Citizens Republic Bancorp Q4 2007 Earnings Call Transcript

Citizens Republic Bancorp, Inc. (CRBC)

Q4 2007 Earnings Call

January 18, 2007 10:00 am ET

Executives

Kristine D. Brenner - Director of Financial Reporting and IR

William R. Hartman - Chairman, President, CEO

Charles D. Christy - CFO

John D. Schwab - Chief Credit Officer

Analysts

Jon Arfstrom - RBC Capital Markets

John Pancari - J.P. Morgan

Scott Siefers - Sandler O'Neill & Partners L.P.

Terry McEvoy - Oppenheimer & Co.

Eileen Rooney - Keefe, Bruyette & Woods

Presentation

Operator

Good day, ladies and gentlemen, and welcome to today's teleconference. (Operator Instructions)

I will now turn the call over to Ms. Kristine Brenner. Ms. Brenner, please go ahead.

Kristine D. Brenner - Director of Financial Reporting and IR

Good morning, and welcome to the Citizens Republic Bancorp fourth quarter conference call. This call is being recorded, and a telephone replay will be available through January 25. This call is also being simulcast live on our web site, www.citizensbanking.com, where it will be archived for 90 days.

With me today is Bill Hartman, Chairman, President and Chief Executive Officer, Charlie Christy, Chief Financial Officer, John Schwab, Chief Credit Officer, and Marty Grunst, Treasurer.

Before we begin, I would like to point out that during today's conference call, statements will be made that are not historical facts. These forward-looking statements involve risks and uncertainties which include, but are not limited to, those discussed in the company's filings with the SEC.

Forward-looking statements are not guarantees of future performance, and actual results could differ materially from those contained in the forward-looking information. These forward-looking statements reflect management's judgment as of today, and we expressly disclaim any obligation to update and/or revise information contained in these statements in the future.

Now I'll turn the call over to our CEO, Bill Hartman.

Bill?

William R. Hartman - Chairman, President, CEO

Thanks, Kristine, and good morning, everyone, and welcome to our conference call.

It's obviously a very interesting quarter and frankly year, for our industry. And given the current operating environment and the reported unexpected results for the industry this quarter and for the year, we do believe that our GAAP earnings per share of $.37 for the quarter and $1.33 for the year are respectable.

As to our fourth quarter specifically, we did not, as you notice, provide fully for charge-offs for the quarter based on the fact that $11.5 million of the charge-offs had already been provided for in terms of specific reserves.

We also do feel that the current loan loss reserve level of 1.72% of loans is now adequate to address losses in our existing portfolio based on the current economic climate.

Despite the significant industry headwinds and the credit quality challenges we've experienced, we do think there are a number of accomplishments for the year 2007 that are significant.

First of all, we were able to grow our commercial loans by 11.5% for the year, driven primarily by the strength of our C&I and asset-based lending businesses, which more than offset the decline in our commercial real estate business. As you look at our credit quality statistics, the quality of our C&I and asset-based portfolio is holding up quite well, and we continue to feel good about those portfolios. We look for continued growth in those portfolios in 2008 without compromising our credit quality standards.

Second, our wealth management business generated its fourth consecutive year of profitability growth and revenue growth since we reorganized that business with our open architecture concept in 2003. The growth was driven by increases in both trust and brokerage income. We believe synergies from our new regional leadership structure implemented in the fourth quarter of 2007 will help improve wealth management sales in 2008.

Third, treasury management sales, SBA loan closing and brokerage fees from the newly acquired Republic branches are all up over 2006, demonstrating the beginning of some revenue synergy momentum as a result of the merger. These areas will also receive strong focus in 2008.

Number four, we exceeded our first year cost synergy target from the merger of $21.7 million for the first year. We exceeded it by over $3 million, and we're using some of those savings to invest in profitable growth initiatives that we think will provide good returns on capital. Our expense management philosophy continues to be to try to keep total costs close to flat while still supporting initiatives that improve profitability.

Number five, our focus on increasing the number of checking and savings accounts resulted in production of new accounts exceeding 2006 levels by 25%, with cross-sales of these accounts improved from 11% to 43%. We do expect continued improvement trends in deposit sales in 2008 as we've reinvigorated our sales and sales management processes in literally every business that we're in.

Obviously, in this kind of an economy the wild card is credit costs, so I know you'll be very anxious to hear the comments of John Schwab, our Chief Credit Officer, and after that Charlie Christy, our Chief Financial Officer, will talk about the financials. Lastly, I will conclude the call with some comments about what our focus for 2008 will be.

So John, we'll turn it over to you.

John D. Schwab - Chief Credit Officer

Thank you, Bill.

Citizens' fourth quarter of 2007, the metrics played out essentially in line with what we had suggested to you at the end of the third quarter. Over 70% of our $19.7 million in net charge-offs was related to real estate, commercial and residential.

Of the $19.7 million, $3.6 million was residential first and second mortgage, up slightly from the third quarter but down more than $1 million from a year ago fourth quarter. While residential charge-off rates increased slightly to 53 basis points, we note that first and second mortgage loan NPLs and OREO levels are both increasing. To the extent residential non-performings continue to increase, there may be some level of increased charges as some of these assets move into OREO.

Commercial real estate charge-offs of $10.7 million were 54% of the quarter's total net charge-offs, with the majority concentrated in the land development, land hold loan portfolios. Non-performing land development and land hold loans have decreased $3.3 million from the third quarter. Also of note is the $85.6 million or 28% decrease in the outstandings of these portfolios since 12/31/06.

We also experienced higher charge-offs quarter-over-quarter in the construction and income-producing real estate portfolios, but 34% lower than the second quarter. Non-performing construction and income-producing assets have increased over the last several quarters, however quarter-over-quarter nonperforming income-producing declined nearly 20% while construction nonperforming increased $10.2 million.

Of our aggregate $3.1 billion in commercial real estate exposure, over 34% is owner-occupied commercial real estate, the lowest risk portion in this portfolio as demonstrated by years of actual loss experience.

We believe most of the risk in the commercial real estate book is concentrated in land development, land hold and construction as reflected in the non-performing numbers. We observe also that while income-producing property may experience periods of vacancy or deficit cash flow, the projects have moved beyond development and construction risk and will therefore retain value over time.

Income-producing properties has been the only segment within commercial real estate where we have approved increases in our exposure.

As shared with you previously, Citizens Republic has virtually no exposure to the subprime mortgage market. Our credit challenge in 2008 is to work through the commercial and residential real estate issues we have identified through a number of proactive credit risk management practices.

To the extent that in reviewing our release none of you has formulated a question about Citizens' continued negative provisioning in the fourth quarter and the adequacy of a loan loss reserve which is now less than non-performing loans, I would like to help both ask and answer the question.

First of all, based on a number of factors we will go through with you here, we believe strongly that our existing loan loss reserve is adequate to deal with the credit issues in our loan portfolios. Now let's explore this in more detail.

Fact: While our loan loss reserve as a percentage of total loans has remained relatively stable and strong among peers - 1.83 percent at the end of '06 to 1.72 at the end of '07 - our non-performing loans have risen disproportionately $59 million at the end of '06 to $189 million at the end of '07.

In digesting the acquired loan portfolio we have, over the past 12 months, taken several steps to address proactively the largely commercial real estate issues.

One, conducted two deep dives into the commercial real estate portfolio as a basis for one, marking $104 million of loans as held for sale at a net mark of $68 million, and two, taking an additional provision expense in the second quarter which, together with Citizens' historically strong loan loss reserve, would be used to work through anticipated increases in non-performings and chargeoffs.

Secondly, completed four quarterly watch meetings - those are the risks rating seven or worse on our platform - confirming and updating action plans on each credit. Beginning with the second quarter of '07 watch meetings, we reviewed in each successive quarter, fewer credits, less dollars of outstandings, and downgraded fewer credits and less dollars. In the fourth quarter, as many dollars were upgraded as were downgraded, and while the total watch portfolio increased fourth quarter over third quarter by $35 million, the trend of new watch credit is declining.

Thirdly, we approved all new or renewed investment commercial real estate exposures - over $473 million - under Citizens' commercial real estate senior credit officer approval process, thereby ensuring consistency in both underwriting and risk rating.

Fourthly, we virtually shut down any new approval of land hold or land development loans.

Next, our loan review group independently reviewed $858 million in commercial real estate exposure in the markets, resulting in less than 5% of those credits downgraded to watch.

Lastly, reviewed over $545 million commercial real estate tax credits, i.e., those are not watch, and downgraded to watch in those reviews less than 5%. This first review focused on most land development and land hold loans over $500,000, and the larger construction and income-producing, those concentrations over $1 million. Our next review later this month will include a deeper look into income-producing.

Of the $12.1 million in fourth quarter commercial net charge-offs, we held specific reserves against these charges of $11.5 million, essentially eliminating any need to provision further to cover charge-offs.

The collective sum of these actions confirms to us that our proactively credit risk management practices identify issues early, rate appropriately, turn the monitoring and action plan lights on brightly, value collateral conservatively, reserve accordingly, and charge on a timely basis have enabled us to avoid surprises and remain comfortable with the current reserve levels. It is clear to me that the large preponderance of commercial real estate risk in the portfolio has been reviewed, identified, provided for, and strategized.

A few minutes ago I commented our firm belief that our loan loss reserve is adequate to deal with identified credit issues in our portfolios. We all should recall that legacy Citizens' strong reserve levels were built to cover a largely C&I portfolio whose underlying collateral was heavily accounts receivable and inventory. The value of such short-term collateral is far more susceptible to short-term deterioration.

The merged company is now dealing principally with real estate collateral supporting commercial and residential real estate loans. Over time, real estate will retain a higher level of value, so in the current market our strategy is to mark the value of our OREO to fair market values supported by new appraisals and factored costs to exit if appropriate. The loan loss reserve now covers potential future declines in the values underlying the non-performing portfolio, not OREO.

The current market environment for moving real estate in our footprint is depressed and volatile. As a result, our workout strategy will be prudent in selecting the time to move these assets off the balance sheet.

A closing note on consumer. The bump in indirect charge-offs is seasonal and widely spread, comprised of over 270 separate charges. Lastly, we refreshed the FICO scores in the consumer portfolio in 2007, and note that over 60% of the portfolio carries FICO scores in excess of 700 and nearly 80% over 650.

While a protracted depressed economic environment, particularly in Michigan, implies a further burden upon our commercial and consumer portfolios, we believe we are more than adequately reserved to deal with what we have and will, going forward, provision to keep us in that position.

Charlie?

Charles D. Christy - CFO, EVP

Thanks, John. Good review.

Before I review the financial results, it should be noted that the fourth quarter and full year 2006 financial results still represents legacy Citizens only except for the 2006 year-end balance sheet, which included the acquisition of Republic which closed on December 29, 2006. Therefore, most of the differences between the 2007 quarter end and full year comparisons to 2006 are due to incorporating Republic.

Net income for the quarter was $28 million, down $3.8 million from the third quarter.

Earnings per share for the quarter was $.37, down $.05 from the third quarter.

Return on assets was 0.83%, down 13 basis points from the third quarter, and return on equity was 7.11%, down 109 basis points from the third quarter.

Our net interest margin was 3.26%, down 13 basis points from the third quarter, all of which were in line with our expectations.

Our fourth quarter financial results also included $3.3 million of severance and benefit costs associated with the strategic business alliance with PHH Mortgage and operational efficiency changes, a $0.9 million liability charge as a result of our proportionate membership share of Visa USA in the recent litigation, and a $0.4 million merger related benefit.

Excluding these items, net income would have been $30.5 million or $0.40 per share.

For the full year 2007, net income was $100.8 million or $1.33 per share. These results include $8.2 million of restructuring and merger-related expenses in connection with the Republic acquisition as well as $10.1 million of conversion activities and other transaction-related expenses that are not classified as merger-related expenses.

A few of the key highlights for the quarter and the year:

We exceeded our goal of $31 million of annual cost savings which was identified when we announced the Republic merger, even after we invested more into the Cleveland, southeast Michigan and Wisconsin markets. Our goal was to recognize 70% of the $31 million or $21.7 million of those savings in 2007. We actually were able to achieve over $24 million in 2007 and are still on track to exceed the $31 million target by approximately $3 million over which will be realized in 2008. These extra cost savings help us fund other profitable growth initiatives in some of our key markets.

On an end-of-period basis and in a comparison of the third quarter of 2007, total loans increased by $282 million, driven by good customer demand for commercial and industrial loans across all of our markets which increased $321 million, which includes $143 million from our Citizens Bank Business Finance Division. That's our asset-based lending unit. Our commercial real estate increased by $29 million.

Following normal industry trends, consumer loans were down $68 million.

Total deposits were up $360 million, driven by an increase of $267 million in time deposits and $94 million in core deposits.

For the year, total loans were up $270 million, driven by $529 million in total commercial loans, a decrease in consumer loans of $160 million and a decrease in mortgage loans of $98 million.

Our commercial and industrial loans were up $552 million or 27% while commercial real estate loans were down $23 million.

Total deposits were down $396 million, primarily due to the $206 million branch divestitures completed in April. These were required by the Federal Reserve as part of the Republic merger and disintermediation in the marketplace.

We launched several revenue initiatives during the third quarter and are already seeing results in higher service charges on deposit accounts, good volume in our SBA lending, and continued strong performance in Treasury management sales and brokerage and investment fees.

Key drivers for the fourth quarter were net interest income was down by $2.7 million from the third quarter of 2007 due to a lower net interest margin, partially offset by an increase of $116 million in average earning assets driven by the good commercial loan demand.

Our net interest margin was down 13 basis points to 3.26% when compared to the third quarter, primarily due to deposit price competition resulting in lower spreads as rate declines on deposits did not keep pace with the Federal Reserve rate reductions, the continued shift in our deposit mix, continued pricing pressure on commercial loan spreads, and the movement of loans to non-performing status.

In the first quarter, we anticipate net interest income will be slightly lower than the fourth quarter of 2007. We expect to see a continued migration of low-cost deposits to high-cost deposits as well as there's one less day in the quarter.

Additionally, our expectations include the effects of loan and deposit pricing pressures, the full quarter impact of the movement of commercial real estate loans to non-performing status during the fourth quarter of '07, and stable to increase in average earning assets.

Provision expense of $6.1 million compared to $3.8 million in the third quarter. Net charge-offs totalled $19.7 million or 84 basis points of average portfolio loans, where were in line with our expectations.

Compared to the third quarter of '07, net charge-offs increased $11.8 million, primarily due to higher commercial real estate charge-offs and some seasonal indirect consumer charge-offs.

Our loan loss reserve totalled $163.4 million or 1.72%. This is down from the third quarter by $13.6 million or 20 basis points in the loan loss reserve percentage.

$11.5 million in net charge-offs in the quarter were against loans that were specifically reserved in prior quarters. Charge-offs of specifically reserved loans don't require replenishment of loan loss reserve since loans have been basically marked to fair value.

We believe that our current level of loan loss reserve adequately reflects the inherent risk in the overall loan portfolio due to a number of factors. John has reviewed some of these.

In the fourth quarter of '06, we classified $104 million of commercial real estate loans to held for sale and took appropriate fair value adjustments at that time. When we merged with Republic, we were required to net their specific reserves against the appropriate loans and now carry them at their fair value.

Over the year, we have expended significant resources to evaluate the commercial real estate portfolio to make sure we have rated the loans properly, have obtained updated appraisals where needed, have charged down loans to their current fair values, and have been prudent to reflect the needed specific reserves when evident. And a [high] majority of our non-performing loans are collateralized with real estate which are currently carried at their fair values.

These factors, along with our credit risk underwriting, monitoring, and proactively loss mitigation processes help us gain the comfort that we are adequately reserved.

We anticipate that net charge-offs for the first quarter of '08 will be slightly lower to lower than the fourth quarter 2007 results due to anticipated increases in seasonal consumer net charge-offs, continued pressure on commercial real estate - especially in land development and construction portfolios - and expected appraisal results. Provision expense is expected to be more consistent with net charge-offs.

Non-interest income was $29.3 million, a decrease of $1.3 million from the third quarter. The decrease was primarily the result of lower mortgage fee income, other income, and unrealized loss in deferred compensation plan assets.

We anticipate that total non-interest income for the first quarter of '08 will be consistent with or slightly lower than the fourth quarter of '07 due to continued decreases in mortgage loan originations. Not surprising.

Non-interest expense for the quarter was $78.9 million, an increase of $1.5 million from the third quarter of '07. As previously mentioned, the increase was due to additional severance costs, operating efficiency changes and our portion of the Visa litigation charges, partially offset by a merger-related benefit. On a combined basis, these total $3.8 million.

Excluding these charges and benefits, total NIE is very close to our current run rate for Citizens. Future quarters may reflect increased savings in our investments and possible initiatives, merit increases, capital expenditures and other strategic changes, but should remain relatively within the range of this level.

Excluding the restructuring and merger-related expenses and additional expenses related to the merger activities, we anticipate total non-interest expense for the fourth quarter of '08 will be slightly lower than the fourth quarter of '07.

Our effective tax rate for the quarter was 23.5% compared to 28.4% in the third quarter of '07. We anticipate the effective tax rate for the full year of '08 to be approximately 22% to 25%.

[Inaudible] capital ratios continue to remain strong. Our tier-1 was 9.10%. Our total capital is 11.57%. Our tangible common equity ratio was 6.08%, and our leverage ratio was 7.61%.

Back to you, Bill.

William R. Hartman - Chairman, President, CEO

Thank you, Charlie.

I did comment on our business trends at the beginning of the call, and as I look ahead to 2008, the most important business challenge to our industry at this point in time, other than credit quality, is deposit growth, and that's something we're going to be spending a tremendous amount of time on in our company.

As a result of our retention numbers, which are better than industry averages, and our improved sales production, we are growing market share in a number of savings and checking accounts that we have, but we are not yet growing deposit balances as cash is being used much harder by consumers and businesses, particularly in Michigan.

We are seeing deposit balance growth in our Wisconsin markets as a result of our new sales process, but we think it will take us awhile to get there in our Michigan markets due to the economy. As our sales trends continue to improve, we do think we can get there in Michigan as well.

In addition to improving our sales focus and our action plan, we've made deposit growth a more heavily weighted component of our incentive plans throughout the company.

We think that the real estate markets are going to continue to be challenged in 2008 and that values will continue to show declines. We don't think there will be meaningful improvement in the operating environment in terms of spreads on loans and deposits because pricing competition is currently and expected to remain fierce.

We hope, however, and we think that we could likely see some pricing leverage in our loan portfolio later in the year as the market becomes more rational given the liquidity and capital challenges of the industry.

We expect continued growth in our commercial loan portfolio and continued declines in our consumer loan portfolios, where demand, of course, is weak.

On balance, we do see profitable total loan growth for our corporation in 2008, and we think we can do that while maintaining very acceptable credit quality.

Outlining our three priorities for the year, number one would be to improve the profitability of our revenue generation with a heightened focus on return on capital. To that end, we have re-engineered our commercial incentive plans and are now compensating our bankers based on the profits they generate that exceed our cost of capital. We're strongly aligning our bankers with shareholder value.

Priority number two would be to improve and aggressively manage our credit quality. John covered this very well in his report. Clearly, we've proven we have the processes, the culture, the discipline and the expertise to do this well. The key question will be the trends in the economy, markets and environment. We're committed to addressing problems early and to keeping the integrity of our balance sheet and the quality of our earnings intact.

Priority number three would be expenses. We expect to manage our expenses aggressively in 2008 in order to invest in profitable growth initiatives while at the same time we don't want to significantly increase our total corporate expenses.

A couple examples:

In 2007, we opened only one new branch and we'll likely open only one new branch in 2008. Obviously, we'll consider no bank acquisitions in 2008. In 2008, we'll be focusing on improving our fundamentals and the basic blocking and tackling necessary to improve our company in the most difficult banking environment any of us have seen in our careers.

Based on the directional guidance we gave in our earnings release on the various earnings drivers, we do expect earnings for the first quarter of 2008 to be lower than the first and fourth quarters of 2007, with the actual magnitude of the decrease being dependent on the exact amount of provision expense we take.

We did bring our loan loss reserve down this quarter because most of the charge-offs were against the specific reserves, as both John and Charlie had mentioned earlier, and frankly because we saw no need to charge earnings for those reserves again.

The actual amount of provision expense we take in the first quarter will be somewhat dependent on how much the portfolio deteriorates as a result of the economy and which loans deteriorate and how they are reserved for.

As we look ahead to our credit quality of 2008, we do anticipate that our charge-offs for 2008 would be lower than 2007's level unless there is significant further deterioration in the economy. It is likely at this time, therefore, that our first quarter loan loss provision expense may be the highest quarterly provision expense that we take in any quarter of 2008.

That would conclude our prepared comments. We'd be happy to answer any questions that you have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jon Arfstrom from ABC Capital Markets. Your line is now open.

Jon Arfstrom - RBC Capital Markets

Thanks, guys. RBC. How are you doing?

William R. Hartman - Chairman, President, CEO

Good morning, Jon. We're doing well.

Jon Arfstrom - RBC Capital Markets

Good. Thanks for all the detail. It was very helpful.

John, can you talk a little bit about the velocity in and out of the non-performing category? I'm just trying to get a sense, you know, as to whether or not the flow in is slowing at all.

John D. Schwab - Chief Credit Officer

Well, it is slowing if you're referring to the commercial or residential or any particular piece, Jon, or just in general?

Jon Arfstrom - RBC Capital Markets

In general, but comments on both categories would be great.

John D. Schwab - Chief Credit Officer

C&I is remaining fairly strong comparatively, but the commercial real estate nonperformers, the big ones have all been identified and, as I tried to explain, in the numerous initiatives we undertook during the year, those have been identified and put where they belong.

There is very little big that is out there that I am particularly worried about. There will be some increased [troubles] of both commercial and residential nonperforming as we go through. That's just because of our economic environment. And how we deal with these as non-performing assets and other real estate will be a longer-term solution.

Jon Arfstrom - RBC Capital Markets

Okay. I'm not sure if you can answer this, but any help would be appreciated.

But you made a fairly confident statement on your loan loss reserve and obviously, as analysts and investors, we look at the NPA level, and you talked about the difficulty in determining how long it would take to reduce some of the OREO levels.

And I'm just curious how you feel about the timing of the resolution of some of these credits, you know, are the bids way below what you think is an appropriate valuation? And how long do you think you'll sit with some of these properties on your books?

John D. Schwab - Chief Credit Officer

Yeah. Okay.

A couple things, Jon. First of all, differentiate between non-performing loans and non-performing assets.

When a loan becomes a non-performing asset, an OREO property, we have already taken a discount on that asset through, in the case of real estate, fresh appraisals - market values, liquidation values, and we mark in a new market value of that asset in OREO having taken the charge down to that level.

The velocity of moving these assets off our balance sheet is going to be managed more prudently, and I'll make the differentiation between a C&I portfolio that one of our legacy companies had dealt with. That stuff tends to move fairly quickly in and out of non-performing status, and it comes, your collateral's there and you move on.

The real estate is different. The real estate retains value. As an example of how this has changed, when we took $23 million of the legacy Republic's real estate loans that were in our held for sale category and had moved non-performing, we sold those in the first quarter and had marked them at $0.65 on the dollar. And we moved those, again, in the first quarter, and received a slight excess over what we had marked to in adding all the pools together.

And we have tested the market here in the fourth quarter to see what if we wanted to do that again, and the market is about $0.20 to $0.25 below what we had taken in the first quarter, and frankly, I don't think taking $0.40 on the dollar is really prudent for our shareholders at this time.

So we're going to be a little more protracted and thoughtful about how we move through these other real estate assets, and on an individual basis there may be cases in which we can do a sale. But we're not going to be wholesale selling pools of these mortgages into this updraft.

Jon Arfstrom - RBC Capital Markets

Okay. Two other questions here that I think are important.

Charlie, what kind of testing do you go through on your goodwill from Republic at the end of the year, and just talk a little bit about your comfort with that.

Charles D. Christy - CFO, EVP

Yes. We recently completed our annual analysis using the specific process described in FAS 142 and it has indicated no impairment.

FAS 142 also includes some guidance on performing more frequent reviews if certain events occur, so we'll make sure we just stay in compliance.

But basically, we passed at this point.

Jon Arfstrom - RBC Capital Markets

Okay. Okay.

And then, Bill, just could you comment a bit on your commitment to the dividend? Obviously, when you model through your expectations, it looks like you're more than covering your dividend, but obviously high relative to the rest of the group, and I was just curious to your thoughts on that.

William R. Hartman - Chairman, President, CEO

Sure. No, I appreciate that, Jon. And frankly, when we talk about the dividend, we're really talking about the capital management strategy and philosophy in general.

And first of all, we do feel good about our capital position relative to our peers and relative to the volatility that's inherent in our different businesses. We are in an economically challenged environment, and going forward it's important for us to maintain an appropriate amount of cushion in the capital position.

So as we go throughout the year, the board and I will continue to evaluate the dividend decision. We'll do that each quarter. We'll base it on our earnings, our capital position, the credit and capital markets, and how we can best improve shareholder value.

To date, our capital management strategy has been to prioritize dividends first, capital position second and buybacks third. Clearly, buybacks are going to continue to be an extremely low priority. I would not look for much in the way of buybacks this year. We are going to, based on our performance and the markets, continue to evaluate the dividend and capital position.

So Jon, I guess I can't really give you a complete commitment that the dividend is 100% safe because I don't think in this kind of a banking environment it would be prudent for me to do so, but we do understand the importance of the dividend.

Jon Arfstrom - RBC Capital Markets

Okay, great. Thank you.

Operator

Our next question comes from John Pancari from J.P. Morgan. Your line is now open.

John Pancari - J.P. Morgan

Morning.

William R. Hartman - Chairman, President, CEO

Morning.

John Pancari - J.P. Morgan

Just looking at your reserves, just - and given the guidance that you've given, I know, you know, things are still up in the air in terms of what you may have to provide for in coming quarters given the uncertainty in the economy and everything, but just looking at your expectations for charge-offs and your expectations for provisions to more closely match charge-offs, it's implying that you're, you know, the relative size of your reserve to loans should continue to come down a bit.

If you could just confirm that, and also, do you have any type of floor that you think that this should bottom out at in this type of environment?

Charles D. Christy - CFO, EVP

John, this is Charlie. How you doing?

John Pancari - J.P. Morgan

All right.

Charles D. Christy - CFO, EVP

You know, I think we're going to kind of take that on a quarter-by-quarter basis because really what you have to do is, depending on how the portfolio moves from a, we'll call it risk perspective, either improving or getting worse, will depend on our comfort zone, whether or not we need to take the reserve up or down.

And also it depends on the multiple portfolios and the different pieces of those and how well we have carried things or how low we're carrying things at fair values.

So there's a lot of factors that go into calculating a loan loss reserve.

As far as a floor, I would say that we have never really had a philosophy of having a floor, but we clearly would never probably be anywhere near where the industry average has been in the past. Unless, you know, we got into a wonderful environment where everything is rosy and so on, I think we're a couple years away from being anywhere near that.

John Pancari - J.P. Morgan

Okay.

And then also, on the credit side, John, you'd indicated that you're going to continue to evaluate, you know, scrubbing the portfolio or you're going to evaluate the income-producing portfolio in '08.

Can you just give us a little bit more color on what you're going to look out there, where you're going to start within that portfolio, and the timing as well?

John D. Schwab - Chief Credit Officer

Yeah, John.

We are planning to continue our review of the investment commercial real estate portfolio throughout the year. The first pass we did in the fourth quarter was primarily focused on the land development, land hold and construction, and we set a higher threshold, I think as I mentioned, on the income-producing.

So in looking again - and we will be looking at some of the same loans we looked at in the first pass, we will be looking at land hold, land development, construction - and we will dial the needle down a little deeper on the income-producing.

Last time we just look at loans that had an aggregate exposure in excess of $1 million. I personally view income-producing as the least risky of those four categories, so that's why we did it that way. But we're going to look at everything.

And I guess I'm probably making this point for the umpteenth time, or trying to, is that all of these activities that we undertook during the year - what I call credit risk management practices, whether it was the watch, whether it is looking at investment commercial real estate that was pass credit and all the while we're approving these credits under our watchful eye of our senior credit officers I just don't think there's much out there that we haven't already looked at, but we're going to continue to keep doing, as Bill said, the blocking and tackling of credit fundamentals just to be sure we're identifying anything that shows signs of trouble.

John Pancari - J.P. Morgan

Okay. All right.

And then, can you give us a little bit of color on the - within the consumer portfolio itself, how you're feeling about that, home equity particularly?

John D. Schwab - Chief Credit Officer

Delinquencies are up. Non-performers are up. I think we will see some fallout and probably some - a blip up of charge-offs related to that.

A number of people are concerned about what I call the LTVs of the residential mortgage and home equity portfolios. LTVs are important to me at the date that the loan is originated. I think if we were to do fresh appraisals on residential property in the markets in which we operate, there are a lot of properties that are going to be under water.

So I concentrate more on the ability of the individuals to pay. Credit scores are very important, but let's face it. Largely, Michigan is so far under water that if we were to spend the money and do fresh appraisals, we'd be under.

Charles D. Christy - CFO, EVP

Hey, John, this is Charlie.

You know, if you look at the direct consumer, we show in the press release our delinquency rate is at a 1.55. That ain't all bad. That's a very strong performing portfolio.

We still have LTVs, at least when we underwrote, were in the 80% range, and same with our residential mortgages. As John said, we are in Michigan and many of those have moved to a different thing, but the performance of those, especially on the direct and the home equity at a 1.55 delinquency rate is, to me, is a very strong message that we're dealing with A paper.

John D. Schwab - Chief Credit Officer

John, I would also add that the home equities at origination - any home equity loan in excess of 90% LTV at origination is insured.

John Pancari - J.P. Morgan

Okay.

And then on the home equity, I mean, what percentage are in the second lien position?

Charles D. Christy - CFO, EVP

Say that again?

John D. Schwab - Chief Credit Officer

Second - first versus second.

Charles D. Christy - CFO, EVP

We're more second than first.

John D. Schwab - Chief Credit Officer

It's largely - I would say the majority of them, probably 70% - are in a second.

Charles D. Christy - CFO, EVP

Around that range.

John Pancari - J.P. Morgan

Okay. All right. And then lastly, one more question outside of credit quality, actually.

In terms of your ability to pick up market share, I know you'd indicated that you're succeeding at picking up, you know, a higher number of accounts, but the balances are difficult to come by, which is not surprising.

But, you know, given the disruption in the market from Comerica's, you know, strategic shift, shall we say, are you seeing opportunities there? Can you give us anything tangible, given the changes that we're seeing over at that bank?

William R. Hartman - Chairman, President, CEO

Yes, very much so.

First of all, obviously Comerica is very much aware of the fact that all of the other banks are trying to prey on their clients since they're making their move to Texas, so everyone is calling more aggressively on their clients. And obviously, as you would expect, they're not sitting back not doing anything about that.

Clearly, we are getting much more opportunity there as a result of our aggressive and disciplined sales and sales management processes. We are getting more looks. We are winning more business from Comerica, which is good.

We are also in general picking up business. I mean, if you look at the growth in our C&I portfolio, you know, that would represent share improvement, so both in our commercial and consumer businesses, we are gaining share. We are projecting to do that again.

I think the challenge that kind of frustrates us a little bit, John, is that despite the share improvement in numbers of checking and savings accounts given the current Michigan economy, it's been a little harder to get the balance growth.

But I think that our sales numbers are continuing to trend upward, and those two lines will cross and we'll be able to do that as well.

So yeah, I feel pretty - not pretty good, I would say I feel very good about our ability to compete and win in the marketplace.

John Pancari - J.P. Morgan

All right. Okay, thank you.

Operator

Our next question comes from Scott Siefers with Sandler O'Neill. Your line is now open.

Scott Siefers - Sandler O'Neill & Partners L.P.

Good morning, guys.

William R. Hartman - Chairman, President, CEO

Morning.

Scott Siefers - Sandler O'Neill & Partners L.P.

Just kind of had, I guess, a couple questions.

First, John, maybe if you could talk a little bit about watch list migration. I guess I'd be curious if you haven't mentioned it already to just talk about sort of the rates of migration from the watch list into non-performing, how that compares to, you know, say the last year and, more importantly, an even longer time horizon if you could.

John D. Schwab - Chief Credit Officer

I think, Scott, in order to - we had a big spike up in the second quarter of movement into our watch because that was the first time we had a look at the legacy Republic portfolio.

The rate of movement into watch since then has been dropping off, both in numbers and in dollars.

So I guess one could conclude from that that the stuff that is appropriately in watch is there, and the level of future incoming is going to be continuingly diminished.

And as I've often said, just because a credit is watched does not necessarily mean it's a problem in the end run.

Scott Siefers - Sandler O'Neill & Partners L.P.

Okay.

And then, I guess switching gears a bit, just on pricing - I guess particularly on the commercial side since that's where you guys are seeing the best growth I wonder if you can talk about the extent to which, you know, I guess just given the deterioration in the market, you're pricing aggressively to help pick up market share, anything, if you could, shed there would be helpful.

William R. Hartman - Chairman, President, CEO

Yeah, maybe I'll take a crack at that one, Scott.

First of all, we're very, very conscious of pricing and are really putting a lot more emphasis on return on capital at this point. So therefore, we have been able to make some pricing improvement in the commercial real estate portfolio in some of the opportunities we're looking for there, and that is encouraging.

At this point, one of the things that's been a little bit interesting is that the pricing in the C&I portfolio is not as improved as much as you might think it would have given industry conditions, particularly relating to the capital positions of our competitors and liquidity in general.

We do think that will happen, however, later this year. We do think that there'll be more opportunities to improve our pricing on the C&I portfolio, and clearly our new incentive plans really are strongly encouraging bankers to get that extra eighth of a percent or that extra quarter of a percent that, when applied to a lot of new originations, can really have some impact on our margin altogether.

So while we want to grow share, I'd say that we want to do that more by good sales management and adding value to clients and providing better solutions as opposed to competing purely on the basis of lower price, particularly in this environment.

Scott Siefers - Sandler O'Neill & Partners L.P.

Okay.

John D. Schwab - Chief Credit Officer

Scott, I might add to that.

As you know, our asset-based lending unit has been very successful since we started that in the spring of '06, and the margins and overall fee income that that unit generates are really quite a different pattern than the rest of the commercial portfolio.

Scott Siefers - Sandler O'Neill & Partners L.P.

Okay. Thank you.

And then I guess I just wanted to ask kind of another question on the dividend only because, you know, that's probably 9 out of every 10 questions that I guess I receive on Citizens.

You know, given what appears to be obviously a deteriorating credit environment industry wide, I guess you guys are up near sort of a if, you know, kind of $20 million of charge-offs in a quarter sort of became the run rate, it doesn't necessarily push the numbers too hard until you get to a point where you're essentially paying out what you're earning.

So I guess I'd just like a little more color on kind of what it would take to sort of dip the balance and maybe cause you guys to think that you'll - maybe take another look at the level might be prudent.

William R. Hartman - Chairman, President, CEO

Well, I think it's a good question, Scott, particularly in light of the first part of your question where you said if charge-offs get to be $20 million a quarter, which would really be $80 million for the year.

And first of all, when I made my comments that we think that the provision expense for the first quarter will likely be the highest of the year, I guess what I would say is at this point, we don't anticipate $80 million of provision expense for the year.

So I think that would be an important thing to factor into your thinking on that particular point.

And beyond that, as I said, we're just going to simply look at how we're doing on earnings and credit quality and capital and liquidity and evaluate that decision in the best interest of the shareholder.

Obviously, we know the dividend is important. I think in this kind of an economic environment, it's a little harder to predict your credit quality and exactly where you're going to come out, but we're going to stay attuned to it, and we do think that the capital cushion is important for us to have. We are committed to that.

So it's a decision we're going to evaluate every quarter, and do it in the best interests of our shareholders.

John D. Schwab - Chief Credit Officer

At the risk of - I'd just like to jump in, Scott, and add to that.

If you look at our release and study the breakdowns in the commercial loan portfolio and look at what I call the riskier pieces of the commercial portfolio the land hold, land development, construction - and observe the reductions in our outstandings in those portfolio year-over-year, so I throw that on top of the credit practices that we have implemented during the year in identifying trouble early, that we're working the portfolios down in those riskier pieces, and I think that will have a longer-term positive impact on what we're talking about here and that's charge-offs and provision.

Scott Siefers - Sandler O'Neill & Partners L.P.

Yeah. Okay. Great. Thank you very much.

Operator

Our next question comes from Terry McEvoy with Oppenheimer. Your line is now open.

Terry McEvoy - Oppenheimer & Co.

Good morning.

William R. Hartman - Chairman, President, CEO

Good morning, Terry.

Terry McEvoy - Oppenheimer & Co.

I was wondering if you could share with us what percentage of the charge-offs last year were legacy Republic, and then what percentage of the growth in NPAs in Q4, the $87 million, were legacy Republic as well?

William R. Hartman - Chairman, President, CEO

Going back to '06, Terry, the significant majority of the charge-offs were related to Republic.

Does that answer your question?

Terry McEvoy - Oppenheimer & Co.

Going back to '06?

Charles D. Christy - CFO, EVP

Oh, yeah. I think since '06 and through '07, we would say a higher majority of the charge-offs coming from the commercial real estate portfolio were originally underwritten in the Republic portfolio.

And then the growth in non-performing loans obviously has been coming from commercial real estate, too, and has been a higher percentage coming from that portfolio.

Terry McEvoy - Oppenheimer & Co.

Okay.

John D. Schwab - Chief Credit Officer

Yeah, I'm looking at a list of charge-offs for 2007, Terry, and it's nearly - well, there are four loans in here in the top 20 that were C&I. The rest are all commercial real estate. And 88% of the charge-off dollars came from the legacy Republic organization.

Terry McEvoy - Oppenheimer & Co.

Okay.

And then, Charlie, it sounded like on the last call you would evaluate or test goodwill on an annual basis. Now it's a quarterly basis, monthly basis - is there a change in practice now with valuing goodwill or is that how it was done from day one?

Charles D. Christy - CFO, EVP

No, there's no change in practice. You still have an annual test.

The one thing there are, there are a number of points that you look at that you ask questions - and you always have done that on a quarterly basis because you want to follow 142 - and those are things that - have you sold off pieces of the business you purchased or other factors that have caused a trigger point that, you know, should then accelerate that test.

And so that's something that hasn't changed. You only should look at that once you get into a goodwill situation. That's inside 142. But our annual testing is - we just completed that, and we'll go back to the annual unless some other triggers get tripped.

Terry McEvoy - Oppenheimer & Co.

And then just a last question for John.

Without talking specifically in numbers, where do you think a bulk of the charge-offs will come from in 2008? Will it continue to be the land hold, land development side or do you start to see that moving into other areas of your commercial and consumer portfolio?

John D. Schwab - Chief Credit Officer

I think it will, Terry. Very clearly, the land hold, land development.

Terry McEvoy - Oppenheimer & Co.

Thank you very much.

Operator

Our next question comes from Eileen Rooney with KBW. Your line is now open.

Eileen Rooney - Keefe, Bruyette & Woods

Hi, guys. Most of my questions have been already asked, but just one follow up on the commercial loan growth.

Were there any geographic or industry concentrations in that and also just, were there any loan participation?

Charles D. Christy - CFO, EVP

This is Charlie.

Basically, we did have some asset-based lending. I noted that there was $143 million growth there, and there were some participations in the SFA funding from large corporation-level type participations.

And then we did recognize good growth in the Cleveland market, our Wisconsin markets, and our southeast Michigan markets, which really has been the trend for the last number of quarters.

William R. Hartman - Chairman, President, CEO

Yeah, we also are starting to see some good growth from our northeast Ohio initiative as well.

John D. Schwab - Chief Credit Officer

It's also - Eileen, this is John - the asset-based lending unit is really essentially the only part of our company that lends out of footprint, for the most part.

Eileen Rooney - Keefe, Bruyette & Woods

Thanks for that.

Operator

At this time, there are no further questions in queue.

William R. Hartman - Chairman, President, CEO

Okay. Well, thank you all very much for joining the call. If there's any questions that we can answer for you at any time, don't hesitate to call. Have a great weekend.

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