Fulton Financial Management Discusses Q2 2012 Results - Earnings Call Transcript

Jul.18.12 | About: Fulton Financial (FULT)

Fulton Financial (NASDAQ:FULT)

Q2 2012 Earnings Call

July 18, 2012 10:00 am ET

Executives

Laura Wakeley

R. Scott Smith - Chairman, Chief Executive Officer, Member of Executive Committee and Ex-officio Member of Risk Management Committee

E. Philip Wenger - President, Chief Operating Officer, Director, Member of Executive Committee and Ex-officio Member of Risk Management Committee

Charles J. Nugent - Chief Financial Officer and Senior Executive Vice President

Analysts

Casey Haire - Jefferies & Company, Inc., Research Division

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

David Darst - Guggenheim Securities, LLC, Research Division

Frank Schiraldi - Sandler O'Neill + Partners, L.P., Research Division

Richard D. Weiss - Janney Montgomery Scott LLC, Research Division

Nicholas Karzon

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

Bob Ramsey - FBR Capital Markets & Co., Research Division

Russell Gunther - BofA Merrill Lynch, Research Division

Mac Hodgson - SunTrust Robinson Humphrey, Inc., Research Division

Blair C. Brantley - BB&T Capital Markets, Research Division

Operator

Good morning, ladies and gentlemen. Welcome to the Fulton Financial Corporation Announces Second Quarter Earnings Conference Call. This call is being recorded. I would now like to turn the call over to Laura Wakeley, Senior Vice President of Corporate Communications.

Laura Wakeley

Thank you, and good morning. Thank you for joining us for Fulton Financial Corporation's conference call and webcast to discuss our earnings for the second quarter of 2012. Your host for today's conference call is Scott Smith, Chairman and Chief Executive Officer of Fulton Financial. Joining him are Phil Wenger, President and Chief Operating Officer; and Charlie Nugent, Senior Executive Vice President and Chief Financial Officer.

Our comments today will refer to the financial information included with our earnings announcement, which we released at 4:30 yesterday afternoon. These documents can be found on our website at fult.com by clicking on Investor Relations and then on News.

On this call, representatives of Fulton may make forward-looking statements with respect to Fulton's financial condition, results of operations and business. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond Fulton's control and difficult predict -- to predict and which could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. Fulton undertakes no obligation other than required by law to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In our earnings release, we've included our Safe Harbor statement on forward-looking statements, and we refer you to this section of that release and we incorporated into today's presentation. For a more complete discussion of certain risks and uncertainties affecting Fulton, please see the sections entitled, Risk Factors and Management Discussion and Analysis of Financial Condition and Results of Operations set forth in Fulton's filings with the SEC.

Now I'd like to turn the call over to your host, Scott Smith.

R. Scott Smith

Thanks, Laura, and good morning, everyone. We're pleased that you were able to join us today. Before Phil Wenger discusses credit and Charlie Nugent covers the financial details, I have a few comments on the quarter. When we conclude, we'll be happy to take your questions.

We reported diluted net earnings per share of $0.20, up 5.3% over the first quarter and up 11.1% over last year. Our return on average assets also increased, and as you know from previous calls, ROA improvement is one of our key priorities. While we experienced success on a number of fronts in the second quarter, 2 in particular standout: continued improvement in our credit quality and strong other income growth. Looking first at credit and Phil will provide more detail. We were pleased to see further decrease in the provision for credit losses. Nonperforming loans also decreased due in part to the sale of a group of non-accruing loans. We continue to see overall improvement in our credit quality in what, from our perspective, is still a less than robust business environment. Total loans outstanding increased modestly at the end of the quarter. We would like to think this may be an indicator of a pickup in loan demand, but our expectations remain tempered by persistent customer uncertainty. We continue to expand the foundation for potential future loans growth by growing our retail and commercial account base again in this quarter. While we do not share actual account growth metrics for competitive reasons, our recently completed retail deposit promotion generated higher than normal new account activity when compared to the same period last year.

Turning to noninterest income. Sales gains from residential mortgage loan activity were again strong, and as long as interest rates remain low, this area will likely continue to make a solid contribution to income. We also saw a healthy increase in deposit account related birth for each [ph] revenues linked quarter.

Earnings pressure came largely from 2 areas: net interest margin contraction and higher expenses. While I would like to say that both items are specific to this quarter, I do not believe that to be the case. Given the current and anticipated rate, regulatory and competitive environments, these areas will present continued challenges and will receive close management scrutiny.

On the margin, we -- lower interest rates produced another reduction from -- in our funding costs. We have shown consistent decreases in our cost of funds over the last several quarters, as we adjusted our mix some time to lower cost core deposits. Those past actions have been effective. However, during the second quarter, the rate of decline on earning asset yields accelerated and put greater downside pressure on the margin.

Expenses were up this quarter. We're all aware of the increasing attention to enterprise risk management and compliance functions, both a primary focus of certain provisions of the Dodd-Frank Act. We anticipate that the expectations for these areas and the resource commitment to them will continue to increase. We've engaged outside consulting firms to help us evaluate and examine both areas. They are providing us with broader insight into industry best practices. This investment will help us be better prepared to meet the demands of a larger, more complex organization that will inevitably accompany our next phase of growth.

Overall operations continue to generate increasing levels of capital. We've increased capital back -- we've -- we have reinvested capital back into the profitable business lines and increased our cash dividend. With the acquisition front rather quiet, the board approved a stock buyback of up to 5 million shares through the end of the year. The last time we did a stock purchase was in 2007. Our repurchase activity will be dependent on market conditions and when we feel that it will benefit our shareholders.

At this time, I will turn the call over to Phil for an overview of credit and then to Charlie for a financial discussion. Phil?

E. Philip Wenger

Thanks, Scott. As we mentioned in our press release, we were pleased to announce improvement again in our overall credit metrics. As we discussed, we sold a portfolio of nonperforming commercial loans that aided our overall improvement in credit quality. I'll give you the details on that sale in a moment. We were also successful in reducing nonperforming loans to our individual resolution activities at a pace greater than that which we have seen in prior quarters. Also, we have continued to reduce our exposure to problem loans, as I will discuss also in a moment.

Now let me give you the details. Overall, delinquency declined and the lowest it has been at quarter end since the end of 2008 at 2.81% of loans or $337 million.

Emergency delinquencies, those accounts under 90 days past due, picked up slightly since the end of the first quarter from 0.71% to 0.86% of loans. This is not unexpected as there will continue to be some fluctuation in delinquency given general economic conditions. We were able to reduce nonperforming loans by $50 million from $284 million to $234 million. As we mentioned, we sold a portfolio of nonperforming loans, all of which were under $1 million in balances with a total bank balance of $44 million. We periodically evaluate loan sales and again this quarter, as we did in the fourth quarter of last year, we performed a cost benefit of holding and collecting these loans over time versus selling to an investor. Our analysis reflected the sale would be an appropriate strategy. We sold the pool to 1 investor. The pool was comprised of $11 million of C&I loans, $30 million of CRE loans and $3 million of construction loans. The charge-off associated with this sale was $21 million. The amount of our allowance for credit losses allocated to these loans was $24 million, though we are able to execute the sale without a related loan loss provision expense. As I mentioned, the loan sale, as well as our ongoing workout and collection efforts, reduced our non-accrual exposure. We generated $55 million in new non-accruals this quarter versus $37 million in the first quarter of 2012. However, we were able to resolve through payments and charge-offs, $51 million, which in addition to the sale and a $5-million reduction in over 90-day accruing loans, drove the improvement in nonperforming loans. Additions to non-accrual for the first half of this year totaled $92 million versus $160 million for the same period last year. We were able to reduce our problem loan levels or exposure to loan relationships, rated special mention or worse, by nearly $160 million.

Given these metrics, we are able to reduce our loan loss provision from $28 million to $25.5 million for the quarter. The allowance to nonperforming loans ratio increased to 101% from 91% at the end of the first quarter of 2012. And our allowance now stands at 1.98% of loans.

Total net charge-offs were $46 million or 1.55% of average loans on an annualized basis as compared to $28 million or 0.94% of average loans in the first quarter of 2012 and a 1.3% for the second quarter of 2011. Troubled debt restructurings increased slightly from $103 million to $109 million. Of this total, $81 million or 74% are accruing loans versus $71 million or 69% last quarter. The $6 million increase to TDRs was primarily driven by 2 loans related to the hospitality industry that were restructured to reflect current market conditions.

Now moving to loan demand and activity. Our ending balances increased despite the reductions from the loan sale and non-accrual resolutions. Our ending balances increased just over 1% from the same period last year, with that growth coming from our CRE and residential portfolios. Although new loan demand remains very modest, we continue to have good success with gaining market share. After a slight increase in the first quarter, our construction portfolio did decline 4.4% in the second quarter, and we expect we will continue to see quarterly fluctuations in this area until the market reaches a greater level of stabilization.

General market conditions and customer sentiment remain consistent with the first quarter. Our customers have a generally positive outlook. However, they continue to be cautious on expanding or taking on additional debt. Our Pennsylvania market shows the most strength with Maryland, Virginia and Delaware close behind. New Jersey continues to be the more challenged state in our footprint, although we are making good progress with asset quality there as we have across the entire footprint.

Mortgage activity, as we mentioned in the press release, remains a highlight. Applications are strong and increased slightly to $824 million versus $812 million in the first quarter and $477 million in the second quarter of 2011. Application volume is up 72% over the second quarter of 2011. The increasing trend in purchase versus refinance activity continued this quarter with purchases comprising 42% of our closed loans this quarter versus 31% in the first quarter. We are seeing a shift in our current pipeline through an increasing position of refinance activity, given the yet again historically low rates. Our current pipeline is $520 million versus $458 million last quarter and $215 million a year ago.

So to summarize, we made good progress this quarter in improving our credit metrics. Ending loan balances increased modestly, and with a gradually proving economy, our seasoned teams are working hard to take advantage of market opportunities.

Now we'll turn the discussion over to Charlie Nugent for his comments. Charlie?

Charles J. Nugent

Thank you, Phil, and good morning, everyone. Thank you for joining us today. As Scott mentioned, we reported net income of $0.20 per share for the second quarter, an improvement of $0.01 or 5% over the first quarter. Net income also increased 5% to $39.9 million in the second quarter from $38.1 million for the first quarter. Unless otherwise noted, comparisons are this quarter's results to the first quarter of 2012.

The growth in our net income resulted primarily from an increase in other income and a decrease in the provision for credit losses. These improvements were partially offset by slightly lower net interest income and an increase in other expenses. Net interest income decreased $1.2 million or 1%, primarily as a result of the 7-basis-point decline in the net interest margin to 3.78% in the second quarter from 3.85% in the first quarter. The depression in our net interest margin resulted from asset yields declining more than funding cost. Yields on earning assets decreased 13 basis points to 4.48% in the second quarter from 4.61% in the first quarter. Our costs in interest-bearing liabilities decreased 6 basis points to 0.93% in the second quarter from 0.99% in the first quarter. The decline in yield on assets was largely driven by investment securities, which yielded 3.19% in the second quarter as compared to 3.36% in the first quarter. Prepayments on mortgage-backed securities and the resulting accelerated amortization of premiums were essentially unchanged from the first quarter. However, the average portfolio yield continued to decline, as reinvestments of cash flows were at rates lower than the overall portfolio yield. Yields on loans decreased 9 basis points from 4.94% in the first quarter to 4.85% in the second quarter. Competition continued to place downward pressure on loan yields. The cost of interest-bearing deposits declined 6 basis points to 0.62% in the second quarter.

Time deposit costs decreased 6 basis points to 1.3% for the second quarter. $725 million of time deposits matured at a weighted average rate of 0.88%, while $648 million of certificates of deposits were issued at a rate of 0.43%. In the third quarter of 2012, $726 million of time deposits are scheduled to mature at a weighted average rate of 0.96%. Average total interest-earning assets grew $141 million or 1%. The growth was realized primarily in our investment portfolio, which grew $111 million or 4% as result of purchases in the first quarter. Additional increases were seen in short-term other interest earning assets, which grew $28 million and loans held for sale, which grew $15 million. Average loans decreased by $13 million in comparison to the first quarter. Ending loan balances increased as Phil discussed. Average deposits declined $85 million with $161 million or 4% decrease in time deposits being partially offset by a $76 million or 1% increase in demand and savings deposits. Non-interest-bearing demand deposits increased $104 million with a $70 million or 3% increase in business accounts and a $30 million or 5% increase in personal accounts. Interest-bearing demand deposits increased slightly by $20 million or 0.8%. Growth in personal and business accounts was offset by decreases in municipal accounts. Savings deposits decreased $48 million or 1.4% almost entirely in municipal accounts. This decline resulted from a reduction in rates paid on municipal accounts. Other income for the second quarter increased $1.4 million or 3%, excluding the impact of security gains. Mortgage banking income increased $1.1 million or 11% as a result of a 6% increase in new loan commitments to $656 million and a 5% improvement in spreads. The growth in volume was driven by persistent low interest rates.

Service charges on deposits improved $525 million -- no, I'm sorry, $525,000, sorry about that, including a $204,000 or 8% increase in cash management fees, $193,000 or 4.5% improvement in deposit service charges and $129,000 or 1.6% increase in overdraft fees. Other service charges and fees increased $952,000 or 9%, primarily due to a $518,000 seasonal increase in merchant fees and a $280,000 increase in foreign exchange fee income as a result of higher transaction volumes.

Trust income grew $445,000 or 4.7%, almost entirely in brokerage income due to the strength of the equity markets and the enhancement of our recurring revenue model. The $1.6 million decrease in the other noninterest income category resulted from gains on the disposition of 2 branches and 1 operations facility in the first quarter.

In the second quarter, net security gains were $1.5 million as compared to $1.3 million in the first quarter. Net security gains during the second quarter were almost entirely realized gains on bank stock sales. Operating expenses increased $1.4 million or 1.3% to $112.1 million for the second quarter. Salaries and benefits decreased $269,000 or 0.4%. This decline reflected the net effect of a $1.1 million seasonal decrease in payroll taxes and an $830,000 decline in health insurance cost. This decline was partially offset by a $1.6-million increase in stock compensation expense due to the annual grant of stock awards.

Operating risk loss decreased $1.3 million or 39% during the second quarter. Provisions for potential losses on mortgage loans sold decreased to $680,000 in the second quarter from $2.6 million in the first quarter.

The other category of noninterest expenses increased $2.4 million or 15%. This increase included $2.2 million in consulting expenses primarily related to the enterprise-wide risk management and compliance efforts that Scott discussed.

In prior quarters in response to questions, we have provided estimates of quarterly expense run rates. In our current operating environment, with issues such as increasing regulatory and compliance demands, continuing loan workout cost and a pending core systems conversion that can contribute to expense volatility, we are reluctant to provide specific estimates of future expense levels.

Thank you for your attention and for your continued interest in Fulton Financial Corporation. Now we'll be glad to answer your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we will go first to Casey Haire with Jefferies.

Casey Haire - Jefferies & Company, Inc., Research Division

Just a question, I guess, on the securities yields here. What is the new -- what is new money getting in the securities book relative to the existing yield?

Charles J. Nugent

Yes, the -- on the CMOs, the market rate right now for the CMOs we're buying, which are relatively short, is 1.4%. And Casey, we didn't do a lot of buying in the second quarter, but the transactions -- the securities we bought in the first quarter are detailed in the analyst presentation on our website. And the average yield on securities purchased in the first quarter was 1.81%.

Casey Haire - Jefferies & Company, Inc., Research Division

Okay. So it's 1.4% today. It was 1.8% in the second quarter?

Charles J. Nugent

Yes -- no, 1.8% the first quarter and the second quarter it was 1.4%.

Casey Haire - Jefferies & Company, Inc., Research Division

Okay, got you. Okay, and then...

R. Scott Smith

And this is Scott. I'm sorry. Go ahead.

Casey Haire - Jefferies & Company, Inc., Research Division

So on the deposit side, how are you guys -- do you guys -- can you give us an update on how you're feeling around flexibility and on deposit costs going forward?

Charles J. Nugent

Yes. We think our deposit costs will continue to decline, and we mentioned -- I mentioned, I think, that we have $726 million of time deposits scheduled to mature in the third quarter at a rate of 0.96%, and we mentioned that we are holding CDs in the second quarter of 0.43%. So we would expect to see continuing decline in our deposit cost, but it's not enough to offset the decline in asset yields.

Casey Haire - Jefferies & Company, Inc., Research Division

Okay. And then just last one, switching to credit, provision down $3 million here, but if you exclude the bulk sale, provision was actually flat. So I'm just wondering -- it doesn't seem like there's a lot of loan growth here. Why not -- you got the NPAs moving out. Why not push that -- why not more credit leverage in the quarter?

E. Philip Wenger

Well, Casey, this is Phil. And overall, we continue to feel better about our credit and have seen a declines in the provision, but at the same time, we're seeing economic conditions that are not improving at any kind of rate and some people think they might actually be declining. And we're still headed into a period of time, I think, at the end of this year where a lot of decisions have to be made at a high level that could have an impact on the economy. So we're trying to be as conservative as we can from a loan loss provision standpoint.

Operator

And next, we will go to Chris McGratty with KBW.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

Given the outlook on growth and in context to margin, can you talk about your appetite to restructure some of your FHLB. I know the prepayment penalties are significant, but what about a blend and extend to kind of mitigate some of the pressure here?

Charles J. Nugent

Chris, we look at that all the time, and our Federal Home Loan Bank advances are relatively short, and the penalties can go from 10% to 15%. And it doesn't seem to make sense to take that significant penalty when the advances aren't that long. And we’d have to take -- those penalties are pretty significant and it would be hard -- it just doesn't make economic sense to us to do that.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

I guess, I'm a little confused. The penalties are large but the duration's short. Aren't the durations on these liabilities pretty far out in terms of...

Charles J. Nugent

And it depends. Most of them are maturing in 2016 and 2017.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

So they're longer duration liabilities, right? Okay.

R. Scott Smith

Yes. Well, it depends on what you think is long. We don't think that's long to take a significant penalty. You can extend those out, but you have to increase the rate on those I think.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

Well, there's a way -- I think there's a way to do it where you work the penalty into the rate and pick up some benefit without taking the hit in the book.

Charles J. Nugent

You can take a penalty and it's considered in the new advance and it's extended out. That doesn't seem to make a lot of sense to us either.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. Maybe switching to the -- maybe I missed this. I had to jump on a few minutes late. The expenses, is there a contemplation internally to go through another round of expense initiatives given where revenues are and given the kind of the growth picture that you guys painted?

R. Scott Smith

This is Scott. Not at this point. I think we still think our efficiency ratio's in pretty good shape, and we are, as I mentioned, and investing in the future because we are optimistic that this economy is going to turn around, and we're going to be in a situation where we’re going to need to absorb some pretty significant growth. So we're investing in technology and systems and branches and other things, and we think we need to keep doing that through this so that we are ready for that growth that's bound to come. Now that doesn't say we won't continue to monitor. We have always been very frugal about expenses and very careful about how we monitor all that, so we will continue to do that. But I would say not expect an announcement from us that we're going to cut expenses by some dramatic number at least short term.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. I guess, what I'm struggling to kind of marry the 2 -- that comment against the retracted expense guidance. I'm just trying to just kind of think about the expense run rate for the back half of the year. It sounds like it's going to be higher than what you previously guided to, but should we expect growth from Q2 levels?

R. Scott Smith

Well, we've been saying for many quarters now, credit's going to be lumpy. I think we've got to say expense is going to be lumpy because there are -- the expenses associated with working out problem loans from quarter-to-quarter can jump around pretty significantly and how that all works out and other non-reoccuring items come up. So it -- I guess what we're saying to you is that rather than try to give you guidance that -- very specific guidance that we have the pressure coming from these increased expenses and we'll continue to have some pressure on that. We have the -- as you know, the IT conversion coming up, and that will continue to have some, again, quarter-to-quarter, maybe a little lumpy but some expense issues around it. So we're going to manage it very carefully, but to give you a run rate that we can say is fairly accurate is going to be difficult to do short term.

Christopher McGratty - Keefe, Bruyette, & Woods, Inc., Research Division

Just one last one and I'll jump back in the queue. The buyback, I think, I believe -- correct me if I'm wrong. It expires at year end. Two questions, do you expect to be able to get this done this year? And is there thoughts of re-upping it, I guess, next year?

R. Scott Smith

Well, we have it in place in case we feel as though the price of the stock is at a -- in a situation where it makes sense to the shareholders to buy some back. That will depend on what opportunities present themselves to us or don't. That will depend on where the market thinks the price ought to be and a lot of other factors. So we're going to -- we have it in place, and we'll make that decision here on a almost day-to-day basis based on how we see things unfolding and what other opportunities for capital we see out there.

Operator

And we'll hear next from Collyn Gilbert with Stifel, Nicolaus.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Just a follow-up on the buyback question. So I guess, Scott, it just still seem like you have a lot of capital, more than enough to sort of deploy in other ways, either through the buyback or increasing your dividend. How are you thinking about that?

R. Scott Smith

I think we still don't have final resolution on capital, but we have a lot better feel for what the requirements are going to be than we did, say, 6 months ago. And that's part of the reason we put the buyback in place. I think we've talked in previous calls about the fact that many of our shareholders are very dividend conscious, so I think we'll look. As earnings and our expectations about the economy provide the opportunity to increase the dividend, we'll take advantage of that situation. Acquisitions are still out there, and there's a little more noise around that than there was 6 months ago, so I think we need to be prepared for those opportunities. The buyback is there as well, and as I said earlier, I'm not predicting this economy will turn around quickly but it could, and we could see a pretty significant growth curve if that happens. And we want to be prepared from a capital standpoint to absorb that and move on. So that's kind of the way we look at it. I think we feel good about our capital base in terms of -- as you mentioned, of it being certainly adequate, and we'll look at ways to -- ideally, what we do is reinvest that in capital and revenue-generating activities, and as the economy provides those, we'll certainly want to do that.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Okay, okay. Should I read into your order of your comments in terms of dividend acquisitions and then buybacks?

R. Scott Smith

I didn't really -- I didn't think it through to do that, but as we said before, we very much -- the feedback we get from our -- a lot of our owners is they like dividends. So I think you can say we'll do that when we feel appropriate, but there needs to be earnings and so forth to do it. Between buybacks and acquisitions just going to be opportunistic depending -- if the stock goes to $14, I don't think we'll be buying a lot back. If we get an acquisition -- if I get a call this afternoon and somebody's for sale, then we might go with that risk. So I can't tell you because both of them are opportunistic, and if we had an announcement, I'd make it. Otherwise, I have to keep my mouth shut.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Yes, okay. okay. And then, Charlie, just a question for you. Can you talk about what your strategy is at this point on the investment portfolio? I mean, that had been growing a bit and then, obviously, you shrunk a bit this quarter. How should we think about that and just kind of the overall balance sheet going forward?

Charles J. Nugent

Collyn, we evaluate additional purchases everyday because we have strong cash flows coming from the portfolio, and we made a significant addition to the investment portfolio in March for this $585 million. It worked out to our advantage because at that time, I think 10 year went up to a 10 30 -- 2.30, 2.35, so we got better yields. Since that time, we haven't been doing a lot of purchases. We're a little apprehensive with where yields are and just the risk reward in that.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Okay. So we probably continue to see pay down then as you're not going to reinvest assuming no change in the rate environment?

Charles J. Nugent

No change in the rate environment, yes.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Yes, okay. Okay. And then just a question, which I guess you kind of answered it by withdrawing your expense guidance. I'm just trying to reconcile, the $2.2 million in consulting fees that came in this quarter seems like a big number that wasn't in your projection. Is that kind of why you're now withdrawing expense guidance? It's because you're anticipating things coming in that you can't predict or I'm just trying to still get my arms around that expense number in the direction that it's moving.

Charles J. Nugent

We project that we were getting a normalized run rate or trying to in response to questions, and things were a little bit more -- it's harder to estimate that run rate, so what we try to do is, on the call, we went through each one of the expense categories and tried to get an exact detail for every line item, the reason for the change and if there was anything unusual in there so you could do a better job in projecting a run rate. But it's -- the operating environment, like I mentioned, is it's tough to project what quarterly earning -- quarterly expenses are going to be.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Okay. Let me ask it a little bit differently. So in terms of the additional regulatory expenses that could be coming down the pike, I mean, are you kind of -- do you think you're 50% there for the stuff that's with your visibility over the next 12 months? Do you think you're 25% there?

R. Scott Smith

Collyn, this is Scott. I think I just read the other day that 70% of Dodd-Frank isn't written yet, so it's going to be awfully hard to project where -- what the costs are going to be because...

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

No, I know. I get that. Apart...

R. Scott Smith

What we're trying to do is anticipate some of that and put the systems, the software and the people in place to manage all this, but we get interpretations almost weekly from all of that. And to expect what else is going to come out of that and tell you candidly what we think it's going to be down the road, it's hard to do.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

No, I know. I meant just with what you know now given your kind of exam cycle, given BSA, I mean, some of the issues that are facing you in the near term. I meant more from that perspective, but if the answer is it's just too hard to quantify it, okay.

R. Scott Smith

I'm hearing from around the table here. We think we're halfway through it, so we'll give you that, and don't bet your life on it. But that's kind of where we are. That's a kind of a feel, if you will, rather than a quantitative analysis.

Collyn Bement Gilbert - Stifel, Nicolaus & Co., Inc., Research Division

Okay, okay. And then just one final question, maybe this is for Phil. So the 2 loan sales you guys did in, obviously, this quarter and then in the fourth quarter. You saw like about a 50% loss rate on those pools. Is that kind of where you think the portfolio is running? Or do you -- are you finding yourself kind of tending to sell the lower quality loans? Or how should we think about loss severities of the portfolio that's currently left?

E. Philip Wenger

Well, again, you know that just fluctuates so much from loan to loan and type to type. We feel good about the provision that we have in place for what's left, and I think this sale really bore that out, Collyn.

Operator

And we'll hear next from David Darst with Guggenheim Partners.

David Darst - Guggenheim Securities, LLC, Research Division

Could you maybe talk about how you plan to adjust the Basel III and if there's any opportunity for you to repay the Fulton Capital Trust I?

Charles J. Nugent

David, we have $150 million in that trust. The rate is 6.29%, which we think is a good rate. In Basel II, the -- in Basel, the common equity ratio has to be 8.5% and the total, 10.5%. So we need 2% of capital will be our optimum capital. Now 2% of our capital, it's not common, and we see that trust preferred is cheap capital for that.

David Darst - Guggenheim Securities, LLC, Research Division

Okay. So you -- so that's somewhat permanent and not something [indiscernible] ...

Charles J. Nugent

Yes, the 2% I'm talking about is based on the space capital and it's -- the Tier I Ratio is 8.5% and the total is 10.5%, so there's 2% there and 2% on -- in $12 million in risk-weighted average assets, which we have is $240 million. We think that's perfect for us. It's cheaper capital than having common to come up with that ratio.

David Darst - Guggenheim Securities, LLC, Research Division

Okay. Phil, could you go back over the reductions in the -- that you saw on the problem loan list this quarter?

E. Philip Wenger

The problem loans rated special mention or below decreased by $160 million.

David Darst - Guggenheim Securities, LLC, Research Division

Okay. And then just on the expense side, in the OREO expense, in the OREO pool, I guess you did not choose to include any of those in the loan sale, and I guess, we've just gone maybe through this, this spring selling season. That bucket didn't decline very much. Could you give us an outlook of where you think that bucket may trend?

E. Philip Wenger

Yes, well, it's -- that's one of those expenses, David, that is really hard to predict, but those expenses in the quarter were just ongoing expenses. They were not related to the loan sale. We are anticipating, at some point, as we continue to reduce these loans, that those expenses will go down. As you can see from the quarterly results, it hasn't happened yet.

David Darst - Guggenheim Securities, LLC, Research Division

Okay. Are there any large pieces of OREO? Or is it mostly small pieces of residential properties?

E. Philip Wenger

It's all small.

David Darst - Guggenheim Securities, LLC, Research Division

Okay. When would you consider doing another bulk sale of residential and including some of those?

E. Philip Wenger

We look at it every quarter, and we'll continue to look at it. So we may end up doing additional sales and we may not.

David Darst - Guggenheim Securities, LLC, Research Division

Did anything...

E. Philip Wenger

We will continue to look at it as an option to reduce that portfolio.

David Darst - Guggenheim Securities, LLC, Research Division

Okay. How about on the new NPA generation? That number accelerated during the quarter. Is there anything changing there? Or do you feel like you're at a point where that should decline?

E. Philip Wenger

Well, it is declining. I -- that's a number that's really lumpy from quarter-to-quarter, so if you look at it more this 6 months, the last 6 months, it's declined, we believe, significantly. We did the first quarter at the $37 million was by far the lowest, but actually, that number was the lowest that we had in any quarter since the beginning of 2008. So it will continue to be lumpy, but we hope to continue to see improvement. But it may not necessarily be from quarter-to-quarter.

Operator

And we will hear next from Frank Schiraldi with Sandler O'Neill.

Frank Schiraldi - Sandler O'Neill + Partners, L.P., Research Division

Just a -- most of my questions have been answered actually, but just wanted to dole back to the expense side, Charlie, and I know you talked -- you broke it down line item by line item, but just wondering if maybe you could summarize where your thoughts are in -- what in the quarter, what in the second quarter was either onetime in nature or seasonal in nature, seasonal to just the second quarter such as maybe the stock grants you mentioned and excluding OREO costs, which I know are going to bounce around a lot. And it's just tough to say what's onetime and what's not there.

Charles J. Nugent

Well, that's exactly right, Frank. It's tough to say what's onetime and what isn't. We mentioned the $1.6 million in stock compensation expense. We do that once a year. Most of that is recognized. $1.2 million of the expense is recognized right away, so that would be reoccurring every year but not every quarter. Now you talked about the consulting fees whether that's going to up or we have to do more or is going to get down, that's another one that's -- that will be difficult to say if it's reoccurring or not. We had -- in terms of increasing our mortgage reserve, $800,000 for mortgage putbacks, that's lower than it was the previous quarter. Maybe it'll be 0 next quarter. Maybe it will be more. It's just difficult to go through these and say what's reoccurring and what isn't.

Frank Schiraldi - Sandler O'Neill + Partners, L.P., Research Division

Okay. Now understood. And then so the consulting fees are -- you're not comfortable at this point, say, maybe increase in consulting fees. You're not comfortable at this point saying whether that could go up, down or stay the same?

Charles J. Nugent

The -- I think Phil said -- we wanted -- and Scott said we were trying to improve our compliance system and our enterprise risk management. We're not there yet but...

R. Scott Smith

Eventually, that consulting cost will go down, but part of what we're doing is building systems that will add activities and people and so forth that we'll have some cost but -- and so they might not be in consulting fees a couple of quarters down the road, but it could be in other areas. So that's where we're kind of working our way through all that, but we don't have permanent consultants that are going to be here forever. And we're just working through all that with them, and as I said, investing in the infrastructure to make sure that as this company grows, we have the infrastructure in place the work through all these issues around risk management, compliance and all of that.

Charles J. Nugent

And it's like really -- it's like when you go all through all these items, like our mortgage volume is way up, so our overtime cost in mortgages is up, the temporary health is up and you go through that, what's normal and what isn't. It's a judgment call, and what we've been try to do is just give you all that detail, so you can make -- use your judgment to figure out what's reoccurring and what isn't because it's difficult to judge each one of these items.

Frank Schiraldi - Sandler O'Neill + Partners, L.P., Research Division

Sure, understood. And then -- so the consulting fees are really involve updating or upgrading maybe the systems. Is that right?

R. Scott Smith

Well, we're looking at all of that, and this isn't unique to banking. Enterprise-wide risk management, as I'm reading, is a universal issue throughout all industry, and I think regulators, shareholders, customers, all expect the company they're doing business with to be able to manage risk appropriately. And so I think we're all doing things to try to develop systems, to monitor activity and from account opening through transactions through all the processes that happened and make sure and then predictive models that help us that look at if the following assumptions change, then what happens to the end result of all of that, and so it's just -- it's a process that we're going through, as I said, as I think, is part of the new normal for any company and particularly, for banking as we all improve our risk management activities.

Frank Schiraldi - Sandler O'Neill + Partners, L.P., Research Division

Okay. Just finally, just on the -- in terms of your -- in terms of guidance you've given before, I mean, there's been a steady increase in your expense guidance from 2Q to 3Q to 4Q. So are there specific contracts in -- increases in contracts in terms of upgrading your systems that you already know are coming in 3Q or 4Q that you could just basically talk about that as a sort of a unknown cost at this point that's going to come into 3Q that we haven't seen in the second quarter?

Charles J. Nugent

I don't think so. I mean, there are some -- we'll continue to, as I said, explore these activities and as we see need to do some different things. We're not -- I'm not here to tell you we've got risk management done, and we know exactly what it's going to be over the next decade, and it's ready to go. So I think as we get into this and get recommendations from folks that have experience throughout industry on these practices, which ones we'll decide are appropriate for us or not will impact all of that. So we'll manage it as carefully as we can, but we do think we need to invest in the future even though we don't have robust earnings right now.

Frank Schiraldi - Sandler O'Neill + Partners, L.P., Research Division

Okay. Okay, and then just finally for Phil, just looking at the provision, and I think prior -- someone else had asked the question earlier or talked about it earlier. If you include the reserve that you essentially picked up from the loans that you sold in the quarter, the marks were lower than the actual reserves that you had in place. Seems like the provision was sort of equal to the first quarter. I'm wondering if -- throughout 2011, we saw the provision come down quarter-over-quarter. I'm wondering if you feel like we may be sort of at the right levels now here for maybe a bit of a more extended period. Or can you foresee continued decreases in provision quarter-over-quarter?

E. Philip Wenger

Well, Yes, I'd be hesitant to make any kind of predictions, but we do see credit continuing to improve. And if that in fact continues, I believe that there will be continued decreases in the provision.

Operator

And our next question comes from Rick Weiss with Janney Brokerage Firm.

Richard D. Weiss - Janney Montgomery Scott LLC, Research Division

A question regarding the loan growth or lack thereof actually is -- are these loans that are going to other people either for competitive reasons or pricing more aggressively than you? Or is it just basically not even there?

E. Philip Wenger

Well, Rick, this is Phil. The demand on new loans or on new activity is still extremely modest. There still is not a lot of new projects. There are -- people are not investing in fixed assets, and sales growth is pretty small. So growth comes from taking market share. And that's what we're trying to do. Our ending balances did grow slightly, and if you consider the fact that we sold $44 million of non-accrual loans and we disposed or we got payments on a number of -- on another $51 million and we believe we were able to replace $95 million of loans that we aren't getting any income from with loans that we will get income from.

Richard D. Weiss - Janney Montgomery Scott LLC, Research Division

Okay. So that would help a little bit on the margin, to do that, but aside from that, then you still feel as if the -- I think you said the margin, you still expect to see under some pressure next couple of quarters. Is that correct?

E. Philip Wenger

Yes, that's true, Rick.

Richard D. Weiss - Janney Montgomery Scott LLC, Research Division

Okay. And also if -- I wonder if you could give some -- a little bit of color on the mortgage banking. It was very strong again this quarter and just kind of your best guess, how do you think that plays out over the next -- future?

E. Philip Wenger

Well, Rick, again, the -- that mortgage banking can change very quickly, but rates currently are incredibly low, and our backlog going into the quarter was stronger than our backlog was going into the second quarter. So as of now, it looks like we're going to have strong mortgage activity continuing. But again, it change -- rates go up a little, it changes very quickly.

Richard D. Weiss - Janney Montgomery Scott LLC, Research Division

Right. So if the Fed goes and continues its policies of very low interest rates or another more easing, then we do expect that to be good for the mortgage banking part of your business?

E. Philip Wenger

Absolutely.

Operator

And we will hear next from Craig Siegenthaler with Credit Suisse.

Nicholas Karzon

This is actually Nick Karzon for Craig Siegenthaler. A couple of questions. First on the securities portfolio, just wondering if you can give us some color on the level of prepayments and maturities coming up over the next 2 quarters.

Charles J. Nugent

Yes, the -- Nick, we file that with our investor presentation, and our investment people are expecting the same level of prepayments that we have in that presentation. And for the third quarter, we expected cash flows coming from the investment portfolio to be $149 million and the weighted average yield, 3.51%.

Nicholas Karzon

Very helpful. And then second question is going back to the kind of capital return. Kind of -- in your conversations with regulators, kind of how big is the 30% number? Kind of what is the target in terms of the capital return level that we could see longer term?

R. Scott Smith

You're talking about dividends, the payout ratio?

Nicholas Karzon

Yes, yes. So kind of dividends and then kind of combined dividend and buyback.

R. Scott Smith

Yes, there's some flexibility around that. I think we've done a lot with stress testing with the regulators and capital planning with them, and so we -- that's a continuing and evolving process with them. And I think, as I said earlier, we're all getting a little more comfortable about what capital requirements are and are going to be. So I think there's a little more flexibility around it than there once was, but that's an ongoing process. And as we contemplate moves in the capital, we always talk with the regulators about their comfort level with it.

Operator

And we'll go to our next question from Mike Shafir with Sterne Agee.

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

So a lot of my questions have been answered. Just going back to the securities portfolio for a minute. It looks like you guys are predicting about $150 million in cash flows on a quarterly basis, and those outflows are coming out of the 3.51% rate. And you're probably looking for that securities book to stay relatively flat it seems like in the near term, and the reinvestment rate is somewhere around that 1.40% on the CMOs that you're buying.

R. Scott Smith

Yes.

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

Okay. And the -- also just thinking about capital, I mean, it looks like you guys are going to get to 10% TCE very quickly here organically. So in your conversations with the regulators or just internally, if we think about a fully levered institution where you guys feel like you're operating at kind of maximum strength from a capital deployment standpoint, where is that level now? If you're headed towards 10%, is it 8%? Is it 8.5% on TCE? And kind of how do you guys think about that in context of, internally, you've been asked a lot of questions on M&A, buybacks, and I realize that it's all opportunistic in nature. But maybe you can give us a little context on if you were to go into the M&A market, where would you like to go? What kind of size institution would you be interested in?

R. Scott Smith

Okay. A lot of questions there. Obviously, any conversation with regulators is confidential, so we really can't talk about that. As far as acquisitions are concerned, I think we've talked in the past about we have identified some geographies where we think critical mass would be very effective for us to gain. But having said that, you only -- the banks get -- they say the banks get sold and not bought, so we have to look at who's for sale and then who else is interested and how rational they're going to be. So I do think we -- you can look to us to stay within the footprint we're in now, unless something very unique comes up because we feel like we have opportunities within that footprint where we -- where critical mass could be fairly rewarding to our ability to capture market share and ultimately, earnings. So yes, we're -- we'll be looking at those kinds of things. I mentioned earlier there's a little more noise now than there was, but it's certainly not an overwhelming onslaught of folks putting out For Sale signs.

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

Okay. And then just on the capital level, is there an internal goal that you could share with us?

R. Scott Smith

I'm not comfortable doing that. Charlie, do you think that we...

Charles J. Nugent

No, but we have our own capital plan. We don't disclose what margins are, but you're right on the TCE to tangible assets we keep on building it and it went up to -- we don't have it. It's 9.49% and at June 30 have increased 24 basis points. So we continue to build capital, and it gives us a lot of flexibility as Scott said.

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

Okay. And then just on the M&A front, I mean, I guess, maybe I'll ask this. How big do you think you guys would be willing at $14-billion institution right now?

R. Scott Smith

$16 billion.

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

Pardon?

R. Scott Smith

You said $14 billion?

Mike I. Shafir - Sterne Agee & Leach Inc., Research Division

Well, I'm saying you guys are $16 billion -- I'm sorry. I apologize for the -- you guys are $16 billion, so how big would you be willing to go on the M&A front in terms of increasing the franchise? Would you look at something, $5 billion plus?

R. Scott Smith

Well, you never say never, but what we've said is our sweet spot is between $500 million and $2 billion, but that's not to say, we wouldn't look at a $5-billion company if it became available. And the math all worked and it could -- we can create some real value for shareholders with it, and that's not to say we wouldn't look at a smaller one if with the very strategic locations where we need critical mass and we can work out the math to make it all work for everybody. So ideally, it's in that sweet spot, and it's in the perfect locations, but life isn't that easy. So we have to take what's available and do our analysis and decide whether it's right for us.

Operator

And we will hear next from Bob Ramsey with FBR Investment Bank.

Bob Ramsey - FBR Capital Markets & Co., Research Division

I know you gave it earlier on the call, but I missed it. What was the pipeline for the mortgage bank at the end of the quarter?

E. Philip Wenger

Yes, Bob, this is Phil. And at the end -- well, at the beginning of this quarter, $520 million.

Bob Ramsey - FBR Capital Markets & Co., Research Division

Okay. And this quarter you mean third quarter, right?

E. Philip Wenger

To start the third quarter.

Bob Ramsey - FBR Capital Markets & Co., Research Division

Yes, okay. Got you. And what was the gain on sale margin in the mortgage bank this -- in the second quarter?

E. Philip Wenger

1.66%.

Bob Ramsey - FBR Capital Markets & Co., Research Division

Okay. And you think that's a good proxy for where we'll be in this third quarter as well?

E. Philip Wenger

Well, that does move from quarter-to-quarter. Margins have been strong this year, and I would just say I don't think we see anything that's moving them in either direction right now.

Bob Ramsey - FBR Capital Markets & Co., Research Division

Okay. And did you all do much in the way of HARP refinances this past quarter?

E. Philip Wenger

Of our current pipeline, 10% would be HARP and/or HAMP applications, so that's about where we're running.

Bob Ramsey - FBR Capital Markets & Co., Research Division

Okay. Great. And then last question, based on what you said you all expect in terms of security cash flows this coming quarter, I mean rough math is telling me that your CPR rates are running the low 20s. Does that sound right to you?

E. Philip Wenger

What's -- I'm sorry, what's the CPR rate?

Bob Ramsey - FBR Capital Markets & Co., Research Division

CPR is the constant prepayment rate or the conditional prepayment rate. I can't remember the exact...

E. Philip Wenger

I'm not sure what that would be.

Operator

And we'll go to our next question from Russell Gunther with Bank of America Merrill Lynch.

Russell Gunther - BofA Merrill Lynch, Research Division

Just wanted to follow up on your comments that you'd expect the -- all else being equal, the provision to continue to decline here. Got some decent visibility with where problem commercial NPLs might get resolved and was just wondering if you have any increased comfort in being able to start providing below charge-offs and further releasing reserves. Or would you expect to continue to kind of tack on that to [ph] charge-offs?

Charles J. Nugent

That's a tough question, Russell, and a lot of it will depend on what we see happening in the economy, and you know how that is going right now. So we would really like to get there and -- but I'm not -- I can't say for sure that we are.

Russell Gunther - BofA Merrill Lynch, Research Division

Okay. I appreciate that. And then a follow-up to comments on the loan side and competition, how much do you think the loan production volume you're walking away from due to competitive pricing beyond your tolerance?

Charles J. Nugent

Well, I wouldn't say that we're walking away from it, but we are not getting some deals because of competitive pressures on both pricing and terms.

Russell Gunther - BofA Merrill Lynch, Research Division

Got it. Okay. And then lastly, on the expense side, you mentioned that you were unlikely to have another round of significant efficiencies. Would you consider -- is there any expectation that you might look to consolidate your remaining Pennsylvania charters? And would there be some cost save opportunities there?

R. Scott Smith

We look at that all the time, and as you know, we've done, I think, 22 bank acquisitions and we're down to 6 charters now. So that's -- we constantly look at that, and I would follow up my previous comments. We're in this lean process engineering mode and have been for over 5 or 6 years now. And that produces 7-figure reductions in cost for us on -- continually on an annual basis. So we'll continue to do that, and that provides us ways of decreasing cost where it makes sense to do so. So it's a combination of we need to spend some money in certain areas, and we'll be, as we've always been, very frugal about managing the expenses in other areas.

Operator

We'll go next to Mac Hodgson with SunTrust Robinson Humphrey.

Mac Hodgson - SunTrust Robinson Humphrey, Inc., Research Division

So just had a couple of clarifying questions. I didn't catch it when you mentioned earlier. What was the level of new non-accrual loans in the second quarter?

E. Philip Wenger

Well, the inflow was $55 million.

Mac Hodgson - SunTrust Robinson Humphrey, Inc., Research Division

$55 million, okay Great. And could you give any color on the loan sale? Where are those loans? Where the collateral was from -- which markets they were in? Was it Pennsylvania, New Jersey, et cetera? Any detail there?

E. Philip Wenger

Yes. $26 million in New Jersey; $15 million, Pennsylvania; and then the balance was spread between Maryland, Virginia and very small amount in Delaware.

Mac Hodgson - SunTrust Robinson Humphrey, Inc., Research Division

Was it a surprise given that the bulk was in New Jersey, and I know that's, I think, your weakest market. Was it a surprise that you didn't have to take a larger loss or you had excess reserves there? And did that tell you anything about your strategy for this going forward?

E. Philip Wenger

We -- Yes, we've been -- from day one, we've tried to be very conservative with our provisions, and I think we'll continue to be. But I think this sale bore out that what we've we tried to do, in fact, we've accomplished.

Operator

And we'll hear next from Blair Brantley with BB&T Capital Markets.

Blair C. Brantley - BB&T Capital Markets, Research Division

Just one bigger picture question, given where we are in the current rate environment and the regulatory expenses and things like that, you had mentioned previously about a targeted ROA at the 120 to 130 range. Where did that stand today and your thoughts?

R. Scott Smith

You mean where does the target stand?

Blair C. Brantley - BB&T Capital Markets, Research Division

Yes. I mean, do you still feel comfortable with that being your target? Or has anything changed there from a longer-term perspective or -- because obviously we're going to be in a lower environment for a while so...

R. Scott Smith

My target is 130 to 150, and I think we can get there. I mean, with a little bit of loan growth and some stabilization in some these other issues, I think we can get there. And I think there's a chart in our analyst presentation that shows it by banks, and if you look at that, you'll see some of the banks that are already there. So we need to get some of these credit issues fixed, and we need to get some loan growth. It's in the book -- we're looking at Lafayette Ambassador at 147, FNB Bank at 144, Fulton at 134, Swineford at 160, and then we have Columbia and Jersey, which are -- need to get fixed, but that's -- I think, the lead bank is showing you we can do it.

Operator

And we do have a follow-up question from Russell Gunther with Bank of America Merrill Lynch.

Russell Gunther - BofA Merrill Lynch, Research Division

Real quick. Do you have any thoughts on tax rate going forward?

Charles J. Nugent

The tax rate was lower in the second quarter. It was 25%. We had -- we have a number of tax positions that are detailed in the 10-K. And we settled one, which was $750,000 less than we had accrued, so that $750,000 gone through. I would say the tax rate would be 26%, 27%. Yes, the second quarter is low because that reversal of that as something we had accrued for we're going to have to pay.

Operator

And with no further questions in the queue, I'd now like to turn the call over to Scott Smith for closing remarks.

R. Scott Smith

Well, thank you all for participating in the phone call today. We hope you'll be able to be with us when we discuss third quarter on Wednesday, October 17. We'll talk to you then.

Operator

And ladies and gentlemen, that does conclude the call. We thank you for participating today.

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