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Sterling Bancshares, Inc. (NASDAQ:SBIB)

Q4 2007 Earnings Conference Call

January 29, 2008, 11:00 AM ET

Executives

J. Downey Bridgwater - Chairman of the Board, President and Chief Executive Officer

Zach L. Wasson Jr - Executive Vice President and Chief Financial Officer

Graham B. Painter - Executive Vice President and Director of Corporate Communications

Analysts

John Pancari - JP Morgan

David Bishop - Stifel Nicolaus.

Charles Ernst - Sandler O'Neill.

Brent Christ - Fox-Pit.

John Arfstrom - RBC Capital Markets.

Erika Penala - Merrill Lynch

Bryce Rowe - Robert W. Baird.

Terry McEvoy - Oppenheimer & Company.

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the Fourth Quarter 2007, Sterling Bancshares Earnings Release. At this time, all participants are in a listen-only mode, and later we will conduct a question-and-answer session with instructions being given at that time. (Operator Instructions). As a reminder, today's conference is being recorded. I would now like to turn the conference over to your host Mr. Graham Painter. Please go ahead sir.

Graham B. Painter - Executive Vice President

Thank you, operator and good morning everyone. I am Graham Painter, Executive Vice President, Corporate Communications. This morning Sterling Bancshares released results for the fourth quarter and year-ended December 31, 2007. To discuss those results with you today are Downey Bridgwater, Chairman, President and Chief Executive Officer and Zach Wasson, Exectuive Vice President and Chief Financial Officer.

Before we begin and I turn the call over to Downey, I'd like to remind everyone that the

Safe Harbor statement included in today's earnings release. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for certain forward looking statements including statements made during the course of today's conference call. These forward looking statements are based on the Company’s current expectations and believes concerning future developments and their potential affects on the company.

There can be no assurance that future developments affecting Sterling will be those anticipated by the company. Factors that could cause actual results to differ from those projected in the forward looking statements are set forth for today's earnings release, which is been posted on the investor relations page of our website at www.bancsterling.com.

On today's call our speakers may reference ceratin non-GAAP financial measures which we believe provide useful information for investors. If necessary we'll post reconciliations of these non-GAAP numbers to GAAP results on the investor relations page of the website.

For additional details on these matters and other risk that could affect the company, please refer to the Company’s most recent annual report and Form 10-K, which has been filed with the Securities and Exchange Commission. Sterling has since no obligation to update the information presented on this call.

I'd now like to turn the call over to our CEO, Downey Bridgwater. Downey?

Downey Bridgwater - Chairman of the Board, President and Chief Executive Officer

Thanks Graham and welcome everyone. As noted on our earnings release this morning, 2007 was a record year at Sterling. We had the highest annual net income in the 33 year history of our franchise. For the year, net income grew approximately 16% and earnings per share increased over 9%. We were able to generate these outstanding results despite operating in a challenging interest rate environment and highly competitive banking markets.

Contributing to our success in 2007 were, continued internal loan and deposit growth, the successful acquisition and integration of MBM advisors at Partners Bank of Texas, excellent credit quality, only 9 basis points in net charge-offs for the year, our continued focus on our market segment and the growth of the Texas markets in which we operate.

We always to endeavored to generate consistent transparent quality growth and earnings at Sterling. At a time when there's been so much uncertainty surrounding the financial services industry and significant writedowns to earnings and capital at numerous financial institutions due to various issues within the subprime mortgage market. It's apparent that this approach is serving us well. Therefore, we'll continue to focus on our strategy of serving all the banking needs of small-to-medium size businesses in our Texas markets. We fully understand that the long term success of our franchise depends on our customers being successful.

Turning to the fourth quarter of 2007, net income was up over 4% compared to the fourth quarter of 2006. Healthy average link quarter loan growth over 9% was somewhat muted in the fourth quarter of 2007 due to a lower net interest margin.

Our net interest margin decreased 12 basis points in the fourth quarter of 2007 as compared to the third quarter of 2007. The decrease was primarily related to the 100 basis point drop in the Fed funds rate with the fed orchestrated over the past quarter and competition for interest bearing deposits. The decrease in our net interest margin was slightly more than we had originally forecasted. While we did have fully anticipated the drop in short-term interest rates, we did not anticipate the slow reaction by major financial institution and adjusting the deposit rates on our CDs and higher price deposit products. We believe this behavior was due to these financial institution needs to hold on to whatever liquidity they had until they were able to work through financial issues, they were experiencing related to the subprime residential mortgage crisis. Therefore our higher price deposit products did not re-price as quickly as we would have hoped.

As a result, we made the strategic decision to let them of our higher price CDs, runoff toward the end of the quarter, thereby negatively impacting our deposit growth during the fourth quarter. For the near-term, we plan to utilize more wholesale funding sources such as federal home loan bank advances and other short term borrowings to help fund our growth until bank deposit pricing comes back inline with what we believe to be reasonable. Later in the call, Zach Wasson, our CFO will go into more detail on the margin and what we can expect going forward.

For the fourth quarter 2007, average total deposits increased 2.6% and period end deposits were up 1.3%. The period-end growth was due to increases in non-interest bearing deposits and interest-bearing demand deposits. As I discussed, the period-end deposit balances were impacted by the decreases in CD balances and broker deposits which were down over $60 million at period end.

For the fourth quarter, average loan growth was 9.6% and period-end loan growth was 5.2%. We had good growth in construction loans, commercial real estate loans, and our loans held for sale category which consists of SBA loans and commercial real estate loan. We continue to operate in competitive market for both deposits and loans, and we don't see that changing in the near term.

However, demand remains fairly resilient in our markets. Therefore we expect to be able to generate quality loan growth in the 6 to 8% range and annual deposit growth in the 4 to 6% range for 2008. As mentioned, as the quality was excellent for the full year 2007.

During the fourth quarter, we did have an uptick in both net charge-offs and non-performing loan. Net charge-offs for the quarter were approximately $1.4 million or 16 basis points to average loans. As we had net recoveries last quarter, the combined net charge-offs over the past two quarters are still well below what we would consider an average lost rate for our franchise.

As we stated in the past, we expect over a normal credit cycle on net charge-offs, the average loans ratio will run annually around 15 to 25 basis points with the expectation that we’ll continue to be at the lower-end of that range in the near term.

Non-performing loans increased approximately $8.5 million in the fourth quarter. The majority of the increase can be attributed to three relationships. They are not indicative of any systemic problem in our portfolio, the economy or concentrated in any industry.

Our largest non-performing loan which is placed on non-performing status during the fourth quarter is approximately $4 million, is secured by an assisted living facility in Houston which is under contract to be sold subject to various regulatory approvals and should be paid off sometime during the second quarter of 2008. Some of the increase in charge-offs and non-performing loans is also due in part to a year-end cleanup after a few of our lenders left to work for a newly formed bank.

In 2007, we made a concentrated effort to become a more efficient institution and established a sustainable cost discipline throughout the entire franchise. We were able to improve our efficiency from 63.8% in 2006 to 61.8 % in 2007. However, there is still room to improve, as we envision our optimal operating efficiency ratio to be slightly below the 60% level. As we grow, we must continue to look for ways to become more efficient. As such, we recently entered into a lease agreement to consolidate our central and corporate offices at one central location in Huston. Currently our central department and corporate offices operate at a five different facilities in various locations around Huston. With this agreement, we will be able to consolidate most of our bank operations into one location which will help us be more efficient and enable our team to more effectively serve each other and our customer. We will take a phased approach to occupy the new location over the next three years and the timing of the move is aligned with the renewals and expirations of our existing leases.

Another one of our goals is to increase our non interest income as a percentage of total revenue. We made significant stride in 2007 in this effort for the acquisition of retirement plans specialist, MBM Advisors Inc., as well as increase gains on commercial real-estate loan sale.

In the fourth quarter non-interest income was 18% of total net revenue, up from 15% in the fourth quarter of 2006. We'll continue to look for strategic acquisitions that will help us achieve further revenue diversification while enhancing our ability to serve all of our customer's financial needs.

In the third quarter of 2007 we announced that we entered into a definitive agreement to purchase 10 bank branches in the Dallas and Fort Worth markets from First Horizon. We're still on schedule to close this transaction in February of 2008. We expect it to be neutral to earnings per share in 2008 and accrete even 2009. This strategic acquisition will mark our entry into the Fort Worth market and will also give us a critical presence in the Dallas market.

We expect to add approximately $50 million in loan and $90 million in deposits as result of this transaction. While we continue to have dialogue with bankers from other possible acquisition candidates in various Texas metro areas, price expectations and our desire to acquire at a reasonable price in order to achieve earnings appreciation remains disconnected at the present time.

We'll continue to build relationships with potential bank partners and we'll remain discipline in our approach to the pricing of those acquisition. Houston, Dallas, Fort Worth and San Antonio all are expected to continue to add jobs in 2008.

Economists are expecting Houston to add approximately 60,000 jobs in 2008 after adding an estimated 100,000 jobs in 2007. Both Dallas and San Antonio experienced healthy job growth in 2007 as well.

While the national economy is expected to slow in the near term, the good news is that Houston is predicted to continue to outperform the national economy over the coming year due to benefiting from higher energy prices and being less susceptible to falling home prices.

With that, I would like to turn over the call over to Zach Wasson, our CFO to review our financials in more detail. Zach?

Zach.Wasson - Executive Vice President and Chief Financial Officer

Good morning everyone. Thank you for taking the time to join us on the call. As Downey mentioned, we're pleased with our financial results for the fourth quarter and for the full year of 2007. Net income for 2007 was $53 million or $0.72 per diluted share, up 15.5% from 2006. Net income for the fourth quarter of 2007 was $13.4 million or $0.18 per share, up 4.3% from the fourth quarter ending 2006.

As expected we continue to experience pressure on our margin during the fourth quarter. Our net interest margin decreased 12 basis points from the third quarter of 2007 to 4.62 % due to lower short term rates and stiff competition for interest bearing deposit. Approximately four basis points of the decrease can be attributed to the increase of non-accrual loans during the fourth quarter. The extent of the remaining decrease was slightly more than we were anticipating due to some of the large institutions in our mortgage, continuing to pay up for CDs and other high yield deposit products in the pace of declining Fed bill funds rates.

While there is usually a natural delay between how fast deposits to be priced and movements in short term interest rates. This delay was exaggerated by the strong need for liquidity exhibited by the large institutions during the fourth quarter. To manage the fact that deposit rates were remaining inflated, we made the strategic decision to not lay off some of our high priced CDs to run out. This impacted period and deposit growth during the fourth quarter. However, this strategy should help support our net interest margin in the coming months as we have considerable amount of our CD portfolio re-pricing. We plan to continue this approach for the near term. We will utilize short term borrowings to fund earning asset growth until the deposit pricing environment becomes more rationale.

With the FLMCs, recent action of decreasing federal funds target rate by 75 basis points, we expect that a change in the deposit pricing behaviors of other financial institutions may come sooner than later. Our liquidity position remains very healthy and we will continue to fund our growth in a sensible manner. There recently announced decrease in short term interest rates and possible further rate cuts that continue need to put pressure on our margin. However, with our active management of our funding cost and with the interest rate hedge that we established in 2006, we should be able to offset some of that pressure.

As a reminder, the interest rate hedge is 363 million enforce with an 8% flat price that we added in late 2006. With form now at 6.5% that (Inaudible) significantly in the money. The interest rate hedge effectively changes the mix by our loan portfolio from 59% variable, and 41% hedge, to 49% variable and 51% hedge.

In addition, almost 90% of our CD portfolio re prices within a year, with 55% of the portfolio maturing in the next 90 days, and 75% of the total maturing in the next 180 days.

Over the past tow years, we have worked to position our balance sheet to be more neutral to movements and interest rates, without compromising the makeup of our balance sheet. With 30% of our total deposits being non-interest bearing we were always tend to be more asset sensitive and liability sensitive. However, we gladly make that prime in order to continue to be core funding and a higher net margin than the majority of our peers. While our net interest margin is less sensitive to movements and short term interest rates, than it has been historically, going forward the overall shade for the yield curve, the composition about future loan and deposit, as well as the complication of loan and deposit pricing will all be significant factors in our margin performance.

In 2007 we began the process trial the expenses and establish a sustainable cost discipline to rule-out the franchise. For the full year 2007, non-interest expense totaled $139 million, up $8.2 million as compared to 2006.

Escalating the additional expenses related to free acquisition made since September 2006 same store expenses were actually down by approximately $3 million in 2007. While we have made amenable progress, there is still room work to be done. We seen our optimal efficiency ratio to be slightly below the 60% level, and that will be very difficult to reach this level in the short term. We believe that through our continued cost discipline efforts and our customer focus process improvement projects currently underway we could reach that level some time in the next 10 to 24 months.

From a capital perspective we are well positioned. At the end of the fourth quarter of 2007 Tier-1 capital stood at 9%, a total risk-weighted account was 11%, and our tangible capital ratio was 6.8%. We are in an excellent position to be able to fund our future, internal growth, and take advantage of possible acquisition opportunities, how we managed and employ our capital is always a priority for us, but it comes even more important current operating environment. We will continue to be very disciplined in our capital management efforts.

In February 2008, we are scheduled to close the purchase of 10 First Horizon branches in Dallas and Fort Worth, and we expect that the acquisition will be earnings for the full year of 2008, and we most likely have a slight negative impact to our results in the first quarter. We look forward to expanding our presence in Dallas and entering the Fort Worth market for the first time. We are pleased to begin adding the Dallas advisors for First Horizon to the (Inaudible).

As an update for our share buyback program during the fourth quarter, we did not repurchase any of our common stocks. The effective tax rate was approximately 32% for the fourth quarter of 2007 and 33% for the year. We expect our effective tax rate to be in similar levels in 2008.

As a current update, yesterday our board approved an increase in our annual dividend by appropriately 5% from $0. 21 per share to $0.22 per share. This is the fifteenth consecutive year we have increased our annual dividend.

With that I would like to turn the call back over to Downey, before we open the call for questions. Downey?

Downey Bridgwater - Chairman of the Board, President and Chief Executive Officer

Thanks Zach. In summary, we had a very successful 2007 and we are well positioned for future success. We look forward to executing on our strategy of providing outstanding customer service and competitive banking products to all constituencies within the small and medium sized business segment in Texas metropolitan markets.

With that, I would like to open the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instruction).

Our first question will come from the line of John Pancari of JP Morgan.

John Pancari

Good morning.

Zach.Wasson

Good morning John.

John Pancari

Could you give us a little bit more detail on the other credits that moved on to non-performers in the quarter? I know you mentioned there were largely 3 larger credits, just can you give us a little more detail on the others as well as the collateral values on each one of them?

Downey Bridgwater

Yeah. One was secured by equipment and real estate, and we expect no loss on that. It's roughly about a 1.07 million in size and we'll get that liquidated and should be down and out of that probably in the first quarter. The third one was secured by some real estate but primarily inventory and receivables and we expect no further loss. Everytime we put a credit on non-performing, we put it down on liquidation values, so we take the charge. So, you’re not going to expect to see any additional losses from those lines. But we expect, like I said, two of them to be down and out, and that the second one was about 1.04 million and the one that I mentioned on the call is 4 million. That one is under contract and due to some regulatory requirements that you have to have in selling an assisted living facility it is probably not going to close in the first quarter. It will probably close in the second quarter.

John Pancari

Okay. Good.

Downey Bridgwater

And this is one time item, this is not a – an economic issue or anything driven by any particular industry.

John Pancari

So fair to assume that do you expect the NPA ratio could trend lower and probably be back to the maybe the 45 to 55 basis point range of loans and OREO.

Downey Bridgwater

Yes.

John Pancari

Okay. Alright. And then, related to that you over provided modestly in the quarter to keep the reserve around 103 bps of loans. Is that a level that you're comfortable with and you think it's going to remain there going into '08?

Downey Bridgwater

Well, I've got to caution you and everybody else that the relative measure of reserve to loans is while it is a common view. We have to look at our reserves to the quality of the portfolio as defined by the regulators and by the SEC in our account. So, while we are glad that it remains flat and consistent especially in this environment, we want to make sure we have some dry powder there, but the thing is to make sure that we adequately reserve for all of our loans including those that are criticized and classified. So, it's our intent to make sure that we adequately reserve and we will continue to do so going forward John.

John Pancari

Okay. And then lastly on the margin, I know you indicated that you had elected to let some higher cost deposits roll-off. Can you give us some detail on the roll-off yield on some of these deposits that we can get an idea of the trade of that you are seeing in terms of relying more on short-term borrowings here in the near term?

Zach Wasson

Right, John, our CD is maturing over the next three, six, nine months or somewhere in the range between 4.5 to 5%. So with Fed funds at 3.5 and possibility of going lower, that should provide us some significant help on the net interest margin. And John, when we go and we file our 10-K this year, when we look at the interest rate sensitivity of Sterling Banc. In a immediate down 200 basis-point move in rate with a static balance sheet, our net interest income only goes down 1.5% which is probably as neutral as Sterling Banc has been in its complete history. We have a lot of accounts when I look back from historical data. That exposure would have been between 5 and 8%. But with the hedge, with the slight changes in the balance sheet composition, with slight changes in our funding composition, we’ve been able to manage that down to around 1.5% for an immediate down parallel share to 200 basis points.

John Pancari

Okay. And Zach do you have the amount of CDs in that bucket that are maturing there at six to nine months you said.

Zach Wasson

We have 75% mature by six months, 95% of our CD base will mature by the end of one year.

John Pancari

Yeah. Okay. Good, thank you.

Operator

Thank you. And next from the line of David Bishop with Stifel Nicolaus. Please go ahead.

David Bishop

Hey, good morning Zach and Downey.

Downey Bridgwater

Good day.

Zach Wasson

Good morning.

David Bishop

Sort of circle back to the number quick there, I remember the last time the Fed got real dovish here as we got into it, the bar raised a little bit antsy about those floors and renegotiating there. Are you starting to see any sort of pressure there to have to have to get those floors down here? I mean are these contracts air tightened holding in there for relatively well?

Downey Bridgwater

No, because the relative rate that they are paying is pretty low to begin with. Unlike last time where we didn't have those floors and rates dropped from a pretty high level. We've kind of gone through that exercise and that’s now more the norm in our pricing with our floating rate loans is to put a approve on those loans. So, they are generally holding in. We're not seeing a lot of rush to refinance. But if we do, certainly we'll move into floating so that when it goes back to the other direction, we'll be able to catch the lift as we did the last time.

David Bishop

Okay. And then in terms of maybe some commentary, in terms of what you're seeing in terms of the loan pipeline as it shapes up for the beginning of the year?

Downey Bridgwater

That loan pipeline is fine. It's solid. We have good demand in all of our markets. Interestingly, right now we're seeing a lot of customers selling properties or even selling their companies and it's a challenge keeping some very good relationships that have gone to debt on the books, because they’re paying down or paying off due to their increased liquidity. So it's a good problem to have and it's indicative of the health of our customers and certainly our markets, but we'll continue to generate good production, good bookings and funding on the loan side, so not concerned about that at all. As I mentioned, it would be in the 6 to 8% range, net funded loan growth for the year 2008.

David Bishop

Got you. And, in terms of the loans coming over from First Horizon, would there be any reserves reflected attached to those?

Downey Bridgwater

It's very nominal. So, I can't remember the exact amount, but it's just a few hundred thousand, it's very small.

David Bishop

Okay. And then follow on (inaudible). Other expenses increased little bit of over and above what we are looking for there. Any sort of color there? Any sort of seasonality from MBM or anything else in there on a sequential basis there?

Zach Wasson

In our fee income, the fee income was up. Also that was mainly from MBM and we had a slight increase in MBM expenses during the quarter, but our other expenses were up from just a number of small items, all going in the same direction in the quarter. There was no real pattern to it and hopefully we can manage that now going forward.

David Bishop

Great. Thank you.

Operator

Thank you. Our next will go to the line of Charles Ernst of Sandler O'Neill. Please go ahead.

Charles Ernst

Good morning guys.

Zach Wasson

Good morning Charles.

Charles Ernst

Can you first just comment about the recent rate cuts and how the margin has reacted to those 75 we just got the other day?

Zach Wasson

Right, that was somewhat of a surprise I think for everyone. But we have at year-end like I said Charles that we have over 200 basis point decreases in rates and exposure 1.5% of our net interest income. That’s on a static balance sheet. We are aggressively, not aggressively, but appropriately pricing our CDs. We continue to see some of that runoff, but we are moving from 4.5 to 5% rate down to 3.5% rate. With the floor that we put on against our loan portfolio, we have pretty much made it a 50:50 split with between floating and variable. So, I have to go back to the 1.5% number for 200 basis point decrease for a 100 basis point decrease is approximately one half of that.

Charles Ernst

Okay. So you can't say what the margin actually did after the cut.

Zach Wasson

Not in today and for a month. We need a little more time to do that calculation.

Charles Ernst

Okay. And then, Downey, can you just make a comment about the recent de novo that you alluded to earlier in your market and whether that's had any impact on your people or your business, anything like that?

Downey Bridgwater

Yes. We had a few lenders leave and go to another new community bank and we look forward to competing with them fairly. The impact that we have had so far that has been to clean up the some of the loan portfolio, some of the loans that were on the books that were in the portfolio of some of the lender that left. And I alluded to that in the call. So we did that year-end clean up and shouldn’t have those issues going forward.

Charles Ernst

Okay. And when I look at your loan guidance of 6-8%, I mean, it seems pretty conservative to me, its may be part of that conservatism coming from the fact that you have lost a couple of people.

Zach Wasson

No not at all. It has to do with the level of competition and being very conservative in the overall outlook for the accounts, there is a recession nationally, that will impact Huston to some degree not to the degree that it will other places but we will be affected by. So we are taking a conservative approach and like any other outlook or budget plan that we have, we try to look for an opportunity to beat our goal. So we’re certainly going to stretch for that, but we’re going to be rationale on the front end.

Charles Ernst

Okay and then Lastly Zach, you made a comment that First Horizon, when it comes over is going to be a little bit of a negative impact in the first quarter. Is it just that it's coming over to you as a losing proposition from a P&L impact? And then, can you just say what sort of goals you guys have over the year and where you need to get in order for it to be break-even?

Zach Wasson

As far as the coming over, we will have some small onetime charges and with the size of the footings and the expense base that we have, we have to manage that some. So we do see it having a small loss say in the first quarter and somewhere between 400 to 500,000 somewhere in that area. After that, we continue to see our Dallas effort slowing. We have a lending staff existing in our Sterling footprint, that’s very qualified. Plus, we are picking up a lender or two on the First Horizon acquisition. We see the branch offices giving us significant presence in the Dallas area and entrance into Fort Worth. So we think highly of Dallas and Fort Worth and we expect those to become a larger contributor to Sterling Bank.

Charles Ernst

Is there anything you can say about where those branches need to be, whether it's deposits or loan in terms of when they start to make a positive contribution?

Downey Bridgwater

Well they will get to break-even during 2008. So it's going to have a really a mutual impact on Sterling's, so some of the location -- they had their structure very different from the way we’re going to structure those branches. So they had a much more traditional large bank approach and we are taking approach that we used in our metropolitan area. So we have a different growth mode and we expect those branches to get to reasonable growth and reasonable levels certainly by the end of 2008, but some of them they did not allocate deposit to them and so on and so forth, so we intend to rectify that and have those go forward.

Charles Ernst

Alright, great. Thanks a lot you guys.

Downey Bridgwater

Thanks Charlie.

Operator

Next we go to the line of Brent Christ of Fox-Pit

Brent Christ

Good morning guys. It looks like the loan sale gains were down a little bit this quarter obviously off of a really strong third quarter, but could you give us a sense of how much you guys sold in the quarter and to the extent any market disruption had an impact.

Zach Wasson

What it was not market disruption, what we saw during the quarter was some SBI loans that we just continuously turnover. But we – during the quarter we accumulated some commercial real estate loans that we will over the next quarter or two turnaround and say some of those into the open market. We have not seen, and in this business that we do these are smaller sized commercial real estate loans. Our portfolio averages about $1 million. Our loan devalues anywhere between 50% and 60%, loan devalue. So, this is a very conservative portfolio and one that has still held up extremely well in this environment.

Downey Bridgwater

And the majority of these are SBA 504 first league real estate loans.

Brent Christ

Got you. And would you anticipate the, I know its somewhat lumpy depending on when you actually sell them. But would you anticipate the run rate in terms of the fee income picking up a little bit from here as to look at to 2008?

Zach. Wasson

Yes. Fourth quarter was a light quarter, and we would like for it to be smooth every quarter the same amount, but in this business that’s just not feasible.

Brent Christ

Sure. And then, looking at your end of period loan growth it seemed to be primarily concentrated within the construction portfolio. Could you give us a sense of whether that was residential or commercial related?

Downey Bridgwater

It's firstly all commercial. We have very little exposure to residential construction and then the type of residential construction that we have is to small builders or to individual consumers that occupy those homes with their contract type customer homes. So we're not in the builder business necessarily as other banks maybe. So we feel very comfortable with that part of our real estate portfolio.

Brent Christ

Got you. And then just in terms of credit quality, more broadly you mentioned the kind of three specific credits contributing to the rise in non-performers, but no real kind of correlation between the three of them. Are you seeing any kind of broader signs of pressure within the Texas economy, are there specific portfolios that you're more worried about today than you were three or six months ago?

Downey Bridgwater

Within our portfolio, no.

Brent Christ

Yeah.

Downey Bridgwater

We're seeing with other lenders those that might focus on land acquisition, lot development, home construction in the under $200,000 or under $250,000 home. In all of our markets they’re having some issues and they're definitely negative trends going on there, but we just really aren't exposed to that market at all.

Brent Christ

Got you. And then last question. You mentioned the cleanup related to some of the loans from lenders that have locked the bank. What exactly did you do with some of those?

Downey Bridgwater

It will charge-off some of the loans that were within their portfolios. They're below the limits that would be reviewed by other lenders or committees or something. It was within their own loan limit authority and some of the loans that were in their portfolio we moved to non-performing, and we’ll be cleaning them up throughout the rest of this quarter, first quarter. And that’s difficult when you have a lender leaves you might have one or two but when you have a handful or more leave at once you have to make sure that you get to the portfolio and get it cleaned up. So that’s what we did.

Brent Christ

So it was essentially just a more thorough review of their portfolios?

Downey Bridgwater

Correct.

Brent Christ

Got you. Okay thanks a lot guys.

Operator

Thank you. And next we will go to the line of John Arfstrom of RBC Capital Markets.

John Arfstrom

Thanks. Good morning guys.

Downey Bridgwater

Hi John.

John Arfstrom

Just to follow-up on the NPO total. What else is in there in terms of sizes and any estimates as to timing in some of those might be resolved?

Downey Bridgwater

Well, they dropped down significantly in size from those top three that I mentioned. To the next largest one is around $800,000 and then it drops off from there. There's couple of SBA loans and a lot and a couple of quicker loans and so on. So they're much, much smaller so they dropoff after that.

John Arfstrom

Okay good.

Downey Bridgwater

So it’s not the ordinary.

John Arfstrom

Okay. Are you seeing any easing in deposit pricing pressure yet?

Downey Bridgwater

Yes.

John Arfstrom

Okay.

Downey Bridgwater

And absolutely we've crossed the board now. With this last 75 basis point we figured would be the pin that popped the balloon. And that’s exactly what's happened, is we are now beginning to see all the banks and our markets now begin to drop almost the price of every single product. But you know they hung on to it in the fourth quarter for obvious reasons so.

John Arfstrom

Are they material drafts or is it?

Downey Bridgwater

Yes. I mean, you’re right, as 50, 70, 100 basis point drops in pricing.

John Arfstrom

Okay. Good. And how about loan price. Loan pricing competition, has that eased at all?

Downey Bridgwater

No.

John Arfstrom

Okay.

Downey Bridgwater

And I don't expect it to in the near term. I don't know exactly what the bigger banks are going to do. I have a sense of what might happen relative to the issues that they have had in other parts of the country. It's very difficult historically they've shut off lending to either entire industry groups or collateral types or those types of things. So, we actually view this as an opportunity for us to cherry-pick some customers, bankers, and ultimately some banks too.

John Arfstrom

Okay. And then lastly, can you just give us an update on the dual risk grading system. I think you talked about it last quarter and the quarter before?

Downey Bridgwater

Right, it is, for all practical purposes complete, and we are beginning to build a track in that system and over the period of say certainly 2008, we'll be able to validate our own data stat such that the longer we're utilizing that system, the more valid it becomes. So we're really at kind of the starting point now of looking at that and using it on our portfolio.

John Arfstrom

And, generally do you think that allows you to carry modestly lower reserves or has it changed anything?

Downey Bridgwater

We don't know yet. Sensibly that might be the case, but we believe that that will be certainly as accurate as I think any bank can be with that type of system. That's one of the key reasons to do that is to make sure that we are as accurate as possible with the provisions and the relative allocation of that reserve to the loans we have in the portfolio.

John Arfstrom

Alright. Thanks.

Downey Bridgwater

Thanks John.

Operator

Thank you. Next we go to the line of Erika Penala of Merrill Lynch.

Erika Penala

Hi.

Downey Bridgwater

Hey Erika. Good morning.

Elena Kim

Hi this is actually Elena Kim calling for Erika Penala.

Downey Bridgwater

Oh! Sorry.

Elena Kim

Oh that's alright. I just have one quick question as I think most of my questions have already been answered. But I just want to know you did give guidance for 6% to 8% loan growth for 2008. Are there any loan segments, I know that you just mentioned the pricing in loans that you want to cherry-pick, but are there any specific loan segments that you think are promising for '08?

Downey Bridgwater

Well, we look at C&I loans as a big part of our core, commercial and industrial, operating credits equipment loans, also owner occupied real estate as the big piece of what we do. I mean, about 50%, more than 50% of our real estate portfolio is owner-occupied, so that is another part of the operating entity that we like to bank those businesses. So those are the things that we'll continue to focus on, and we believe that we'll continue to grow within those segments.

Elena Kim

Alright, thank you.

Operator

Thank you. (Operator Instructions). And we'll go to the line of Bryce Rowe with Robert W. Baird.

Bryce Rowe

Thanks, good morning guys.

Downey Bridgwater

Hi Bryce.

Zach Wasson

Good morning.

Bryce Rowe

Can you guys talk, or maybe Zach, talk about the short-term borrowing capacity and how much of the CDs that are repricing you would expect to runoff if pricing kind of stays where it is.

Zach Wasson

We have significant short-term borrowing capacity both in the Fed funds market and in the Federal Home Loan Bank system. We want to monitor our CD base. We want make sure that the CDs that are leaving us are really just the rate shoppers, not core relationships. So, it's going to be a balancing act between maintaining relationships and loosing some of the high-cost rate shopping CDs. So, we don't have a particular target. I think its one that will change overtime which have one that we think we can add to our net interest margin by letting some of the high-cost ones leave and borrowing at significantly lower rates.

Bryce Rowe

Okay. And Zach, what is the mix of the First Horizon deposits coming over?

Zach Wasson

It is a good bit in CDs and money market. We have about $90 million coming up half of it is CDs. The rest of it, DDA and money market accounts.

Bryce Rowe

Okay. And one last question on credit quality. What's the level of potential problem loans there at the end of the year?

Downey Bridgwater

I think you've got that in the press release with the non-performing loans.

Bryce Rowe

Okay.

Downey Bridgwater

Out there and that should be pretty it is.

Bryce Rowe

Okay, thank you.

Downey Bridgwater

And also look at the 30- to 89-day pass due loans. You will notice that those went down from the previous quarter.

Zach Wasson

About $39 million on September 30th \to around 30 million at 12/31.

Bryce Rowe

Okay, thanks guys.

Operator

Thank you. Next we'll go the line of Terry McEvoy Oppenheimer & Company.

Terry McEvoy

Good morning.

Zach Wasson

Good morning.

Terry McEvoy

There is just one question have the big banks changed there approach or attitude towards small and mid-sized business lending which is your sweet spot. Has that changed at all for the better or for the worst?

Downey Bridgwater

The only noticeable change is their aggressive pricing approach.

Terry McEvoy

That's it. Thank you.

Downey Bridgwater

Within our niche, their structure is generally still pretty reasonable, but the pricing is very aggressive.

Terry McEvoy

Thanks for the call.

Operator

Thank you. And we have a followup from the line of Erika Penala of Merrill Lynch. Please go ahead.

Erika Penala

Hi, actually my question has already been answered.

Operator

Thank you. And gentleman, there are no further questions in queue at this time.

Downey Bridgwater

Okay well, thanks for joining us today and we appreciate your interest in Sterling and look forward to speaking to you again next quarter. Good bye.

Operator

Thank you. Ladies and gentleman, this conference will be available for replay after 12 PM Central Time today until February 5th at midnight. You may access the ET&T executive playback service at anytime by dialing 1-320-365-3844 with the access code of 904767. That does conclude your conference for today. Thank you for your participation and for using the AT&T executive teleconference service. You may now disconnect.

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Source: Sterling Bancshares, Inc. Q4 2007 Earnings Conference Call Transcript
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