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Executives

William H. Callihan - Director of IR

James E. Rohr - Chairman and CEO

Richard J. Johnson - CFO

Analysts

John McDonald - Banc of America Securities

Edward Najarian - Merrill Lynch

Michael Mayo - Deutsche Bank

Jason Funk - Ferris, Baker Watts

Nancy Bush - NAB Research LLC

Robert Hughes - Keefe, Bruyette & Woods

Matthew O'Connor - UBS

David Hilder - Bear Stearns

Jon Jacobson - Highfields Capital Management

PNC Financial Services Group, Inc. (PNC) Q4 FY07 Earnings Call January 17, 2008 10:00 AM ET

Operator

Good morning. My name is Regina and I will be your conference facilitator today. At this time, I would like to welcome everyone to the PNC Financial Services Group Fourth Quarter and Full Year 2007 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. [Operator Instructions]. As a reminder, this call is being recorded.

I will now turn the call over to the Director of Investor Relations, Mr. Bill Callihan. Sir, please go ahead.

William H. Callihan - Director of Investor Relations

Thank you and good morning everyone. Welcome to today's conference call for PNC Financial Services Group. Participating in this call will be PNC's Chairman and Chief Executive Officer, Jim Rohr; and Rick Johnson, the company's Chief Financial Officer.

In the following comments, we refer to adjusted results for the current period as well as various prior periods. We believe having these adjusted results in addition to our reported results helps provide a clear picture of PNC's results and trends. In order to put all of the periods we discussed on a comparable basis, these adjustments report our investment in BlackRock as if we had also recorded it on the equity method of accounting prior to closing the BlackRock/MLIM transaction on September 29, 2006.

We also adjust as applicable for the following types of items in order to illustrate their impact on integration cost, net effects of our BlackRock LTIP share obligation, the Visa indemnification charge, our 2006 gain on BlackRock/MLIM transaction and the cost of our 2006 securities and mortgage loan portfolio repositioning. In each case, as appropriate adjusted for the impact of tax. We provide details of the adjustments and reconciliations to GAAP of these and other non-GAAP financial measures that we may discuss in today's conference call in our earnings release and financial supplement and our presentation slide and the appendix for this... in the appendix of this call and in various SEC reports and other documents. These are all available on our corporate website at pnc.com in the Investor Relations section.

The following statements also contain forward-looking information. Actual results and future events could differ possibly materially from those that are anticipated in our statements and from historical performance, due to a variety of factors including those described in today's conference call, in our earnings release and related materials, in our 10-K and 10-Q and other SEC reports available to our... that are available on our corporate website. These statements speak only as of January 17th, 2008 and PNC undertakes no obligation to update them.

And now I would like to turn the call over to Jim Rohr.

James E. Rohr - Chairman and Chief Executive Officer

Thank you very much Bill, and good morning every one and thank you for joining us today. The last 6 months, I don't have to tell this group, has been an extraordinary time in our industry. They marked by unprecedented volatility and many of the financial services industries are reporting substantial losses, write-downs and work force reductions. It's interesting that after several mostly predictable years, we are seeing market conditions that no one could have predicted. Credit losses which were at historical lows are now increasing, liquidity of many companies are constrained and the need for capital is driving consolidations and infusions from offshore investors. Clearly, an unusual market place we are living in.

So given all of those challenges, we are pleased with where we are today and we're satisfied with how our businesses are running. Good news is, we're growing our diverse revenues streams faster than our expenses and we continue to deepen our customer relationships, and we're deploying capital to grow our businesses. And we like our strategic decision making because we rewarded material exposures to sub-prime mortgages and other issues that are currently plaguing the industry.

We had a good year in 2007, given the operating environment. We delivered solid financial results, we completed several significant acquisitions that will further the growth of our franchise and at $139 billion, our assets are at record levels.

For the quarter and full year, we saw significant increases in net interest income, we saw strong fee growth excluding the CMBS and trading, which we'll talk about in a moment, and we continue to manage our expenses effectively. And we expect these trends to continue in 2008.

However, we're not without disappointments. PNC is not immune to the current market volatility and our fourth quarter results did not meet our expectations. As I shared with you in December, we experienced earnings pressure in two primary areas. One, credit deterioration primarily related to our residential real estate development portfolio, and the under performance in our CMBS origination business and trading activities. Today we also reported charges for our share of the estimated Visa's litigation exposure.

For several quarters... let's talk about the real estate fees first, we've been experiencing a downturn in the credit cycle. We've been saying for years that we were at unsustainable low levels of non-performing assets. Our non-performing assets did increase to 0.34% of total assets from 0.22% in the fourth quarter, still remarkably low levels and we brought a bank this year that have zero NPA, so obviously unsustainable as well and we converted them on to our platform late in September. And these combined with the deteriorating residential real estate market contributed to this increase in NPAs, but still again at low levels.

Our relationship managers are increasing their focus on adverse credits to help us through the cycle, and we have a proven ability we believe to manage through this kinds of credits, we've have done them before. Most of the credit quality issues we are hearing about today relate to residential real estate development. This represents less than 2% of our assets, a very small percentage relative to many of our peers. The other troubled area, with regard to CMBS and trading, we are comfortable that will... and we expect that to return to profitability this year.

Given our strong business model and our ability to create positive operating leverage, we can... we believe we can continue to deliver solid results in this challenging environment. Looking at our adjusted full year results, we achieved year-over-year adjusted net income growth of 12%, while our EPS on an adjusted basis was essentially flat due to the fourth quarter.

We will discuss our financial performance in more detail in a few moments. But let me offer some highlights from our business segment.

In Joe Guyaux's Retail Banking business, we continue to grow customers. We added more than 300,000 net new checking account relationships in 200... in 2007 and that includes the acquisition of Mercantile. We also saw more customers using online bill payment, a key to increasing customer retention and profitability. The percentage of consumer DDA households using the system in the fourth quarter increased year-over-year from 23% to 33%, boding well for retention.

Regarding our acquisitions, we successfully integrated Mercantile in September, adding them to our industry leading technology platform and we captured the expected cost savings in the fourth quarter. We are already seeing growth in our converted Mercantile branches with a 60% increase in the production of consumer checking accounts from the fourth quarter compared to the same period last year. This increase reflects the opportunity we see for growth in the former Mercantile branches and we are pleased that some 20,000 Mercantile customers now bank online with PNC. Another item, my initial credit card mailing to Mercantile customers took place in the fourth quarter and we achieved 140% of our goal.

Also with regard to a strategic decision in the fourth quarter for Retail, we decided to focus our brokerage business in footprint activities where we have a competitive advantage. As a result, we announced the plan to sell Hilliard and Lyons and we expect the sale to close in the first half of this year.

Now turning to Bill Demchak's Corporate & Institutional Banking business, they made great progress this year. This segment delivered good results on a relative basis despite a challenging environment. Our relationship approach which is supported by a broad array of products and services generated almost 50% of total revenue from non-interest income in 2007. This segment with its national capabilities continues to deepen relationships with its middle market customers, providing them with a broad array of credit, liquidity and capital markets products and services.

In fact for 2007 we remained number one in arranging middle market loan syndications in the Northeast, and in the U.S., we are number two in both transaction and dollar buy. Harris Williams was selected as the middle market investment bank of the year by a leading trade publication, and they had a record year. And we had a record year in our national asset-based lending group, ending the year with loan outstandings of approximately $5 billion. Not to be less, treasury management revenue is up 14% year-over-year.

As we turn to PFPC, Tim Shack and his team has done a wonderful job. Our global fund services provider reported revenue growth of 8% in 2007, driven by robust sales pipeline. Core earnings continue to show significant improvement as we transform this business segment from information processor to an information provider. During the fourth quarter, we completed two acquisitions to further that strategy. By adding the capabilities of Albridge Solutions and Coates Analytics, PFPC can now facilitate the flow of information both to and from financial advisors, broker dealers and fund companies.

PFPC continued its international expansion in '07 also by opening its sales office in London and obtaining a license that allows it to provide depository services to the $1 trillion Luxembourg market and as we know, our international services there are growing at approximately 40% per year.

Just earlier today, Larry Fink and BlackRock reported another very strong quarter of core earnings, well that's asset under management now at $1.4 trillion. The strategic decisions we made to grow the distribution network to expand the product range and our overall focus on investment performance in client service should continue the benefit PNC.

As we look forward to 2008, we believe our industry will continue to face challenges from in-market liquidity and credit deterioration. We believe this is good and bad news for PNC, because of our relative strength position. As a matter of fact, we look at it as a year of opportunity, when we look at competition with our competitors. As for the economy, we currently see growth in '08 albeit at a slower pace in '07. Assuming a reasonable economy, we're focused on maximizing the strength of our franchise in 2008 at a time when others have lost significant revenue streams or are laying out employees.

We look to execute our business plan this year by really taking advantage of PNC's products and services to new markets as well as our existing markets; and as a result, we believe we're well positioned for an even better year in '08 than '07. Now Rick will provide you with more detail of our financial strategies.

Richard J. Johnson - Chief Financial Officer

Thank you, Jim and good morning everyone. Overall, this was a very good year for PNC, despite our fourth quarter challenges. First, our business model with its diverse revenues streams continue to deliver solid results. Second, on an adjusted basis, our revenues continue to outpace our expenses, creating positive operating leverage; then third, our moderate risk profile and flexible balance sheet, position us well for the current environment.

Our reported earning per diluted share in the fourth quarter were $0.52. These results included a $0.24 charge related to our BlackRock long-term incentive plan obligation, a $0.16 charge related to Visa and a $0.15 charge for integration cost, primarily due to the additional provision of $45 million related to our Yardville acquisition. The Visa charge represents PNC share of our estimate of Visa's litigation exposure. We expect this loss to reverse on completion of Visa's pending IPO and given the temporary nature of this charge, we excluded it from our adjusted results.

Our adjusted earnings per diluted share in the fourth quarter were $1.07. This included $26 million of valuation losses for commercial mortgages loans held for sale and trading losses of $10 million. In the aggregate, these items were marginally better than what we disclosed in December; but significantly below our original expectations. Adjusted earnings also included a $78 million increase to the provision for credit losses versus the third quarter, primarily related to residential real estate development. This is a bit more than we disclosed in December and I will have more to say about that later.

For the full year, our reported earnings per diluted share were $4.35 or $5.05 on an adjusted basis, when you exclude the BlackRock LTIP activity, integration cost and the Visa's litigation charge.

Now I'd like to focus the remainder of my comments on our key business strategies; delivering diverse revenue streams with a high concentration of fee income, creating positive operating leverage and maintaining a moderate risk profile. Now as it relates to our moderate risk profile, we'll also comment specifically on today's priorities; managing asset quality, maintaining our strong liquidity profile and building our capital strength.

As slide 5 shows, we continue to grow high quality diverse revenues streams. Overall adjusted revenue for 2007 grew 18%, a significant achievement in this environment. We are differentiated by our high quality diverse revenue streams which require relatively less credit capital than our peers. Our fee-based businesses account for 50% of total revenue. On an adjustment basis, they grew 10% on a year-over-year basis, despite the challenges in our CMBS and trading activities.

Asset management revenue increased 10% on a linked quarter basis, due to BlackRock and our wealth management businesses which continue to deliver record results through strong revenue growth and disciplined expense management. Fund servicing revenue grew 3% on a linked quarter basis, driven by our emerging products, primarily offshore activity and our Albridge acquisition.

On the consumer side, our consumer service fees and deposit service charge revenues increased 3% on a linked quarter basis, and were up 12% for the full year, due to organic growth and the addition of Mercantile and Yardville. In addition, brokerage revenue remains strong with full year growth of 13%, driven by the strong performance of our in-footprint brokerage business and Hilliard Lyons.

On the Corporate & Institutional side, corporate service revenue in the fourth quarter returned to more normal levels following an outstanding third quarter. For the full year, they grew 14% due to strong results by treasury management services, midland commercial mortgage servicing and Harris Williams' M&A advisor services.

Now let's take a minute to talk about our commercial mortgage origination business. We had about $2 billion in held for sale loan to year-end. While we clearly understand the risk involved with this business, our decision early in the quarter not to fully hedge our inventory in an environment when credit spreads are widening, cost us $26 million. Since then, we have hedged all new originations and currently have several securitizations in the pipeline. Our intent is to significantly reduce our inventory in the first half of 2008.

So this is a good business for PNC and we will continue to be active in originating, securitizing and servicing commercial mortgage loans. And this and our trading business is very similar. We simply took positions that were adversely affected by unprecedented widening of credit spreads. I should point out that our customer related trading business met expectations for the quarter. Despite these challenges, the diversity of our fee income sources enabled us to grow these revenues by 10% over the prior year on an adjusted basis.

Our next largest contributor to revenue is our deposit franchise, which accounts for 27% of adjusted revenue, growing 5% on a linked quarter basis and 34% for the full year. We are differentiated by our ability to gather low cost deposits through multiple channels and including consumer, small business banking, corporate banking, treasury management and midland loan servicing. We were successful in growing our average non-interest earning deposits base by more than $250 million on a linked quarter basis.

On the interest bearing side, revenue growth was enhanced by our strategy of focusing on relationship customers rather than pursuing higher rate single service products. Our strategy is to remain disciplined on pricing, while targeting specific markets for growth as opportunity arise. Consequently, our results this quarter benefited from lower deposit cost associated with lower rates. We are seeing some price easing in certain geographies; however, overall, this remains a competitive market.

Our smallest contributor to revenue is credit, which represents 6% of adjusted revenues and grew 25% for the full year, primarily due to Mercantile and growth in our commercial client base. We continue to deploy credit capitals to service our customers and where it meets our risk return criteria. As a result, we saw average total loan growth of about $2.3 billion over last quarter, primarily driven by loan demand in our Corporate & Institutional segment and our Yardville acquisition.

We are very comfortable with the diversification of revenue resulting from our business mix. Overall, this approached delivered 18% growth in adjusted revenue for the full year.

Now as you could see on the slide 6, we create a positive operating leverage on an adjusted basis in 2007. This was accomplished with 18% growth in adjusted revenues and a 15% growth on adjusted expenses. Overall, adjusted net interest income growth was 12%.

In the fourth quarter, we saw incremental savings and operating expenses related to the mercantile integration. We said we expected a reduction in operating expenses of $108 million annually and we have met that goal. You might notice that our effective tax rate for the quarter was approximately 21%, but this simply reflects the impact of lower reported earnings while our permanent tax credits remain consistent with expectations.

Now, PNC is well positioned from a risk perspective because of the strategic choices we've made and our operating discipline. Let's start with asset quality. Strategically, we have substantially avoided many exposures; sub-prime mortgages, high yield bridge and leveraged finance loans that are creating challenges for some of our peers. And our commercial real estate portfolio is relatively small compared to the peer group. On a daily basis, we make credit decisions based on our assessment of risk adjusted returns and as a result, our asset quality continues to be strong with non-performing assets representing only 0.34% of total assets at quarter-end. However, we did see a sizeable quarter-over-quarter increase in non-performing assets, but it was in line with our expectations for this stage of the cycle.

Our exposures continue to be very granular, our largest non-performing asset is $20 million and our average non-performing commercial loan is less than $500,000. That being said, we do expect non performing assets to increase in the first quarter, but at a slower pace then what we saw in the fourth quarter of 2007. We recorded a provision of $188 million, which includes the provision of approximately $45 million related to the Yardville acquisition. The remaining increase in the provision over the third quarter was primarily related to deterioration in our residential real estate development portfolio.

Our commercial real estate portfolio is well diversified. The outstandings as a percent of Tier 1 capital remains relatively low compared to our peers. Our outstandings in the residential real estate development sector is only $2.1 billion, which represents only about 4% of total loss. The majority of this exposure is in our footprint. Overall, our portfolio continues to be very granular and manageable and the average size of these exposures is about $2 million. We recognize this as an area of heightened concern and we remain diligent in our underwriting practices and in our ongoing credit assessments.

Next, let's talk about interest rate risk management. Our duration of equity at the end of the year was 2.1 years positive, providing us with continued flexibility to invest opportunistically and benefit from lower rates. Our net interest margin was essentially flat as the decline in deposit rates kept pace with asset re-pricing. The reduction in the Fed rates were marginally beneficial for net interest income. But the more significant benefit ill take effect when first, the spread between Fed funds rate and LIBOR eases, as it's beginning to do and you're seeing that in the market today. And second, when our deposit base re-prices, and this will take some more time to work its way through.

From a liquidity perspective, PNC's loan to deposit ratio of 83% is among the lowest of our peers and from a contingency perspective, we have unused burrowing capacity of more than $30 billion. So we are very comfortable with our overall liquidity position.

Next, let's talk about capital. We are adopting the Tier 1 capital ratio as our primary metric for capital management. This metric provides better alignment of capital management with our balance sheet risk. We're doing this for a number of reasons. First, we believe Tier 1 provides a better measurement of risk and is more consistent with our economic capital methodologies. Second, Tier 1 is a regulatory capital concept and is better aligned with capital approaches used by the rating agencies; and third, it allows us to access the hybrid capital markets as a recognized part of our capital structure.

Our Tier 1 capital at year-end was 6.8%. That's above the well capitalized level from a regulatory perspective. However, this level of capital is a little thinner than I would like in this environment. This happened because we grew our balance sheet more than expected and we closed an acquisition earlier than expected. That being said, our focus in 2008 will be on building our capital ratios and I am confident in our ability to do so. This is why; first, we have ability to grow earnings; second, we can access the hybrid capital market without diluting earnings per share; and third, we do not plan to use our capital to repurchase shares for the foreseeable future. As a result, our Tier 1 capital ratio target for year-end 2008 and potentially sooner is between 7.5% and 8 %.

On a final note, I'd like to report that we have resolved our cross-border leasing issue with the IRS, with an additional charge of a nominal amount of $7 million after taxes. This significant uncertainty is now eliminated from our balance sheet, a major accomplishment.

If you look to full year 2008, compared to 2007 on an adjusted basis and based on our economic forecast of 2% GDP growth in 2007, we expect to see loan and deposit growth percentages somewhere in the mid single-digits. Total revenue growth will exceed 10%, driven by strong net interest income growth as well as solid growth in non-interest income. We continue to expect to create positive operating leverage with expected non-interest expense growth in the high single-digits. And given our mid single-digit loan growth expectation, we expect the provision in 2008 to be between $400 million and $500 million, depending on the pace of change in the credit cycle. We also expect our effective tax rate to be approximately 32%.

In summary, we believe our industry including PNC will continue to face challenges for market volatility and credit deterioration. Even so, as we seek to maximize the value of our franchisee in 2008, this business model and our business strategies should serve us well. With that, I will turn it back to Jim.

James E. Rohr - Chairman and Chief Executive Officer

Thank you, Rick. In closing, it was another solid year for PNC. I believe our performance validates our approach and reinforces our commitment for the key strategies that we've delivered these results. Most important, we believe we are well positioned for the current environment. As we continue our efforts to build a great company, we will focus on revenue side of growing high quality revenue streams to a diversified business mix; on the expense side, we believe that we will achieve positive adjusted operating leverage through growing the businesses with its good expense management and maintaining a modest risk profile. Given what we see now, and assuming a somewhat stable economy, we expect '08 to be better than '07 and we are comfortable with the range that First Call has for our '08 expectation. And with that, we would be happy to take your questions.

William H. Callihan - Director of Investor Relations

Operator if you could give our participants the instructions please.

Question And Answer

Operator

Thank you. [Operator Instructions]. Your first question comes from the line of John McDonald with Banc of America Securities.

James E. Rohr - Chairman and Chief Executive Officer

Good morning John

William H. Callihan - Director of Investor Relations

Good morning John

John McDonald - Banc of America Securities

Hi, good morning guys. Question for Rick and may be Jim on capital. Rick, would you say buybacks look like there on hold for 2008 and would that also mean acquisitions probably also on hold for 2008? And then secondarily, might you consider some kind of debt issuance or other kind of capital enhancement activity this year to get your capital levels up to where you want them?

Richard J. Johnson - Chief Financial Officer

Yes. I think in terms of buy back, I think at least for the first half of the year, no doubt. I think we'll be on the sidelines as it relates to that and we will have to reassess our capital position at mid year. I think as it relates to issuing an access of the capital markets, but we certainly feel that we have access to that and as I mentioned, I think we will be strongly considering some kind of Tier 1 capital issuance, which is not dilutive to earnings per share. And we have done that throughout 2007 and we will be looking at that in 2008.

John McDonald - Banc of America Securities

Okay. And then may be Jim's comments on acquisitions given the capital levels down?

James E. Rohr - Chairman and Chief Executive Officer

With the acquisitions, I think it's important to note it John, I think we have tremendous opportunity just by operating our businesses as we see. I think in the last presentation we made, we talked about how much opportunity upside, there are opportunities in the new markets that we've entered and we like the success that we are having in Mercantile and the outgo already. And so I think... I think our focus really this year is going to be to continue, get excess of cost saves out of there and drive revenues through our existing and our new franchises.

Acquisitions, I think at this point in the credit cycle kind of interesting to do, I think as we know in real estate in the past, it takes probably three years to work its way through the cycle, that's when... that's why we are glad we have a lower relative percentage than our peers. So I think we would rather just run our business.

John McDonald - Banc of America Securities

Okay. And then just a follow-up Rick, on the margin and NII, did you give an outlook for the early '08 or '08 at all on margin or NII growth?

Richard J. Johnson - Chief Financial Officer

No, I think as it looks NII, clearly we see growth in NII and I mentioned that we will see strong growth through the entire year. On the margin, I'd say it will be stabled up throughout the year, given the... what we are seeing right now in terms of Fed easing throughout the year, as well as our expectation of little bit steeper curve than what we are seeing today.

John McDonald - Banc of America Securities

Okay, thanks.

William H. Callihan - Director of Investor Relations

Next question please.

Operator

Your next question comes from the line of Ed Najarian with Merrill Lynch.

James E. Rohr - Chairman and Chief Executive Officer

Good morning Ed.

Edward Najarian - Merrill Lynch

Good morning.

James E. Rohr - Chairman and Chief Executive Officer

Ed?

Edward Najarian - Merrill Lynch

Question on the $400 million to $500 million provision, if we look at that level, does that include some additional reserve build-in and not just reserve build-in on a dollar basis but reserve build-in on a reserve to loans outstanding basis as well?

Richard J. Johnson - Chief Financial Officer

Yes I think so Ed, because I don't expect charge-offs to reach that level through the course of the year. So I think absolutely, would result in some reserve building over the course of the year.

James E. Rohr - Chairman and Chief Executive Officer

We'll tell you, our loan growth in the mid single-digits; it'll be tied to that.

Edward Najarian - Merrill Lynch

Right. So I guess the question I am asking is, would you expect your year dollar reserve to increase faster than the mid-single digit pace?

Richard J. Johnson - Chief Financial Officer

Yes, yes it would.

Edward Najarian - Merrill Lynch

Okay.

Richard J. Johnson - Chief Financial Officer

I think you'll have the combination of loan growth as well as to the extent that there is a further deterioration that will bring probably some excess reserving over charge-offs in the near term.

Edward Najarian - Merrill Lynch

And then secondarily, I know this is a kind of hard thing to look out on, you mentioned you expect NPAs to increase in 1Q, but increase at a slower pace than they increased in 4Q. Any outlook for credit quality beyond 1Q or any kind of tentative, sensitive outlook you think that pace of NPA growth will continue to decelerate?

Richard J. Johnson - Chief Financial Officer

The challenge there Ed is everything is based upon our view of the economy, what we think is going to happen over that period and based upon the economic forecast of war economist and where that's at. I think you see it building Q1, a little bit in Q2, leveling off maybe through the second half of the year. But that's based upon a forecast and those forecast are changing pretty rapidly.

Edward Najarian - Merrill Lynch

So, suffice it to say if that's sort of the tentative outlook that would not really be a... excuse me, a refreshing scenario of outlook?

Richard J. Johnson - Chief Financial Officer

No that's a 2% GDP growth outlook.

Edward Najarian - Merrill Lynch

Okay. Thank you very much

Richard J. Johnson - Chief Financial Officer

Sure.

William H. Callihan - Director of Investor Relations

Next question please

Operator

Thank you. Your next question comes from the line of Mike Mayo with Deutsche Bank.

James E. Rohr - Chairman and Chief Executive Officer

Good morning Mike.

Michael Mayo - Deutsche Bank

I have five little questions; one is where is consensus spec? You are saying it okay.

Richard J. Johnson - Chief Financial Officer

First call consensus for us in '08 is $5.94 to $5.35.

Michael Mayo - Deutsche Bank

Right. Well, this $5.94 to...

Richard J. Johnson - Chief Financial Officer

Low end is $5.35 and the upper end is $5.95.

Michael Mayo - Deutsche Bank

Okay, that's a wide range I guess.

Richard J. Johnson - Chief Financial Officer

I agreed

Michael Mayo - Deutsche Bank

And then second, Mercantile cost savings you got where you wanted? Is there more to go or is that pretty much it?

James E. Rohr - Chairman and Chief Executive Officer

Certainly more to go

Michael Mayo - Deutsche Bank

About how much more you think?

James E. Rohr - Chairman and Chief Executive Officer

We haven't given an estimate on that, but I think they were continuing to see opportunities for cost saves in Mercantile. We are also investing in Mercantile in terms of hiring people that produce fee income. So there will be more cost saves coming up.

Michael Mayo - Deutsche Bank

And then third; Yardville, how much that add in different categories like NPAs, revenues, expenses?

Richard J. Johnson - Chief Financial Officer

It was... in terms of NPAs, it was pretty marginal, $17 million. I think in terms of overall loans was about $1.3 billion. What other categories you look for Mike?

Michael Mayo - Deutsche Bank

In revenues and expenses, if we were to back out Yardville to look at linked quarter revenue and expense growth?

Richard J. Johnson - Chief Financial Officer

Yes, you are talking Yardville's revenue number is about $10 million.

Michael Mayo - Deutsche Bank

And the expense is?

Richard J. Johnson - Chief Financial Officer

$10 million.

Michael Mayo - Deutsche Bank

Okay.

Richard J. Johnson - Chief Financial Officer

Yes.

Michael Mayo - Deutsche Bank

And that's for... that's the impact in the fourth quarter or would that be a whole quarter?

Richard J. Johnson - Chief Financial Officer

That's the impact in the fourth quarter and we closed, it's two months for them.

Michael Mayo - Deutsche Bank

And then fourth; the new capital issuance is that factored into your expectation for 10% revenue growth because if the issue say, some preferred with the dividend rate that would be a drag on revenues. So was that in your numbers already?

Richard J. Johnson - Chief Financial Officer

Absolutely.

Michael Mayo - Deutsche Bank

It is, okay.

Richard J. Johnson - Chief Financial Officer

Absolutely yes.

Michael Mayo - Deutsche Bank

And then lastly, I guess your home loans bank borrowings went up $4 billion this quarter and $6 billion in the last two quarters, at the same time I guess securities are up also. So to get back to your capital target, do you think about maybe downsizing the balance sheet in that area?

Richard J. Johnson - Chief Financial Officer

Not downsizing, I think what you saw there is we just saw a great opportunity in the market to be able to borrow cheap and invest, right and enhance earnings. I think over the long although, we don't want to be as dependent on those kinds of borrowings and I think we will probably be taking a look at that over time and converting that back in some longer term funding.

Michael Mayo - Deutsche Bank

Okay. Actually, just one last one, I keep reading the name of PNC in the paper as a takeover target and I haven't heard you guys say that, but just how Jim, how do you respond?

James E. Rohr - Chairman and Chief Executive Officer

I don't see us as a takeover target.

Michael Mayo - Deutsche Bank

Okay, thank you.

William H. Callihan - Director of Investor Relations

Next question please.

Operator

Yes. Your next question comes from the line of Bob Hughes.

James E. Rohr - Chairman and Chief Executive Officer

Good morning Bob.

William H. Callihan - Director of Investor Relations

Good morning Bob. Bob?

Operator

With KBW, Bob your line is open. Okay, Bob has withdrawn his question. Your next question comes from the line of Jason Funk with Ferris, Baker Watts.

James E. Rohr - Chairman and Chief Executive Officer

Mike had five questions for us.

Jason Funk - Ferris, Baker Watts

Good morning gentlemen.

James E. Rohr - Chairman and Chief Executive Officer

Hey Bob, good morning Jason.

Jason Funk - Ferris, Baker Watts

How are you today?

James E. Rohr - Chairman and Chief Executive Officer

Good.

Jason Funk - Ferris, Baker Watts

A couple of questions here. One, you guys adopted FAS 159 which you did not do so for your BlackRock investment. Could you comment on that?

Richard J. Johnson - Chief Financial Officer

Yes, I think that we adopted... we will adopt January 159 and we've got two very small strategy structure repose in CMBS where we're going to get a fair value. It's not going to have that big of an impact on our results overall. If we would adopt 159, our BlackRock investment, we'd have a wonderful capital ratio immediately and then we'd have a tremendous amount of volatility in our overall earning stream over time, we just didn't think that was reflective of our view of our investment in BlackRock, which is a long-term investment.

Jason Funk - Ferris, Baker Watts

Okay, great. One more, another question about credit moving forward, what is the multi-family default that you had an CMBS and the litigation matter. What do you see for a commercial real estate credit quality in general for the industry moving forward?

James E. Rohr - Chairman and Chief Executive Officer

Well, generally speaking of this, our commercial credit quality is doing extraordinarily well and with regards to that one customer, although we don't make customer contact, we have no economic risk there; and we don't have any comments on the litigation or either. So we... but we're comfortable with the credit quality in the commercial space at this point.

Jason Funk - Ferris, Baker Watts

And what is your view moving forward for the industry as a whole? Do you think it's going to hold up or...

James E. Rohr - Chairman and Chief Executive Officer

I think it will hold up fairly well. I think if we have a... it depends on the economy, if the economy grows 2%, I think the commercial real estate market will hold up much better than the residential piece, which will clearly have overbuilt and enjoy the sub prime problems in the rest. Commercial really doesn't have those kinds of issues.

Jason Funk - Ferris, Baker Watts

Okay, all right, thank you.

James E. Rohr - Chairman and Chief Executive Officer

Sure.

Operator

And your next question comes from the line of Nancy Bush at NAB Research LLC.

James E. Rohr - Chairman and Chief Executive Officer

Good morning Nancy?

Richard J. Johnson - Chief Financial Officer

Good morning.

Nancy Bush - NAB Research LLC

Couple of questions here. Jim, I was intrigued by your comments about taking in products to new markets and about your other comment about no acquisition. So can you just kind of flush that out a little bit, what new products to what new markets?

James E. Rohr - Chairman and Chief Executive Officer

We, in our most recent presentation we showed for example Yardville I think it is probably the easiest example, our bank ex-BlackRock, if you just take the bank itself, its 50% fees that all the various products and services that we deliver to customers through the bank. Yardville which is the number one market share player in three of the 10 richest counties of America has 29% fees. They don't have any private banking activity, they have no credit card capability, they have no brokers, no branches, they don't do merchant servicing for their small business customers in a region they don't... they didn't have remote deposit. And so we look at, we look at opportunities like that and to put those products in the hands of those sales people in that region to the extend we reported, we expect a 15% IRR while taking the costs out to the extend you don't give us any credit for the revenue stream any growth in revenue, but if we can drive that revenue from 29% to 40% or 50% like we kind of rest of the company rest of the bank, we can truly enhance that acquisition.

We look at and you have the same issue is at Mercantile, although they have a little bit higher component of fees and then when we look at Greater Washington with the Riggs acquisition, we have been able to, we have been able to increase their percentage of fees and our fee growth by over 10 full percentage points in a year and a half or 2 years I guess now. So those are the kinds of things we think we can do in those new markets and it's a tremendous opportunity for us without having to do an acquisition.

The acquisition environment, your second question, I... it's going to be interesting to watch. I mean credit quality is clearly going to be an issue for the next year or two and I am sure there will be opportunities. Our first and foremost issue is just to run our business. I think we have a great opportunity. In the markets we were in, are doing very well. I mean the Maryland market, the New Jersey market, Eastern Pennsylvania and even the stability that we have in the Midwest, we don't have as you know in Ohio or Michigan where, the default rates are so high. I mean we've got stable markets and growing markets and I think that give us a real opportunity.

Nancy Bush - NAB Research LLC

So you are talking about enhanced delivery within the footprint, not outside the footprint?

James E. Rohr - Chairman and Chief Executive Officer

Yes. Some of our businesses are outside the footprint; our treasury business, our real estate business, our Midland, our secured lending business with business credits. So some of our businesses are outside the footprint, but the branch business I think we'll just mind the existing footprint for a while.

Nancy Bush - NAB Research LLC

Okay. And on the residential real estate front, I am assuming that most of the issues you are seeing right now, are related to Mercantile, are they mostly Northern Virginia/Metro DC issues or are there some outside that area?

James E. Rohr - Chairman and Chief Executive Officer

Well it's across the board but our residential real estate is concentrated in that region. So there is something kind of evolving, when we announced the Mercantile deal, they had no non-performers at all. That was an unsustainable comparison. The non-performers today would be less than 50% Mercantile. But they were larger real estate lender than PNC was. So they have contributed significantly to the increase in the NPAs

Nancy Bush - NAB Research LLC

Great. Thank you.

William H. Callihan - Director of Investor Relations

Next question please

Operator

Your next question comes from the line of Bob Hughes with KBW.

James E. Rohr - Chairman and Chief Executive Officer

Welcome back.

Robert Hughes - Keefe, Bruyette & Woods

Yes, sorry, I failed reaching for the mute button. Was there any impact on the quarter, in the income statement or your book basis for BlackRock associated with the Quellos acquisition in the fourth quarter?

Richard J. Johnson - Chief Financial Officer

No, actually there wasn't because what BlackRock ended up doing was that the shares they were planning to issue actually went into trust, so there was a new underlying write-up with respect to our investment in BlackRock.

Robert Hughes - Keefe, Bruyette & Woods

Okay.

Richard J. Johnson - Chief Financial Officer

That won't incur until that... those shares actually come out of trust and actually get delivered to the third party.

Robert Hughes - Keefe, Bruyette & Woods

Okay. I was hoping you might be able to provide a little bit more color on your actions against the construction book. Obviously, we don't really see the delinquencies, but I think you said a lot of $190 million increase in NPLs was related to construction credits. Can you give us a little bit more color on what you are seeing or are those loans actually gone delinquent, have you run through interest reserves or is this reflective of a reassessment of collateral values?

James E. Rohr - Chairman and Chief Executive Officer

It's really reassessment of the collateral value. When we've... it's interesting, its very interesting portfolio Bob, frankly it's lots and lots of small loans, it could just be an average NPA is $500,000. The largest deal is $20 million in the whole NPA portfolio. So what you need to do on those cases, you really need to work with those borrowers and in some cases the people that we have done business with for years and years, and you want them to stay friends for life, just because there is a residential real estate downturn doesn't mean that, you throw everybody out. It's real opportunity to make a customer for life, but you have to be careful. You work with those people that you are talking about small loans, $500,000. $1 million, $1.5 million a piece, so there is terrific... there's more opportunity to resolve those issues and that would be for real large loans, which is good but at the other hand it takes a lot of shoe leather to work with $500,000 loans. So we are just going to be very aggressive in pursuing those.

Robert Hughes - Keefe, Bruyette & Woods

And could you give us an indication of what your total reserves are now set aside against the residential development portfolio?

James E. Rohr - Chairman and Chief Executive Officer

Yes but...

Richard J. Johnson - Chief Financial Officer

We don't have a specific on residential, I don't have that for you.

Robert Hughes - Keefe, Bruyette & Woods

Okay.

James E. Rohr - Chairman and Chief Executive Officer

But we have it, when we do the reserving we do it by customer, but we just don't have it broken down.

Richard J. Johnson - Chief Financial Officer

Yes.

Robert Hughes - Keefe, Bruyette & Woods

Okay. And Jim, when you're talking about [indiscernible] expecting a better year on '08. That's off of the 505 basis, adjusted basis for '07?

James E. Rohr - Chairman and Chief Executive Officer

Yes.

Robert Hughes - Keefe, Bruyette & Woods

Okay. And then if we think about this quarter's results say, ex-the cross border lease charge of $1.09 and you normalize some of the trading results and in commercial mortgage back activity, activities maybe you get to a run rate that's closer to $1.30 at the same time I think a lot of investors might view the 2% GDP growth assumption as somewhat optimistic next year. What else is going to help you get to better results in '08?

James E. Rohr - Chairman and Chief Executive Officer

Well, I think we see net interest income growing nicely next year. I think with a reasonable economy, the free income piece that is especially some of the things I was talking to Nancy about, I think will do well. BlackRock have another good year, I would think. So when you look at the revenue side, whether it is net interest income or fees, I think with just a reasonable economy, I think we're going to see nice growth there. We've been pretty disciplined on the expense side, so I think the expense piece is okay and I think Rick talked about $400 million to $500 million provision and I think that leaves us to another solid year if we are able to do some other things and you know and be a little more aggressive and have a little luck here and there I think we are going to have a real good year, but I think at this point we are comfortable with the range.

Robert Hughes - Keefe, Bruyette & Woods

Okay thanks guys

William H. Callihan - Director of Investor Relations

Next question please

Operator

Yes. Your next question comes from the line of Matthew O'Connor with UBS.

William H. Callihan - Director of Investor Relations

Good morning Matt.

James E. Rohr - Chairman and Chief Executive Officer

Good morning Matt.

Matthew O'Connor - UBS

You guys won a lot of sensitivity to the credit cost and macro assumptions and can you just give us a sense of if GDP is flat for the year or may be 1%, how much increase there will be in the credit cost versus the $400 billion to $5oo billion that you are assuming.

James E. Rohr - Chairman and Chief Executive Officer

I am not sure and I think one of the things that is an advantage to us is that the $1 million or $2 million loans aren't so sensitive to GDP growth. You are talking about local loans that get to handle differently than $40 million and $50 million development, so I don't think we are as sensitive to other people, it obviously wouldn't be positive, but I don't think we are as sensitive as other people. The other thing is that most of our real estate issues are all concentrated; most of our real estate in general is concentrated in Mid Atlantic space, where the real estate market is held up better than the rest of the country. So using a GDP number across the nation probably isn't fair I don't think to compare that to what might happen in Mid Atlantic states. So we... I am not as concerned as I might be if I had a national franchise or if that was a very large portfolio. It's only 2% of our total loan.

Matthew O'Connor - UBS

Okay I mean if we have a mild rescission for this year and it impacts many markets, I think there is some concern that some other markets that we are in, its just taking a bit longer for the slow down to occur so, is there... have you run some sensitivities for that?

James E. Rohr - Chairman and Chief Executive Officer

We run sensitivities, but again we are... I think it would be worst, but not significantly.

Matthew O'Connor - UBS

Okay. And just separately; of the $2 billion of residential constructions that you disclosed, you said that most of those were small. Should we assume that from a vast majority of that are smaller builders versus bigger ones?

Richard J. Johnson - Chief Financial Officer

Yes that's correct. Yes.

Matthew O'Connor - UBS

Okay. And then just lastly, I think almost every conference call you're asked about PFPC, but as I look back over the last several quarters, the earnings have been roughly flat in that business. And I am just wondering one, what are the prospects are going forward there? And then two, question you always got you revaluate keeping this business as far as PNC overall?

James E. Rohr - Chairman and Chief Executive Officer

Well, we like it as part of PNC significantly. I think we are doing a very good job. Tim and his group have done a very good job in terms of diversifying the revenue stream with that company. They over the last five years, they have grown the net income substantially and not with these tune of acquisitions, it really differentiates from in a way that they have never were before in terms of... in the past they were information processor and now they are becoming an analytical provider for their customers. It opens up a whole new customer base especially in the separate account and the managed account area. So I think there is a... we are optimistic that once those two organizations really get integrated into the systems, there is a tremendous growth opportunity for PFPC. So I didn't imagine that Albridge Solutions could do for us, what I think it will do; and it's brought a lot of customers to us. So I think there is a really good future for PFPC.

Richard J. Johnson - Chief Financial Officer

Yes and actually if you look to what happened in 2006, we had about a $14 million tax cut in that business, so the actual if you adjust for that, the actual growth in PFPC will be in net income is about 17%. So, while... and it's kind of a step to business; big clients come on; some clients go up; so they just keeps reaching new levels of overall earnings growth.

Matthew O'Connor - UBS

Okay. That was helpful. Thank you very much.

William H. Callihan - Director of Investor Relations

Next question please.

Operator

Your next question comes from the line of David Hilder with Bear Stearns.

Richard J. Johnson - Chief Financial Officer

Good morning David.

David Hilder - Bear Stearns

Good morning and I think that actually touched on the first part of my question. I guess the second part would be, just wondering how you arrived at the 2% GDP number as the one that to base your forecast around, because that would seem to be perhaps more optimistic than others; especially, given the outlook for the first half of the year?

James E. Rohr - Chairman and Chief Executive Officer

Well, we have a solid year and Stuart Hoffman who has been named the economist of the year by the Wall Street Journal a number of times is the most accurate forecaster; and that's his number. So that's how we came to that number. He can talk about that at great length.

Richard J. Johnson - Chief Financial Officer

And I think the other thing too is, for GDP forecast isn't as critical. If our GDP growth was actually lower than that, my guess is our net income growth is going to be even stronger than what we expected to be, it probably be a little bit of an impact on fee income growth and then separately or probably have a higher provision. But I still think in most environments, we're still going to be able to deliver good earnings growth in the New Year.

David Hilder - Bear Stearns

Thanks very much.

Richard J. Johnson - Chief Financial Officer

Okay.

William H. Callihan - Director of Investor Relations

Next question please.

Operator

Yes. Your next question comes from the line of Matt Botein with Highfields Capital.

Richard J. Johnson - Chief Financial Officer

Good morning Matt.

Jon Jacobson - Highfields Capital Management

Hi, it's actually Jon Jacobson, Highfields Capital. Let me just walk you guys through a couple of numbers which may not be 100% accurate but there is sort of directionally correct, then I want to ask a question. So with PNC stock rate now last sales sort of $58, over the last year stock is down roughly 20% from market capital, roughly $25 billion to well under $20 billion today, $20 billion today. At the same time your 43 million shares of BlackRock have appreciated from $150 a share to $210 or roughly 40% over that time period. So that's $6.5 billion investment at market a year ago is now worth over nine. So sort of putting on this two numbers together, the non-PNC part... so the non-BlackRock part of PNC has declined in market value from roughly $18 billion a year ago to just under $11 billion today or something like 40%. So here the question, so in this first question is, do you think that's appropriate particularly given that you guys have done a much better job sort of managing your business than virtually all your competitors, number 1. And the second question is does it bother you as much as it bothers us, and then I guess the punch line question is that... do you think it's incumbent upon the management to sort of take actions to sort of rectify so that this disconnect and create value for shareholders?

James E. Rohr - Chairman and Chief Executive Officer

Yes. One is this, certainly, we are disappointed in the valuation of PNC. We think we have done a much better job in our peers in this environment and I think that's... so I agree with you on that. And that's true whether it's corporately or personally. So because we all are big investors in PNC and we spent a lot of time in managing the risk here and we do agree that we've done a better job. I think the issues that faced the industry are also faced PNC as a financial services company and although we've not... we are not been impacted by sub-prime and others, but we are not immune to the fact that the entire industry's share price performance is down substantially across the industry. As a matter of fact, I think our peer group was down 27% last year and I think we were down 11% last year or so.

William H. Callihan - Director of Investor Relations

Excuse me, just a moment. Jon, are you still on?

Jon Jacobson - Highfields Capital Management

I am.

William H. Callihan - Director of Investor Relations

Okay because we are hearing from some places that the call went dead; I just wanted to make sure.

Jon Jacobson - Highfields Capital Management

No, I am still here.

William H. Callihan - Director of Investor Relations

Thank you.

James E. Rohr - Chairman and Chief Executive Officer

Okay, thank you. So you know we are disappointed, the share prices have done better than our peers but we are still disappointed in that as well. So I think to answer your question, yes, we are disappointed.

Jon Jacobson - Highfields Capital Management

And the third question?

James E. Rohr - Chairman and Chief Executive Officer

The third question in terms of trying to do what we can do to get the share price back I think we are communicating with our shareholders as best we can in order to let them know how the franchise is operating. We are taking some actions on the risk side where the fourth quarter was disappointing, the fact that the year wasn't. And I think when we look ahead to 2008 we can make statements about 2008 that I believe lot of people can't, so I think that's important for us to keep working and keep delivering.

Jon Jacobson - Highfields Capital Management

Okay, thanks.

James E. Rohr - Chairman and Chief Executive Officer

Thank you.

William H. Callihan - Director of Investor Relations

Next question please.

Operator

: There are no further questions in the queue at this time.

William H. Callihan - Director of Investor Relations

All right. Jim, do you have some closing remarks?

James E. Rohr - Chairman and Chief Executive Officer

No, thank you very much for joining us this morning, I think as we've mentioned 2007 was a good year for PNC, not a great year and we are looking forward to 2008 being better. Thank you for joining us.

William H. Callihan - Director of Investor Relations

Thank you.

Operator

: Thank you for participating in today's PNC Financial Services Group earnings conference call. You may now disconnect.

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Source: PNC Financial Services Group, Inc. Q4 FY07 Earnings Call Transcript
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