loan trends, not non-performing loan trends. We are doing this to highlight portfolio trends without those trends being distorted by the Franklin relationship, which is a renegotiated loan but is not a non-accrual loan. We are receiving interest income on the $224 million of Franklin loans.

Our quarter end non-accrual loans totaled $687 million and were 1.48% of total loans. As we noted in our third quarter 10-Q, we undertook an aggressive review of our construction and development portfolio throughout the fourth quarter. Through this ongoing review, we identified credits totaling approximately $1.4 billion, which required further detailed credit analysis.

The estimated collateral values and repayment abilities of some customers led to our increased net charge-offs and loan loss provision this quarter, as we released in December. Our underlying economic assumption in taking these charges and provision is that 2008 will continue to be a difficult year for the residential markets.

The largest proportion of these charge-offs and provision were from the former Gold Bank franchise on the West Coast of Florida and the Arizona and correspondent portfolios. All of the West Coast of Florida exposures were originated prior to acquisition by M&I. Although more detail is provided in the credit slides, the charge-offs by business were as follows: $40 million for the West Coast of Florida; $26 million for Arizona; and $24 million for our correspondent business.

On the retail side, our team ran a detailed statistical review of our residential loan portfolios. This statistical review involved the mapping of properties by zip code as well as the review of pricing trends in those zip codes and updating FICO scores and loan to values on all the underlying properties.

In large part, this residential review focused on the Arizona market both because we have our most sizable, non-Wisconsin exposure there and because of the real estate trends in that marketplace. The results of this review indicate charge-offs will increase but will remain in an acceptable range.

With regard to Franklin, as we noted in November, we were a participating bank with Huntington in the Franklin relationship. At that time, our accruing outstanding loans were $282 million. Those accruing loan balances have subsequently declined to $224 million through a combination of pay downs and charge-offs.

As we have noted before, all of our Franklin related loans were performing but with the restructuring, we have moved this relationship to the renegotiated category. Under GAAP, these loans will be on non-performing but accruing status. We have taken charge-offs of $48 million or 17% of our principal.

We worked closely with Huntington during this restructuring and are comfortable that the process used to assess loss content is a bottoms up analysis based on the actual collateral. The final structure allows us to categorize $224 million of our relationship as renegotiated.

As such, interest on this balance is accruing and paid monthly. We expect these loans will perform as agreed to and will be reclassified as performing during the first quarter.

In terms of our expectations for the future, we continue to expect to see non-accrual loans and real estate owned to increase. As we have noted before, it is important to remember that most construction credits are complex and that it will take time for us or any lender to work through them. We are working with developers and others toward resolutions. Nonetheless, these resolutions will take time and any new situations may continue to be additive to our non-performers.

Sometimes the best resolution will be to take the underlying property to maximize our interest which will cause increases to REO for a period of time. As we expected, our REO increased this quarter to $115 million, which is up from $77 million in the prior quarter.

Like our loan portfolio, our REO is also very granular. The largest REO property is below $10 million. We have another two commercial properties over $5 million.

We continue to expect that REO balances will increase going forward and view this as a natural progression as we gain control of projects and move toward ultimate resolution.

A few final comments regarding credit quality -- as I mentioned earlier on this call, we have provided more detail regarding our non-accrual loans on the credit quality slides that appear on our webpage. Although I will not go through these slides individually, there are a few key trends to identify.

The CNI portfolio continues to perform well, with 34 basis points or approximately $50 million on non-accrual status. Our non-performing loans are concentrated in the construction related components of the commercial and residential real estate portfolios. For our residential and consumer portfolios, the loss and non-accrual levels continue to perform better than the bank as a whole.

To provide a little more granularity on our commercial non-accrual loans, the following may be helpful: our largest non-accrual loan is approximately $20 million and is a Florida multi-family credit, as we identified last quarter. More broadly, we continue to expect the multi-family portfolio to continue performing well.

We continue to aggressively manage our non-performing loans with the expectation that charge-offs over time will trend closer to our historical average. The stresses in the national housing markets will continue to affect us and we intend to continue addressing them proactively. We are committed to returning M&I to a level of solid credit quality.

Changing focus to the organic balance sheet growth trends compared to the same quarter in 2006, fourth quarter 2007 average loans were $45.4 billion, which is $3 billion, or 7% higher than the fourth quarter of 2006 average. CNI loans increased on average by $1.1 billion or 9%. For 2008, we expect CNI loan growth to post growth rates in the mid single digits.

Commercial real estate increased on average by $1 billion, or 7%. To repeat comments we made before, we continue to see softness in the construction market for residential developers and to some extent throughout the commercial real estate business. This has translated into slowing new construction throughout all of our markets, less investor activity in new construction units, and our expectation that CRE growth for 2008 will most likely be in the mid single digit percentage range.

Fundamentals in the apartment, hospitality, medical office, and warehousing segments are positive. Retail and office demonstrate some softening.

On the deposit side, there’s really only a couple of things to note, as many trends remain consistent with prior quarters. We continue to open net new DDA accounts in the retail division each month, although growing DDA balances has been more challenging as customers have opted to move excess liquidity into higher rate products.

Non-interest bearing deposits increased compared to the third quarter of 2007. As we have seen in prior years, our DDA balances grew in the fourth quarter, reflecting our usual seasonality and we expect our DDA balances to fall in the first quarter as they historically have.

Reflecting recent deposit market dynamics, the increased level of high priced competition has caused our bank issued deposits to be relatively flat in comparison to the fourth quarter of 2006 as we have maintained our pricing discipline.

A few final comments -- as we look toward 2008, we expect our financial results to reflect the benefit of the franchise investments but also include the cost of further investments as highlighted earlier on this call. Again, these include accelerated de novo growth, building out our product capabilities in our new markets, hiring the professionals to pursue that growth, providing those professionals with the tools to achieve our growth targets, and ­continuing to expand our wealth management business.

As you are aware, every economic cycle brings its own set of challenges. This economic cycle has been marked by a challenging yield curve, wider funding spreads, competitive pricing pressures on most loan products, slower absorption of housing in all of our markets, and normal movement between deposit products in search of higher yields.

On the other side of the equation are the positives we have witnessed and continue to believe will be part of our future at the bank, such as solid expansion in all of our bank markets, expansion of our wealth management businesses, a smooth integration of United Heritage, Excel, North Star, and First Indiana into M&I, and overall reasonably well-contained expense growth.

Through solid organic growth and acquisitions, we have made strides toward further diversifying M&I Bank’s geographical source of earnings. It is the combination of all these factors that provides us with the confidence of continued future growth.

This concludes our prepared remarks. Mark and I are now ready for the question-and-answer portion of the call. Operator, you may now open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Terry Mcevoy with Oppenheimer.

Terry Mcevoy - Oppenheimer

Good morning. Mark, you mentioned earlier about trying to wind down the relationship with Franklin Credit. Could you just run through a timeframe when you think that can occur?

Mark F. Furlong

It probably happens over a three to five-year period, most of the credit.

Terry Mcevoy - Oppenheimer

Okay, and then in terms of the wealth management revenue of $70 million, does that also include the loans, deposits, and the full relationship with a private banking customer? Or is that number even higher? And then in the future, given that it’s right around 10% of revenue, do you think you are going to break that out for us for some further clarity?

Gregory A. Smith

The private banking revenue would be separate from that, so that would indeed say that the wealth management business is higher. We are currently lining up exactly what that segment reporting is going to be when our 10-K comes out but I would fully expect that wealth management will be broken out as a separate business line.

Terry Mcevoy - Oppenheimer

Thank you.

Operator

Your next question comes from Steven Alexopoulos with J.P. Morgan.

Steven Alexopoulos - J.P. Morgan

Good afternoon, everyone. A couple of questions; Greg, looking at the $0.58 to $0.60 run-rate range that you gave before, what’s the amount of provision expense you are assuming for that range?

Gregory A. Smith

As we look at what a normalized provision might be, we sort of have taken a couple of cracks at it but there’s still a lot of uncertainty out there in the real estate markets and what we are looking at is a loan loss provision that’s in that $50 million to $55 million per quarter range. So certainly higher than what we had in any of the prior quarters in 2007.

Now, that will depend on the trends in the real estate market as well as how the disposition strategies move forward.

Steven Alexopoulos - J.P. Morgan

When you look at tangible equity post the first Indiana deal, I have it coming down to a little over 8%. I’m curious now looking forward when you think about using capital potentially for share buy-backs, how are you thinking about that given what’s going on in the loan portfolio today?

Gregory A. Smith

Well, we continue to hope to do buy-back activity as we go into 2008. We bought 4.5 million shares last quarter and we would expect to continue to buy back. It’s going to depend on market conditions certainly as we look forward.

Steven Alexopoulos - J.P. Morgan

Do you have a target currently, Greg, of what you think the full year might look like?

Gregory A. Smith

We have some internal thoughts on that but again, until we see how market conditions evolve, I’m going to hold off from that.

Steven Alexopoulos - J.P. Morgan

Okay, and just a quick final question -- what was the basis point impact for the margin from the retirement of the debt?

Gregory A. Smith

The retirement of the debt -- are you referring to the --

Steven Alexopoulos - J.P. Morgan

The $1 billion.

Gregory A. Smith

The $1 billion, well, it’s pretty minimal in terms of the margin in 2007 because we didn’t retire that debt until December 17th. But that debt would have locked us in to a funding cost far away from where we could fund $1 billion today.

Steven Alexopoulos - J.P. Morgan

Okay, but a positive benefit from that will carry through into the first quarter?

Gregory A. Smith

Yes.

Steven Alexopoulos - J.P. Morgan

Okay. Thank you.

Operator

Your next question comes from the line of Tony Davis with Stifel Nicolaus.

Tony Davis - Stifel Nicolaus

I wonder if you could contrast a little bit, give us a little more color here on the asset quality product -- what you are seeing today, what Mark is talking about right now in terms of a risk classification migrations, gross new non-accrual in-flows, the dollar amount of classified or criticized loans today versus where you were say three to six months ago? Any color on that?

Mark F. Furlong

Would I say that the speed of in-flow has changed, I suppose so in the second half of the year, just because I think that’s when the real estate cycle slowed down. It was probably more evident to all of us.

You know, most of our business, most of the issues are really construction development, so it’s a combination of the -- we worked with a developer and maybe done seven or eight successful developments and now they are in, they have two or three more, they are queued up and a piece of that is land and some of it is partially constructed or in the process of being constructed.

And so it’s more related to absorption, so if absorption stays low into 2008 on the residential housing side, then I think that will cause -- that will exacerbate that problem. We certainly -- our opinion is that this continues through 2008, so we hope we have taken a conservative look at what we are aware of today.

Anything that we’ve found, we’ve tried to deal with as opposed to hope that it would get better and would correct next year. I mean, that’s the issue so I don’t know that we’ll be really good predictors.

I think the in-flows could continue in the first or second quarter. Obviously if we thought we had something with an impairment, we dealt with it in December so our hopes of course, charge-offs would be lower in the first half of the year given what we did but it’s just -- you know, we don't have a crystal ball. It’s hard to be a good predictor of what’s going on in the residential housing market right now, so I think we’ll have to see.

Another piece of that is the disposal of those assets will go through a combination of -- some of it we’ll probably hold for a period of time and some of it we may have strategies to dispose of in larger pieces. So it’s hard to be real predictive on that right now.

Tony Davis - Stifel Nicolaus

You’ve given us some pretty good guidance here on the provision line, Mark. You find it as an acceptable range. Could you be a little more specific in terms of what an acceptable charge-off range might be this year you think?

Gregory A. Smith

Tony, in terms of charge-offs, again we’ve got to see how the real estate markets pan out. What we saw in the first three quarters of 2007 tended to be running in the low 20 basis point range, or even a touch lower. I would expect as we go into this year, the numbers will run higher than that. The question will be, depending on how the real estate markets evolve, how much higher than that. But over time, we certainly expect we’ll get back to our historical charge-off range. I’m not going to call for that in the next couple of quarters though.

Tony Davis - Stifel Nicolaus

Finally, what’s -- the loan growth was surprisingly strong here. I wonder if you could just give us some color on that. What your loan officers, for example, are saying about commercial borrow additives right now versus say back in the fall? Are you seeing increases in facility draw rates and what does the backlog look like?

Mark F. Furlong

In the commercial businesses, most of our portfolio are the privately held companies. The groups of shareholders are a small group, the kind you can put in a room and put around a table, so they run a business differently and the business is run really with a long-term outlook. There probably is liquid or a strong capital position as they’ve ever been. They’ve done some expansion and some growth but they haven’t outdone it on M&A, so their credit quality is pretty good.

There still is a fair amount of consumer demand. There is a fair amount of export business that happens in our customer base -- not just Wisconsin but really throughout the customer base. So on the commercial side, they are in pretty good shape.

On the commercial real estate side, you kind of heard Greg talk about a couple of segments that maybe have slowed a little bit but by and large, other than the residential housing component, the commercial real estate business is still in pretty good shape and absorption in the communities we do business in or lend in is still pretty good. So we are still optimistic about that as well too.

The segment that we talked about earlier too, the smaller lending relationships that we find in our business banking side, they are in pretty good shape as well.

So some of the things we saw at the turn of the century really aren’t evident today. The recessionary trend at the turn of the century that caused liquidity positions to tighten up a little bit and consumer demand to slow down, that really isn’t the case today and so -- actually I think they are off to a good year in 2008 and they had a pretty good year I thought in 2007 and the teams are pretty strong, our tenure is very, very good and so I am optimistic that this group will again have a very good year in 2008.

Tony Davis - Stifel Nicolaus

That’s helpful. Thanks, Mark.

Operator

Your next question comes from the line of Kevin St. Pierre with Sanford Bernstein.

Kevin St. Pierre - Sanford C. Bernstein

Good afternoon, guys. I was wondering if you could give me a little more of your thinking -- as we look around at what some of the other banks have pre-announced that they are going to do this quarter in terms of the reserve, boosting reserve to loans up into the 130s, 140 basis point range, I am curious as to why you didn’t choose to get more conservative and build reserves by more. 107 basis points of reserve to loans and about 72% reserves to non-accruals just -- maybe you could let us into your thinking a little more as to why we didn’t see more of a reserve build.

Gregory A. Smith

Sure, Kevin. Our reserve analysis and coming up with the 107 is predicated on the losses that we expect to see in our portfolio and with the analysis that we’ve gone through, going through both the construction and development portfolio, going through the residential portfolios, this is the type of build that was warranted from that analysis.

Our historical loss trends have been lower than other banks. Certainly this quarter is not in line with our historical loss trends but at the same time, we’re comfortable that the 107 was a significant step in building our reserve to the right level. We believe that given what we know today, it is the appropriate level.

Mark F. Furlong

Let me just add a little color too on the consumer side; historically, our consumer businesses have run with very good credit quality and that has been the target segment we’ve looked at. We haven’t been an originator of credit other than the 720, 730s on residential and home equity.

When we’ve taken properties and historically they have recovered at par and oftentimes above par, so in the analysis that our folks did in looking at those portfolios, looking at home equity as well, they did a variety of degradation of recovery rates to develop loss history far in excess of anything we’ve experienced.

I don’t know that you’d call it recessionary like, but they deteriorated those quite a bit and they just don’t develop a lot of loss reserves needed in that portfolio. Our view is most of the loss reserve really is associated with the commercial side of the business, whether commercial real estate or construction, or the CNI businesses, just because our loss experience would indicate that’s where the embedded losses really are.

So we share your interest in trying to build reserves to levels that are higher, but we don’t necessarily think they are warranted at this point in time. And we are still confident that, you know, maybe we don’t get back to the 15 to 20 basis points of losses that has been the heritage of M&I and maybe that makes sense when you start to reach outside the market you’ve been in for 160 years.

But we are pretty confident that we’ll get this construction development matter behind us. I wish I could pick the month. That’s not possible today but we will get it behind us and the rest of the commercial real estate and business banking and CNI businesses and the consumer businesses are still performing at the levels that we have historically experienced and we have no reason to believe that they won’t continue that.

Kevin St. Pierre - Sanford C. Bernstein

Thank you very much.

Operator

Your next question comes from the line of Eric Wasserstrom with UBS.

Eric Wasserstrom - UBS

Just to follow-up on that last question, in terms of your -- what sort of economic scenario is embedded in your expectations now? Because it seems like you are pointing to what is effectively very moderate deterioration outside of the construction and real estate portfolios and pretty robust balance sheet growth. I’m just trying to understand what you think -- where you think things might be headed in your region.

Mark F. Furlong

Eric, what we’ve really been focused on first of all, just to reiterate on the real estate side, reflecting the status of the real estate markets today, which pretty clearly are continuing to be in a downturn. That is reflected and expected to sustain for a period of time here.

On the commercial side, we continue to see strength, so I wouldn’t want to say gangbusters economic growth on the commercial side but as exports have helped bolster a number of our local economies, that’s certainly a factor on the commercial side. And we’ve really seen pretty consistent performance in that portfolio.

When it comes to the residential side, the residential side really on the consumer side, I think what you are really seeing with our numbers is the strength of that franchise and the strength of our underlying borrower. As you’ve heard us say before, we’ve never made a business of originating sub-prime product and our portfolios tend to run with FICO scores in the 730s, so to the extent we have stressed that portfolio and we have stressed that portfolio in lines of what you see in the residential markets today, and assumed further deterioration in those residential markets, the portfolio still stays up pretty well.

Eric Wasserstrom - UBS

Okay, so it seems like it’s sort of like a status quo to moderately worse environment. That’s sort of how I’m interpreting your comments.

Gregory A. Smith

Well, certainly a worse construction development, a worse residential market with continuing down draft, and particularly we’ve stressed the Arizona and Florida portfolios in that analysis. We’ve gone through the whole franchise but those are the ones that you see the most deterioration in.

Eric Wasserstrom - UBS

If I could just ask on one other topic, have you altered at all how you are approaching the correspondent business?

Mark F. Furlong

Well, there are certainly some correspondents that we no longer do business with, if that’s what you mean. Certainly when you look at some of the development projects in certain parts of the country where we thought they had a pretty good grasp of the market there, it would appear that they didn’t. So to some extent, I think you are right in that.

A lot of the business we do in correspondent is CNI related in stock loans and holding company loans and it’s things inside the core bank, their relationships are commercial as well as commercial real estate. In fact, about half of it is the real commercial relationships.

So to some extent, we are and you know, it’s tougher if you haven’t been a customer to -- and of course, [bought inside] and you are in a development project somewhere, a lot tougher if we don’t have experience with somebody when we are in a tough cycle to build the relationship at the toughest of times. So certainly there’s been some structural changes like that.

Eric Wasserstrom - UBS

Thanks very much.

Operator

Your next question comes from the line of David George with Robert Baird.

David George - Robert Baird

A couple of questions; on the other income and other expense numbers that you’ve reported, I’ve obviously -- and what I’m trying to get at is just kind of what a run-rate would be -- I’ve taken out obviously the branch sale gains out of the other income but I’m not sure if there is anything else I need to take out when considering what a normal run-rate would be. And if you just kind of look back, if I take out the 17, it still is notably above -- that other income, other fee income line is still quite a bit higher than what you guys have been typically reporting. And I also wanted to kind of do a similar exercise on other expense if you don’t mind.

I obviously know what’s in the release. I just want to see if there’s anything extraordinary in there that’s not pointed to in the release. Thanks.

Gregory A. Smith

Sure, David. First of all, on other income, the branch sale gain on a pretax basis is $29 million, so that’s going to be your big swing factor in there, otherwise I’d really suggest there’s not anything particularly notable in the other income side.

In terms of non-interest expense, there are probably three other items to take into account which we did not call out. Number one, we have our annual stock option awards in October, which because of the number of employees who vest immediately and that they are at retirement age, that is a one-time impact in the fourth quarter each year. And that was about $5.5 million, $6 million.

In addition, our professional fees for the fourth quarter were higher than usual, probably to the tune of close to $7 million higher than the prior quarter. A number of consulting assignments came through, as did some further costs as we were working on the REO, so some of the expenses for that.

And then finally, another item of about $4.5 million -- we purchased some software from Metavante in October and while you are affiliated companies, that is an expense. If we were separate companies, a good part of that would actually be capitalized, so we took that expense as well.

So I think I just walked through about an extra $17 million. As a matter of fact, if you were to take those items as well as the three items we had discussed earlier, the charitable contribution, the debt termination expense, and Visa, you take all those numbers as well as the Tulsa branch sale gain through the efficiency ratio calculation, you come up at 51%.

David George - Robert Baird

So we should theoretically, all else being equal, Greg, get some of that back, I guess FICA will be seasonally higher in Q1 I assume, but we should get some of that back in Q1?

Gregory A. Smith

Yes.

David George - Robert Baird

Thanks, that’s helpful. Appreciate it, Greg.

Operator

Your next question comes from the line of Ken Usdin with Banc of America.

Kenneth Usdin - Banc of America Securities

Thanks. Greg, just one quick follow-up there; so does the $0.58 to $0.60 core, that didn’t back out those line items you just ran through, did it?

Gregory A. Smith

No, the only items I really backed out would have been the charitable, the Visa, as well as the debt termination.

Kenneth Usdin - Banc of America Securities

Okay.

Gregory A. Smith

Although at the same time, to be fair, Ken, those other numbers do bounce around a bit too, but we didn’t make any explicit adjustment for those.

Kenneth Usdin - Banc of America Securities

Okay. Can I just ask you on correspondent lending, can you just give us a little bit more color on geographic mix and where the pressure points are more specifically within that portfolio?

Mark F. Furlong

You know, I don’t have a pie chart in front of me of the geographic mix. We have a couple of developments with some relationships in California and those are going to be -- those are troubled and they are included in the non-performing loans right now and they are ones we are working through. So we’ll work through those but other than that, they are not in one location. We have something in Florida but they are not -- they are places that you hear about in the country, Southwest coast of Florida and Arizona and a little bit in California, places that are hotspots now for a slowdown in the real estate market. I don’t think anything more than that. They are the kind of developments we do where individual loans are a few million dollars and what do I mean by that? You know, the under $10 million oftentimes, the individual loans oftentimes they start out with a land loan that’s $2 million or $3 million or $4 million and then eventually becomes a vertical construction, so stuff like that. They are generally not in the large loan relationship size.

Kenneth Usdin - Banc of America Securities

Okay. My last question, just you had made comments earlier about how some of the loans that have gone bad in the last couple of quarters or couple of years were pre-originated before the acquisitions and I’m just wondering, have you rethought at all your philosophy on doing acquisitions, especially in this environment?

Mark F. Furlong

Well, I think from the bank side, it is going to be difficult for a period of time to do bank acquisitions when you go through a cycle like this. We know a heck of a lot more about our portfolio and a heck of a lot less about somebody else’s portfolio and that’s part of it.

The second part would be in doing the due diligence on goals -- you know, we were doing that with September numbers in ’05 and the first week or so of November, so we really hadn’t seen the full effect of the slowdown, particularly as it hits Southwest Florida.

So the answer is I think in the near-term, you are correct that there is a heck of a lot less appetite here for an acquisition when you are going through a cycle like this in the core banking business.

Let me give you a little perspective though on something else. We have a fair amount of optimism about what’s going on at M&I and it really is, it’s kind of -- it does have some positives as a result of acquisitions.

What’s happened really over six or seven years is that M&I has diversified into other markets and that has been a great advantage to us, that as well as the build-out of lines of businesses. This construction development issue is almost -- not 100% but almost entirely related to Arizona, the Southwest coast of Florida, and some selected spots on the correspondent business.

What that means is the other markets are performing very well, so the St. Louis, Minneapolis, I’d say generally Wisconsin, the Indianapolis team looks like they have a pretty good book of business. The Orlando market, they are all doing well as well as the retail business at M&I, which includes business banking, the CNI business, the wealth management business. There is some advantage to the diversification, part of which comes through acquisitions that we build around. So that’s where we feel optimistic about where the business is going to go because we have -- we think at this point in time in the cycle, based on all the things we know, while there are no certainties or guarantees, that the issues we have are relatively isolated, although they’ve kept us pretty busy.

Kenneth Usdin - Banc of America Securities

Okay, thanks.

Operator

Your next question comes from the line of Heather Wolf with Merrill Lynch.

Heather Wolf - Merrill Lynch

A quick question on slide three of your credit slides, I’m wondering if you can give us -- you’ve given us the amount of the total loans reviewed. Can you give us the total exposure in construction and development left in Arizona correspondent banking and West Coast of Florida?

Gregory A. Smith

Just give me one second, Heather. In terms of -- and I’m just going to talk toward the total portfolio here, if you don’t mind, within those markets -- in terms of the overall Arizona exposure, commercial vacant land, commercial construction, and residential vacant land, that whole -- those combined categories -- I’m sorry, residential construction developer -- those combined categories are probably about a $1 billion, $1.1 billion in total.

In terms of the West Coast of Florida, really the focus category is going to be on the commercial vacant land and the commercial construction. That portfolio is just about $0.5 billion.

Heather Wolf - Merrill Lynch

Okay, and what about the correspondent banking?

Gregory A. Smith

Just overall on the correspondent side, the correspondent portfolio is about 2.7. Those components on the construction side are in total going to be under $1 billion.

Heather Wolf - Merrill Lynch

Okay, so it sounds like there is still a fair amount of exposure in Arizona and in the correspondent book that didn’t get reviewed in this kind of detailed analysis. Is that correct?

Mark F. Furlong

Well, let me start with -- this goes through a pretty rigorous review at M&I on a regular basis. It didn’t go through this one specific review exercise that’s taken place over the course of pretty much the last three months. But they all have loan committee requirements and it didn’t escape a relatively significant review.

What you have to be careful of is that when some businesses go bad, like some of the construction development, it doesn’t mean that every contractor and developer has lost. In fact, many of them have done great projects and are in fine shape, as with the substantial portion of our portfolio and will never be in the non-performing or even downgraded category.

So you have to be real careful how you draw a conclusion on that. While I think there is some risk, as I said, that we could have some additional non-performers in the next couple of quarters, by no means do we look at the rest of this portfolio and have a woe-is-me feeling that we are going to end up with a substantial part of this portfolio in that category. That’s just not the nature of their business and our track record with them and their experience and liquidity is strong.

So I’d just be careful of drawing a conclusion on the remaining exposure. In a recession, you can look at a CNI portfolio and five or six years ago, someone could have drawn the conclusion that anyone that has manufacturing in their portfolio is in trouble and then lo and behold, like always, the recession recovered and those businesses performed incredibly well for most of us.

Heather Wolf - Merrill Lynch

I understand that but if I did the math right, it looks like for Arizona, the correspondent banking, and the West Coast of Florida, you’ve taken losses of anywhere between 8% and 12% on the loans that you’ve reviewed. And I’m trying to figure out, of the remaining exposure, what is a reasonable assumption here? I know that’s tough for anybody, but why should we not look at the rest of this exposure and think we could see some migration in it?

Mark F. Furlong

Well, I did say that I thought that there was risk that there’d be some migration. I just think you have to be careful to -- when you look at Arizona and say there’s $1.1 billion there and we looked at $319 million, that there’s another 700 or 800 to go. I mean, that -- I don’t know that we have a good way to say there’s another certain dollar amount per market I would look at.

We went through a pretty thorough review, some of which are non-performers, some of which are performing right now and may very well not become a non-performer, but we knew they had some element of risk that differentiated them from the rest of the portfolio.

This review remember started with all construction and development projects greater than $1 million, so the intent was to capture the big stuff.

Heather Wolf - Merrill Lynch

Okay, and then can you tell us or remind us again how much raw land exposure you have in these three portfolios?

Gregory A. Smith

As we look at those individual portfolios in particular, I am going to try to tie this out -- let me tackle it a different way. In terms of vacant land in Arizona, you have to focus as much on -- well, there’s two different components. We’ve got the residential component, which is really just individuals with pieces of land, et cetera, which is a number that’s going to be in total a little north of -- is going to be north of $1 billion. And that is part of the portfolio which on the retail side, we have stress tested.

And then West Coast of Florida, there’s really not much in terms of vacant land. Those numbers are going to be around $100 million and on the residential side, it’s really not much at all.

And then on the correspondent side, again vacant land is not a big component of that. The order of magnitude is under $200 million, so the important thing to keep in mind with vacant land is we do stick to the underwriting guidelines with these. We do stick to the loan to values. We don’t play around with those.

Heather Wolf - Merrill Lynch

And I’m sorry, in Arizona you said the residential land you said was about $1 billion. What about the commercial land in Arizona?

Gregory A. Smith

Commercial vacant land is under $100 million.

Mark F. Furlong

A lot of the residential land though, while it hits a certain call code and a regulatory following, a lot of it is developed lots, so there is a fair amount of money that’s imported to those communities already, so -- just be aware that the story’s in the details, so it’s -- I appreciate why you could identify that as some risk, but caution that you draw a conclusion that might not be accurate.

Heather Wolf - Merrill Lynch

Right. No, I understand there’s less risk than the residential side. Okay, that’s helpful. I’ll follow-up a bit later with more questions. Thank you.

Operator

Your next question comes from the line of Rob Rutschow with Deutsche Bank.

Robert Rutschow - Deutsche Bank

Good afternoon. I guess you’ve talked about it before -- in terms of the reserves to loans and the current reserve and your expectation for losses going forward, I wonder if you could give us just a little bit more detail on your assumptions. In particular, I am wondering if you have built in any sort of housing price changes into your models and how that would affect your loss rates going forward.

Gregory A. Smith

Well, in terms of how we looked at a review in particular in the construction development portfolio, let me start there, again we took a look at where the markets currently are and indeed then also took into account our sense of where the markets could go.

On the residential review, we have included further price pressure in the markets, again focused particularly in Arizona as we did that. So we did not necessarily -- we did not take into account just exactly where the market is today. We took into account some further incremental price pressure.

Robert Rutschow - Deutsche Bank

Can you give us a range of how much additional pricing pressure you are looking at?

Gregory A. Smith

We’ve looked at pricing pressure in the 10% to 25% range.

Robert Rutschow - Deutsche Bank

Okay, and you did have loan growth this quarter. Do you feel at this point that you are taking market share of loans in the markets where you are making loans?

Mark F. Furlong

Are we taking market share -- well, I think we’ve been relatively competitive. We’re more cautious on structure and price, I would guess would be a good way to say that there’s still a few folks out there that would take a little less of both, and so that we’ve passed up a fair amount of opportunities for that but I think we are competing pretty effectively in all of our markets today.

Do we get our fair market share? You know, I don’t know that I have a good analysis. I don’t want to wing it. Some markets are probably disproportion, I suppose some were a little bit under but so far we are competing pretty well in each of our markets.

Robert Rutschow - Deutsche Bank

Okay, and I guess you touched on it also before, the home equity line, you haven’t really seen a huge tick-up in losses. Can you just tell us where you are at and what you are modeling going forward?

Mark F. Furlong

Greg will probably share some thoughts on this too but let me take you back a couple of years -- the business line, they made a decision that they didn’t like the credit quality, so the -- and they saw the deterioration out in front of them, so they have been selling most of that business for the better part of almost two years, so in each conference call, people would go through and they’d say when are you going to grow home equity again? And they just couldn’t find the customer and the credit quality and the demographics that we liked, and so pay-downs and normal amortization pretty much overcame new growth and then what we originated added to the additional shrinkage because we sold almost all that.

And I think that’s certainly been one of the positive contributors to the credit quality in that portfolio because what’s in our portfolio, just there’s not very much of it, is the ’06, ’05, and I suppose a very small portion is ’04. I don’t have all that data in front of me at the moment.

And so that has led us to some of the -- I am sure that’s a big reason for the positive credit quality in home equity. I don’t know if you have anything else you’d like to add, Greg.

Gregory A. Smith

Yeah, I’d just add that we looked at this portfolio too as we went through our revenue. The average FICO score in the portfolio is 730. The average loan to value is right about 80% and over 40% of this portfolio is right here in Wisconsin, so very much in our back yard.

So in terms of the overall portfolio, hopefully that gives you a little bit more support for what Mark was saying about the quality and the risk profile of this business.

Robert Rutschow - Deutsche Bank

Okay. Thank you.

Operator

Your next question comes from the line of Brad Vander Ploeg with Raymond James.

Brad Vander Ploeg - Raymond James

Thanks and good morning. Greg, you mentioned in your comments about the margin that you expect some further compression or some compression, I guess, versus current levels. And I’m just curious how the free cash from the Metavante spin plays into that and if you mean on a net basis or a gross basis or what we should expect to see there.

Gregory A. Smith

In terms of the margin, Brad, and thanks for asking that question, first of all we had the impact of the Metavante cash only for two months of the prior quarter. That will be a positive impact to the margin here in the first quarter in that we will have three months of that cash.

But in terms of some of the other pressures you see in the business today, those could put further pressure on the margin, whether it’s wholesale funding spreads or repurchase activity, as well as non-accrual loans. Those types of items will continue to put pressure on the margin.

Brad Vander Ploeg - Raymond James

Okay, and then just sort of a numbers question. I noticed in the supplemental information you’ve got a tangible common equity ratio calculation and just looking at the third quarter number, it shows 6.42%. I’m just wondering if there are some other intangibles that are on a different line item there that went away as it related to the Metavante spin, or how did that work?

Gregory A. Smith

Well, the Metavante intangibles certainly went away and that number was on an order of magnitude -- I want to say about $1.6 billion, but as I’m looking at the financials, you’ll see that the intangibles, and I’m just looking at the period end financials on page two, the good will and intangibles has changed by virtually nothing between the third quarter and the fourth quarter.

Brad Vander Ploeg - Raymond James

Right. Okay, so that -- the Metavante intangibles would be in that assets of discontinued operations?

Gregory A. Smith

All right. Thanks very much.

Operator

Your next question is a follow-up from the line of Heather Wolf with Merrill Lynch.

Heather Wolf - Merrill Lynch

Just a follow-up on the margin question -- Greg, I think when I went back and calculated the margin implied by the pro forma financials at the back of your second quarter and third quarter 10-Q, it was higher than what you guys are posting now and certainly what you are guiding to. Has there been a change in your margin outlook or has something changed in the pro forma adjustment that we should know about?

Gregory A. Smith

Well, first of all, the numbers that we would have looked at at that point in time, Heather, would have been I believe off of the year-end numbers, so those numbers would be higher.

In terms of the margin, of course what we have right now is two months, not three months in the margin, and also certainly when you think about what we had said on the margin beforehand, the non-performing loan levels are higher than we would have had at that point in time, as has some of the buy-back activity.

Heather Wolf - Merrill Lynch

Okay. Thank you.

Operator

Now I would like to turn the call back to Greg Smith for any closing remarks.

Gregory A. Smith

We appreciate everybody’s time. We appreciate everybody’s questions and thank you very much for joining us today.

Operator

Thank you for participating in today’s conference call. You may now disconnect.

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