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Texas Capital Bancshares, Inc. (NASDAQ:TCBI)

Q4 2007 Earnings Call

January 30, 2008 5:00 pm ET

Executives

Jody Grant – Chairman and Chief Executive Officer

George Jones – President and Chief Executive Officer

Peter Bartholow – Chief Financial Officer

Analysts

John Pancari - JP Morgan

Andrea Howe - Lehman

Brent Christ - Foxx Pitt.

Erika Penala - Merril Lynch

Brad Milsaps - Sandler O’Neill

Jennifer Demba - SunTrust

Dan - KBW

Andy Steff - D. Rowling & Co

John - Hybrid Capital

Andrea Ho - Lehman.

Charles Earp - O’Neil Active Management

Michael Rolf

Operator

Good day, ladies and gentlemen. Welcome to the Texas Capital Earnings Conference Call. My name is Eric. I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will facilitate the Question-and-Answer session towards the end of the conference. (Operator Instructions)

I would not like to turn the presentation over to the host of today’s call, Ms. Myrna Vance, please proceed.

Myrna Vance

Thank you very much, Eric. Yes, thank you very much for joining us today for our year-end Conference Call, our fourth quarter. If you have any followup questions, I would encourage you to give me a call at (214) 932-6646. Now, before we get into the discussion, let me read the following statement:

Certain matters discussed on this call may contain forward-looking statements which are subject to risks and uncertainties. A number of factors, many of which are beyond Texas Capital Ventures’ control, could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. These risks and uncertainties include the risk of adverse impacts from general economic conditions, competition, interest rate sensitivity, exposure to regulatory and legislative changes. These and other factors that could results to differ materially in the forward-looking statements can be found in our annual report on Form 10-K for the year ending December 31, 2006 and other filings made by Texas Capital Bancshares with the Securities and Exchange Commission.

With me on the call today are Jody Grant, Chairman and CEO, George Jones, President, and Peter Bartholow, our CFO. After a few prepared remarks, Eric will facilitate a Q&A session. Let me turn the call over to Jody.

Jody Grant – Chairman and CEO

Thanks, Myrna! Hi, everybody. I know many of you think this is probably anti-climatic since we spoke to you just less than three weeks ago. Hopefully, by the time we finish this afternoon, we will have smooth perspectives on the table and maybe some fresh new information.

Looking at it from a perspective of the year as a whole, we had a great year. We recorded records in many, many of the metrics, just for example, net income at $31.4 million was up by 0.2% from the prior year. EPS at $1.18 was up 7% from the prior year. Loan total for investment at $3.5 billion went up 27.2% from the prior year and 4.5% with each quarter. Total loans at $3.6 billion went up 24.5% from the prior year and 5.5% with each quarter. Demand deposits, again we said in the prior call that they were strong. We were up 3.1% for the year. In part within each quarter, 12.4%. Now, admittedly, I think you have to look at that in the perspective that of the fact that the last quarter usually is our strongest quarter in terms of demand deposits.

Total assets for the company were up $4.3 billion at 17.2%, ahead of last year at 5.1% linked quarter. These were achieved in spite of the fact that we had the large provision that we announced in the last call. In talking about 2007, we had three great quarters and we had the fourth quarter which was more challenging. We expect 2008 challenging, but I believe improving if we look to the latter half of the year. I am generally optimistic. I am optimistic for a number of reasons.

First, I am optimistic because at Texas Capital, we are deep in experience. We have conservative standards which we haven’t compromised in the face of what has been increasingly intensive competition and finally, we have a very disciplined, centralized credit we will process which assures us of good quality control.

I would like to turn to the economy for just a few seconds, and I want to go through this kind of quickly, except for the last part which, I think is some new and interesting data. Again, we are extremely lucky to be in Texas. Energy which is a problem in terms of prices for the rest of the country continues to be a blessing in Texas. The goal and gas industry is operating at the highest level since 1982. One measure of that is a root came up which was up in just one month from November to December 4% which means that it’s extremely healthy. Our total employment is at an all-time high even though our own plummet rate was up from 4.2% to 4.5% from November to December. What this means is that we are experiencing workers moving into the state faster than we are able to absorb them into the labor market, but this is good because we got in-migration and that means we’ve got the resources to fuel our growth in the future.

Personal income, and I only have third quarter data, but it was an all-time high. So the consumer in Texas seems to be poised to continue to spend. And the data strongly suggests that we will outperform the rest of the country.

I’d like to shift to the (inaudible) market so I have the opportunity to spend the last hour talking to David Brown, who heads up a consulting firm called MetroStudy that focuses on the housing markets and the health of those markets in Texas and his focus is primarily Dallas-Ft. Worth. That’s where about 80% of our business is. So, most of this will pertain to Dallas-Ft. Worth. The rest of it, I’ll just make a couple of comments about the other cities. Housing starts in 2007 were down 35%, and that we consider to be great news, because it means that the inventory is lower as a consequence thereof. Housing is now at 6.8 months’ supply in terms of inventory. The peak was 7.8 months, so we are making progress. In 2007 starts with 32,000 units, but we closed 39,000 units which means that we closed more units than we started. Again, we are making progress. The firm expects starts to be down about 10%, or 3,000 units in 2008, which means we should equilibrium in the third and fourth quarter. The lot inventory deliveries were slow in 2007. We had 34 months’ supply; 24 months is normal. At that rate, it means we’ll probably hit equilibrium in about 18 to 24 months. That’s pretty much the picture on Dallas-Ft. Worth. I think from my own perspective the lenders would tell you and, I’m sure George will reemphasize this point: the customers are cautious. They are being conservative, and that’s very good.

San Antonio, the experience is about the same as what I cited for Dallas. Austin seems to be the healthiest economy in the state. I just got a report that was dated Friday, December 14th but I just received it

This is a study that was done which shows that Austin ranks number one out of 381 cities in the country in terms of economic vitality. Looking again though at the housing markets, Austin was down 22% in 2007 and Houston was down 23%, so both of those cities seem to be a little healthier than Dallas Fort Worth is at the present time.

David Brown in closing said well if Florida, California, Arizona and Nevada have flu and Texas has the sniffles.

Just a couple of more data points and we will now move on to something else. From another study, this is dated September 2007, Texas is known to be ranked number one in terms of job growth in the country followed by California and Florida. By S&S say Dallas Fort Worth was number two, Houston number 3, Austin number 14 and San Antonio number 20, so, all of our cities are in the top twenty in terms of job growth. That is terrific. I would like now to just turn to a couple of reasons why I am optimistic as I look to the future. Our principal reason for this relates to our strategy and focus. As everybody knows, we are basically a commercial lender. This means we are not incurring the costs in competing in an over branched and over crowded consumer market. I think we are good in what we do. Our loss ratio since our beginning is 0.10%. As I think everybody knows we are primarily a secured lender, only 7% of our loans are unsecured. For this reason we have experienced a low per charge offs relative to non-performing loans since our existence. We have diversified by a line of business, pass the C-code, by fact of collateral and by geography. In short, I think we are well positioned for the future. And we are particularly well positioned to take advantage of a stabilizing and ultimately improving national and Texas economy, and this is because our organic growth machine remains very, very healthy and I felt the statistics that I cited earlier fortified that.

I now would turn you over to George. I think one of the things he is going do is touch upon, or rather Peter. First he is going to talk about the numbers and then to George he is going to touch on some of the issues that we discussed in the January 11 conference call. Then we will come back for further questions.

Peter Bartholow – Chief Financial Officer

Thank you. We will comment a little bit in more detail obviously than we were able to on January 14th provide a little bit of clarity but I think everything came in at or a slightly better that what we had announced at that time. Net income was $31.4 million as Jody commented, $1.18 that is quite near the very high end of the range that we provided as additional guidance. We do think it is good result in light of the very large increase in provision, $4 million in 2006 to $14 million in 2007. As indicated in the earlier call, the $14 million compares to 2007 guidance, the number incorporated in our guidance and clearly comes from the growth that we have experienced in DDA. The shift in earning asset composition has come from strong loan growth. The speed of liability repricing due to the composition of funding which has become much more rate sensitive as we have depended on interest bearing liability to support growth. And obviously with rates where they are now and are projected to go much stronger contribution from fixed rate and Libor priced earning assets. All of these factors contribute to much less earning assets sensitivity and we have remained asset sensitive but by no means near the level that we were as rates began to rise.

Turning to slide 7. Very strong performance is I have commented and net revenue growth at 19% produced strong improvement in operating leverage throughout the year. So, net interest income growth also of 19%, leading of course to the 27% growth in average loans held for investment. Though net growth obviously overcame the drag of fixed rate earning assets throughout the year.

Non-interest income was up 16% despite significant weaknesses we commented about in the past in mortgage warehouse. Conditions in the mortgage industry reduced the contribution of that group which remains profitable by approximately $0.05 after tax in the last half of 2007 compared to the first half.

Operating leverage is reflected in comparison obviously in the rate of growth of net revenue to that of non-interest expense. All categories of non-interest expense remain well contained with expense growth of 13% for the year.

We did see an adjustment that we commented on in the call earlier of $2 million due to fourth quarter performance in the incentive approval. Before the effect of that adjustment, we would have seen 16% growth in non-interest expense. Again, with net revenues still 300 basis points above the growth rate in non-interest expense. Non-interest income and efficiency ratios are excellent. Its major effect obviously of reducing the incentive expense but the efficiency ratio would still have been just under 60% without that adjustment. We do want to say, however, that that level is probably not sustainable if net interest margin should fall even with the expenses under control. Obviously, again the stability of net interest margin was important throughout the year. Comment again we remain somewhat as sensitive but sharply less so than in the years past. Credit quality cost as I said a minute ago were approximately $6 million higher than the number incorporated in the guidance in which despite the increase in provision in Q4 ROA and ROE remained at 80 basis points and 11.5% for the full year compared to 88 basis points and 12.6% in the prior year.

Turning to page 8, not much to say about this kind of growth. It is all organic and we had as Jody commented, record growth in average balances of loan sale for investment, more than $660 million for the year and Q2 to Q4 just over $718 million. All growth as I said has been organic reflecting much improved productivity of RNs, especially those who joined Texas capital in the early years and especially more in the last half of 2006.

I think it is going to be hard to find pure growth anywhere in the United States that reach this level. We have continuously and will continue to see as long as the yield curve is like it is, strong growth in loans overcoming and improving the earning asset composition. Total composite growth year on year was 16% on average balances. Again, all customer based deposits, a lean quarter growth of $16 million and DDA was up 3% following the $12 million growth or 2.5% in Q3 though they were essentially flat for the full year.

All measures of DDA performance are counter much more favorable than industry trends. Composition deposits clearly continues to shift to interest bearing liabilities as the industry experiences a lot of difficulty in growing demand deposits.

Slide 9: Again, strong growth through the end of the quarter. We start 2008 in long-term investment, $125 million or 4% better than the average for Q4 2007. Percent lines obviously are more variable and down sharply. Late quarter deposit comparisons are down because of unusual growth in loans that occurred in the last half of the last quarter and the maturity of transaction specific deposits. Quarter-end DDA balances were up sharply from Q3 2007 again, reflecting the fact that we have such strong growth in the fourth quarter of each year, a date statement, not average.

Slide 10: 3.83% net interest margin for the year, down 2 basis points from 2006. Q4 was flat with Q3 and Q4 prior year, reflection again of much reduced asset sensitivity. The company remains asset sensitive but again growth in loans has produced a change in funding composition. Composition of funding puts a limitation on that interest margin but liabilities also now reprice much more rapidly. Level of net floating rate assets funded by fixed rate and zero cost liabilities have decreased substantially as a percent of earning assets since rates began to increase. Stated differently, the funding of earning assets made up of DDA and equity is now under 20% and it was 25% or greater prior year.

And with that I will turn it over to George.

George Jones – President and Chief Executive Officer

Thanks, Peter.

Slide 11: Again showing deposit loan growth over the past six years. As Peter mentioned, demand deposit growth is up a link quarter basis but the (inaudible) is 17% with that average growth in Q4 of $16 million or 3% compared to similar increases in Q3 and as mentioned the driver of the decrease in funding to pause in Q4. Total deposit growth over a six year period was 21% but again as mentioned before we showed a decrease of $96 million in average deposits in Q4, tied really to specific events related to some CDs that matured partially offsetting that decrease, we saw really good deposit growth from most of our lines of business particularly Energy Banking, San Antonio private banking, and corporate banking here in Dallas. The loans held for investment again showed a great growth of 28% over the six years and grew on average $142 million or 4% in Q4 and 27% over Q4 2006. As you might suspect C&I loans continue to be the driver. They provided 54% on the overall loan growth and the regions outside of the DFW area provided 38% of the loan growth in Q4, the balance coming from Dallas specifically from our energy lines of business, corporate lender finance and private banking.

Slide 12: Reflects growth in income and expenses again over the past six years with revenue continuing to outpace the expense growth, non-interest expense as Peter mentioned declined sharply reflecting the partial reversal of some incentive accruals but if you exclude that one time event, the link quarter expense only increased slightly continuing again to reflect our efforts to reduce the expense growth in the company.

Slide 13: We will talk about credit for a few minutes. Our credit experience as Jody mentioned remains quite good. Our net charge of 2.2 million for 2007 really was after $2.5 million taken in Q4. This represents just 7 basis points for the year. I believe it is important to put Q4 results in context of our longer term experience. Even small losses compared to the industry look larger when compared to net recoveries or insignificant net charge offs. Our loss of 7 basis points is consistent with the previous two years. Our net charge of since inception of the company just over $11 million represents just approximately 10 basis points.

I think all of you will recall that we had realized the net recovery of 300,000 for year to date 2007 through Q3. And actually in five of the past eight quarters, we had either net recoveries for three quarters or net charge offs of insignificant amounts for two quarters.

During the past two years in quarters where we have had any net charges at all, the average net charge off ratio in those quarters was just under 14 basis points.

As we mentioned in our earlier non-accruals in ORE increased approximately $15 million to $24,100,000 in Q4 2007.

Let me give you an update on the five credits that I discussed previously on that call that composed the majority of our non-performing loan portfolio. We have not received any reduction on the large $12.5 million loan that was added to our problem loan list or our non-accrual list in Q4 but we have had positive movements over the past few weeks. This loan was the primary driver along with growth of our larger provision in Q4 but it is not indicative of the condition of the rest of our loan portfolio. This company acquired a business approximately a year ago resulting in leadership and financial control problems. Exis Capital and the Board of the Burrough independently engaged outside advisers to report on the control issues. The results of which were not forthcoming until the fourth quarter.

The $10.5 million C&I loan in Houston, that we previously took a $1 million charge off in 2007 was paid this week. We received the $3 million and recorded a $500,000 recovery in January of 2008.

(inaudible). We have completely restructured our last of approved investors and our investors today are primarily large financial institutions like (inaudible) City, Wells, Chase, GMAC, etc.

(inaudible) $4.1 million in loans were part of the bubble, so to speak, before these new underwriting standards took effect. We monitor loan flow in the warehouse daily and we watch trends with certain aging groups. There are no indications today in those aging statistics of any increases in volumes of problem loans in the warehouse and we feel comfortable with our portfolio at year end. Approximately 95% of our warehouse loans have been in the warehouse less than 25 days today and 99% have been warehoused less than 45 days. As mentioned before our provision was $14 million for the year, $9.3 million in Q4 2007 and this provision increased our reserve balance to 95 basis points of loans. The conditions in our industry today warrant intensified focus and tightening of standards and we are continuing to do so as we speak. We believe that 2008 can be a very good year for us but again it will be challenging and we think again, it will be a strong year for us.

If you turn to slide 14, I will not spend much time on that. That really just reflects our net charge offs to average loans since 2003 and again you can see that that performance has really been excellent.

Thanks, George.

George Jones – President and Chief Executive Officer

Let me make a few comments about guidance and I will begin by saying that the plan we have put together for 2008 together with the guidance reflect a very conservative posture on the part of the bank and its management. We did have major assumptions which are listed on slide 15. We expect our loan growth to be less than historical levels. To put that into perspective you would have to extrapolate what normal would be in 2008 and we are predicting about half that. Margin compression obviously, rights doing what they are doing given the action that the Fed took today together with the action that they took several weeks ago, we are down 125 basis points from the beginning of January.

The results for the fourth quarter when we reported a margin of 3.86 reflect largely the first 100 basis points in rate reductions that the Fed has imposed. The last 125 basis points are reflected in the guidance that we are providing to you now. And you will notice from the slide that we expect the Fed funds rate to reach a low of 2.5%, that means we have 50 basis points to go and for planning purposes we have placed that reduction in the month of April and held it steady throughout the rest of the year at 250.

The provision is obviously, the most significant variable and for provision purposes we have assumed outsized provisions. The guidance incorporates a no-loss reserve ratio of 1%. You can extrapolate into your own models and reach your own conclusions about what that specifically means in terms of other provision and net charge offs we have assumed at 15 to 20 basis points which exceeds our 10 year historical average of 10 basis points by a significant percentage. We also expect an improvement in non-interest income. This comes in large part from the warehouse. We feel that the way we operate that business and George gave you some data points on that, but we think that we operate it conservatively. We have seen others step out of this business so we believe there is an opportunity there for us to increase our market share and a lot of the improvement in non-interest income comes from that source. We will continue to contain growth in our non-interest expenses although again that is going to be measured largely by the top-line growth. The greater the top-line growth, it does imply a concomitant increase in growth in the expense line. And so, the guidance that we are giving you today is $33 million to $35 million. Doing it in terms of aggregate dollars is in keeping with what we have done in the past and how to predict the number of shares is sometimes difficult just based upon the fact that it is affected by the price of stock. Therefore, we think we are going to have a good year. We do believe that the first half is going to be slower than the second half. The first quarter in particular will reflect the same dynamics that we have discussed in the last years of guidance that we have given you, that includes FICA expense and other non-recurring type of expenses. Now, we do have one extra day in the first quarter of this year, being leap year. So, any of those of you that got married on February 29 can celebrate your once every four year anniversary.

With that we will go to questions. Let me just say before we turn it back over to the operator, that we have attempted to be as transparent as we possibly could be and we will try to answer your questions with the same degree of forthrightness and clarity but also within the bounds of good reason.

So, with that let me turn it to the operator and we will be glad to entertain your questions. Thanks very much.

Question-and-Answer Session

Operator

(Operator Instructions).

Your first question comes from the line of John Pancari with JP Morgan.

Joseph M. Grant

Hi, John. Good evening.

John Pancari

Jody, can you just comment a little bit on the competition in your market coming from the larger players. Again, you do compete against the larger money center names there in Texas. Obviously, these larger banks tend to in terms credit downturn and pull back notably across their markets regardless of where it is and since Texas is holding up still a little better are you seeing some of these larger players pull back and that could be an opportunity to pick up share?

Joseph M. Grant

Well, what we would love to is see those bigger banks have those knee jerks reactions that emanate from New York and other places and filter down to our markets. As you know, John, the biggest banks, they continue to be upscale in their targeting of commercial clients, targeted mostly on the Fortune 1000, 2000 and also at the bottom end of the market, the branch activity continues to be pretty frenetic down here although there are some signs that is has slowed somewhat recently. We also have a lot of new charters that have been filed and new banks that have been opened during year which we have a hard time understanding but all of that having been said, the competition is keen, the banks that are in our space are doing pretty well for the most part. (Inaudible) & Frost had a pretty good report. Bank of Texas which surreptitiously operates under that name is (inaudible) really the bank local holder but nonetheless they are good competition. We are in the market place being prudently aggressive and I think there is a chance to increase market share and the stronger banks that are well capitalized as we are and that have funding sources and excess capacity on their balance sheets which we have based upon warehouse of funds that we have at the holding company plus a major facility that we have available to us gives us dry powder. So, we think we are well positioned for growth as the opportunity occurs and we do think the opportunity will occur sooner here than it will in the rest of the country.

John Pancari

George or Peter, George in particular. I would like to add some granularity to that, but that’s kind of a 35,000 (inaudible) bright idea.

George Jones

Right. I think the world, John, has some opportunity in 2008 and there is no question about it, but I would position the company hopefully to be able to take advantage of whatever comes but yet some of the pullback does happen, we would like to be right there.

John Pancari

Okay, good. And then secondly, George, if you could help here. I’m just looking at loan growth. Do you have much of that growth only on a quarter basis? Was it in loan participations where Texas Capital has led the deal?

George Jones

Not much, not much at all. Most of this, again, is organic growth from within our existing marketplace that falls into that category, so to speak that $2-10 or $15 million category that really is our sweet spot. Our focus is not on agenting very large credits and putting age groups together. We do have some of that in our portfolio, but that certainly is not our focus and has not been our real growth engine in the company.

John Pancari

Okay. All right. And then lastly, on the credit side. The charge-off expectations are up notably from the historical transition you indicated. Anything specific there that you’re looking at outside of just the general deterioration that you’re saying? In certain parts of your portfolio is in for the broader credit environment?

George Jones

John, let me just make a comment. What we gave you in terms of guidance is what it is. It’s what it’s intended to be, and that is guidance. It’s not a projection of charge-offs. Obviously, we hope our experience is going to be much better, but in terms of giving guidance and in terms of playing, profit-playing, we are being very cautious. So, just be careful not to take guidance as being a projection of fact and something that is going to happen and that is written in concrete, because that definitely isn’t true. Essentially, the $335 million would accommodate net charge-offs of that magnitude and still be able to maintain a reserve of 1% or better.

John Pancari

Okay. And then…

George Jones

John, just one other thing. The way we operate this company in terms of inventing profits and handling our finances as the year progresses; we will take a longer look at this at the end of the first quarter, and we will determine our provisioning based upon the experience in the first quarter and if it’s in keeping with the guidance we have given you, that’s what we’ll do. On the other hand, if it’s better, then our results are going to be better. And we continue to calibrate and recalibrate as the year progresses.

John Pancari

Okay, okay. And then one more quickly and I’ll hop off after that. Just the, in terms of your mortgage warehouse, I know you indicated the $4.1 million that’s in MTA there. How much do you have left in the warehouse that is similar to those types of credits that were originated before the new guidelines were implemented?

George Jones

We believe, John, that we have cleared all those out at this point in time. And, what’s in the warehouse is, we believe, under the new guidelines are readily sellable to those institutions that we have approved or really most any other mortgage investor in the marketplace, and that’s the key. You want to be sure and underwrite because if some of these investors choose not to buy, you have an opportunity in the marketplace to other investors. We believe, as I mentioned today, that based on the ageings we see and track daily, that we see the trends being very positive in the warehouse and we don’t expect a lot of additional problems there. I mentioned to you also that the ageings in the warehouse are certainly very acceptable. If 95% of portfolio at 20 in the warehouse at 25 days or less. Pretty good number.

John Pancari

Okay, all right. Thank you.

George Jones

Thank you, John.

Operator

Your next question comes from the line of Andrea Howe of Lehman.

Andrea Howe

Good afternoon. Andrea Howe. Hello, everyone! Given your pipelines and given the business conditions that you see, do you think there’d be loan goals as possibilities to assimilate? What types of business will be weaker? And what types of businesses, what areas will remain good?

George Jones

As we mentioned before, we have mentioned on virtually I think most of the conference calls. C&I growth continues to fuel the growth of this company. We see a slowdown in the real estate area, so you will probably see from our perspective single-family construction, lot development, even some commercial real estate products slow in 2008. And the focus will be on strong C&I business on a go-forward basis. We are not necessarily picking industries; we pick management teams, and we pick specific companies that have performed well in the past and have a good opportunity to perform well in the future. But we think that again, we are reflecting a slowdown in our projected numbers and so we obviously think that energy is going to a very strong participant in our growth in 2008. Professional service companies, those kinds of industries. But again, we’re looking at management teams and potentials.

Andrea Howe

Okay. On the deposit side, do you think it will be easier to grow money just paying deposits, low-cost deposits as interest rates fall?

George Jones

Well, that certainly was the experience when the French rate fell from 6.25% to 1%, and during that period of time, Andrea, we had the main deposit growth that was generally exceeding the growth of total deposits. That of course came to an end when interest rates started rising from the 1% level. So, in this environment, intuitively, you would have to think that that would be the case. The proof is in pudding. We will be able to tell you more at the end of the first quarter.

Andrea Howe

Okay, great. Thank you very much.

George Jones

Thanks, Andrea.

Operator

Your next question comes from Brent Christ of Foxx Pitt.

Brent Christ

Good afternoon. Just a followup on the loan worth topic. Could you give us a sense of, obviously it sounds like a little bit of moderation, how much of that is a function of you guys just pulling back a little bit vs. just what’s going on in the market?

George Jones

Well, I think it’s a combination of both. We have consistently reminded our lenders. I’ve seen memos going out to the lending staff that have urged moderation, have urged more prudence and more conservative underwriting standards. We also think that the size of the credits will probably be a little larger than the average as we enter a new environment. I think that the projections that we’ve given you are conservative based upon, again, the Texas economy and the prospects of the Texas economy. I do think that we are going to have kind of a hockey stick in terms of this growth and it’s going to be more back-end related toward the second half of the year. And that’s why, in my comments, I said that the first half of the year in comparison to 2007, we are expecting growth in terms of net income and all the other metrics but it’s going to be more back-end related, and then switching gears for us back in terms of the margin it was good to see you were able to hold the line this quarter and I just want to see to what extent the roll off of some of the CDs had in terms of doing the margin this quarter and kind of how you were thinking about the said recent Feds cuts flowing through in terms of order and magnitude, in terms of how much pressure that could cause you near term?

Brent it did have a favorable effect. We also were able to, well these are not term deposits. We have been very successful in ratcheting down the cost of the other categories such as Euro-Dollar deposits. We do not expect, though, to be able to maintain that kind of margin with rates falling to this low as two-and-a-half percent. Our best guess is, just to be open about it, would be that we could be exposed from Q4 levels to the 10 to 15 basis-point erosion in market over the course of 2008. A part of that coming simply from relatively strong growth necessarily being funded with interest bearing liabilities as opposed to DDA not strictly as a function of rate.

Brent, just to remind you that we experienced in the last cycle of rate declines was that even though our margins were declining, that was being more than offset by the growth in our loan portfolio. So, it is the rate-volume game and the volume was overcoming the rate. Just another point of clarity. A lot of the slowdown in growth that we have anticipated really relates to our desire to be more stringent in terms of credit quality. So it does not mean that there is not loan demand out there because it is there, but we are going to be selective.

Brent Foxx

And then the last question I had was just would you still continue to have a little bit of noise related to the discontinued operations and I just want to get a sense of how long we could potentially see that persist into the future?

George Jones

Well we think most of it is behind us. It will within a year, at the end of March as we exited this business. We exited it once and then we had to renegotiate with a deal and renegotiation took place and was effective March 31 2007. And so we had really not twelve but eighteen months expire since we first exited the business. And as a consequence of that, we have seen a tremendous slowdown in loans that have been put back to us. And I do not expect it would be modest as we go forward.

Brent Christ

And is that really the pressure point as long as it is being put back because I did not think you had much

George Jones

I think it is the alleged fraud or something like that and they tend to put these loans back to us. Our initial reaction is to reject them and fight them and sometimes we end up in some kind of settlement. They keep the loan but we pay them $25,000 or something to keep them. So I really do not think that is going to be an issue of any significance as we go forward.

Brent, what we did at yearend was provide in that discontinued-operations category a reserve. The bottom line number you see is after that, a reserve that we estimate to be our maximum level of exposure on those kinds of issues that have been put back to us as of 12/31/07. So we tried to take a fairly conservative approach in terms of what that lost number might be. And hopefully, and our experience is, it will probably be better than that.

Brent Christ

So you could potentially recoup some of that?

George Jones

Well, we are not banking on that, but there is a possibility.

Brent Christ - Fox-Pitt

Okay. Thanks a lot.

George Jones

Thank you Brent.

Operator

The next question comes from the line of Erika Penala with Merril Lynch. Please proceed.

Erika Penala

Have you started to see the subtypes meaningfully impact deposit pricing in your marketplace?

George Jones

Absolutely. We have seen that in every month since it started as I mentioned Euro-dollar deposits are running 54 plus basis points, and that December average does not reflect what’s current today. 54, 50 to 60 basis points are low levels of Q3. (inaudible) manifests itself in dramatic increases and DDA in other lower cost deposit category is yet to be seen but because of the repricing it has been very sensitive to the decreases.

Erika Penala

Okay. Could you give us a little bit more color on earlier stage, credit indicators as you see them at yearend in terms of delinquencies and classifications?

Jody Grant

It is really expected in what we reported. That’s about it. With some improvements that George noted already occurring in Q1, battling in net recovery.

George Jones

I think we have spoken to that with clarity and we have been comprehensive in what you have said Erika.

Erika Penala

Okay. Thanks for your time.

Operator

Our next question comes from Brad Milsaps with Sandler O’Neill. Please proceed.

Brad Milsaps

Doing well. Most of my question is regarding the discontinued (inaudible) but I do want to ask you a quick question regarding your current deposit rates looks like really across the border. You have cut all your (inaudible) marker is rate to just below 3%, did that reflect obviously last week’s cut but did it mean that you sensed that you are going to be able to push that even lower?

Jody Grant

For certain categories you can’t push lower. I mean like there are still loans that realistically they can’t go that much lower but nothing you’ve seen of course reflects like any of the adjustment in that current 75 basis points earlier this month yet to be seen but we are aiming to reprice again much more rapidly than we had historically that I would say.

Brad Milsaps

Okay. Great. Thank you.

Operator

Next one comes from the line of Jennifer Demba with SunTrust. Please proceed.

Jennifer Demba

Good afternoon. Just wondering if you could give us a sense of what the loan growth was by market in 2007 and where you ended up the yearend loans in Houston in particular.

George Jones

As I mentioned Jennifer, the 38% of the loan growth in Q4 really came from the markets outside of Dallas. We had good growth particularly in San Antonio and Houston in terms of loan growth. Austin has been and will continue to be a good market for us primarily in deposit generation and that continues to be a good market for us there. Dallas obviously making the difference, I can mention the 4 or 5 areas within the company in Dallas that did provide a pretty substantial growth.

Jennifer Demba

Where did you guys end up the yearend loans in Houston Georgia? What was year-over-year growth?

George Jones

Let me check that for sure. Well it is past 400… something like that.

Jody Grant

While George is looking for that answer, Jennifer, in San Antonio we were able to increase selling there by 50% last year. Just on the order of 50%. And there was an extraordinary, you would never know where this loan growth is going to come from and intuitively it would like San Antonio would be maybe the least likely place, but it was a great year for us there and the guys down there did a great job.

George Jones

Jennifer, the Houston loan portfolio is approximately $498 million at the end of ’07 and that was about A 44% increase over 2006. So they have done well.

Operator

Next question comes from the line of Dan with KBW. Please proceed.

Dan

Okay. Just a quick question with regard to the guidance that you gave for ’08 and what the rate cuts and I know you have been running the security; this caller how you think about that going forward in terms of will the run off continue or what has happened to yield curve to enable you all to start putting money back there?

George F. Jones Jr.

It would have to be a lot different from what we see it but we anticipate during the year that is will simply continue to run down. (inaudible) run of $68 million during the year, that implies a rate of $5 to $6 million dollars a month and it has been relatively consistent in terms of the percentage of the portfolio’s decline. I did not know how that played into this guidance and since some sort of that run off continues or …In the sense that a run off continues and we are not able to make in the kind of securities and maturities that would fit us, any new investments.

Dan

Great. I appreciate that.

George F. Jones Jr.

No free money.

Operator

The next question comes from the line of Andy Steff with D. Rowling & Co. Please proceed.

Andy Steff

Hi guys.

George Jones

Hi Andy.

Andy Steff

Obviously, most of my questions have been answered but I was wondering if you could tell us the balance of construction and development loans at year end?

George F. Jones Jr.

Let me give you a little perspective on that on our commercial credit, real estate credit. Our market risk real estate that we talked about, that is about 27% of the portfolio. Are you interested in the breakdown between single family and lot developers?

Andy Steff

Yup.

George F. Jones Jr.

Commercial real estate kind of…. I will answer the question you are interested in.

Andy Steff

The total that you gave includes commercial.

George F. Jones Jr.

That’s correct. If you are specifically looking for single family construction and lot development loans, that is about 8.4% of the overall portfolio.

Andy Steff

Roughly, how much is that is residential versus lot development?

George F. Jones Jr.

Lot development is about 5% and single family construction is about 3.4% of that number and that has been fairly consistent. Those percentages have been like that for some time.

Andy Steff

And then overall construction development was how much of total loans?

George F. Jones Jr.

I would have to check that specifically. I can get back to you specifically on that. One thing that we think, Andy, is really positive is that it relates certainly to the single family side and the lot development side is that 95% of that is all in Texas. So, you can break it down by market but that makes us still pretty good in today’s environment. We are just not doing much outside of Texas.

Andy Steff

I might add, one thing I failed to mention in the conversation I had with David Brown that I related to you he did say that Texas unlike the other markets around the country that he follows we have seen very little price erosion in terms of sales. Now, that does not mean that developers are cutting special deals and providing incentives and so forth but the prices have remained pretty flat and have held up pretty darn well. And that is encouraging to us.

George F. Jones Jr.

Great. I appreciate it. I will get back to you on that construction number.

Andy Steff

Sure.

Operator

Your next question comes from the line of John of Hybrid Capital.

John

Hi guys. I want to congratulate you on your loan growth for the year. We are certainly encouraged to hear you and Jody mention the things you had to say about the Texas economy. I certainly think nobody around here thinks that what we are seeing now parallels what we saw in the mid-80s but I wanted to see if there are any comparisons whatsoever you can draw from what is going on now to what happened back then in the early to mid-80s.

Joseph M. Grant

That is actually a question I can field with great certainty. There is absolutely no connection between what is going on now and in the mid-80s, early to mid-80s. We had the perfect storm of economic and political events that lead to a complete meltdown in the Texas economy and the Texas real estate markets in the 80s and as you know we lost 9 of the 10 largest banks either to failure or acquisition and we lost 94 of the top 100 savings and loans. And there is absolutely no indication that we have any bank in the state that I am aware of that has not got any significant problems. In the underlying economy, we have one area of weakness and that is housing. This is the first time in my recollection and I would begin in terms of how I look at the economy post World War II but it is the first time since then that I know of that a decline in the economy has been led by housing. And this whole deal with subprime lending, for those who were not involved in it, we did not see it necessarily. It was not that visible and fortunately, we did not participate in it. The type of borrower that we finance is not in that segment of the market necessarily. So, this is just a complete and entirely different situation. There is absolutely no parallel, no correlation. You could not draw any … I look for a rebound sometime in the second half of the year. I am saying it is going to be a sharp rebound but I think that it is going to be a turn around. And if you take housing away, the rest of the economy looking at Texas looks pretty darn good. And as I said our total employment is up in the state. Total construction employment is up interestingly. And a lot of that relates to public works, it relates to commercial construction and each month when we had this housing problem that has been the big bugaboo, we have seen monthly increases in construction employment. So, it indicates that the Texas economy again taken as a whole is pretty darn healthy.

I might just add one of the data point for you, that is out of the total employment in Texas construction employment and that includes state, federal, private, everything is less than 6% of total employment. Now, housing is still a significant part of the economy. We are going to get through this and we are going to get through it in pretty darn good shape and I think we will be strongly positioned to take advantage of the opportunities that will exist as recovery begins.

Andy Steff

That’s great. Thank you for the color.

Operator

Your next question is a follow up from the line of Andrea Ho with Lehman.

Andrea Howe

Hello again.

Joseph M. Grant

Hi Andrea.

Andrea Howe

If you think that the growth will be much better in the back half of the year, do you think that credit will be toughest and therefore net charge of higher in the earlier part of the year.

Joseph M. Grant

Well, Andrea that is a hard question to answer and all we can do is give you an answer based upon what we know today. And we have disclosed everything that we know today. If we had anything else that we were terribly concerned about, it would be out there as part of the public record and we are being more cautious. George indicated that one of the loans that was a real problem for us has been paid. We are going to incur $0.5 million recovery. The largest loan was the catalyst for pre-announcement. As George indicated we have seen progress there and we are hopefully optimistic but we have got a way to go and we hope we will be able to give you better news. But there are no certainties in this world and we take it one day at a time but we think we have got our arms around this portfolio. In addition, to our own in-house staff, I will just remind you, that we bring in for loan review an outside consulting firm consisting of OCC examiners and this dejavu (inaudible) in this context it relates back to the last question. When I was in Texas merging bank shares in the 80s, our principal OCC examiner is the same person who does our internal loan reviews today. We can actually sit at the same table and have a civil conversation. In fact, she is tough. She covers about 60% to 65% of the portfolio. She samples the portfolio from top to bottom obviously to get that kind of coverage. She is looking very carefully at the largest exposures. I think our processes together with the scrutiny we get externally from the consultant that I have just described to you is as good a process as any bank certainly in Texas has maybe than any bank in the country has.

Remember, we have been through this before and we are deeply experienced in early identification and an attempt to weed out these loans before they become problems and we have had a great deal of success in doing that. The heated competitive environment that we have in Texas is a big plus for us in that context because a loan that we look at that we might not look upon that favorably may look really golden to somebody else who does not have the deep experience and perspective that we do.

Andrea Howe

Fair enough. Thanks again.

George Jones

Let me go back quickly to the question that was asked about construction loans as it relates to our overall portfolio and try to give as much color on that as I can. 36% of our loan portfolio today is real estate loans, overall. Of all real estate loans, 43% are real estate construction, i.e., the other 57% are what we call permanent loans. Of the construction loans that we have in the company about 89% are commercial or market risk real estate loan. So, hopefully that gives some color to the previous question and if there is additional need to discuss it, please call us and we will.

Operator

Your next question comes from the line of Charles Earp with O’Neil Active Management. Please proceed.

Hi, Charlie.

Charles Earp

Hey guys. How are you today?

Jody Grant

Pretty well.

Charles Earp

Good, can you just real quick say what the attitude of the energy companies is right now, whether they are actually money or if they are just using their cash flow and investing it on their own.

Jody Grant

No, they are borrowing. And obviously, pay downs come more rapidly and in bigger amounts than they used to but the good thing about this energy play in Texas is that the Barnett Shale just continues to be a gold mine for those looking for the gas play and because the operators there have been so successful, it encourages new entries into the market place and we have got more opportunity than we can say grace over.

Charles Earp

Are you seeing much growth on a net basis, Jody?

Jody Grant

Yes, absolutely. In other words, new loan growth is exceeding payoffs and by some significant margin.

Charles Earp

I know that you guys are probably careful about what you exam as credit but you did make a comment that there was some positive movement. Could you comment on that and also is there any sense that you can give us on the collateral behind the credit?

Jody Grant

The problem with talking about any credit and particularly one where we are involved with the consortium of banks, the negotiations are delicate and we have to be very circumspect in whatever we say and it behoves us and we are going to have a better result in the final analysis if we say less rather than more about this particular situation.

Charles Earp

Okay, fair enough. Thanks a lot, you guys.

Operator

Your next question comes from the line of Michael Rolf.

Michael Rolf

All right. Can you guys talk a little bit about your hiring plans for the year? And maybe if you see some opportunities to pick up some lenders from competitors?

George Jones

Yes and yes. We definitely see opportunity out there. The history of our company has been to take the opportunistic and take advantage of what’s out there in the marketplace today. I think there will be more opportunity in 2008. We are very selective. We are not in the marketplace trying to fill offices. We are trying to find the absolute best people we can find to join our company and grow our portfolio, but in times like these, we typically find very good people looking for other opportunities, so our goal would definitely be to find the premium players in each one of our marketplaces and bring them all. We do, and we always have had, and I’ve told you we’ve had, some capacity in the company today for growth. And we want to keep that capacity because that’s the way you compete in a very competitive marketplace is you have healthy capacity with your players to really get out there and hit the long ball. But again, opportunistic, look for people who are excellent and can produce for the company.

Michael Rolf

Great. Thank you.

Operator

We have no more audio questions in cue at this time.

George Jones

That being the case, let me just make a couple of ad lib closing comments. I’m a little bit amused by the question related to the ‘80s. I’ve almost started having facial tics, tremors, and vapors, but looking at 2008 in the current environment makes me feel very, very good. I’m relaxed. I sleep well at night, and I’m really comforted by the processes, the team that we’ve got, and the economic environment which we’re operating. Obviously, energy is a great underpinning to this economy. It is the fastest-growing segment of our business. When you look at all of our lines of business and our geographical markets. So, we believe that we’re in as good a place as we could be in given the circumstances in which we’re operating today. And certainly there are uncertainties about the economy, but I think we’ll get through this housing problem that the country faces. I think we’ll get through it in, I would certainly hope that most of the big if’s have been taken as we look at the large financial institutions. There’s no certainty of that. But again, we have been scrupulous in trying to limit our exposures and to be very circumspect in terms of who we bank. That having been said, we hope we’ll reporting very good quarters in the first half of the year and even better quarters in the second half of the year. We look for a solid 2008. We have given you guidance, which we think is conservative. On the other hand, if the year-end folds as we have suggested, we are not going to be disappointed. We would like for it to be a lot better, but we are just going to conduct our business as best we can and continue to operate in a conservative, sound manner and the chips will fall where they will.

With that, let me thank everybody on our team who has participated in this call. A lot of good work goes into these calls, getting ready for them. We’ve tried to be as transparent as we could possibly be today. I think we have given you more information and more detailed information than we’ve ever given you before, both as it relates to already-reported results plus a guidance and what that guidance is built upon. I encourage you to call us if you have further questions; direct those calls to Myrna. She’ll find the appropriate person to answer them if she doesn’t feel comfortable in answering them herself.

With that, we appreciate everyone who follows the company, all of the analysts. We obviously particularly appreciate our investors who continue to stay with us and who we value very, very highly. So, it’s time to bring this call to a close. We’ll join you in toasting the New Year, and we look forward to it being a very good year.

Michael Rolf

Thank you very much.

Operator

Thank you for your participation in today’s conference. This concludes our presentation. You may now disconnect, and have a good day.

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Source: Texas Capital Bancshares, Inc. Q4 2007 Earnings Call Transcript
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