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Executives

Myrna Vance - Director of Investor Relations

Jody Grant - Chairman and Chief Executive Officer

George Jones - President

Peter Bartholow - Chief Financial Officer

Analysts

John Pancari - J.P. Morgan

Andrea Jao - Lehman Brothers

Erika Penala - Merrill Lynch

Robert Patten - Morgan Keegan

Brent Christ - Foxx Pitt

Brad Millsaps - Sandler O’Neill

Michael Rose - Raymond James

Jennifer Demba - Suntrust Robinson Humphrey

Charlie Ernst - Sandler O'Neill Asset Management

Andrew Stapp from B. Riley & Company

Texas Capital Bancshares, Inc., (TCBI) Q1 2008 Earnings Call April 16, 2008 5:00 PM ET

Operator

Welcome to the Texas Capital Bancshares Conference call. (Operators Instructions). Please note this conference is being recorded.

At this time, I would like to turn the conference call over to your moderator.

Myrna Vance - Director of Investor Relations

Thank you very much, Jamie, and thank all of you for joining us today for our first quarter conference call. I am Myrna Vance, Director of Investor Relations. Should you have any follow-up questions, please give me a call at 214-932-6646. Now, before we get into our discussion today, I need to 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 Bancshares' 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, and exposure to regulatory and legislative changes. These and other factors that could cause results to differ materially from those described in the forward-looking statements can be found in our Annual Report on Form 10-K for the year ended December 31, 2007 and other filings made by Texas Capital Bancshares with the Securities and Exchange Commission.

Now, let's begin.

With me on the call today are Jody Grant, Chairman and CEO; George Jones, President; and Peter Bartholow, our CFO. And, after a few prepared remarks, our operator Jamie will facilitate the Q&A session.

At this time, let me turn the call over to Jody.

Jody Grant - Chairman and Chief Executive Officer

Thanks, Myrna. Welcome everyone. It's another beautiful day in Texas and I am delighted to say that’s both in the perspective of weather and the economy. Fortunately, the economy is a little more predictable than forecasting the weather. The state is in very good shape and I'll come back to that in a minute.

First, I would like to just congratulate George Jones who, as you know, will be elected to CEO and -- President and CEO of the company at out Annual Meeting on May 19 and I am looking forward to that happening. And if George then stubbed his toe between then, it will happen. He will do a great job and you will be in good hands.

We had another very very good quarter, particularly I think in view of the economic surroundings that we found ourselves in, albeit they are better in Texas than elsewhere.

Earnings per share were 30%, which was in-line with guidance and in-line with -- well, we didn’t give guidance I guess on a quarterly basis, but it was in-line with expectations by the analysts that cover us.

Net income was up 6% on a adjusted basis. That is, if our provision had been the same as it was last year, that number would have been 28%. EPS was up 3%. And again, if you normalize that adjusting the provision back to what it was in the first quarter of last year, that would have been up 24%.

The only reason I emphasize this and obliviously there are good reasons to have a higher provision this year than last, but the end of underlying fundamental earnings power of the company remains very very strong. And this is in spite of the impact on margins. As you know, the flood has reduced the Fed Funds rate by 200 basis points since December 11 of last year and this obviously has caused our margin to go down. We are at 365 versus 385 for the fourth quarter of last year. The Fed's next meeting is April 30 and we will see what happens then and I will comment more on that in my closing remarks.

The provision was in-line with the guidance that we have given you, $3,750,000 for the quarter. This compares to $1,200,000 for the first quarter of last year. This leaves our reserves as a percentage of loans held for investment at 0.97 versus 0.95 for the fourth quarter of last year, and George is going to comment more and give you more granularity on this when we turn it over to him, and we also had an improvement in non-performing loans. They were down by $7,366,000 to $16,690,000; that’s a decline of 31%, which we feel very good about, again given the environment in the country as a whole.

Growth was also in-line with our expectations. Loans held for investment were up 4% from the last quarter and that would be of course 16% on an annualized basis. They were up 26% year-over-year.

The Texas economy remains in very very good shape and particularly strong compared to the rest of the country. Just as an example and focusing on a few data points, unemployment rate in Texas and the latest number we have this February, I don’t know why it takes him so long to calculate numbers for the state when it seems like they can do it pretty rapidly for the nation as a whole, but we were at 4.1% in February versus the nation's 5.1% in March.

Again, to give you some data points with regard to how that relates to specific cities. Austin was at 3.5%, clearly the strongest economy in the state. If you use the unemployment rate as an indicator, San Antonio was at 3.9%, Fort Worth at 4%, Houston 4.0%, and Dallas was 4.2%. I guess both intuitively and by these measures you would have to say that Dallas is probably overall the weakest market in the state, although at 4% relatively speaking we are very very strong.

Just again down the line, the strength of the Texas economy as a whole, for the first two months of this year, we added 33,000 jobs. This compares to the nation for the first two months of the year which lost 152,000 jobs. So we are doing exceedingly well again compared to the rest of the country.

I have got some housing statistics this morning, which hadn't really been released yet. We use a firm called MetroStudy that tracks housing statistics particularly in the Dallas Fort Worth Metroplex, but when you look at the state as a whole as well, I am going to give you a few data points as it relates to Dallas.

Our inventory event so in houses at the end of March was 20,000 units and this is down from a high of 30,000 units, so we are eating into that inventory at a steady rate. And as a consequence of that, it's the expectation of MetroStudy that we will reach equilibrium some time toward the end of the year. That inventory represents 6.7 months of inventory versus a high of 7.8 months.

Another point, housing starts in the first quarter were 5,200 in the Dallas Fort Worth area, which is the lowest in 10 years. Obviously that’s good. The builders are being very cautious. They are being very prudent and this is helping us to lower this inventory.

Again another indicator of the strength of the overall economy in Texas, in spite of the terrible housing market and certainly we have seen declines here in for permanents and starts that are quite high and they are pretty much in-line with the nation as a whole. But if you look at total construction jobs, we have added 4,000 jobs in the first two months of the year in the state as whole. So you have to take commercial construction, everything that’s going on in the public sector and even with the weak housing market, we are still adding construction jobs. So, all in all, we are delighted to be in Texas and I am sure every other bank in the country wishes that they were in Texas as well and more than in a lot of other places.

With that, let me turn it now over to Peter, who'll go into the financials in more depth, and Peter will turn it over to George who will cover the rest of the presentation.

Peter Bartholow - Chief Financial Officer

If you'll turn to the Sixth Slide, as Jody commented, the net income was $8 million or $0.30 a share and we do regard that as very good performance in light of some tough comparisons in our own balance sheet and of course the issues specific to Q1 and those to the industry generally.

We had EPS growth 3% from Q1 '07 and 25% from Q4 '07. 25% is obviously based on the sharp reduction in provision for loan loss from the fourth quarter.

The company is, as we will comment in more detail in a moment, is much less sensitive in terms of earning asset and margin issues, but there are a number of factors that contributed to the reduction in margin that Jody has mentioned earlier.

Combination of net interest margin reduction, the reduced number of days in the quarter represented in combination $0.06 per share; that's using Q4 as the baseline. The reduction in provision from Q4 was also very sharp, but as Jody mentioned, was actually tripled from a year ago, last year. FICA and other expenses related to Q1 were an additional $0.02 per share.

We had much improved operating leverage throughout 2007 and again for Q1 compared to Q1 2007. That good trend in operating results and operating leverage continued into 2008 compared to Q4 '07, but it was masked by the reduction in net interest margin and the impact of the Q1 variables that we have spoken to so many times. But George will comment in much greater detail about credit quality, but it's good and with respect to provision, non-performing assets and net charge-offs, which are all consistent with the guidance we gave for the full year.

Turning to Slide 7. We had very strong performance on a year-over-year basis in net revenue, growth of 15%. That's obviously driven by loan growth of 25%, the improved composition of earning assets, which largely overcame from reduction of -- in net interest margin.

Expense growth of 9% is a significant reduction from prior year comparisons or earlier year comparisons. The level of build-out expense relative to our total expense base has decreased significantly. We saw a substantial linked quarter contraction in -- not that substantial but it's for the first time that we have actually had a linked quarter contraction in net revenue about 128,000.

Net interest income was down 932,000 due entirely to the reduction in NIM with the added benefit of our cost of the reduced number of days.

Loan growth of 5.6% with loans held for investment of 4% were consistent with the guidance and really reflect the very strong growth on an average basis that began with a strong Q4 of '07.

Before the effect of the net interest margin reduction, the efficiency ratio was actually just under 60%. We have the difference in days which equates to about $400,000. We had Q4 '07, we had a reduction in the incentive accrual of 2 million. In Q1, we have an increase in FICA and other related expenses of over $700,000. Though as adjusted, we saw good improvement in the ratio of non interest expense, earning assets, as well as, as I mentioned, the efficiency ratio.

We saw in Q1 for the first time in several quarters a very strong contribution from our mortgage warehouse division, very strong growth. We did have lower spreads there because the nature of the pricing portfolio, but that's offset by substantial increases in fee income.

Obviously with the margin compression, ROA and ROE are obviously reduced, but given the circumstances that we have spoken about I think are good performance.

Turning to Slide 8. Strong growth continues organically and balances for average loans held for investment. Linked quarter growth obviously very good and again really showing the impact of such strong growth at the end of Q4 '07.

As stated earlier, this reflects a much improved productivity on an average basis of the employed relationship managers. Exceptional also I think, it appears anywhere in the United States, despite what we recognized as a downward slope in the trend of growth.

Linked quarter growth of 4% is consistent with our view that over 2008, we will see total loan growth at perhaps approximately half of the rate of growth that we have experienced in the years 2004 to 2007.

We have seen, George will comment briefly later, a sharp increase in loans held for sale due to a very strong position we have in that industry. We have a balance sheet, which is helping mitigate the effect of the Fed rate decreases with loans now 90% of earnings assets.

Deposit levels are flat with Q1 '07 and down slightly from Q4 '07. This is very consistent with what we already see as an industry trend where we see the cost associated with grown deposits, especially with reduced growth in loans held for investment, emphasizing for us the use of other funding sources. The reduction in Q1 is due again transaction specific maturities as well as some seasonal factors, which affect commercial banks every year.

On Slide 9, we had I guess the lowest growth that I could recall in linked quarter loans held for investment, up just 31 million. That is consistent though with plan and the guidance that we gave earlier in the year. Q2 has been historically very strong in terms of loan growth, while Q1 we have always had or frequently had seasonal issues affecting that activity. Again, loans held for sale volumes can be much more variable, and on a date statement basis they were up sharply.

Deposit, because of the short-term nature of those, we fund those essentially incrementally with short-term funding. We saw deposits grow at quarter-end by 100 million compared to the Q1 2008 average balances. Again, deposit growth clearly is effective by seasonal rates. We would expect some improvement in 2008.

Turning to Slide 10, more comments of the net interest margin. 365 for us is a recent low, off 20 basis points from fourth quarter. We are much less sensitive than in past years, but to-date the rate of decrease in the Fed funds rate play significant pressure on net interest margin in Texas Capital's model. We expect NIM will stabilize and improve when Fed has finished reducing rates.

We saw for the first time that the reduction in NIM actually produced a reduction in the net interest income, in fact, because the reduction in NIM was not offset by growth in this quarter. Contributing to a favorable trend in net interest margin, obviously are earnings asset composition, which loans now at 90% of earnings assets. Loans held for sale are the lowest in terms of rate, I should comment, but have fees of just under 100 basis points that supplements what is the effect of reducing net interest margin.

Fixed rate earning assets are obviously a plus today. Securities loans and leases, we have a significant portfolio, a growing portfolio of LIBOR price loans. They have a favorable spread in recent periods. There is a favorable spread between LIBOR, Prime and Fed funds, very strong in fourth quarter, sharply narrower in Q1, and thus far in Q2 again widening significantly.

From a negative side related to net interest margin, obviously the steep decrease in Fed funds rate has a sharp Effect on forwarding rate portfolio, which for us today is about 88% of the portfolio if you exclude leases and the premium finance portfolio.

We have seasonal and industry trends in DDA that put additional burden on margins. We had significant issues with the timing of repricing of our LIBOR price loans. We had a concentration of repricing that occurred after the spread between LIBOR and the Fed funds rate a decrease earlier in Q1. We had meaningful success in reducing cost in key deposit categories, but although our repricing could not keep up with the rapid decrease in rates. Our model works better in a ramp situation obviously than in a short scenario.

I should mention that global liquidity issues haven't increased the cost of gathering new deposits especially in a commercial business. That causes us in Q1 caused us to emphasize the use of other borrowed funds especially when loans held for investment growth was not strong. Obviously and also in this environment, we have a reduced contribution from DDA and stockholders activity in terms of NIM, very valuable, but those levels are not supported though on increase in net interest margin.

With that, I will turn it over to George to describe growth, credit borrowings, and other issues.

George Jones - President

Thanks Peter.

Turning to Slide 11, and as we stated before, demand deposit five-year growth rate is good, may have slowed somewhat in the past year as you can see. New term growth of average DDAs on a linked quarter basis decreased 3% but actually were up 7% on a year-over-year basis.

If you look at the average total deposits with a five-year growth rate of 20%, they were flat or slightly down on a linked quarter and a year-over-year basis. While most of the deposit decline was related to known specific transactions, we do believe that the liquidity issues in the financial markets today has really contributed as Peter said to an increase in the cost of deposits.

The five-year growth rate for the loans held for investment was 28%. Average loans grew $146 million or 4% in Q1 '08 and 26% on a year-over-year basis as we have shown before. The strongest average loan growth on a linked quarter basis came from loans held for sale, as Peter mentioned, our mortgage warehouse line of business. This was on an average basis $51 million or 26% of the total average loan growth in Q1.

We really are seeing so many warehouse lenders cut back or actually go out of business that today we can selectively grow our business safely with better customers, better investors, better pricing, and better underwriting than we have see in the marketplace in years.

In loans held for investment, Energy, Dallas Corporate Banking, and our San Antonio region each contributed approximately 14% of the loan growth. All regions outside of Dallas would include the San Antonio region contributed 30% of that loan growth.

C&I loans contributed 36% of the total average loan growth with real estate loans contributing 26% and as we have said the loans held for sale an additional 25%.

We have talked about our growth of loans in Q1, but I want to comment on our current pipeline that's been building in Q1 and extends into Q2. Today that pipeline of future business is large and robust and the transactions are beginning to be better structured and somewhat better priced. Customers and prospects seem to be less concerned about price and structure but more interested in their ability to access funding. We have begun to see some of the competition turning more than focus on capital and liquidity more than their customers and hopefully we can begin to reap some of the benefits from that those actions, a little bit too early to predict at this point in time.

If you move to Slide 12, this slide reflects growth in income and expenses over the past five years with revenue continue to outpace expense growth. Linked quarter expense growth was up compared to Q4 '07 mainly due to FICA taxes and other issues that we see in Q1 every year.

Q1 2008 compared to Q1 2007, our non-interest expenses increased roughly 9%, but Q1 always shows higher growth and we expect the growth of expenses to slow for the balance of the year. Normalized expenses on a quarter-by-quarter basis have basically averaged the same since September of 2007 if you normalize.

On Slide 13, our credit experience we believe remains quite good. Our business model and its emphasis on credit quality have produced excellent results over an extended period of time.

Net charge-offs were 2.6 million in Q1 '08 all from credits which had previously been identified and for which there were specific reserves. This represents 29 basis points for the quarter, and I believe as Peter mentioned this loss rate is consistent with the guidance that we gave you for 2008.

Looking at non-accruals and ORE, these totals decreased to 17 million from 24 million in Q4 '07. This basically was a function of some of those charge-offs of roughly $3 million and net reductions of over $3 million.

We showed a provision to the loan loss reserve of 3.8 million in Q1 that increased our reserve balance to 0.97% of total loans. We believe, as Jody has mentioned that the Texas economy with one of the credit storm better than most parts of the country. Although I have some fallout, we are cautiously optimistic that our strong credit culture will continue to provide above average results in 2008 and beyond.

If you move to Slide 14, this slide graphs the net charge-offs to average loans for the past four years plus Q1 '08, again reflecting our good credit experience. And with the exception of 2004, our reserve for loans in Q1 is higher than the past three years and our non-accrual loans were down from 2007. Our reserve to non-accruals and non-performing loans remains good, up slightly from 2007 levels.

Jody, I'll turn it back to you.

Jody Grant - Chairman and Chief Executive Officer

Thanks George. We believe we’ve had another very very solid quarter and we are optimistic about the rest of the year as George indicated. We do have a strong pipeline and our funding is in good shape.

With regard to guidance, it remains at 33 million to 35 million. Like last year we were reluctant to change guidance after only one quarter’s results. Hopefully, we’ll continue to perform well and we may give you some new numbers at the end of the second quarter.

As George said, we are cautiously optimistic about the economy. We would much rather be in Texas than any place else.

With regard to rate cuts and I will put my economist head on and take my banker head off for a second, the Feds next meeting is April 30. Fed funds rate stands at 2.25. Everybody will remember that the Fed funds rate got down to 1%, the lowest in 40 years and that set the stage for the credit crisis and the subprime loan debacle that we’ve seen since then. I don’t believe that the Fed is going to take real interest rates down below zero again. And that’s what we are looking at for quite a long time.

This is reinforced by the fact that we had two descending votes when the Fed met in March and lowered the rate to its current level. Also, yesterday’s PPI number of 1.1% rate month increase was a pretty startling number and year-over-year the PPI has been up 6.9%. Now, a lot of people including the Fed have concentrated on the core rate, which year-over-year is up 2.7%, but I think given what’s happening in the commodities markets today, less and less attention is being paid to the core rate. We could have another 25 basis point dropping in the Fed funds rate, but I think we are pretty darn close to the bottom.

Consequently, I’m more optimistic, certainly than I was back in the 2003-2004 timeframe when the Fed was ratchetting rates down so rapidly, more optimistic that our margin will stabilize at a level that isn't hopefully too much below where it is now but that all depends upon what the Fed does.

As Peter said, we are less interest sensitive than we used to be, so we should be able to write out this interest rate cycle as we are in better shape than we did in the past.

With that, operator, let me turn it over to you for questions and we will be glad to try to answer any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from John Pancari from J.P. Morgan. Please go ahead with your question or comments.

John Pancari

Good afternoon. Can you give a little bit more detail on the loan deposit growth? I know we’ve just seen the differences between the linked quarter growth rates on an average basis versus the period and numbers. I’m just trying to see which ones should we take as being more indicative of the ongoing trends, both from the loan and deposit side.

Peter Bartholow

John, this is Peter. As I said, the strength of Q1 linked quarter averages was really built on Q4 outstandings. We had, if you will recall, a significant surge really in the last third of the fourth quarter that did not have that big an effect on the quarterly averages but obviously left us in a position, as I recall, we started the quarter 4% above the linked quarter average. So we essentially maintained that level. Q1 is always our weakest quarter. George commented on the pipeline. So I don’t believe the point-to-point growth in either loans or deposits is necessary indicative of where the second, third, and fourth quarters would be.

Pipeline is strong. Deposit issues are addressed. We can control those to some degree provided in the commercial markets if you are willing to pay the price. But as I commented, the demand for liquidity worldwide has made us look at alternative funding sources especially when most of the growth is in a very short-term earning asset category, loans held for sale.

John Pancari

Okay. And you indicated the pipeline is stronger. What specific areas you really see the strength still in the pipeline, is it specifically C&I versus commercial real estate, if you can just elaborate?

George Jones

John, this is George. Primarily we see it in the C&I portfolio, but we are seeing some very good real estate, commercial real estate transactions today also. But I would say preponderant it's C&I portfolio and we are continuing to see good demand and good growth in our loans held for sale category. We are very cautious about that. We understand what the mortgage markets are today, but as I mentioned before, we really do have an opportunity here to selectively grow that portfolio, I believe, on a very safe and sound basis today with new underwriting standards and new investors.

John Pancari

Okay. And then lastly, the other non-interest income bucket stood at about 1.1 million in the quarter. It was pretty much, essentially zero last quarter. What was that this quarter?

George Jones

Mortgage warehouse.

John Pancari

Okay. So that's…

George Jones

Pretty strong performance there.

John Pancari

Okay. So it's all from the warehouse?

George Jones

No it's not all. It's never all from anywhere but, in terms of linked quarter, remember we disclosed in Q4 that we had had a mark-to-market in that portfolio so, without having to do that, we have a strong comparison.

John Pancari

Okay, good. All right. Thank you.

Operator

Our next question comes from Andrea Jao from Lehman Brothers. Please go ahead with your question or comment.

Andrea Jao

Good afternoon everyone.

Joseph Grant

Hi Andrea.

George Jones

Hello Andrea.

Andrea Jao

Hi. Last January, I believe the expectation was for 10 to 15 basis points in compression for the full year and you already had 20 given a greater number of Fed cuts.

George Jones

Greater number and faster.

Andrea Jao

Right. So what do you think is -- how much more compression do you think we will see over the remainder of ’08, other than what's already happened?

George Jones

As Jody mentioned, that’s going to be a function of how far the Fed is willing to take it down.

Andrea Jao

And if we’re going to assume just the cuts that we have had so far?

George Jones

The cuts we’ve had so far, we believe clearly, I mean we had on a linked quarter average basis, 130 basis point reduction between Q4 and Q1. It’s a little less than that from Q1 to Q2; we believe certainly so far it is. But unless the Fed goes much farther than I think even the markets predict, it will be less than the Q1 experience. If they go about it a little more slowly from here, things should be quite a bit better not only in expansion of margin but less contraction.

Andrea Jao

Okay.

George Jones

Remember, the guidance was predicated on reaching 2.5% by the end of April and we’ve reached 2.25% by the middle of March. That has a significant effect too. 0.25% by the middle of March.

Joseph Grant

Andrea, I might just add that the biggest cuts that we had, beginning with the December 11 cut, were on January 22 and January 30 and those cuts were baked pretty well into the numbers that we reported for the quarter and then of course the last cut was 75 basis points which occurred on March 18 and that isn’t obviously fully reflected in the quarter.

Andrea Jao

Okay. With respect to expenses, you earlier mentioned that expenses should slow for the balance of the year, so how do I interpret this? Can I assume that seizing the elevated employee cost a little bit in the second quarter or should we continue to grow albeit at a slower pace for the remainder of the year off the first quarter levels?

Joseph Grant

I think some growth at a reduced pace. Remember we had the surge in Q1 that comes from normal Q1 events so I couldn’t relate it. We also had restoration for lack of other term of the incentive accrual based on our progress towards plan versus Q4 where we had the $2 million reduction. As George commented, the level of expenses hovering around 26 million and there are no expense categories that are expected to be significant in terms of increases from here, normal growth, additions for staff, and so forth but nothing of significant consequence.

Andrea Jao

Okay, perfect. Thank you so much.

Operator

And our next question comes from Erika Penala from Merrill Lynch. Please go ahead with your question or comment.

Erika Penala

Good afternoon.

Peter Bartholow

Good afternoon.

Erika Penala

Does the guidance that you gave last quarter for 15 to 20 basis points of losses still hold?

George Jones

Yes.

Peter Bartholow

Yes. Our guidance on credit remains the same today.

Erika Penala

Okay. And you all had talked about the global liquidity pressure really making deposit gathering more expensive than it has to be given where Fed fund is. When do you think we’re going to start seeing the easing of that pressure in ’08?

Peter Bartholow

Erika, you probably talk to your people of investment banks that the margin are putting the largest amount of pressure on the global liquidity. So your perspective would be much better than ours or your firm’s would be.

Erika Penala

I’m not sure about that. But what about -- are the big or the more troubled commercial banks still aggressive in terms of your deposit offers?

Peter Bartholow

We don’t really see that on a retail basis, but when I’m talking about commercial, we have commercial customers that can go to markets where the funding rates are driven by LIBOR. So you have got international pressures, the spread between LIBOR and Fed funds, clearly has an impact on the commercial deposit rates.

Erika Penala

Okay. Thank you.

Operator

Our next question comes from Bob Patten from Morgan Keegan.

Robert Patten

Good morning guys or good afternoon guys.

Joseph Grant

Hi Bob.

Robert Patten

Had a long day. I guess, could you give us some color on the pipeline, where the growth is coming from, what types of requests you are seeing and just a general health of or I guess the general demand from your customer base?

George Jones

Yeah. Bob, this is George. Again, as I mentioned, most of the demand is the C&I portfolio, which typically is a majority of our customer base, working capital lines of credit, a few acquisition opportunities in the commercial side, commercial real estate side, we are seeing few commercial projects being built, pretty good demand in most markets. San Antonio is quite healthy, as you saw first quarter had very good growth. Dallas, of course Dallas is 65% of the company, so you are going to see a greater proportion in the Dallas area. But we are seeing pretty good loan demand statewide. Again, it's really a little bit early to predict much, but it's encouraging to see this early in the year the pipeline looking as full as it is today. Now obviously we got to close those loans and we will close them all, but it's encouraging even in this environment we are getting an opportunity to take a look at some pretty good credit.

Robert Patten

Okay. And in terms of loan officers, have you guys added any, have you lost any for the competition over the last couple of quarters?

George Jones

Yeah, we added actually five in the quarter, five relationship managers, we lost one. That's very unusual for us as a matter of fact. We typically don’t, as you know, lose many people. This was a very unique opportunity for this individual and we didn’t discourage that at all. We are continuing to selectively look for good people in the marketplace in all our markets. We are adding relationship manager in Austin. We are looking in San Antonio and Fort Worth. So we will hopefully have an opportunity to again selectively build staff across the state.

Robert Patten

Okay. And where are you seeing the stress in terms of your customers right now? Is it in the middle market from an asset base standpoint? Is it from a receivable standpoint, where are you generally seeing the weaknesses across your customer base?

George Jones

Well, it's still residential, residential development, single family, although our portfolio looks quite good related to that, but we see a definite slowdown on the residential side. But it's -- we are encouraged with the economy as Jody mentioned and we think we are cautiously optimistic, we will have a good year.

Robert Patten

Okay. And last question. From the funding side, do you guys have any elasticity on your deposit side that you can say for rate space, no more rate cuts? Is there anything you can do on the deposit side or on the hedging side to help your margin over the next several quarters following up Andrew's question?

Joseph Grant

It's hard to do much with our business model, Bob. When rates catch up and when deposit, customer deposits including demand deposits, which historically for us has lagged loan growth catch up a little bit, we think we will be just fine.

Robert Patten

Okay.

Joseph Grant

When we -- we should actually -- as when the rates hit bottom, we should actually see some improvement in margin.

Robert Patten

Okay. And I guess, I would say, one more question.

Joseph Grant

Okay.

Robert Patten

You are keeping your guidance of for net income for the year?

Joseph Grant

Correct

Robert Patten

For margins, you left 20 bits right off the top, what gives you guys the confidence and where do you think you are going to make it up?

George Jones

As Jody mentions, when we gave guidance, we knew about the first rate cuts -- the first two rate cuts. The third was steeper than we would have guessed and came faster and then you have the unique circumstances in Q1 relative to the rest of the year. So Q1 doesn't -- there's nothing about Q1 today that would make us change that guidance.

Robert Patten

Okay. Good year guys. Good job. Thanks.

Myrna Vance

Thanks.

George Jones

Thank you very much.

Operator

Our next question comes from Brent Christ from Foxx Pitt. Please go ahead with your question or comment.

Brent Christ

Good afternoon. You guys had the large problem of credit that come on non-performing status last quarter. Could you give us an update as far as the status of that and then to the extent it impacts and the kind of the dynamic with the charge-offs and non-performers this quarter?

Joseph Grant

Yeah, Brent. We continue to work and negotiate with that particular company and that particular credit and it’s a little bit difficult to give real specifics today. I mentioned the exposure. I think the last time we talked that the exposure is down from where we were before, where we reported it before. And, we continue to work with the company and we will continue to work with the company over a reasonable period of time. But I am not avoiding your question, but it is very sensitive today so I can't get too specific on that specific credit, but our exposure is down from where we were.

I think I mentioned a couple of things in our previous call outside of that particular credit that were non-performers at the end of the year, but have had some progress. I mentioned that there was a commercial real estate in Houston that was supported by an appraisal and reserves. That was in the process of foreclosure. We have foreclosed that particular property. We have valued it at what we think is a good appraisal value today and we are currently marketing that particular property.

We think it's reasonable that we ought to have some progress on that before too long. There was a $2.5 million C&I loan in Houston that we had taken a previous charge-off last year. We in effect recovered all of that 2.5 and actually $0.5 million more than that that contributed to a recovery at the end or in the first quarter. That was paid. Our mortgage warehouse non-performers are about the same position. We are continuing to work some of those down. We have had very good success in selling some of those, slightly still warehouse assets that were as you remember caught in the bubble sometime before we actually changed the underwriting and investors. That’s about the same but we are continuing to work that down. So, we feel as I mentioned before the charge-offs were recognized problem credits with proper reserves placed against those credits, we believe. So this is nothing new that has popped up.

Brent Christ

Got you. I guess I'm kind of take it as is, you guys reiterated the charge-off guidance for the full year, 15 to 20 basis points and you are at a run rate higher than that already here in the first quarter and to the extent that there was anything lumpy in there that may not be kind of recurring going forward at least that you see right now?

Joseph Grant

Well, as we have always said, provisioning and charge-offs will be lumpy. That’s the nature of our model today. But we, again, feel like that we today can live within that guidance of 15 to 20 basis points that we gave you. It’s a little bit hard to predict. There is no real run rate that you can look at as it relates to charge-offs in our company. Our hope would be certainly to reduce those on a go-forward basis, but again we feel we can live within that guidance that we gave you.

Brent Christ

And then with respect to the what amounts of reserve you have been slowly bringing that up over the past couple of quarters, which seems like a move in the current environment and I know it's formula driven, but is there a level kind of longer-term that you would like to see that migrate to to kind of be comfortable with managing over a longer timer time horizons?

Peter Bartholow

We don’t really know, again you mentioned the methodology. Part of that methodology is certainly, it relates to the economy. And if the economy weakens or the economy gets a little better, we can tweak that methodology to reflect the market in which we’re working in. And the reserve has gone up over the last couple of quarters because the methodology worked and we feel comfortable in staying with that methodology. We don’t have a predetermined percentage of our loan portfolio that should be kept in the reserve. We’ll work with the methodology and see what it drives in terms of coverage.

Brent Christ

And then lastly, I think last quarter you guys gave some good details in terms of your exposure from a real estate perspective and I was just wondering if you can kind of give us an update in terms of how the real estate related portfolios are doing and to what extent you are seeing any stress? I know you mentioned the residential sides still holding up pretty strong.

Peter Bartholow

I mentioned to you before we have a little less than 8.5% in residential market risk real estate exposure. That includes a lot of development and single-family construction, and that portfolio has held up and is holding up quite well even in this environment. It slowed obviously, we are not doing that much, certainly on the lot development side at this point in time but it's reflective of the market. The commercial real estate portfolio is about 26 to 27% of the overall portfolio; that includes by the way the portfolio I just mentioned to you, the single-family exposure. That portfolio has held up quite well. Again remember, we have always told you that we do earn the right commercial projects to the permanent market with a higher rate, good coverage ratios, hopefully a little bit more equity than some of our competitors and we see today in the markets we are in, we are pretty comfortable with our commercial portfolio.

Brent Christ

Okay. Thanks a lot.

Peter Bartholow

Okay.

Operator

Our next question comes from Brad Millsaps from Sandler O’Neill.

Peter Bartholow

Hi Brad.

Brad Millsaps

Hi, good afternoon. I just had a couple of quick, kind of, housekeeping questions. First, I was going to see if you could talk about the mortgage warehouse business just one more time, just curious what the volume was like in the quarter? How many loans were you able to sell versus kind of where you were at the end of the year versus where you ended the quarter?

Peter Bartholow

We probably had in March one of the biggest months we’ve had in a long time in terms of production. Obviously, we don’t keep all those on the books. They stay on the books for 10 to 20 days. So, the actual production and what we show on the books is quite a different number. But we’ve had at least $100 million delivery days in terms of delivering mortgage loans to the permanent investors. It is, as I mentioned before, the market, if you do it right in today’s environment, we believe there is a selective opportunity in that marketplace today. Again, you need to be cautious. You need to underwrite and you need to approve the permanent investors that you are very comfortable with. But we’ve done that at this point in time and we’re comfortable with our exposure. Our outstanding during the month of March probably was as high outstanding as we’ve ever had in the history of the portfolio even in the re-fi days we were smaller in obviously the bank loans. But again we are cautious, we are underwriting it we believe properly, basically Freddie and Fannie guidelines and we’re having no trouble with any of our investors accepting the paper.

Brad Millsaps

Okay. And then another question on deposit service charges given your commercial focus. When you guys expect that you will see may be a bigger jump in those fees given what rates coming down lower earnings credit rate. I'm just curious as we move throughout the year, how to think about that?

Joseph Grant

Brad, if we are doing that right, we are getting about as much out of the balances as we are out of the fees. Now, the way it works for us is we actually prefer balances and what you described is one of the reasons why we think we can see some strengthening in the DDA balances.

Brad Millsaps

Okay. And then final question. Just curious on the share count. It looks like you issued something in the neighborhood of 240,000 shares since the end of the year. I'm not sure what I missed, could be related to options or something, but the average diluted number was down a fair amount; I know the stock was off some, but just kind of curious, if there is anything else in that calculation that is worth mentioning?

Peter Bartholow

No share buybacks, no treasury shares, strictly just option exercises, and the impact of the share price on the treasury on the computation for diluted shares.

George Jones

I would like to be able to say that I got all of those shares as a good-bye gift, but unfortunately that didn't happen.

Brad Millsaps

Great. Thank you.

Operator

Our next question comes from Michael Rose from Raymond James.

Michael Rose

All of my questions have been answered. Thank you.

George Jones

Thank you.

Joseph Grant

Thank you, Mike.

Operator

Our next question comes from Jennifer Demba from Suntrust Robinson Humphrey.

Jennifer Demba

Yeah. Brent actually asked my questions as well. Congratulations on your upcoming retirement Jody.

Joseph Grant

Thank you very much, Jennifer. I appreciate it very very much.

Operator

The next question comes from Charlie Ernst from Sandler O'Neill Asset Management.

Charlie Ernst

Good afternoon to you guys.

Joseph Grant

Hey Charlie.

George Jones

Hey Charlie

Charlie Ernst

I just want to ask one more question on the margin, I know we have kind of beat it to death a little bit. But in terms of the eventual rebound whenever rate cuts stop, does a big slowdown in the degree of rate cuts actually end up turning the margin that means that within kind of three months that your funding is able to start to catch up or does it actually have to stop the rate cuts?

George Jones

Anything that still had to mature, this is obvious, anything that had to mature that the last rate cut is not going to get carried it to a lower level until that but the steepness of that means it will reprice sharply. And I think, what you are describing can occur. Now as you know and we state over and over again, there are way too many variables and to isolate out one effect on our margin.

Charlie Ernst

Right.

George Jones

Composition is a huge part of it. Just the fact that we grew so much and loans held for sale; that's one area where it hurt the margin, but not net interest income. The other issue is LIBOR. As we said, Q4 we had an unusually high spread, large spread between LIBOR and Fed funds or the Prime rate. Q1: that narrowed sharply. If it stays like it is today, that will be very beneficial.

Charlie Ernst

Okay. And so, I mean incrementally the math, I mean barring even any further rate cuts will get a little tougher just because of the held for sale portfolios since the period-end number was so much bigger than the average.

Joseph Grant

Well, if that number moves around quite a bit, so you can't -- the quarter-end number will not necessarily predict the average balance number.

Charlie Ernst

Right. Okay. And then my last question is can you just remind me real quick what the events are surrounding the mark from last quarter in other fees?

Joseph Grant

Say again.

Charlie Ernst

What the events were surrounding the negative mark last quarter in other fees?

Joseph Grant

Sure. The loans held for sale that were tied up and couldn't be so buyers that were nagged on commitments and then they get staled and we have to go through a mark-to-market process. We have actually been able to dispose off a decent number of those, couple of million dollars and did have a profit on disposition.

Charlie Ernst

Okay, great. So the other fees this quarter should be pretty core that there is not a whole lot else in there?

Peter Bartholow

Core. I thought you said poor.

Charlie Ernst

No.

George Jones

That's right.

Charlie Ernst

Okay, great. All right. Thanks a lot guys.

Joseph Grant

Let me just add something to what has been said about this margin business. It's obvious that when rates are going down very very rapidly, all of our assets, not all of our assets, but vast majority of them adjust very quickly and particularly the CD portion of our portfolio adjust much more slowly. So intuitively, if we do have a decline or a flattening, not decline but a flattening of the decline in rates, your CD portfolio is going to begin to catch up with the rapid decline in rates on assets. So even before they reach top, so your premise that you outlined at the outset was exactly correct. But we don’t know -- nobody knows where rates are going specifically or how rapidly they are going to recover or how long they are going to stay at low levels.

George Jones

We had more of a ramp scenario between Q3 and Q4 and the margins held quite firm.

Peter Bartholow

Charlie, also as I mentioned before on the other side of balance sheet, we are seeing loan pricing firm a little bit and we are cautiously optimistic we can improve on the lending side some of our spreads. I think that is a natural progression from what we are seeing today basically with the liquidity issues that are out there and again as I mentioned we are cautiously optimistic that we are going to be one of the beneficiaries of some of that -- some of those issues we see out there.

Charlie Ernst

Thanks a lot.

Operator

Our next question comes from Andrea Jao from Lehman Brothers.

Andrea Jao

Hello again.

Joseph Grant

Hello.

George Jones

Hi Andrea.

Andrea Jao

Hi. Just wanted to check in on whether the regulators have already come to visit us, their schedule to visit? But if you have already spoken to them, I was hoping to hear a feedback on a couple of things as well as what you saw on a couple of things i.e. capital levels and the loan to deposit ratio, which has for the past couple of quarters trended higher above 100%.

George Jones

We cannot speak to any specific issue that comes up with the regulators. There are no issues with respect to either of those matters, Andrea.

Andrea Jao

Okay. Did they already come to visit? They are already done.

George Jones

There is so much that happens all the time.

Andrea Jao

Okay. Great. Thank you so much.

Joseph Grant

Okay.

Operator

Our next question comes from Andy Stapp from B. Riley & Company.

Joseph Grant

Hey Andy.

Andrew Stapp

Hey. How are you guys doing?

Joseph Stapp

Good. All my questions have been answered.

Joseph Grant

Okay Andy. Thanks.

Andrew Stapp

Thank you.

Operator

(Operator Instructions). Ladies and gentlemen, at this time, I am showing no additional questions.

Joseph Grant

Let met just -- this is Jody making some closing comments. So this is my last call. I would like to say that I leave the company with the greatest confidence both in its future short-term and long-term. We have a wonderful banking team here, a wonderful leadership, and I couldn’t be leaving it in better hands. I would also like to say that one of the greatest pleasure I've had has been interacting with this street, which I particularly enjoyed doing. We had a public offering in August of 2003. So I have been at this for nearly five years, a little short of that. During that time, I have made many good friends and have grown the respect each and every person that I have interacted with. It's been challenging and interesting. I particularly enjoyed the financial conferences and road shows both road shows that we have gone on and those that have come through the bank where we have had the privilege to have personal contact with many of you. I appreciate the many courtesies that have been extended to me over the time and the respectful manner in which I have always been treated and I hope that you feel that I have reciprocated our voice intended to and apologize for any occasion where I may have offended anybody.

I will be officing here within Texas Capital Bank until we move to our new headquarters across the street, which is now estimated and our underlying estimate for December 1 of this year. I will move across the street as well, but will be officing with BancCap Partners where I am assuming a greater role. You my recall BancCap Partners is a private equity fund, which was incubated within Texas Capital Bank and has been functioning since its inception about a year-and-a-half ago.

BancCap now has a bank open and operating in Atlanta and will be targeting another bank very shortly and I can't say where that’s going to be. I will be joining in as a Senior Advisor initially and look forward to that interaction. We will be moving again across the street and we will be subleasing from Texas Capital Bank. I hope when any of you are in either this building or the new building that you will come by and say hello. I will always welcome the opportunity to see you and once again just thank you very very much for all the courtesies. I will miss you. But hope this isn’t good-bye and that you will stay in touch.

Thanks so much. I think we have had a great quarter and I again look forward to a great year. That concludes the call.

Operator

Thank you for attending today's conference call. You may now disconnect your lines.

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Source: Texas Capital Bancshares, Inc., Q1 2008 Earnings Call Transcript
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