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Pacific Capital Bancorp (NASDAQ:PCBC)

Q4 2007 Earnings Call

January 31, 2008 11:00 am ET

Executives

Tony Rossi - Investor Relations

George Leis - President and Chief Executive Officer

Brad Cowie - Interim Chief Financial Officer

Dave Porter - Chief Credit Officer

Don Lafler - Former Chief Financial Officer

Analysts

Brett Rabatin - FTN Midwest

Brent Christ - Fox-Pitt

Joe Morford - RBC Capital Markets

Andrea Jao - Lehman Brothers

Aaron Deer - Sandler O'Neill Asset Management

John Pancari - JPMorgan

Scott Carmel - Philadelphia Financial

Julianna Balicka - Keefe Bruyette & Woods

Operator

Good morning ladies and gentlemen, thank you so much for standing by and welcome to the Pacific Capital Bancorp Q4 2007 Conference Call. (Operator Instructions). I will now turn the conference over to Mr. Tony Rossi, of the Financial Relations Board, please go ahead.

Tony Rossi

Good morning everyone and thank you for joining us to discuss fourth quarter results with the management of Pacific Capital Bancorp. With us today from management are George Leis, President and Chief Executive Officer; Brad Cowie, Interim Chief Financial Officer; Dave Porter, Chief Credit Officer; and Don Lafler, the company’s former Chief Financial Officer and now a consultant to the Finance Department. Management will provide a brief summary of the results and then open up the call to questions.

During the course of the conference call, management may make forward-looking statements with respect to the financial conditions, results of operations and the business of Pacific Capital Bancorp. These include statements that relate to or are dependent upon estimates of assumptions relating to the prospects of continued loan and deposit growth, improved credit quality, the health of the capital markets, the company’s de novo branching and acquisition efforts, the operating characteristics of the company’s income tax refund program, and economic conditions within its markets.

These statements involve certain risks and uncertainties many of which are beyond the Company’s control. Forward-looking statements speak only as of the date they are made. Pacific Capital Bancorp does not undertake any obligation to update forward-looking statements to reflect circumstances or events that occur after the date of forward looking statements are made. This time I would now like to turn the call over to George Leis, George?

George Leis

Thank you, Tony. Good morning and thank you for joining us today. I’m going to provide a brief overview of the fourth quarter of 2007 and then I will turn the call over to brad who will review financial results in more detail. Following Brad’s remarks, I will conclude with a discussion of our outlook for 2008. We generated $0.26 in earnings per share in the fourth quarter of 2007, which compares with a loss of $0.02 per share in the same period last year. Excluding the strategic actions included in our press release and the impact of the RAL and RT program in each quarter, our earnings per share was $0.32 in the fourth quarter of 2007, an increase of 39% over the $0.23 we earned last year.

We believe our results in the fourth quarter represent solid progress on our efforts to improve the performance of the core bank. Our fourth quarter performance is driven by continued strong loan growth, solid non-interest income, and improving expense control. Excluding the impact of bridge loans, and loan sales, which I will discuss in a few minutes, we generated annualized loan growth of 10% during the quarter. Our experience in the fourth quarter underscores the value of the diversity of our lending business.

Earlier this year, our construction and residential real estate lending businesses were significant contributors to our loan growth. However, given the weakness in the housing market, we indicated that we expected the growth rates in these portfolios to slow, which they did in the fourth quarter. But we had solid growth in a number of other portfolios in the fourth quarter, including annualized growth rates of 23% in the C&I portfolio, when bridge loans are excluded, 11% in commercial real estate portfolio, and 16% in the home equity portfolio.

The diversity of our lending is one of the foundations of our business model, and we believe it positions us to effectively manage through slowdowns that might be experienced in particular areas of the economy or specific geographic regions.

Turning to our non-interest income, we had solid increases in most of our fee-generating areas, including 9% growth in service charges on deposits and 5% growth in our wealth management income. We also continue to improve the management of our cost structure.

Excluding the impact of the strategic actions we took in both quarters, the total non-interest expense for the core bank declined by 9.3% over the prior year. This resulted in the operating efficiency ratio for the core bank improving to 61.6% from 62.5% in the fourth quarter of 2006.

Turning to our credit costs, we recorded a provision for credit losses in the core bank of $6.8 million, which was higher than our provision in third quarter. This was largely attributable to the downgrade of the two commercial relationships to non-accrual status during the fourth quarter.

One relationship was an $11.6 million loan to a company that is in the auto parts industry. However, the borrowers receiving interest from potential acquirers for the company and we expect a satisfactory resolution to this problem credit within six months. The second relationship consist of $33 million in credit facilities with a residential home builder. This borrower has been a customer for almost 30 years and we have historically had excellent credit experience with the company.

The current relationship consists of financing several construction projects in Reno, Nevada and one project in the Central Valley of California. Both of these areas have seen a significant weakness in the housing market. Approximately two thirds of the aggregate relationships relates to projects in Reno and the remaining third in the Central valley.

We have current appraisals on most of the properties, and have applied significant discounts to the existing appraisals on the other properties for the purpose of determining our potential loss exposure. Based on this current analysis, we believe our exposure is relatively modest. We expect the remaining principal to be paid off over the next 18 to 24 months as houses and lots are sold.

We have one other borrower with a construction project in Reno. This is a $19 million loan and it is current. We also have approximately $66 million in various construction loans in the Central Valley, all of which are current. In aggregate, our total construction loan exposure to Reno and the Central Valley areas including the non-performing loan mentioned above represents only about 2% of our total loan portfolio.

The remainder of our construction portfolio is performing well. Excluding the non-performing relationships that I just discussed, our total non-performing construction loans represent 1.19% of our whole construction portfolio at December 31, 2007, which compares to 1.24% at September 30, 2007.

Here on the construction portfolio, the remainder of the loan portfolio remains generally stable. We are seeing slight increases in delinquencies in most portfolios, as you would expect in a slowing economy. But we are not seeing any trends that would lead us to believe that our provision expense will be more than 4 to $6 million per quarter for the foreseeable future.

Before I conclude, I would like you briefly discuss two additional steps we took during the fourth quarter to continue to reposition our balance sheet. First, we recorded a $3 million loss in order to mark-to-market certain mortgage-backed securities. The recognition of the loss on these securities will ultimately give us greater flexibility to manage the securities portfolio in a way that will be most beneficial to the company in the future.

Second, we identified $353 million in residential real estate loans that we decided to sell. Approximately, $285 million of these loans were sold at the end of the fourth quarter. The remainder were sold in the first quarter and are shown as loans held for sale on our December 31 balance sheet. We believe these sales will improve our balance sheet flexibility and help mitigate pressure on our net interest margin. At this point I’m going to turn the call over to Brad who will review additional financial results for the fourth quarter.

Brad Cowie

Thank you, George. The core bank’s net interest margin decreased by three basis points to 3.62% during the fourth quarter of 2007 from 3.65% in the third quarter. Our more disciplined approach to Loan pricing and controlling our funding costs enabled us to keep our net interest margin relatively stable during the quarter despite the reduction in interest rates by the Federal reserve.

Our non-interest income totaled $14.2 million in the fourth quarter of 2007, compared to $9.9 million last year. Excluding the impact of strategic actions, our non-interest income increased to $17.2 million compared to $16.7 million in the prior year. As George mentioned, the growth was primarily driven by increases in service charges on deposits and wealth-management fees which were partially offset by a decline in other income.

Turning to our balance sheet, our total loans were $5.36 billion at December 31, 2007. At the end of the year we occasionally have a customer who requires a bridge loan which is typically paid off quickly. For the purposes of analyzing trends and growth rates in the portfolio, we typically exclude these bridge loans that are on the books at year end.

Excluding bridge loans and the impact of the residential real estate loans that were sold, our total loans increased at an annualized rate of 10% from September 30 2007. Excluding deposits related to the RAL program, total deposits were $4.74 billion at December 31, 2007, compared to $4.8 billion at September 30, 2007, and $4.92 billion at December 31, 2006.

Our available-for-sale securities in increased by approximately 21% to $1.18 billion in the fourth quarter. The sale of our residential mortgage loans was executed as a securitization through Freddie Mac in which our proceeds were delivered in agency-conforming securities.

We have already sold $147 million of what we received and we intend to keep the remaining securities that we receive to help manage our deposit collateral and liquidity requirements. Our total loan provision for credit losses in the fourth quarter was $4.8 million. This consisted of $6.8 million provision for the core bank and the negative provision of $2 million related to the RAL program which reflects collections made during the quarter. A higher provision reflects the two larger relationships that went on non-accrual status that George discussed earlier.

At December 31, our total non-performing assets were $76.7 million compared with $25.7 million at September 30, 2007. The two large relationships that we have discussed accounted for 89% of the net increase in non-performing assets during the quarter. As a percentage of total assets, our non-performing assets were 104 basis points at December 31, compared to 36 basis points at September 30.

Our ratio of allowance to non-performing loans was 61% at December 31, 2007, compared to 177% at September 30, 2007. When evaluating our allowance coverage ratio it is important to keep in mind that although the new relationships that went into the non-performing category are large, the inherent loss in them is relatively small. As such, it is appropriate for the allowance coverage ratio to decline.

Excluding RAL’s, net charge-offs were $1.4 million in the fourth quarter. On an annualized basis, this represents 10 basis points of total loans. This compares to 23 basis points for the third quarter of 2007. During the fourth quarter, we completed the $25 million stock repurchase program that was authorized in August 2007. Over the course of the program, the bank spent $25 million to purchase approximately 1.1 million shares at an average price of $22.86.

Now I will turn the call back over to George. George?

George Leis

Thanks Brad. I would now like to provide an update on the 2008 RAL and RT programs. We are just a few weeks into the program, but the initial results indicate that the increased risk-management controls we put in place are having the desired effect. The most encouraging data that we have is the first two payments of tax refunds that we have received from the IRS.

We have a significantly higher funding rate on the outstanding RALs than we did in our first two payments received last year. This provides strong evidence that our new risk-management controls are working effectively and gives us more confidence that we will significantly reduce our loss rates from our experience last year.

Volume trends are also tracking according to expectations. We continue to expect our overall transaction volume during the 2008 RAL and RT season to increase 10 to 15% over the 2007 season volume. And we still expect the mix to be approximately 25% RAL and 75% RTs.

Moving to the core bank, I would like to talk about some of the assumptions we are using for our 2008 performance. We are projecting total loan growth of 8 to 10% with most of the growth coming from the C&I and commercial real estate portfolio as well as loans to our wealth management clientele. We expect an 8 to 10% increase in wealth management fees, which will be partially driven by the acquisition of R. E. Wacker Associates that was completed this month.

We expect to keep operating expense growth at between 4 to 5%. We expect our provision for credit losses to range between 18 and $22 million. While this is in the range of provision that we recorded in 2007, it should be noted that approximately $13 million of that provision related to portfolios that we no longer hold. As such, we are expecting to reserve at a higher rate for the rest of the portfolio this year which reflects our expectation of weaker economic conditions.

And finally, we expect our net interest margin to continue to compress as interest rates continue to drop. Overall, we are expecting higher earnings in both the core bank and RAL businesses this year when you exclude the impact of one-time items in 2007. Despite the slowing economic conditions that are projected for 2008, we believe we are still well positioned to create significant value for our as shareholders. We would be now happy to address any questions you might have.

Brad and I are joined on the call today by Dave Porter our Chief Credit Officer and Don Lafler, our former CFO, and now a consultant to our finance department. Operator, we are now ready for our first question.

Question-and-Answer Session

Operator

All right, thank you. (Operator Instructions). Just one moment please for our first question, and that is coming from Brett Rabatin with FTN Midwest. Please go ahead.

Brett Rabatin - FTN Midwest

Hey, good morning everyone.

George Leis

Good morning Brett.

Brett Rabatin - FTN Midwest

I wanted to I guess first spend a minute just talking about the construction portfolio and then the construction loan that went on non-accrual in the fourth quarter. I didn’t quite understand, the loan is -- as two areas you indicated were soft and so you had gotten some updated appraisals and you felt like the loss exposure was minimal.

I didn’t understand why on the size of that loan there wasn’t some meaningful write-down to give you a comfort. Given what has happened in those markets? Maybe you can just talk about the underwriting there and if it was so conservative that the loss exposure is minimal. But I didn’t quite understand the discussion about that one large credit and why the exposure there is modest for losses going forward?

Dave Porter

Brett, this is Dave Porter. In this particular case, we looked at what we do when we have a non-accrual loan, we look at the underlying collateral and get a current value that we can then evaluate in terms of the length of time we expected to go through that -- liquidate the collateral and in addition any selling costs that are part of that. This particular borrower has had property in the Reno area for many years and has had a very low basis in that property. So as we looked at current values, there was actually some pretty good equity remaining in that collateral. So as we go through and evaluate our potential exposure on this, we take all that into account as well as discounting as we mentioned to the current values that we’re seeing in the market.

Brett Rabatin - FTN Midwest

Okay, and then I wanted to get some more color on -- it sounds like you’ve got about -- it sounds like 107 to $110 million of exposure to Reno and the Central Valley in aggregate, is that a fair assessment based on the percentage that you gave?

Dave Porter

Approximately that amount, yes.

Brett Rabatin - FTN Midwest

And so 110 or so of the 650 is in those areas. Can you talk about the remaining 650 and just where the exposure is and how much is commercial versus residential?

George Leis

Yes, of that 650, about 55% of that would be commercial real estate, Brett. And about 45% would be residential. The residential would be within footprint of the bank, so on the central coast. And that portfolio, although the absorption rates in general have slowed, that portfolio is -- we continue to see performance there. There are sales occurring at current values. But we still see equity and liquidity with our borrowers to continue to keep those current.

Brett Rabatin - FTN Midwest

Okay, and then just one last question on credit. It looks like you had about 5 million, besides those two credits, about 5 million added to non-accrual in the quarter. Was that a handful of miscellaneous credits, or one credit, any color on that?

George Leis

Yes, Brett, that was really a handful of miscellaneous things including some small business and SBA credits and then a little bit of -- I think a small amount of residential and home equity.

Brett Rabatin - FTN Midwest

Okay, and then one last one and I will hop off. The other expense line item was a little higher than I thought it was going to be. Obviously, personnel was lower, I missed the clarity on -- were there any reversals of bonus or incentive pay in the fourth quarter? And then was there anything unusual in the other bucket, so to speak?

Brad Cowie

This is Brad. No, there were no unusual items. I think one of the reasons is -- well, first of all, our salary expense has declined from the previous year. And also, our staff-related expenses have declined significantly.

Brett Rabatin - FTN Midwest

Okay, so that might be -- aside from what you might have seasonally with RAL, although I know RAL is full year in terms of a lot of the expenses, that might be a good run rate going forward?

George Leis

Yes.

Brett Rabatin - FTN Midwest

Okay, great. Thank you.

George Leis

Thank you.

Operator

All right, thank you. Our next question is coming from line of Brent Christ with Fox-Pitt. Please go ahead.

Brent Christ - Fox-Pitt

Good morning.

George Leis

Good morning.

Brad Cowie

Good morning.

Brent Christ - Fox-Pitt

Could you share with us any updates in terms of your recent conversations with the IRS regarding their proposals surrounding the RAL program?

George Leis

Sure, this is George, I will talk to that. We’ve had a lot of discussions with not only the IRS, but all of the industry players. And I think the thing that we have come away with is we don’t get the sense that the IRS wants to eliminate the RAL. What we know that they’ve opened a 90-day window for comment and we are taking a leadership position in that by meeting with the industry leaders to see how we can make that product better.

The one thing that is very encouraging from our standpoint is that our RAL season, the results of our lower loss rates are really -- seem to really be taking effect. The lower loss rates give us some flexibility in the RAL business that we really didn’t have before, so we are encouraged by that. Communication with the industry is going strong. We are going to -- in the 90-day window that the IRS opened, we are going to make sure the IRS hears, certainly from us, on what we are doing to make that product better. And more importantly, to make sure the IRS realize that 6.8 million taxpayers used our RAL business last year and we think it’s an important and relevant product.

Brent Christ - Fox-Pitt

And you don’t anticipate that just being out there in the public having any negative impact on volumes or consumers potentially choosing to use the product this year?

George Leis

Again, we’re two weeks or three weeks into this season; that does not make a year. But the early results are very encouraging. The volume -- we are hitting our volume projections both from the pro side and the – from the independent side. So we are very encouraged by that.

Brent Christ - Fox-Pitt

Okay, and then back on credit for a second, just in terms of the provision guidance for this year, does that contemplate any reserve build, or is it just a kind of a function of charge-offs and loan growth?

Dave Porter

Brent, this is Dave. It is really, it anticipates kind of a normal cycle, not a normal cycle, but a weakening economic cycle. To the extent we have losses, provision will go to losses to the extent we have problems, then we will have more provision going to the allowance for downgrades.

Brent Christ - Fox-Pitt

Okay. And then last question, just to clarify on the salary expenses this quarter, there were no bonus accrual reversals?

George Leis

No.

Dave Porter

No.

Brent Christ - Fox-Pitt

Okay, and so what was really the driver behind the 2 million sequential reduction in staff expenses?

Brad Cowie

I think, this is Brad again. I think that the fourth quarter reflected the true benefit of the staff reduction strategy and the cost control strategy that we implemented at the beginning of 2007. Throughout the year, we didn’t see the full benefit because as people were displaced there was some severance cost which offset the salary reductions. We also had some recruiting expenses that went into there. So I think that the run rate that you see right now in the quarter is more accurate of what we expect going forward.

Brent Christ - Fox-Pitt

Okay, thanks a lot.

Operator

All right, thank you. Our next question is from the line of Joe Morford with RBC Capital Markets. Please go ahead.

Joe Morford - RBC Capital Markets

Thanks, good morning everyone.

George Leis

Good morning.

Dave Porter

Good morning.

Joe Morford - RBC Capital Markets

I guess first, just on the again on the credit side. I was just curious if you could give us some color on what happened with the classified trends, or watch-list trends in the quarter?

George Leis

In terms of classified trends, obviously it was really impacted by the two large credits, Joe. Other than that, the classified trends and watch list trends were relatively stable.

Joe Morford - RBC Capital Markets

Okay, great. And then the second question is just on the margin. I was wondering if you at this point could quantify at all the expected impact of the rate cuts over the last couple of weeks on the core margin, margin excluding RAL? And how much of the cuts you think you can pass on to the customers in terms of the lower deposit rates?

George Leis

Yeah, this is George, and I will take a shot at that and maybe I’ll turn over to our finance guys in a second. The projections that we put out include the 75 basis point rate cut. We haven’t really absorbed the full effect of yesterday’s 50 basis point cut, but we think that, you know, that NIM, we’ll definitely see some compression in our net interest margin. I think we’re reluctant to give you any specific guidance right now since we haven’t figured out the full effect of that 50 basis point change.

But I think one of the things that we wanted you guys to look at was I think we did a good job in the fourth quarter of 2007. We were able to absorb a good portion of the rate cuts, the last set of rate cuts, by lowering our deposit rates. And the good news is that in our market, our competition is also aggressively driving down the deposit rate.

So I think we stand a good chance of we are not going to expand margins by any stretch of the imagination. But I think we will have the ability through our disciplined pricing -- deposit pricing strategies, stay even or not lose as much. And I think the fourth quarter of 2007, I’m very proud of the discipline that we put in the company.

Brad or Don, do you have any other color on that?

Brad Cowie

I think that is good.

Joe Morford - RBC Capital Markets

But I guess with for the 75 that we have seen, it sounds like you’re having a good success in lowering deposit rates and the competition is cooperating there. Would you be expecting maybe to pass on half of that or two-thirds or perhaps even more then?

George Leis

Everyone is taking a look here. We have been pretty good at passing about two-thirds of that rate cut into our deposit rates. And the market has been cooperating. So we think that we can do that without chasing away any deposits.

Joe Morford - RBC Capital Markets

Okay, fair enough, thanks for your help.

George Leis

Yep.

Operator

All right, thank you. Andrea Jao with Lehman Brothers, please go ahead.

Andrea Jao - Lehman Brothers

Good morning everyone.

George Leis

Good morning.

Dave Porter

Yeah, good morning.

Andrea Jao - Lehman Brothers

Just wanted to dig a little deeper into the funding that you are raising for the RAL program this year. How much CDs are you using at what cost, if you could share that with us? And is it just CDs you are using on balance sheet, are there other borrowings? Then please move on to the off-balance sheet funding, are you still using the conduit, to what extent? Given market conditions, what costs can you raise off-balance sheet funding for the RAL program?

Don Lafler

Okay, this is Don and I’ll give a shot at it and if I miss any of those items, let me know. We have added already by December 31st, a $185 million of brokerage CDs and we continued adding more brokerage CDs for the RAL program during the first quarter, and I believe we got to about 300 or $350 million on that. Funding on that is -- there’s nothing special.

These are short term brokerage CDs, so they are coming in at market rates and with the reduction. We should be -- we are not adding any more after these market changes. But we did add some before the December rate change and some after. So there was a positive impact to us as what we added in December and early January from the December rate cut.

The other balance sheet -- on balance sheet components we have, some of that is overnight funding and we use a regular mix of the Fed funds purchased and repos on which we are using our securities as collateral. Some of this is from the FHLB, some of it is from other financial institutions. We have completed -- in December we completed the arrangement of our securitization, which we have done each year for the last four or five years.

The maximum size of the securitization is $1.6 billion. We anticipate using the high point -- at the high day of the season, about $1.5 billion of that. That comes in at a variable cost based on LIBOR, and – or excuse me, based on the rate -- the selling rate of commercial paper that the conduits use for their funding. And consequently again to the degree that those rates are responding to the rate cuts we have had in the last week, we are getting a better rate on that funding than we had anticipated going into the program.

Andrea Jao - Lehman Brothers

Okay, so it looks like the funding is better than we thought it would be last December. But wouldn’t it still be a little bit more difficult compared to last year. Therefore, the net gain on sale number would come under pressure in the first quarter? Or am I thinking about things the wrong way?

Don Lafler

Well, I don’t think that we have experienced any more difficulty finding funding this year than we had in prior years. And we have again, with a bit lower rates, we in fact, expect that the funding will be more profitable for us of this year. And that we should see, in fact, all things being equal, we would see a larger gain in the securitization. Now, the securitization gain is always dependent not only on the size of the facility.

And on the rates that are paid on the funding. But it also depends on how many loans are sold into the funding. So, for instance, if we sell and fill securitization facility all at once as quickly as we can, and then just let it run off as it is -- as the loans are paid to us by the IRS, then that will mean that our total volume will be equal to or less than the maximum amount of the facility. But if we find that because of the rate changes that we’ve had that it is more efficient for us to sell more, as loans pay off through the securitization facility, we will resell more loans.

So we will cycle -- go through one or two cycles, in the securitization. And consequently, some years we have had a situation where we, for instance, have the securitization facility of 1.3 billion but ending up selling 1.8 billion into the securitization facility during its term. And when we do that then we will have a larger gain in the securitization, even though the securitization facility maximum size may not be as large as another year.

Andrea Jao - Lehman Brothers

Okay. That is good to know, it sounds like.

Don Lafler

It is all just a question of balancing out our cost of funds and where we find the least expensive funds to try to work that. And that will determine the amount of the gain in the securitization.

Andrea Jao - Lehman Brothers

Okay, so it sounds like the gain should increase from last year.

Don Lafler

I would expect that to be the case.

Andrea Jao - Lehman Brothers

Okay, perfect. And then, you’ve also mentioned that losses on the RAL side are tracking as you hoped they would. So your -- you think you can come out with just 100 bits of losses this year?

Don Lafler

Let’s clarify. We have not charged any loans off at this point. What we have been discussing so far is that we have received two payments from the IRS. And the rate of payment is significantly higher than we have got from corresponding payments in prior years. So, we will then have as we get to the end of February is the first time we actually start to charge loans off, based on what our payment experience has been.

So we, this is too early for us to talk about loss rates. But from the standpoint, at least as George indicated, we have strong evidence that our payment rate is significantly higher than it has been at this stage of the program in the past. And that is the basis on which we would say we are very confident that we will have a significantly lower loss rate when we get to the end of the quarter.

Andrea Jao - Lehman Brothers

Okay, perfect, thank you so much.

George Leis

Thank you Andrea.

Operator

All right, thank you. Our next question is from the line of Aaron Deer with Sandler O’Neill Asset Management. Please go ahead with your question.

Aaron Deer - Sandler O'Neill Asset Management

Hi, good morning everyone.

George Leis

Good morning.

Brad Cowie

Good morning Aaron.

Aaron Deer - Sandler O'Neill Asset Management

Just following up the question on the RAL loss rates, George, you said that that is a result of the expected lower loss rates on RAL, that that would provide you with more flexibility in that business. What did you mean by that?

George Leis

One of the things that we’re always looking at is as we come in at a 100 basis points, for us, that’s -- that is significantly lower than we have historically had. And the loss rates are the biggest expense in that unit. And I think that as we continue to drive down our loss exposure in that unit that gives us the flexibility around pricing.

And that is important to have, because it’s not something that we have you know, actually looked at before. So, being able to price RALs lower, if that is what the market says we need to do, we are positioning ourselves to do that. That is what I meant by that.

Aaron Deer - Sandler O'Neill Asset Management

And is it your sense that that by pricing them lower that that might relieve some of the regulatory scrutiny?

George Leis

Not for me to really predict what the regulators want. But I think, certainly, one of the things that we hear is the cost of the RAL. And if we have flexibility around pricing, then we have the ability, if it’s necessary, to lower price, whether it’s based on supply/demand, market forces or regulatory. That is kind of the way I want to think about that.

Aaron Deer - Sandler O'Neill Asset Management

It looks like you have completed the share repurchase authorization. What is the expectation that? Is that the thought that the Board might -- re-approve another authorization on that front?

George Leis

We will probably let a quarter go through the work, something we’re all sort of looking at right now and talking to some of the advisers in the field. We have nothing in front of the Board right now. But again, something that we evaluate pretty much at every Board meeting.

Aaron Deer - Sandler O'Neill Asset Management

Okay, and then just lastly, the securities were quite a bit higher in the quarter. And it sounds like some of that might have been temporary. But, just wondering, what are the thoughts there in the securities portfolio and what might be a good run rate to think of at this point?

Don Lafler

This is Don. Aaron, when we got the securities back from Freddie Mac for the loan sales, we looked at those, and we looked at what was going to be maturing in our securities portfolio over the next six months. And we found that we had approximately 200 million that is likely to mature or be called in the next six months. Because of the use of the securities both for the RAL program and for other pledging or collateral purposes, we needed to consider over this next six months to had we done nothing with respect to the loan sales, we would need to consider purchasing to replace those securities.

And with the receipt of the securities from the loan sales, we decided simply that we would keep approximately 200 million of the securities -- of the 353 that we received back from the loan sales. But we would keep about 200 million of those. And that way, as the other 200 million, so to speak, ran off, we would have these securities on hand to replays of those. And not have to go out and repurchase additional ones.

So, what I would expect to see is I would expect to see that the balance is going to run down over the next six months by about 200 million. Then I would estimate that we will have a relatively stable portfolio for the remainder of the second half of the year.

Aaron Deer - Sandler O'Neill Asset Management

Great. That is very helpful. I appreciate the time.

Operator

Thank you. Our next question is coming from John Pancari from JPMorgan. Please go ahead.

John Pancari - JPMorgan

Good morning. I wanted to see if you can discuss collateral levels a little bit more in detail, in terms of your update on your average LTV and your construction portfolio or lowering the cost for that matter?. And then also, obviously, they are more of a historical measures, so for some of the credits that you are re-appraising the collateral, as they may be entering classified, or any of the non-performers, can you give us an idea of how the valuations have changed on some of those properties? Thanks.

George Leis

Yeah. This is George. I’m going to set this up and then turn it over to Dave in a second. One of the things that we wanted you all to know, we really -- the one thing that we are proud of, we really haven’t changed our underwriting standards at our bank. We feel that they are conservative. And as Dave goes through what the average loan-to-value is, what the average size is, what the maximum loan-to-value origination is, you will see that. That is what sort of put us in good stead here. So Dave, may be you can give them the specifics.

Dave Porter

Yeah, again thanks George. John, on the loan-to-values on the construction portfolio, we are probably at an average of 70% loan-to-value in that portfolio. We underwrite both to a bulk valuation at the outset and also to a loan-to-cost as well. Not one -- one not to exceed 75% on the bulk valuation which already has by the way about 10 to 15% discount off of a retail value. What we are seeing in terms of -- what we are seeing in terms of market values really depends on that funding area. I think if you go into the Central Valley, you will see discounts in the -- arising in the 30 to 40%. In certain instances, as we went into the Reno markets, where area, if not quite as severe as that, but certainly may be in the 20 to 30% range.

And so we take that into account as we evaluate projects that we have on a watch basis. And we review watch-type credits on a quarterly review to consider financial performance, liquidity, and collateral values. On the construction portfolio, our average loan size is about $2.5 million through the portfolio. And again, I think George did a good job in kind of putting brackets around our exposure in the Central Valley and Reno areas.

Aaron Deer - Sandler O'Neill Asset Management

In terms of those brackets, just to confirm, it doesn’t look like you have much else -- in terms of exposure outside of your core markets there in the Central Valley and the construction portfolio?

George Leis

No. We don’t.

Aaron Deer - Sandler O'Neill Asset Management

And that average size I mean, the 2.5. When I put that next to this large credits, one of these large credits of $33 million facility that moved on, could you give an idea of anything else some thing to in that range, the number of loans that may be in that ballpark?

George Leis

Yeah, John, what you have to kind of remember is that the 33 million includes maybe eight or nine different facilities. So the collateral base isn’t really a $33 million property. It is really dispersed than one -- perhaps eight different facilities that encompass several hundred different properties.

Aaron Deer - Sandler O'Neill Asset Management

But one relationship, though?

George Leis

But one relationship, correct.

Dave Porter

And by the way, a recourse relationship, which we tend to have in all of these construction relationships.

Aaron Deer - Sandler O'Neill Asset Management

But with the home -- with the builders and everything, obviously the relationship is what really it comes down to -- and that is what I’m getting at. Any other relationships that may ballpark in that size?

George Leis

Ballpark in that size, probably -- now, let me get back to you on that John. I don’t have it numbered right in front on me.

Aaron Deer - Sandler O'Neill Asset Management

I will hop off of credit. I just have one question outside of that. On the deposit pricing ability it seems like you -- you’re much more confident in your ability to continue to pass on the Fed cuts to depositors. That is a notable -- that is going against what we are hearing from some of our other banks. They are optimistic but not as optimistic as you are sounding. I just want to see if you could give us a little more detail, what products are you really seeing that ability, and any other color around why you are so confident on that front.

George Leis

The confidence comes from the competition. It is a couple of things, John. That are new bank. One, we just hired new Head of Retail Bank -- this person is a 35-year-old Wells Fargo employee, came from Greater Bay Bank most recently to oversee a retail bank. I think she has the ability to instill a level -- to continue the work that we have started in sort of a disciplined pricing strategy.

Second is our financing team here. Treasury, Finance gives me sort of up-to-the-minute reports on what is going on in deposit rates. Third, we’ve brought in a company called Novantas to come in and give us a more, sort of micro view of the markets that we operate in. Something our bank didn’t have before. And that sort of intelligence into the markets down to zip code sort of areas, and more important what the competition is doing in those markets.

Again, we think it will give us a level of competitive advantage that we don’t have. And for 2008, we made sort of a strategic decision to not price our deposits or our time deposit money centrally -- not centrally, globally. That we will go down to market levels and be a little more granular in how we price. But I think that this thing really helped us. At the end of the day, is that in our market, in the community bank arena and the bigger bank arena, those guys have been as aggressive as we have in dropping the rates.

The test for us, quite honestly, is in this short period of time where rates are falling so fast, that’s something that, again, we are sort of in control, central mode. Seeing how we do that. I think the accounts that we are looking at, CDs, of course, and our NOW accounts and money market accounts have been dropped. And I think we can go some more on those as well. I hope that helps.

Aaron Deer - Sandler O'Neill Asset Management

Okay, it does, thank you.

George Leis

Yep.

Operator

Our next question is coming from Scott Carmel with Philadelphia Financial. Please go ahead.

Scott Carmel - Philadelphia Financial

Hi good morning, you spoke a little bit about the IRS side of the regulations. Can you give us some updates on what may be happening on the legislative side, maybe the House sponsored Bill? And I think there is something brewing in the Senate as well. Can you give us an update on what you are hearing and what possible effects those might have?

George Leis

A couple of things. We have, in Washington, we have folks on the streets. So we keep abreast of everything that is going on legislatively. It is awfully hard for me to predict or comment what’s going on in the legislature right now. Because those things happen all the time and particularly, in this industry we hear things all the time. The thing that is different about our RAL business now than might have been in the past is that we have a sort of conduit from Washington --from Washington to here. I think the thing again that is so important for us is in this sort of 90-days, that the IRS has opened up a window for comments is for us to ensure that the IRS hears from the 6.8 million people that we serve in the RAL business. And that is something we are going to be really aggressive in pursuing.

Second thing, is the effect of the loss controls that we put in place. I might sound like a bit of a broken record here, this might be little treachery to your exact question to ask. But it is really important for us to demonstrate to you guys and to the world that we could lower our loss rates down to 100 basis points and maybe in the next season, even a little lower. And that is the thing that will give us a level of flexibility.

And the last thing I wanted to point out, again a little maybe treachery may be to your question great refund transfer business. And one of the other things very important to us and to the sort of market out there is that refund transfer business does not have any risk. Does not have any interest rate, and it is -- we have become the market leader in that business. That is something I wanted to make sure -- remind everyone of, so you gave me the opportunity to do that. I hope I answered your question there. We have a conduit into Washington. It is really difficult for me to predict what is going on there. We are informed. We are taking a leadership role in that product.

Scott Carmel - Philadelphia Financial

Maybe little more specifically, I think the Taxpayer Protection Act that passed the House last year and is supposedly coming up in the Senate this year. You have any sense of the probability of that passing is or what kind of effect that will have on your business?

George Leis

Certainly, it all depends on what the specific provisions end up -- end up to be. The legislative history on these issues has been that they have been submitted -- they have been submitted by various legislators and then they get changed in committee and then they get approved or they don’t get approved, and they don’t move through. So, it could be anywhere from a total prohibition on the product to no change whatsoever. So, we model what we believe would be the impact of these kinds of changes. But to comment on any specific legislation until it gets further along out of an individual proposal or committee is really just a speculation on our part.

We are expecting, however, that from the standpoint of overall managing of the process that the presentation that we make to the IRS and explaining what the value of the product is to people will also be useful in terms of our approach to the legislators to explain why this product is of a value to the customers. And why it is important for it to continue to be in place. In some form, weather changed from what it is exactly now. But why it is needed.

It is a very important point to make sure people understand that these products are a major way in which people are able to receive the tax preparation service that enables them to get the earned income tax credit that they have coming to them. They do not feel comfortable providing -- to trying to prepare their taxes themselves. And without our ability to withhold the tax preparation fee for the tax preparer, these customers are not going to get their tax returns done.

So, this is an important thing for us to point out to the IRS. And we believe the legislators will also see it as part of the IRS process, the value of these products to our customers.

Scott Carmel - Philadelphia Financial

Great. Thanks for your comments. I appreciate it.

Operator

All right, thank you, Manuel Ramirez with Keefe Bruyette & Woods. Please go ahead with your question.

Julianna Balicka - Keefe Bruyette & Woods

Hi, This is Julianna on Manuel’s line please. I was -- wanted to touch base again on the construction exposure in Central Valley and I apologize if you already covered this. The $66 million that you talked about, how many loans and how many relationships is that, please?

Dave Porter

Julianna, this is Dave. Specifically, I don’t have the number of loans off-hand. I would say it’s probably made up of not more than five or six relationships.

Julianna Balicka - Keefe Bruyette & Woods

Great. And then the second question I had -- two more questions. One is for the non-performing loans, the $33 million relationship -- have you gotten new appraisals on those properties? Did you mention how much the hair cut was to value or...?

Dave Porter

We did receive some new appraisals in October of ‘07. We just received a new appraisal recently on one of the properties. I did talk about generally, what we’re seeing in terms of discounts, both in the Reno market and in the Central Valley. I believe in the Central Valley, we were looking at something in the 30 to 40% range and a bit less in the Reno market, maybe to 20, 30%.

Julianna Balicka - Keefe Bruyette & Woods

Right, but nothing specific on those two loans then -- or nothing specific on that particular relationship then, right?

Dave Porter

We did take very specific discounts on the relationship to calculate our exposure position.

Julianna Balicka - Keefe Bruyette & Woods

Right.

Dave Porter

That was based on very recent data that we receive both on sales and from appraisers.

Julianna Balicka - Keefe Bruyette & Woods

Okay, that works. And you are still looking up -- what was the previous question about what was the next largest construction exposure at this point?

Dave Porter

Could you say that again?

Julianna Balicka - Keefe Bruyette & Woods

And you are still looking at -- the question that was asked a little earlier about your next largest construction exposure?

Dave Porter

Yes.

Julianna Balicka - Keefe Bruyette & Woods

Thank you very much, that was it.

Operator

All right, thank you and we have a follow-up from Andrea Jao. Please go ahead.

Andrea Jao - Lehman Brothers

Hello again.

George Leis

Hello Andrea.

Dave Porter

Hello.

Andrea Jao - Lehman Brothers

Two follow-up questions. Loan growth of 8 to 10% driven by C&I, you know that’s pretty good. I was hoping to see what gave you the confidence that loan growth would be that good in 2008? And then my second question was on the retail banking side. Was that you Colleen Anderson, you were referring to, from Greater Bay and Wells Fargo, and how different would her approach be to retail banking from what you were already laying out?

George Leis

Okay, Andrea, to let you know, her name is Sandi Eason. Well, her approach -- why we brought Sandi into the company is we want to expand and grow our small business banking capability. In addition to what we have already done in our retail franchise, which was to segment 10 branches and make them wealth management offices. And really grow the 40 remaining branches and grow small business banking.

By the way, we have Simi Valley, we have an office in Simi Valley, coming out of the ground, opening for business in February. It is in a community called Wood Ranch. We have already staffed up the group and we are ready to hit -- that branch, we are looking to really start with a bang. So, I think those are the primary areas that we are looking for -- sort of a subtle, but important change in our community banking area. I will have Dave speak to the first part of your question.

Dave Porter

Andrea, I think on the commercial loan side, if we look at what we did in 2007, we actually, had about 22% growth in commercial loans for 2007. Then about only 11% growth in non-residential real estate, which would be our commercial real estate. This group in commercial banking has been able to, for several years, have double-digit growth in assets. I think through the relationships we have, and the experienced managers in that division, we expect that to continue.

George Leis

The adjacent markets that we have moved into, Andrea, really helped us continue to grow, both in Glendale, California and in Calabasas California, adjacent to Ventura, have been really strong markets for us. The individuals that are managing those offices came from local banks in that market. The results have been very strong. As have the -- as have they been in our own markets. That is why we are optimistic about our ability to grow.

Brad Cowie

And the competition around us is -- it was a little confused right now. We think the combination of our discipline pricing in our commercial lending fees, those expanded markets we have moved into, and taking advantage of the confusion of existing -- some of the other community banks in our markets, and we even had some of the big players, gives us that sort of edge to go in there. Again, we have not really altered our credit underwriting, so we are the consistent player in that market.

Andrea Jao - Lehman Brothers

Okay, great, this is good to hear, thank you.

Operator

A follow-up from Manuel Ramirez, please go ahead.

Julianna Balicka - Keefe Bruyette & Woods

Yes, hi this is Julianna again. Quick question, on the construction loans in Central Valley and Reno, were those syndications?

George Leis

No, they weren’t Julianna.

Julianna Balicka - Keefe Bruyette & Woods

Okay, thank you very much.

Operator

Management, there are no further questions at this time. Please continue with closing comments.

George Leis

Once again, I just want to say thank you for joining us today and we look forward to speaking with you next quarter. Thanks again guys for being on the call.

Operator

This concludes the Pacific Capital Bancorp Q4 2008 Call. Have a nice rest of the day.

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Source: Pacific Capital Bancorp Q4 2007 Earnings Call Transcript
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