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Executives

John Rice Jr. - Investor Relations

David I. Matson - Vice Chairman of the Board, Chief Financial Officer

Philip B. Flynn - Vice Chairman of the Board, Chief Operating Officer

David Anderson - Executive Vice President and Controller

Analysts

Andrea Jao - Lehman Brothers

Heather Wolf - Merrill Lynch

Steven Alexopoulos - J.P. Morgan

Todd Hagerman - Credit Suisse

Lana Chan - BMO Capital Markets

Julian Castarino - Prospector Partners

Robbie Schaufer - Samlin Capital

UnionBanCal Corporation (UB) Q1 2008 Earnings Call April 24, 2008 11:30 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the UnionBanCal Corporate earnings conference. (Operator Instructions) I would now like to turn the conference over to our host, Mr. Jack Rice. Please go ahead.

John Rice Jr.

Thank you and thanks to all of you for joining us this morning. Here with me are Phil Flynn, Vice Chairman and Chief Operating Officer of the company, and David Matson, Vice Chairman and Chief Financial Officer. David Anderson, Executive Vice President and Controller, is here as well.

Mr. Matson will review first quarter’s financial performance and provide guidance for second quarter and full year 2008. Mr. Flynn will then provide significant details about performance in our loan and deposit activities with detailed focus on loan loss provisioning and credit quality.

Please note that the press release for the quarter ended March 31, 2008, was released yesterday after the close of market and has been posted in the investor relations portion of the company’s website at www.unionbank.com.

That press release contains certain non-GAAP financial measures, which we will discuss during today’s call, together with the most directly comparable financial measures calculated in accordance with GAAP and the specific items excluded in the calculation of each non-GAAP financial measure.

Before we begin, this conference call includes forward-looking statements that involve risks and uncertainties. Forward-looking statements can be identified by looking at the fact that they do not related strictly to historical or current facts. Often they include the words believe, expect, anticipate, intend, plan, estimate, project, continue, forecast, or words of similar meaning or future conditional verbs, such as will, would, should, could, or may.

A number of important factors could cause actual results to differ materially from those in the forward-looking statements. A complete description of the company, including related risk factors, is discussed in the company’s public filings with the Securities and Exchange Commission. All forward-looking statements included in this conference call are based on information available at the time of the call and the company assumes no obligation to update any forward-looking statement.

Thank you and now Mr. Matson with the first quarter financial review and second quarter and full year guidance.

David I. Matson

Thank you, Jack and thank you for joining us on the call this morning. First quarter earnings were $0.79 per share. This included three non-recurring items, a $0.10 per share write-down of goodwill for the insurance brokerage business, a $0.06 per share gain on the redemption of Visa common stock, a $0.02 per share for a reversal for reserves related to the Visa litigation. Excluding these items, earnings were $0.81 per share.

Compared with the fourth quarter, total revenues increased nearly 3% with net interest income up almost 5%, due primarily to strong loan growth, lower borrowing costs, and the hedge related income. Lower funding costs and wider credit spreads more than offset a decline in the yield on loans as both deposits and loans repriced slower, consistent with the prevailing rate environment.

Net interest margin grew 3 basis points. We managed the overall level of the bank’s interest rate risk to provide for consistent growth and earnings over time, and capital stability. During the course of 2007, we moved towards a more liability sensitive interest rate risk profile in order to protect the bank from falling rates.

The growth in fixed rate assets during 2007 and in the first quarter of 2008, planted largely by shorter term funding coupled with our ability to price deposits lower, has enabled us to position the bank favorably for lower rates.

The growth in net interest income for the first quarter of 2008 was partially driven by this changing mix in the balance sheet. In addition, we continue to use derivatives to adjust our interest rate profile as necessary, complement the core balance sheet changes.

For the quarter, average non-interest bearing deposits were 29% of total deposits and our overall cost of funds declined 47 basis points to 2.26%. Sequential quarter loan growth was strong at over 4% and was primarily centered in the C&I and commercial mortgage portfolios. Phil will provide additional details shortly.

Non-interest income increased 1% on a link quarter basis, but included a number of non-recurring and unusual items in both the fourth quarter of 2007 and the first quarter of 2008.

Non-interest expense in the first quarter was $437 million. Excluding the $8 million provision for off-balance sheet credit losses, the goodwill write-down of $18.7 million, and a Visa litigation reversal of $5.1 million, non-interest expense was below our normalized run-rate of $420 million to $425 million per quarter.

Total provision for credit losses, which included the provision for off-balance sheet credit losses, was $80 million for the first quarter, up $20 million from the fourth quarter. This increase in provision expense was driven primarily by accelerated deterioration in the homebuilder portfolio and higher-than-expected first quarter loan growth.

At quarter end, our capital levels were strong with our tangible common equity ratio at 7.42%. Share repurchases were negligible in the first quarter, consistent with our January forecast. We believe that capital preservation is our top priority with the current environment and that our capital strength is a competitive advantage. We will continue to manage our capital conservatively.

Now let me provide our financial outlook for the second quarter and the remainder of the year. We are in an uncertain operating environment with elevated risks. This makes financial forecasting performance more difficult than usual. We will provide our estimate from the second quarter and full year results based on the best information available to us today.

The forecast information I will provide is on a continuing operations basis and therefore excludes the gain on the sale of our insurance brokerage business that will be reported in the second quarter, as well as the related write-down of goodwill reported in the first quarter. These items, and all prior period operating results of the insurance business will be reflected in discontinued operations beginning in the second quarter.

On this basis, earnings per share from continuing operation were $0.89 in the first quarter of 2008. Our current forecast anticipates fed fund rate cuts of 50 basis points by the end of the second quarter, with no additional rate cuts for the remainder of 2008.

Our expectations for the second quarter earnings from continuing operations is $0.95 to $1.05 per share. On a sequential quarter basis, we expect net interest income to increase approximately 6%. We expect total average non-interest bearing deposits in the second quarter to increase about 1% to 2% versus the first quarter, with title and escrow deposits about flat.

Average total loans are expected to grow approximately 4% on a sequential quarter basis. We expect most of the loan growth in our C&I, commercial mortgage, and residential mortgage portfolios. Excluding the Visa gain recorded in the first quarter, we estimate non-interest income will increase approximately 6% to 8% on a link quarter basis.

We forecast non-interest expense of $410 million to $415 million for the quarter. This includes expenses of the insurance brokerage business. We estimate total provision for credit losses to be $60 million to $80 million for the quarter. We estimate an effective tax rate of approximately 33% for the second quarter.

Our second quarter forecast assumes approximately 138 million average shares outstanding and no material share repurchases.

For the full year, our range for earnings from continuing operations is $4.00 to $4.35 per share, with strong net interest income growth largely offset by the total provision for credit losses of approximately $225 million to $300 million. Our provision forecast reflects our assumption that we are in or are entering a recession.

I’m going to pass the baton to Phil. Phil.

Philip B. Flynn

Thank you, David. So this morning, I will provide more detail on our first quarter results and our outlook for the balance of the year. We are generating strong core earnings growth, driven by robust loan growth, stable deposits, and expanding net interest margin and disciplined expense management. Despite the large loan loss provision we took in the first quarter and our expectation for increased reserving throughout the year, we expect to achieve earnings per share in line with our original goals.

In addition to talking about our earnings expectations, I will as usual provide detail on our loans, particularly the homebuilders and the residential mortgage portfolios, as well as comment on the home sales and pricing situation in California and the general economy.

Loan growth was much stronger than expected this quarter, with average growth of 4.4% or $1.8 billion over the fourth quarter, or more than twice what we had anticipated three months ago. Growth was spread across the entire portfolio, with commercial loans up about $1 billion, commercial real estate mortgages up about $500 million, and residential mortgages up about $300 million. Commercial loan growth was well diversified.

In general, we are seeing the benefits of having a strong balance sheet and ample capital in this difficult period. Many of our competitors have been forced to substantially reduce their lending activities due to capital constraints, allowing us to grow while maintaining strict underwriting standards and attractive credit spreads.

For example, in the commercial mortgage lending business, we are experiencing a substantial backlog of new applications, while booking loans with average LTVs of less than 60% and debt service coverage ratios in excess of 1.4 times.

We also had encouraging deposit results this quarter. As expected, non-interest bearing deposits were about $500 million lower than the fourth quarter. However, interest-bearing core deposits were flat and we’ve expected a significant run-off. We have been very successful in managing down our interest costs on deposits without losing customers.

Net interest income was 5% higher than the fourth quarter, $21 million more than expected. For the second quarter in a row, our net interest margin increased to 354 basis points. The combination of loan growth, stable deposits, very well managed reductions in rates paid on interest-bearing deposits, and interest rate hedges were responsible for the increase in net interest margin and we expect to see an expanding net interest margin for the rest of the year.

We also continue to keep tight control over our expenses. We reported non-interest expense of $437 million. Excluding the non-recurring items mentioned earlier by David, our non-interest expense for the quarter was approximately $415 million, which was lower than the fourth quarter.

Given that our first quarter expense base is normally higher than our fourth quarter due to payroll taxes, we were very pleased with this. Between the strength of our net interest income and our expense control, core earnings were 7% or $15 million better than the fourth quarter.

I would now like to turn to the credit results we reported and discuss the $80 million loan-loss provision. And when I say loan-loss provision, I am including the off-balance sheet items.

We charged off only $12 million net in the first quarter, a low 11 basis points of total average loans. Our non-performing assets increased by $75 million to $132 million at quarter end, or only 30 basis points on the loan portfolio. The bulk of the non accrual increase came from five homebuilder credits totaling about $51 million. These credit results are significantly better than peer banks which have recently reported.

Despite these relatively strong results, we took a substantially larger provision than we had expected. There were several reasons we took this action. Our homebuilder portfolio experienced much more rapid downgrades than we had expected. Home prices on average in California deteriorated at a very rapid pace, with the median price of an existing home falling 14.1% in the first two months of this year.

The most dramatic housing corrections in California occurred in the inland areas, specifically Sacramento, the Central Valley, and the Inland Empire. Coastal urban areas are performing better due primarily to limited supply, greater affluence, and less prevalence of sub-prime mortgage products.

For example, in the Bay area, home prices declined about 5% in the past year through February, while in the Sacramento metropolitan area, prices were down nearly 31% in the same period, and still a significant inventory overhang remains.

In addition to the homebuilder loans, we are beginning to see some deterioration in other sectors of our commercial real estate portfolio, the construction and buildings material related sectors of the commercial portfolio and in small business loans.

We also believe that the economy is facing a significant slowdown and likely recessionary environment. And finally, we saw very significant loan growth in the quarter, with $2.3 billion of point-to-point growth to $43.5 billion at quarter end.

All of these factors encouraged us to take a conservative posture in reserving. In the past six months, we’ve added $140 million to our loan loss reserves and experienced only $15 million in net charge-offs; thus we are positioning ourselves for a tougher credit environment.

We believe that we have built a very resilient credit portfolio, to date clearly outperforming peer banks. Nonetheless, in the face of a difficult economic outlook and in particular an extraordinarily bad housing market, we want to be very well-reserved as we move forward.

Let me discuss in some detail what we see occurring with the homebuilders. We spent a lot of time this quarter combing through the portfolio to ensure that every loan and borrower was reevaluated and if necessary, regarded. We were conservative with our regarding, even in the face of significant sponsor support.

We have outstanding loans of $815 million, with total commitments of $1.4 billion. Outstandings were down by approximately $35 million and commitments were down by $200 million during the quarter. As I said, we moved five loans totaling $51 million to non-accrual.

Total reserves available for this portfolio now, both allocated and unallocated, are $133 million.

Geographically, the loan distribution continues to be about a third in the Bay area, about a third in the L.A. region, including the Inland Empire, about 10% in San Diego and the balance in other parts of California and out of state.

Our top 10 customers comprise about 50% of the portfolio and no single relationship comprises more than 10% of outstanding loans, and we have sponsor recourse on almost the entire portfolio.

Our residential mortgages of more than $14 billion continued to perform extraordinarily well in this environment, with only 43 basis points or $61 million of delinquencies, less than one-sixth the industry average.

We had only $18 million of loans in foreclosure at quarter end.

Vintage analysis shows delinquencies and foreclosures associated with the 2003 to 2005 period, the peak period, total about $37 million and $11 respectively.

We have a very strong pipeline in excess of $2.5 billion at quarter end but we have found that the fallout rate on these applications has increased to more than 40%, with many more declinations than we have previously seen.

We have been able to maintain strict underwriting guidelines and still book more than $900 million in loans.

New loans continue to mirror the whole portfolio with FICO scores over 740 on average, and LTVs of less than 65%. The residential portfolio remains geographically diverse with about 40% in the greater LA and Ventura region, about 20% in the greater Bay area, about 30% in San Diego and Orange County, and the remainder in the Inland Empire and Central California.

The HELOC portfolio has $2.5 billion outstanding and another $3.4 billion in undrawn commitments. The average FICO scores of these borrowers are about 740, with an average loan balance of about $62,000. The average LTV is about 60%.

Net charge-offs totaled 6 basis points compared to the year-end ABA average of 44 basis points. Total delinquencies were 39 basis points against a California industry average of about 200 basis points. The geographic concentrations are similar to the residential mortgage book. We continue to believe that we really don’t have a lot of problems in either of these two portfolios.

I would now like to discuss our outlook for the balance of the year. For the second quarter, we expect growth in net interest income of 6% for the first quarter, or about $30 million. This is being driven off of growth in average loans of about $1.8 billion, or 4%, and additional income from our interest rate hedges.

The loan growth during the quarter is expected to come from about $800 million in commercial loans, $500 million in residential mortgages, and $500 million in commercial mortgages.

Beyond the second quarter, we expect to see significant moderation of loan growth with another $800 million to $1 billion in total average growth in each of the third and fourth quarters.

So overall, we expect 2008 average loan growth of about 13% over 2007.

Regarding deposits, we anticipate the non-interest bearing deposits will grow about 2% in the second quarter, or about $250 million, while interest bearing core deposits will be flat. And for the rest of the year, we expect non-interest bearing deposits will grow by about $100 million and interest bearing core deposits about $200 million.

For the year, we expect net interest income to continue to grow beyond the second quarter as loan growth and disciplined deposit pricing, coupled with our hedge income will drive net interest income of about $144 million more than we expected when we gave guidance in January.

As a result of these factors, our net interest margin is expected to continue to grow during the year with margins in the 360 to 370 basis point range.

Turning to non-interest income excluding the insurance business and the non-recurring Visa gain, we expect non-interest income to increase about 8% in the second quarter and we expect to end the year very close to our original guidance. The non-interest expenses are expected to average about $410 million a quarter, which of course excludes the insurance business.

Our improving core earnings will serve us well as we face a difficult economic situation, particularly here in California. This economic outlook has caused to take a conservative view toward credit for the remainder of the year. We are anticipating loan loss provisions of $60 million to $80 million for the second quarter, and $225 million and $300 million in total for the year.

We expect charge-offs to begin to accelerate, which will drive the provision levels that we are projecting. We believe that these ranges are in line with an economy that either has or will enter a recession and will result in deterioration across the portfolio.

Our strong core earnings power will offset a great deal of the anticipated provisioning, leading us to forecast a second quarter EPS range of $0.95 to $1.05, and full year EPS of $4.00 to $4.35 on a continuing operations basis. Even in these unpredictable times, we continue to believe that on a continuing ops basis, we will achieve our goals of revenues which exceed those of 2006, positive operating leverage, a decline in efficiency ratio, and EPS growth without buy-backs.

Finally, I would like to spend some time on what we see happening in the California economy, where most but not all of our revenues and income are generated. California has been hit hard by the housing market slowdown, both in jobs and in housing prices and most dramatically, in the inland areas. California has lost almost 72,000 construction jobs in a 12-month period preceding February and another 40,000 jobs in the financial sector, principally in non-depository mortgage lending institutions. We lead the country in home price depreciation and foreclosures for the state were up 131% versus 60% nationwide, based on the 12-month period ending in February.

Given the uncertainties and lack of consensus in the financial markets about whether we have faced the worst or we are about to, we remain cautious in our outlook. Fortunately, we have the capital strength and the earning power to sustain us and allow us to continue to have positive results despite difficult times.

So thank you and we’d be happy to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We have a question from Andrea Jao with Lehman Brothers. Please go ahead.

Andrea Jao - Lehman Brothers

Good morning, everyone. With respect to commercial and commercial real estate, which are the drivers for loan growth in coming quarters, how much of a deterioration have you factored in? And what are the things you are looking at that give you confidence that these things will not go the way, or won’t deteriorate more than what you have factored in at this point?

Philip B. Flynn

Boy, I could talk about that for about a half-an-hour, Andrea, but I’ll try not to. First of all, you’ve seen us significantly increase our guidance for loan loss provisioning and we’ve done that based on an assumption that we are going to have deterioration beyond just the homebuilders and that it is going to creep in a more significant way into the rest of our commercial real estate portfolio and to some degree into other areas, like commercial loans and small business loans.

The loans that we are now putting on and obviously we are experiencing very strong loan growth, is of a very high quality. The fact that a lot of our competitors are out of the market means that we can be very picky about our underwriting standards and still book a significant amount of business. And I gave you the example of what’s going on in the commercial mortgage business. The conduits are out of business, the securitization market is dead. Some of the big lenders who were active in that market are essentially out of that business completely, so we are able to book extremely safe loans in the commercial mortgage book right now and grow it pretty much as much as we want. And in fact, we are actually limiting the growth to some degree right now.

On the commercial side, we are having very balanced growth across all of our areas. Obviously the energy business is doing extremely well and we are growing that significant, but likewise our core California commercial business is growing nicely too.

So we are generating a lot of loans but in a period of time when the competition is so much less, we are really able to get appropriate pricing and appropriate underwriting standards in place to book this stuff.

So we are very comfortable that we can grow this portfolio and that the outlook we’ve given you as far as reserving should cover a very difficult economic environment, and that’s why increased things so substantially.

Andrea Jao - Lehman Brothers

Great. Now on the homebuilder side, could you give us an idea or examples of what you are doing to work with stressed borrowers to contain or limit your losses?

Philip B. Flynn

Sure. Union Bank takes a view toward all of our markets and in particular the specialty markets like real estate that we need to be consistent through all the cycles. That is why you see us entering this cycle with the homebuilders, for example, having the lowest exposure of any of our peer banks. So we didn’t ramp up our lending business dramatically during the boom times of three years ago. We’ve been a steady lender throughout.

So we have a core group of borrowers we intend on supporting and working with through this crisis in order to help them get out the other end of it, help us get out the other end of it, and have the long-term customers into the future just like we’ve always had.

Not all of our homebuilder clients fall into that category clearly and in those cases, we are appropriately moving loans and relationships into our workout group where we will work out the credits using whatever means necessary, including if necessary foreclosure, et cetera.

To date, almost all of our sponsors at this point who have been able to, who have been asked to remargin loans, have done that. But clearly when we -- you’ve seen us move five loans into the workout area now and put them on non-accrual, the stress that is being caused by these dramatic home price declines is stressing some borrowers to the point where even if they want to try to remargin loans, they are just not able to.

Andrea Jao - Lehman Brothers

Thank you very much.

Operator

We have a question from Heather Wolf with Merrill Lynch. Please go ahead.

Heather Wolf - Merrill Lynch

Just a follow-up on the homebuilder portfolio; it looks like to date you haven’t taken much in the way of losses and it looks like if I calculate it correctly, you are about 16% reserved against it. I am curious if you can give us any kind of color on what kind of loss severity you expect and whether or not you think that reserve can cover it from here.

Philip B. Flynn

Sure. We have in fact taken no losses to date, which means that when you compare us to other peer banks who started taking losses two to three quarters ago, we’ve actually clearly entered this situation with a much higher quality portfolio than others.

That’s not to say we aren’t going to have some losses and we expect to start generating losses like this quarter and accelerating throughout the year.

We believe, Heather, that the provisions that we have set aside will cover the losses that we are going to incur in the homebuilder portfolio but I am not going to hazard a guess as to what those losses might be, other than to tell you that we’ve taken a very conservative view toward risk grading a portfolio and a very conservative view in reserving against it.

Heather Wolf - Merrill Lynch

Okay, and then on the C&I loan growth, can you give us any color on what portion of it was new customers versus increased utilization from old customers?

Philip B. Flynn

I was looking at a utilization report the other day. Overall the portfolio utilization has gone up about 1% to 2% in the past quarter or so, which doesn’t sound like a lot but on a portfolio this size, is somewhat significant. A lot of the growth though I believe is coming from new borrowings, either from new customers or from existing relations.

We had -- in the second quarter we had about $1.3 billion in C&I, about $400 million out of our petroleum, but about a couple hundred million out of power and utilities, and the rest spread out between national and commercial.

So I can’t tell you exactly how much of that was new customers or drawn or customers drawing down on their lines. We have not had much at all in the way of draws against back-up lines because customer were knocked out of the capital markets. That isn’t -- that really isn’t the sweet spot of our customer base.

Heather Wolf - Merrill Lynch

Okay, that’s very helpful. Thanks a lot.

Operator

We have a question from Steven Alexopoulos with J.P. Morgan. Please go ahead.

Steven Alexopoulos - J.P. Morgan

I am curious; when you stress test the residential mortgage portfolio, can you give us a sense of what type of price decline on average you think you could absorb before you see net charge-offs really start to increase in that portfolio?

Philip B. Flynn

It’s hard to answer the question that way, Steven, but let me try it this way -- what we are doing now on appraisals is assuming a bulk sale appraisal. So instead of in normal times where you would appraise a property assuming a certain amount of sales over a certain period of time and then discount back the cash flows generated, we are now appraising as if you were doing basically a fire sale, sell it tomorrow scenario. And that’s what is resulting in appraised values falling out of line with loan covenants, that’s what is trigger remargin calls, et cetera.

So the goal is to essentially reserve the -- grade the portfolio and therefore reserve the portfolio as if you were going to try to liquidate it right away, which of course results in very draconian reserving.

So trying to go the other way, as you asked, and what happens if home prices fall 10%, another 20%, that’s not -- that’s a little more difficult to try to answer.

Steven Alexopoulos - J.P. Morgan

Okay, and you were referring to the residential mortgage portfolio, not the homebuilder portfolio?

Philip B. Flynn

No, I was referring to the homebuilders.

Steven Alexopoulos - J.P. Morgan

Okay. My question was more on the -- just the residential mortgage portfolio.

Philip B. Flynn

I’m sorry. On the residential portfolio, as you have seen we continue to have incredibly good credit metrics and it’s been stressed now for what, 18 months probably? We’ve looked, for example, at that peak period of ’03 to ’05 when home prices were the most and we are not getting an unusually high percentage of our delinquencies. Of course, we hardly have any delinquencies in truth, but there is not any particular heavy weighting toward that end of it.

The fact is we still have had a lot of cushion underneath our loans and we continue now to generate new loans at lower prices using the same LTVs. So I have to tell you, we just don’t believe we are going to have a lot of problems there. We stressed this portfolio quite dramatically recently and we just can’t generate more than just a handful of losses out of it. You know, $5 million or something. It’s just not a significant number.

Steven Alexopoulos - J.P. Morgan

That’s real helpful. I just wanted to get a slightly better understanding on the provision guidance, the 225 to 300. Are you assuming an outlook where net charge-offs are up substantially over the next couple of quarters and that’s why you need that provision? Or are you anticipating you are going to continue to build the reserve?

Philip B. Flynn

You’ve seen us build the reserve a lot. We certainly expect to see charge-offs beginning to grow. At what point we are not building the reserve is hard to forecast. My guess is we will continue to build the reserve at least for another quarter and maybe beyond that before charge-offs rise to a similar level. But clearly embedded in that type of reserve forecast is a significant increase in charge-offs coming.

Steven Alexopoulos - J.P. Morgan

Okay, because I mean, we’ve been running here really minimal charge-offs, $10 million, $11 million, $12 million a quarter, so it’s reasonable over the next couple of quarters we could be up $50 million, $60 million of charge-offs.

Philip B. Flynn

I’m not going to guess.

Steven Alexopoulos - J.P. Morgan

Okay. Those are my questions.

Philip B. Flynn

If we do, we have built our reserves to deal with it.

Steven Alexopoulos - J.P. Morgan

Okay. Thanks.

Operator

We have a question from Todd Hagerman with Credit Suisse. Please go ahead.

Todd Hagerman - Credit Suisse

Phil, just a follow-up on the mortgage question; as you mentioned, the mortgage statistics for the company are just simply remarkable and one of the things that we have seen this quarter in particular is that many of your competitors started to see a fair amount of stress within what they believed were prime-based portfolios, if you will, in the market. What do you attribute the success that you are having, particularly if I think about the product mix that you have with you do have some in terms of the low doc, no doc type product but the fact that you have such high conviction that you are not going to see any meaningful stress within that portfolio, given what we are seeing from some of your competitors, what gives you that comfort or what can you point to that suggests that you’ve been that much more successful in recent years in terms of the underwriting?

Philip B. Flynn

It all comes down to we are underwriting people right up front with very strong credit, very good credit scores, significant income, significant debt service coverage. And on top of that then, we are being very disciplined and have been now for many years on making sure that those folks put a lot of equity into these homes that we are financing. That’s given us a lot of cushion but it’s also given a borrower profile of people who were not stressed going into their home purchases.

We’ve only got 41 loans in foreclosure, so we can actually -- it’s not real hard to open up the files and read what is going on. And what we are seeing is the usual life events that cause people to default -- divorces, maybe job loss, maybe illness, stuff like that. That’s what is driving at this point our foreclosures. It is not gee, I don’t have equity in the home anymore so here’s the keys. That’s just not what we are seeing and I know that we are an anomaly in the marketplace. I mean, I’m very happy we are.

But the fact is we’ve been through a lot of stress and strain here and we are just not having these problems that you are seeing with other institutions. We seem to have found the sweet spot of this market.

Todd Hagerman - Credit Suisse

And I’m assuming that again, just the terms of the product demand and the growth that we are seeing in the portfolio, that mix of product really hasn’t changed all that much?

Philip B. Flynn

Well, you know, the stated income stuff and no doc we’re not doing really anymore because of the non-traditional mortgage guidance that came out of the OCC, so that’s changed. But otherwise, as far as doing hybrid arms, that’s what we do. We are still generating the bulk of our production in that 31, 51 period, mostly 51 arms.

The other thing that is going on is we were never in the teaser rate business, so you don’t have a lot of rate shock going on in our portfolio and every one of our loans, our borrowers had the option to fix it at the time they come to a reset and some of them are taking advantage of that.

We’ve also got a situation where rates have come down a lot so there isn’t a lot of rate shock when rates are resetting. So although we were in this non -- unusual sort of product mix, the fact is it’s all about the borrowers and how much equity was in the homes.

Todd Hagerman - Credit Suisse

Okay, that’s terrific. And if I can ask just one final question, just switching gears a little bit -- just in terms of the non-accrual loans in the homebuilder segment, you know, as you’ve mentioned, you’ve been very aggressive in terms of risk rating, if you will. How are you thinking about now just in terms of with the risk rating guidelines that you’ve deployed with that portfolio and the special assets department, if you will, you’ve just moved on $51 million into non-accrual. How do you balance between being a secured lender against making that decision to place the loan on non-accrual at this stage of the game?

Philip B. Flynn

Well, it’s all really being driven by appraisal values at this point, so once we get to a point of view where we’ve triggered a covenant based upon appraised values, then we are turning to our sponsors and the guarantors and saying you need to remargin the loan. If they are able to do that and we feel that the sponsor has the willingness and ability to continue to support the loans, then we are tending to leave those on non-accrual -- I mean, I’m sorry, leave those on accrual.

But if someone is not able to pay or to remargin the loan or we are sensing that we are going to enter into a difficult negotiation, or we think that ultimately the sponsor is overly stressed and isn’t going to be able to support the loan much longer, then we are moving it to non-accrual.

Another way to think about this is we have downgraded almost three-quarters of this portfolio now. And what we are really doing now is looking at sponsor support as being the triggering decision between accrual and non-accrual, okay?

Todd Hagerman - Credit Suisse

Okay. And I’m assuming of the $51 million, I’m assuming actually part of that is or was performing?

Philip B. Flynn

Actually, let’s see -- we’ve got -- we moved $51 million of homebuilders to non-accrual this quarter and we moved one in the fourth quarter. And of those, there’s a total now of call it almost $70 million and about $30 million of that is actually still as of the end of the quarter, still current on their loan. But a little more than half of it is not.

Todd Hagerman - Credit Suisse

That’s helpful. I appreciate it.

Operator

We have a question from Lana Chan with BMO Capital Markets. Please go ahead.

Lana Chan - BMO Capital Markets

Good morning. I wanted to make sure I understood some of the guidance that you gave earlier, Dave. Did you say that the first quarter earnings from continuing operations when you back out the insurance was $0.89?

David I. Matson

Yes, I did, Lana.

Lana Chan - BMO Capital Markets

Okay, so if I look at the guidance for the second quarter and again, can you give us what the numbers are going to come out on the expense side? Is that 410 excluding the insurance business or including?

Philip B. Flynn

Yes, it is -- excluding it.

Lana Chan - BMO Capital Markets

Okay. And then the second question is can you give us your total loan exposure in the Inland Empire and Central Valley?

Philip B. Flynn

Total loan -- all sorts of loans?

Lana Chan - BMO Capital Markets

Yes.

Philip B. Flynn

No, I don’t have the number. I’m sorry, Lana.

Lana Chan - BMO Capital Markets

How about for just the homebuilder portfolio?

Philip B. Flynn

For the homebuilders, we only have two substantial borrowers in the Inland Empire, one of which is very strong and is already in the process of liquidating his inventory, so we don’t expect problems there. So our Inland Empire exposure that’s at any risk is quite small, probably I’m guessing $30 million-ish, probably. Maybe not even that much.

We really don’t have much at all in the Central Valley. I think we have one project in the Sacramento region and that’s it. So we have -- as I think you may have heard me say before, in financing homebuilders, we have tended to stick to projects that are near urban centers, near the coast, near job centers, and we haven’t done a lot in the outlying Inland Empire, or inland regions of the state.

Lana Chan - BMO Capital Markets

Okay. I appreciate the color. Thank you.

Operator

(Operator Instructions) We have a question from Julian [Castarino] at Prospector Partners. Please go ahead.

Julian Castarino - Prospector Partners

I was wondering -- it sounds like you are expecting some very nice asset growth, loan growth. I was just wondering about the tangible capital ratios ending the quarter at 7.42%. How low would you feel comfortable taking that down to?

David I. Matson

We have operated within the range of 7% to 8% and we are pleased that we are at a higher range and that the range between 7% and 8%, 7% is still quite a bit north of our peer group.

Julian Castarino - Prospector Partners

Okay, and the tier one ratio went up sequentially but the tangible -- equity to tangible app ratio went down sequentially. I was just curious; I know that’s not unusual per se but I was just curious if you knew why that would have happened?

David I. Matson

That’s the function of the reserve adding in.

Julian Castarino - Prospector Partners

Okay. Great. Thank you.

Operator

We have a question from Andrea Jao with Lehman Brothers. Please go ahead.

Andrea Jao - Lehman Brothers

With respect to the insurance business, I was hoping to get a little more detail on how much revenues would come off and I assume that’s from the insurance commission lines, and how much in terms of expenses, and again I assume that’s on -- in terms of the employee costs would come off on a quarterly basis, on a per quarter basis.

Philip B. Flynn

We had about $17.4 million of insurance commissions in the first quarter. The expense base is expected to run very close to that throughout the year, so frankly it’s about a wash.

Andrea Jao - Lehman Brothers

Okay.

Philip B. Flynn

Revenues and expenses are about equal to each other throughout the balance of the year, so it actually has a very beneficial impact on our efficiency ratio.

Andrea Jao - Lehman Brothers

Okay. And then hoping to get your thoughts behind the sale of the insurance business, because I could be mistaken but I was under the impression this is one of the businesses that you were hoping to grow going forward.

Philip B. Flynn

Well, we were hoping. We bought a series of brokerages going back what, four or five years ago, integrated those companies, had a management team that did a terrific job of managing those businesses through very difficult times in the insurance market -- the insurance brokerage business has been really tough the last several years, so they’ve managed to keep expenses in line and run a very good business. It just didn’t seem like it was going to be one that was going to be able to meet our expectations for returns.

So we found a great partner in BB&T who is very big in that business, as you know, who wants to expand in California, who is very experienced in running insurance companies, and we’ll enter into a -- we’ll be entering into a referral arrangement with them so that our customers still have a place to go that we are very comfortable with. So it just seemed like the right thing to do for both us and the people in the company, and hopefully it will be a very successful transaction for BB&T as well.

Andrea Jao - Lehman Brothers

And you get referral fees and that means the insurance commission line does not really go to zero, right?

Philip B. Flynn

Yeah, I don’t know how significant that will be, Andrea, to tell you the truth. The other thing you’ve seen us do, you’ll recall that we sold our record keeping business last year. We are really -- we want to and need to grow our non-interest income but we really want to be very focused on how we are doing that and put our management attention and resources into businesses that are probably more closely aligned to our core businesses. And that’s why you saw us shed these two businesses.

Andrea Jao - Lehman Brothers

Shedding the insurance business, will this have a noticeable impact on capital?

David I. Matson

Andrea, with this transaction we are going to add, by reducing the amount of goodwill, we are going to end up adding approximately $100 million of additional capital.

Andrea Jao - Lehman Brothers

Great. Thank you so much.

Operator

(Operator Instructions) We do have a question from Robbie [Schaufer] with [Samlin] Capital. Please go ahead.

Robbie Schaufer - Samlin Capital

There are a number of different EPS numbers here so I just want to make sure I have them clear in order -- the $0.89 that you guys refer to as the continuing ops number for Q1 excluding the insurance business, is that apples-to-apples with the $0.81 or the $0.79? And then, if you could just explain what the delta is to get to $0.89, that would be great.

David I. Matson

Well, the $0.89 is the -- without the insurance business and then the forecast for the rest of the year is without -- is a continued ops, so that compares to the $0.89 that we have. And if we go down to the adjustments that we are talking about, that includes the project Indigo which [inaudible] the insurance as well as the Visa gain and the litigation reversal.

Robbie Schaufer - Samlin Capital

Okay. I guess I just thought that the insurance business was roughly break-even, so I wasn’t clear on what the difference was between I guess the $0.81 and the $0.89 then. Is that the gain on the sale of the business that is being included, or is that something else?

David I. Matson

The first quarter, and it’s in the press release, there is a write-down and then when we had the sale, we had a gain and so the net was about $5 million negative.

Robbie Schaufer - Samlin Capital

Okay. And then the guidance of $4.00 to $4.35, that includes I guess -- is it $0.79 for Q1 or the $0.89 for Q1?

David I. Matson

That includes -- that’s a good question. The full year includes the Visa in there, so that’s -- because that’s a part of our continued operations.

Philip B. Flynn

So it includes the $0.89.

David I. Matson

Yes, exactly.

Robbie Schaufer - Samlin Capital

Okay, and one last question -- I think you made reference to net interest income being about $140 million better than you initially expected. Is that all due to margin expansion or also earning asset growth during the course of the year?

David I. Matson

Well, that’s a combination of a lot of things. It is the asset growth, it is the hedge income that we have in there, it has the rest of the moving pieces, lots of little ones in between.

Robbie Schaufer - Samlin Capital

Okay. Thanks a lot.

Philip B. Flynn

It’s mostly loan growth and net interest margin expansion is what is driving that.

Robbie Schaufer - Samlin Capital

Thank you.

Operator

You have a follow-up from Julian Castarino with Prospector Partners. Please go ahead.

Julian Castarino - Prospector Partners

Thank you. How much in trust preferreds do you have in your capital structure?

David I. Matson

Very little.

Julian Castarino - Prospector Partners

Okay, so if you needed more capital, you could issue trust preferreds for the --

David I. Matson

I think what’s really key is that when you look at our capital, it’s extremely high quality because most of it is common. So we could leverage out the trust preferred. We could leverage out on subordinated debt as well. So it’s a -- while it looks high, it actually is very leverageable, so it could be even higher.

Julian Castarino - Prospector Partners

Okay. And the -- you mentioned the insurance sale will add $100 million in capital. That’s after tax, right?

David I. Matson

Yes.

Julian Castarino - Prospector Partners

Okay, and so I was just -- what does intangible -- does it change the intangible asset that ended the quarter at $447 million?

David I. Matson

I’m going to ask David Anderson to answer that.

David Anderson

The intangible assets will go down about $80 million in the second quarter.

Julian Castarino - Prospector Partners

Okay, they’ll go down by $80 million. Okay.

David Anderson

With the sale of the business.

Philip B. Flynn

Upon the close of the sale of the business. We’ve announced the intention to sell -- let’s make sure we keep that in mind.

David I. Matson

Very good point, Phil.

Julian Castarino - Prospector Partners

Okay, so it looks like pro forma tangible capital ratio of around 7.57%.

Philip B. Flynn

You know, we don’t want to do math on the conference call, sorry.

David I. Matson

If you can follow that up with Jack, that would be great.

Julian Castarino - Prospector Partners

Okay. All right, thank you.

Operator

Mr. Rice, there are no further questions at this time. Please continue.

John Rice Jr.

Okay, well thank you all for joining us and thank you for your investor interest. Any follow-up questions can be directed to me. Have a good day.

Operator

Ladies and gentlemen, this conference will be available for replay after 10:30 a.m. today until May the 1st at midnight. You may access the AT&T executive playback service at any time by dialing 1-800-475-6701 and entering the access code 918373. International participants may dial 1-320-365-3844. And again, those numbers are 1-800-475-6701 and 1-320-365-3844, with the access code 918373. That does conclude our conference for today. Thank you for participating and using AT&T executive teleconference service. You may now disconnect.

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Source: UnionBanCal Q1 2008 Earnings Call Transcript

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