Flagstar Bancorp Q4 2007 Earnings Call Transcript

| About: Flagstar Bancorp, (FBC)

Flagstar Bancorp Inc. (NYSE:FBC)

Q4 2007 Earnings Call

January 30 2008 11:00 am ET


Mark Hammond - CEO

Thomas Hammond - Chairman

Paul Borja - CFO


Bose George - KBW

Frank - Friedman, Billings, Ramsey

Gary Gordon - Portales Partners

Brad Vander Ploeg - Raymond James

Dan Smith

Tyson Strawser - Vision Research

Ron Rubin - Rubin Enterprises


Good day everyone, and welcome tothe Flagstar Bank Fourth Quarter 2007 Investor Relations Conference Call.Today's conference is being recorded. At this time, I would like to turn theconference over to Mr. Mark Hammond, Chief Executive Officer. Please go ahead,sir.

Mark Hammond

Thank you. Good morning, everyone.Welcome to Flagstar's fourth quarter Earnings Call. My name is Mark Hammond,and I'm the Chief Executive Officer of Flagstar. Please note that we will beusing a PowerPoint presentation during this call and we recommend that yourefer to it, as we reference it throughout the call.

This presentation, as well as ourearnings press release that we issued last evening which contains detailedfinancial tables, was posted on our website in the Investors Relations sectionat www.flagstar.com.

I'm here today with ThomasHammond, our Chairman of the Board, and Paul Borja, our Chief FinancialOfficer. Tom will provide prepared remarks about our fourth quarter, as well asthe 2007 year, and then I will update our drivers and provide an outlook for2008. Paul and I will then answer questions. Please note that we will beaddressing the questions that we received by e-mail or questions that we havebeen frequently asked.

Before we get started, I'd liketo first direct your attention to the legal disclaimer on the second page ofthe presentation. The content of our call today will be governed by thatlanguage.

With that, I will turn the callover to our Chairman, Tom Hammond.

Thomas Hammond

Good morning everyone. Thank youfor joining us. Last evening, we announced our financial results for the fourthquarter and full year of 2007. As everyone is aware, the second half of 2007was a period of turmoil resulting in significant stress in the banking industryand, in particular, those banks that are heavily involved in the mortgage andcredit market.

Our financial performancereflects those market conditions. Although the last six months are verychallenging and result in a financial loss, we believe that we have navigatedthe environment well, given that our balance sheet and business strategies wereheavily concentrated in Michigan commercial real estate and nationalresidential real estate lending. We will continue to focus on managing througha period of possible further real estate declines and weakening economy.

However, we believe there are anumber of trends and underlying fundamentals that appear to be very positive.Significantly, higher market share in the mortgage industry, overall increasedloan production, improving gain on sales spreads, the potential for higher FannieMae, Freddie Mac and FHA loan limits, increased credit spreads, and loweringfinding cost, resulting in improved net interest margins are all currentlyoccurring or appear on the horizon and should be considered when reviewing ourfinancial results.

Let's turn to our results. Duringthe quarter, we lost $30.1 million as compared to a loss of $32.1 million inthe third quarter and a gain of $6.9 million in the fourth quarter of 2006. Forthe 2007 year, we lost $39.2 million as compared to a gain of $75.2 million forthe full year of 2006.

Our fourth quarter loss relatedprimarily to increased credit cost; costs associated with selling andtransferring jumbo prime loans out of our available for-sale portfolio in anilliquid market and write-downs above our residuals and our securities.

Turning first to credit cost, thefourth quarter loss includes several significant credit related and marketrelated charges that were not present in the fourth quarter of 2006. Theseinclude a $30 million increase in the provision for loan losses, a $2.8 millionreduction in the valuable of our available for-sale securities, and a $23million reduction in the value of our residuals from earlier securitizations.

In the fourth quarter, we alsosold $538 million in prime jumbo loans from our available for-sale portfolio toother investors, resulting in a $4.3 million loss. We also transferred $1.15billion in prime jumbo loans from our available for-sale portfolio to ourinvestment portfolio, which resulted in a $2.3 million lowering of cost formarket adjustment.

In addition, we incurred $9.5million of losses associated with the underlying hedges of those prime jumboloans which were held in our available for-sale portfolio. Those loans whichare now in our investment portfolio are matched and funded with longer-termfunding at attractive spreads. Cumulatively this credit related and marketrelated charges represented $71.8 million of pre-tax cost that we historicallyhave not incurred.

Now, let's drive some more detailregarding asset quality. The increase in the provision in the fourth quarter to$38.4 million from $30.2 million in the third quarter reflects two factors; anincrease in charge-offs in the fourth quarter to $12.2 million from $5.8million in the third quarter, and an increase in both general and specificreserves.

The charge-offs in the fourthquarter net of recoveries were primarily in commercial real estate loans $4.2million, residential mortgage loans $3.3 million, home equity loans $2.3million and second mortgage loans $1.6 million. The increase in our loan lossreserve reflects the increase in charge-offs and the increasing delinquencytrends in the first mortgage loans and commercial real estate loans.Accordingly, we increased our general reserves by $10.1 million primarily infirst mortgage loans, and we increased our specific reserves by $16 million;substantially, all in commercial real estate loans.

Net charge-offs increased to $30million in 2007 from $19 million in 2006. Overall charge-offs of loans that wehave repurchased from the secondary market declined to $10.2 million in 2007from $13.6 million in 2006. We take a formula-based approach to managingreserves and adjust our allowance based on delinquency trends in the currentenvironment. If delinquency trends continue to deteriorate, we will have toadjust reserve levels accordingly.

Our most recent review suggests atrend of leveling off of delinquencies in commercial real estate loans andsecond mortgage loans, although residential first mortgage loan delinquenciescontinue to increase on a broad basis. The frequency of first mortgage relateddelinquencies will represent our greatest challenge going forward. Therefore,we have added significant resources to our collection, loss mitigation, andworkout staff.

The loss severity of first liens,however, is expected to be lower than on second liens and commercial loans dueto the fact that our average LTV on our first mortgage investment portfolio is73.4% and the average FICO score is 7,119. In addition, the high LTV first mortgageloans typically have mortgage insurance.

On the commercial side, toaddress delinquencies we have also increased our workout staff to work throughthe loans that we move into a serious delinquent status. It is important tokeep in mind that these were typically loans underwritten prudently with equityand personal guarantees that we are operating in recession environment in Michigan.

The write-down of our residualbalances during the fourth quarter reduced our residual balance on our primeHELOC and second mortgage securities from $63.4 million to $47 million. On apositive note, 2007 residential mortgage loan volume was $26.7 billion; anincrease of 32% compared to 2006 despite the fact that industry loan productiondecreased significantly from 2006 to 2007.

December lock-in volumes was thehighest December volume in four years in January 2008, new lock-in productionwill be the highest than any month since 2003. We continue to gain market shareas industry further consolidates. In 2007, we hired dozens of seasoncommission-based loan executives to enhance market share. We almost exclusivelyoriginate confirming residential mortgages for sale via the GSEs and FHA andmaking strong relationships with both of these.

Our scalable lending platformincludes FHA capability as well. We will be situated very well to capitalize onany legislative increase due to Fannie Mae, Freddie Mac or FHA loan limits. Wehave for, example, 138 FHA underwriters to review the expected substantialincrease in FHA business.

Bank net interest margin hasstarted to improve as well. In the forth quarter, our bank net interest marginimproved to 162 basis points, compared to a 152 basis points in the thirdquarter. The increase is attributable to a decline in funding costs followingthe fourth quarter rate cuts especially reflected in our FLB advances.

We also saw an increase in ourgain on sale margin. During the fourth quarter, our gain on sale margin was 32basis points as compared to a loss of 29 basis points in the third quarter. Ourassets decreased to $15.8 billion, in the fourth quarter, from $16.6 billion inthe third quarter. We continue to be well capitalized with a cushion over theminimal regulatory capital ratios.

In the fourth quarter, our corecapital ratio was 5.78%, and our risk based capital ratio was 10.66%. We alsomaintain a multitude of reliable sources of liquidity. These include a growingretail deposit base of $5.1 billion at December 31, 2007 and a vibrant publicfunds division, access to wholesale deposit, a $7.5 billion line of credit withthe Federal Home Loan Bank, and unused line of credit with the Federal Reservediscount window, borrowing capability in the form of Federal Funds, andunencumbered agency and AAA rated mortgage-backed securities that we can borrowagainst through the repo market.

The strength of our fundingcapabilities can be evidenced by the manner in which we were able to easilyrestructure our liabilities though the credit crisis of the last six months.For example, June 30, 2007, outstanding security repurchase agreement stood at$1.7 billion. The events of the summer made that an expensive funding source,but we were able to quickly transition out of repo's and to replace them with a$500 million increase in total deposits and an $800 million increase in FHLBadvances, while reducing our outstanding repo's to 108 million.

In more recent weeks, as retaildeposit pricing has lagged, the decline in interest rates and order has beensomewhat restored to the agency repo market and we've been able to reversecourse and back off on our deposit pricing due to our ample alternative fundingsources. We believe that the advance of 2007 clearly demonstrates theimportance of our deposit franchise and bank charter and explains why thegrowth of our banking operations continues to be a focus of our business plandespite the startup cost for new branches.

Another thing, we want toemphasize that we have historically avoided originating many of the riskierassets that have recently come under scrutiny in the news. As we have saidbefore, we hold minimal sub-prime loans on our balance sheet. At the end of thefourth quarter, sub-prime loans totaled about 1% of total assets. About fiveyears ago, we made the decision to avoid originating sub-prime loans.

Further, we do not have any CDOsor SIVs. In addition to the residuals mentioned earlier, the only securitiesthat we hold are one of three types; AAA rated agency securities created usingprime loans that we originated and securitized on our balance sheet; AAA ratedsecurities created using second mortgages that we originated on our balancesheet; or AAA rated prime securities that we invested in.

While we have scale back, wecontinue to build bank branches. In 2007, we built 13 new branches 7 in Michiganand 6 in Georgia,bringing our total to 164. We also added 15,300 new accounts in 2007 for atotal of 293,200 total retail accounts at the end of 2007.

Looking ahead to 2008, we expectthe banking industry will continue to be challenged in our primary market. Weplan to curtail the expansion of new bank branches to about the same number as2007. Well, some may question our decision to build branches given the currentenvironment; we feel it has paid off, as we were not relying on Wall Street forfunding during the liquidity crisis.

Before turning over to Mark, Iwill just take a step back from financials and talk for a second about someintangibles. We have a seasoned management team who has managed through othertough cycles, including the early 80s, high interest rate, the savings of loancrisis, the stock market downturns of 1987 and 2001.

Our bank franchise hasconsiderable value, and, recently, in three separate independent surveys, ourcustomers ranked as apt or near the top of the list for overall customerservice satisfaction. Flagstar also ranked among the top in terms of ourcustomers likely to refer us to a friend, and a category of customer loyalty.We were also recently recognized by Freddie Mac as a Platinum Service providerwith a top servicing level.

To sum it up, the quarter and theyear were disappointing, but there are many positives. Until we have a greatercertainty on when market and credit conditions stabilize, we are going to guardour capital closely by limiting balance sheet growth, reviewing and possiblysuspending our dividend, and only originating mortgage loans that could be soldto the GSEs or FHA.

We continue to monitor ourcapital plan closely in this environment and if future credit concerns continueto exceed the positive results we are seeing from improvements to our netinterest margin, gain on sales spreads, and our loan production, then we willalso consider additional capital strategies including shrinking the balancesheet and/or raising potential capital.

With that, let me turn thingsover to Mark.

Mark Hammond

Thanks, Tom. Slide on page 15,outlines our 2008 outlook for each of our key drivers. Staring with branchopenings in 2008, we have lowered our previous guidance and now anticipateopening 11 to 15 new branches, but the majority of those being in Georgia.

We are revising our asset growthfrom 10% to 14% to 0% to 2% due to credit market uncertainty; we do not feelthat it is prudent to significantly grow the balance sheet at this point. Weare expecting a relatively flat balance sheet for 2008. We also expect ourbalance sheet to remain flat for our commercial real estate portfolio.

As Tom mentioned in his speech,we are seeing strong residential mortgage loan production early in 2008, so weare revising our origination estimate between $33 billion and $38 billion. Themajority of those above 95% will be agency loans. Given the revised balancesheet strategy, we are also raising our estimates for loan sales from $28billion to $36 billion to a new level of $30 billion to $38 billion.

We are increasing our gain onsale margin outlook for 2008 from 30 to 40 basis points to 45 to 55 basispoints. The increase in margin reflects the more rational pricing environmentwith less competitive pressures that we have been experiencing. About us B011 1:42 early in thenew year, we have seen significant pricing power and currently pricing for gainon sales spread is at the high end of that range.

Turning to bank net interestmargin, we are increasing our outlook from 155 to 165 basis points to 165 to175 basis points. We have recently seen an improvement, and anticipate furtherenhancement particularly due to the anticipated spread increase and ouravailable for-sale portfolio. Net interest margin improvement is the managementfocus for 2008 and we hope to increase them to 2% on a run rate basis by theend of 2008. We intend to achieve this through lowering funding cost andimproving credit spreads without assuming a higher credit risk profile.

We are maintaining our outlookfor retail deposit growth of 4% to 6%. We anticipate good growth, as ourrecently opened branches begin to season, as well as from the 13 or so newbranches we plan to open in 2008. We anticipate flat to minimal growth in ourmatured branches.

We are increasing our estimatesfor both mortgage servicing right sales from $10 to $15 billion to $20 to $30billion. However, we are not anticipating any spread on those sales, as gainopportunities have been minimized by falling interest rates. For quarter, weare estimating to book no gain on both mortgage serving right sales in 2008,but plan to sell a sizeable portion of our portfolio to minimize hedging costand capital exposure.

Finally, we are modeling loancharge-offs of $45 to $55 million in 2008 up from $30 million in 2007. We arealso modeling allowance for loan losses to be 128 basis points, as a percentageof our held-for investment portfolio. This is challenging to predict, and wewill be dependent on the extent of future broad real estate declines and thehealth of the overall economy.

With that, let me turn it over toCFO, Paul Borja for the questions-and-answer session.

Question-and-Answer Session

Paul Borja

Thanks, Mark. I'll be readingquestion we received today from various persons and either Mark or I willrespond to them.

The first set of questions, wereceived are from Bose George of KBW.

The first question: yourcommission number was up pretty sharply versus the last quarter and Q4 of '06,but volume was not materially different and gain on sale was similar to thenumber in Q4 of '06. What drove the increase in commissions? I'll turn this toMark.

Mark Hammond

Okay, thanks Paul. Yes, we'veseen an increase in the commission expense primarily due to the composition ofthe production channels of our origination. And the third quarter we added anumber of retail residential loan originators and the retail residential loanoriginators that were added in the third quarter's closings were reflected inthe fourth quarter.

The retail loan originatorstypically receive a lot higher commissions than third-party channels. Retailoriginators typically receive commissions around a 100 basis points, wherethird-party originator commissions are closer to 10 basis points. And thatdifference is reflected on the commission expense side. However, we have toremember that the retail people are not receiving the same pricing; it would bethe wholesale or correspondent people.

So, the net cost to originatefrom a channel standpoint is not really any different to us. But you are seeingan expense that's reflected on the commission line and not the associatedrevenue. We typically report net gain on sale numbers. So, the associatedrevenue that was offsetting the additional commission cost is not reported onour gain on sale numbers.

So, you won't see the differenceon the gain on sale numbers; different than a lot of our competitors. When wereport year on sales, we are reporting a net number as opposed to higherrevenue number. So, it really is just a composition of originations, as wecontinue to take advantage of our market opportunity to higher retailoriginators given the consolidation that's occurred across the country.

Paul Borja

The next question: your employeecount continues to trend up even if you exclude loan officers. Is thisprimarily driven by employees at the new branches?

Mark Hammond

Okay. It's a combination ofemployees at new branches. We opened a number of new branches in the fourth quarter.It's also increased production staff for new loan production as our new loanvolume is up pretty significantly including processors, closures andparticularly credit people and underwriters. Additionally, we significantlyadded people to our collection staffs, workout foreclosures and loss mitigationstaffs. And the rest of the staff counts are pretty well flat to small decline.

Paul Borja

The next question: your cost ofdeposits was 4.32% in Q4 of '06 and your cost of funds in Q4 '07 was 4.35%, threemonths LIBOR is down by over 200 basis points during that time. Can we expect apretty sharp decline in your cost of funds? How soon will the CDs, wholesaledeposit and municipal deposit start re-pricing down?

Mark Hammond

Okay. Yes, we should expect adecrease in the cost of funds. Cost of deposits that we reported it's anaverage number for the quarter. The improvement that we've seen in the threemonth LIBOR came towards the end of the quarter and into January.

So, there is a tiny differencerepresented in the question. We anticipate that absolutely funding costs willbe going down. We anticipate also seeing net interest margin improvementparticularly towards the end of the first quarter. And as we mentioned for theyear, we are anticipating 165 to 175 bank net interest margin and closer to 200basis points towards the end of the year.

Paul Borja

Next set of questions comes fromthe net Frank B015 0:7 at Friedman, Billings, Ramsey.

First, please provide more detailfor your non-performing assets and: can you breakout loan type vintage and LTV,FICO on these loans that are going delinquent?

Paul Borja

As to that request we've on page6 of the presentation a more detailed breakout than we use to provide regardingnon-performing loans on a loan by loan category. We will provide additionalinformation such as LTV FICO in future presentations and probably also in the10-K.

Paul Borja

The next question: why are theseborrowers not making payments any longer? And: explain your efforts to reduceyour loss exposure on these loans that are not performing I'll turn it to Mark.

Mark Hammond

Well, I also like to add to Paulon page 13 of our presentation, we also provide even more detail on ourcommercial real estate loan portfolio and in addition to the detail on page 6to provide some more color on the delinquencies picture.

As far as: why borrowers notmaking payments? It's a combination of a number of reasons: clearly it's effectof slowing economy certainly we are having more issues in different regional geographicareas in particular California, Arizona, Florida being caused by access propertyand property evaluation declines particularly the higher LTVs the people with ourequity particularly those who've had some sort of life changing event, losing ajob or health issues get into a scenario that they don't have the propertyvalue there that we are seeing people walk away from homes.

Little bit different picture inthe Midwest and parts of New England, whereyou have a slowing economy and lack of demographics that brings as far as jobgrowth and population increase that accreting to overall recession typesituation that's creating an affect not paying.

As far as reducing our exposure,we've a staff that is focused on working with customers and where appropriatetrying to mitigate loss through a series of loss mitigation techniques, whetherit's forbearance plan, whether it's modifications, whether it's loanrestructurings or loan refinances. And this will be something that the industryas well as also we will have to deal with throughout the year.

Particularly, there are concernson the commercial real estate portfolio, because of larger exposure on aprolonged basis. And then on the HELOC and second portfolio, where we don'thave a lot of equity and higher LTVs, although, as we mentioned in the speech,the incidence rate is going to be high on the first mortgage portfolio. At thistime we do have a pretty good portfolio as far as equity position and FICOscores. So, we expect the frequency in incident will be high, but the severitywill probably be a little lower in that portfolio.

Paul Borja

The nest question: explain thesignificance increase in commission expenses in Q4 and also explain yourefforts to reduce your cost structure.

Mark Hammond

I'll take that. We alreadyanswered the first part of that. The second part of that is, we arecontinuingly monitoring our cost structure and trying to focus on managingnon-production related costs clearly in an environment, where we have moreproduction. There is going to be cost associated with handling that production.But we are also dealing with increased cost in handling loss mitigationforbearance collections.

Outside of those, we areexpecting very minimal increases in cost and it's a continuous effort to manageand to be focused on managing the overhead associated with those other areas

Paul Borja

Our next set of questions comesto us from Gary Gordon of Portales Partners. The first question: sounds likenon-home mortgage delinquencies are up a lot, please discuss that a bit. AndI'll turn this to Mark.

Mark Hammond

As we mentioned for the quarterthe commercial real estate and some of the consumer loan delinquencies are up,but one of the positive trend is towards the end of the quarter and going intoJanuary. We've seen the new delinquencies flatten out. Unfortunately anotherdisturbing trend now is we're seeing that once somebody goes delinquent theyare often going down from day 1 mean by that is and years pass sometimes youwould see somebody go delinquent and there might be 30 days delinquent to sixmonths and then either a fall further or [adhere].

One of the disturbing trendswe're seeing is that high portion of customers that go 30 days delinquents aregoing immediately 30, 60, 90 then right into foreclosure. So, positive trend,we are seeing in the commercial real estate and seconds flatten out. Some ofthe negative trends we're seeing that people are going to more severecategories right away. And then on the first mortgage portfolio we'recontinuing to see increases in all categories 30, 60 and 90 and we've not seenthat level out.

Paul Borja

And the next questions from Gary, what was you MSRmark to mark adjustment? And: do you hedge this?

Mark Hammond

Okay. We did not have MSR mark tomark adjustment for the quarter. And our MSR portfolio is part of our overallhedging strategy. We take an aggregate view to managing interest rate risks andwe aggregate all of our different interest rate risks and the MSR portfolioadds to the hedge itself for us towards rising interest rates.

Also on the concern withimpairment performing interest rate, one of the macro hedges that we'verelative to the MSR portfolio is that if interest rates fall, generally we areseeing increased production with increased gain on sales spread, which are anoffset to the potential for impairment.

With that being said, weanticipate, as we mentioned selling a portion of our portfolio through the yearto minimize the aggregation of MSR from a capital standpoint and from aninterest rate risk standpoint particularly relative to systemic large downwardmovement. But if we are for some reason unable to sell a portion of our MSRportfolio to minimize their risk, then we put specific hedges on to protectagainst the downward interest rate risk.

Paul Borja

The next questions come from BradVander Ploeg of Raymond James.

The first couple of questions arerelated: can you elaborate on the securities impairments in the AFS and tradingportfolios? And: can you walkthrough what happened to the residuals?

Paul Borja

In the AFS and trading portfolio,as we’ve both securities and residuals, so let me talk to the AFS securitiesfirst. With the AFS securities, we value those based on FASB 157 requirementsfor level one, two and three. We took a look at the marks that were availableand what is a thin market out there and made an assessment as to whether anykind of impairments were either temporary or other than temporary to the extentthat the marks were other than temporary those are reflected in our profit andloss statement with the remainder being reflected in our other comprehensiveincome. And so, that is really just a function of marks in the market.

As to the residuals, we'veresiduals that we include in both the available for sale line as well as theavailable for trading line. With respect to the residuals, we run variousmodels using market based assumption as allowed under level two for FAS 157.With respect to the residuals, we'll provide details of the different assumptionsin our 10-Q. When we looked at both, the loss portion as well as the discountrates involved and what we were seeing in the marketplace in order to come tothe evaluations for the residuals and the resulting adjustments.

Paul Borja

The next question: what is yourview of the potential raising of the jumbo cap for Fannie and Freddie? And howabout if they can portfolio more, Mark?

Mark Hammond

Yes. This will be great for us.It's a market segment that we've been out for the last six months. We’ve hadvery minimal jumbo origination capability and there will be given the fact thatwe haven't been looking to securitize, it's not been an active both jumbowholesale market to sell loans. And Fannie and Freddie would really create alot of opportunity for us to increase production as well as increase gain onsales spread. So, it would be fantastic for us.

As far as: how about if they canportfolio more? That really won't have a direct impact on us. We don'tgenerally sell home loans to Fannie and Freddie. We generally form MBS and PCsecurities and get their guarantee fee. And then they generally go back intothe market and use their portfolio to buy their own securities. So, I think itwould be good for the overall market if they had more portfolio capability, butit won't necessarily have a direct impact on us.

Paul Borja

The next question with regard tonet gain on loan sales spread just to clarify: where are these loan levelpricing adjustments?

Mark Hammond

Okay we had to deal with threedifferent impacts to increase guarantee fees or Fannie-Freddie creditenhancements on our MBS and PCs in the last couple of months. The three impactshave been, Fannie and Freddie have dramatically raised their loan level pricingadjustments for different various credit risks, and various different productsthroughout their product mix. In addition, our new master agreements werenegotiated and also like the majority of our peers saw our guarantee fees to dobase business with them rise in January.

And then thirdly, Fannie andFreddie have both announced across the board in all products they are going toraise an additional 25 basis point. So, the credit costs have gone updramatically for getting the Fannie-Freddie guarantee fees. The positive ofthat from our perspective is we've been able to pass 100% of that additionalcost on to the marketplace to our production channels and consequently to theconsumers.

So, we've not had to bear thecost of that. In addition of that we've also been able to raise our spread thatwe are getting from the consumers due to more rational pricing environment andless competitor. So, at the end of the day, Fannie and Freddie are receivingmore revenue on a prolonged basis, and we are also receiving more revenue on aprolonged basis.

Paul Borja

Next question: can you describethe secondary market environment right now? Mark?

Mark Hammond

The secondary market is stillvery healthy for Fannie, Freddie Ginnie Mae business and pretty muchnon-existence for business outside of that it pretty much sums it up.

Paul Borja

Right. On to the next question:Are you asset or liability sensitive? And: what will be the effect of recentFed cut rates for you? How about if the Fed cuts again today?

Mark Hammond

Okay. We run a match book and we arenot extremely asset or liability sensitive. We do have the effect that forprime based loans they often adjust immediately the day prime changes, whereasthe liability sometimes takes a couple of weeks to re-price that offset those.So, in a very short term in a one, two week window, we are little bit moresensitive to have such reprising. But generally we run very low sensitivity andvery well matched organization.

The bigger effect to us on thelowering of interest rates has to do with the shape of the yield curve. Andthis has to do with our available for sale portfolios predominantly a 30 yearfixed portfolio but only has a couple of months life with us. So, we generallyhave an “arbritarized opportunity” as we are selling loans for securities in a waythat we are to able to match the 30 year asset with 30 day or 60 day funds.

And that normalized interestenvironment, where we've some shape or steepness to the yield curve thatprovides a nice “arbritarized opportunity” for us. In the last couple of yearsthat's been wiped out. So, if the Fed lowers interest rates and we do not see acorresponding decrease in the longer term yields that will have the mostpositive effect for us.

Paul Borja

And the next question: any sharerepurchase activity this quarter?

Mark Hammond

No, we've had no share repurchaseactivity and do not intend on repurchasing shares. We clearly think our stockprice is good, would be a good buy and a good price. However, we are beingprudent with capital given the not uncertainty of our strategy, but uncertaintyof the broader overall markets. And how much the general economy may slowdownand how much residential, real estate and commercial real estate value is goingto continue to fall. So, looking to be prudent with capital given theuncertainty of the broader market, although we do feel our stock price isattractive.

Paul Borja

Last question from Brad: can youelaborate on areas of concern for your loan portfolio in terms of type andgeography?

Mark Hammond

Yeah. Just as we've mentionedbefore, on the commercial real estate, the residential development loansclearly are concern for us. We have $159 million of residential developmentloans of which $70.6 million are currently delinquent that is a troubleportfolio.

The big question really is goingto be how well our guarantees hold. The new residential construction is atlong-term historic low, and we do not anticipate that some of thosedevelopments, we'll be able to pull out. So, the question mark really boilsdown to how well the guarantees hold.

Other concerns, we've geographicconcerns, as we've mentioned before with the development states or the growingstates where there is over speculation, over building, too high of investmentproperties and where there is overhead. Concerned with Phoenix,concerned with Southern California, concerned with Florida, particularly the southeast coast,and those portfolios are underperforming from a geographical standpoint.

Unfortunately although we had adiversified both the business, do business in all 50 states, we do have a heavyconcentration in Florida, Californiaand Michigan.Those three states represent 50% of our investment portfolio little bit smallpercentage of our production. So, we do have some geographical concerns.

On the HELOC and Fixed Seconds,our concerns are the high LTV piggybacks that we did the lower LTV loan seem tobe performing fine. The higher LTVs even with the good credit scores have comeunder stress and quite frankly that's affect us in two fold, one our investmentportfolio, which we only have a couple of hundred million, but more importantlyit's affected us in our residuals, for the couple being in securities that weoriginated and sold.

So, we are moderating those andworking aggressively to mitigate losses in those. Those affect, we are havingas been a challenge with the media and with consumer groups and with consumerwillingness just to walk away from loans. We haven't seen any thing like thissince taxes in the oil, during the oil bust and people just willing to declarebankruptcy and walk away. We are seeing a lot of that similar type socialphenomena and occur particularly in California,which is also concerning to us.

Paul Borja

The next set of questions arefrom Dan Smith. The first question: please comment on your thoughts abouteliminating the dividend?

Mark Hammond

In Board meeting that we usuallydiscuss the dividend. In our next Board Meeting, we'll have more of a formalreview and generally don't do that with the quarter end Board Meeting. But I'dsay right now that the atmosphere is one of capital preservation until we canhave some more clarity on the severity of potential further credit impacts dueto the further broadening declines.

We feel that we are adequatelyreserved and adequately taken associated charges given the market as it sitshere today. So, we feel that we are comfortable. But, if property were todecline another 10% or we were to enter a broad recession, when unemploymentgoes up to 6% to 7% those clearly would have impacts on credit cost and itmakes sense to preserve capital from that standpoint.

Paul Borja

Next question from Dan: are yougoing to continue to build branches?

Mark Hammond

As we mentioned in the speech,“yes”: we've pulled back at our branch expansion, but we do own the real estatefor two years worth of building and so from that aspect we already have anasset in the real estate that's a non-interest producing asset. You got toremember we built branches the cost to build those are capitalized over a numberof years.

The larger expense is really theemployee expense associated with staffing the branches. Generally have about 6FTEs per branch and we need to balance that off with the advantages of bringingin retail deposits. The advantages to cross sell those customers and build ourcustomer base and build a franchise value and also make sure we've a good solidretail funding source so that we can mange any potential liquidity concerns andnot be rely on Wall Street for funding.

Paul Borja

The nest question: can youaddress original LTV and credit scores versus what you think those numbers looklike today, both locally and nationally?

Mark Hammond

Yeah, on a broad portfolio basiswe do testing. We've not seen a decline on the averages of our LTVs and creditscores. And I think you would expect that in LTVs because we got a broadproperty distribution across the United States and although somemarkets have seen significant decline to 10%, 20% to 25% other markets have hadgains that have been flat. So, the overall average decline across the countryis only a couple of percent and likewise we've had principal buy down orprincipal pay down on some of our portfolio. So, we've not seen a significantincrease on the current LTVs relevant to the original LTVs.

Similar in FICO, we've not seen asignificant decrease in current FICO scores versus original FICO scores. Butyet to remember, we do not lose money on the averages, where delinquenciesoccur, and where losses occur on the tails. And so it is for the percentage ofpeople that do have the FICO score decrease or lose their job, or have propertydepreciation it's that smaller percent that create the 2% to 3% delinquenciesand not the broader average.

Paul Borja

Our next question from [TysonStrawser of Vision Research]. How did the market for repurchase agreementscompared to the third quarter environment? Are you required to provideadditional collateral during the quarter related to these arrangements?

Mark Hammond

Most of the repurchase agreementswe've done have been with Fannie Mae and Freddie Mae, PCs and MBS securities.And we've seen strong abilities used as collateral for repo agreementsthroughout this whole equity concerned. Currently we're seeing very strongexecutions for the Fannie, Freddie at about 10 basis points over and above sortof home loan bank advance costs, which have been some what lower than LIBORcost.

So, we're still seeing decentexecution although we're not relying on those, we do have that as a fundingsource. For the smaller portion collateral that we have on AAA securitiesoutside of Fannie and Freddie that we can use to report. We've had a market forthe last six months made available to us, but the execution hasn't been great.So we haven't done as much repose or been as interested to do repose with theAAA securities that non-Fannie and Freddie brand.

And we've had no need foradditional collateral other than the standard margin cost associated withrepose.

Paul Borja

The next question is from Ron Rubinof Rubin Enterprises.

When evaluating your book value: why do you choose not to have currentvalue of the 78 buildings you own priced into it? But rather, the purchaseprice since they were bought prior to '96. Don't you think your shareholdersshould know about this hidden value during the uncertain time that we are in?

Mark Hammond

I think that's a good question. Even with declines in real estate values,we probably have a value in our buildings over and above book value. But theseaddress the characterization, because most of our buildings have been built inthe last five or six years. And they were built not purchased, and we follownormal GAAP accounting rules as far as depreciation rights and recognitions ofasset values are relative to those buildings.

Paul Borja

The next question from Ron Rubin:What are your intentions in regard to your stock buyback program? Is there anactually process that you have, that you can explain?

Mark Hammond

Yeah. As we mentioned before, we still have authority to buy shares back.However, we feel more prudent, although we think the stock price is a goodvalue, and just they should note that the majority of our board members,including myself, purchased shares in the fourth quarter.

So we feel that the stock does offer a good buy opportunity. Ilooked back to 2001 when we had a similar environment with a slowdown in thebusiness from the Fed cutting interest rates and then trading below booking andstart 2001 was a great buying opportunity.

And so I start to appreciatequite a bit after to that time period and feel there were a similar typeenvironment now. So on the other hand, we need to balance that with theuncertainty at the over -- broader overall economy.

And as I mentioned before we feelwe're well capitalized now. We feel we've adequate cushion. We feel we'reappropriately reserved. We feel we've taken the appropriate write-downs giventhe current market environment we are in.

But if the market were tosignificantly deteriorate more, we want to make sure that that we had adequatecapital to guard against serious market declines and serious broader potentialfor recession.

Paul Borja

And our final question for today,since your banking operation has consistently grown, what is the reason you'veslowed down its expansion and focus more on your mortgage division?

Mark Hammond

Well, I wouldn't say we focusmore on our mortgage division. I think we focus equally on our originatingcapability as well as our banking. Got to remember that the predominant assetwe invest in is on the balance sheet of our bank, on the asset side of our bankis mortgage related.

So the mortgage division has theopportunity to have fee income associate origination gain on sale servicing,but it's also the primary asset gather for our balance sheet as a thrift.

And as far as on the bank branchside and bank deposit gathering, it's also important part of our business andwe continue to focus on that. But we try to find a balance between beingprudence and spending money when we have the money to spend out of earnings.And then also though, continuing to make sure we keep the momentum going forwhat we've been in the last five or six year. So, it's a balance that we try tofind.

Paul Borja

That's our last question. Withthat I will turn it back to Mark Hammond.

Mark Hammond

I'd like to thank everyone. Thisconcludes our conference call and I hope everyone has a great day. Thank you.

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