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Zions Bancorp. (NASDAQ:ZION)

Q2 2012 Earnings Call

July 23, 2012 5:30 pm ET

Executives

James R. Abbott - Senior Vice President of Investor Relations & External Communications

Harris H. Simmons - Chairman, Chief Executive Officer, President, Member of Executive Committee and Chairman of Zions First National Bank

Doyle L. Arnold - Vice Chairman, Chief Financial Officer and Executive Vice President

Analysts

Jennifer H. Demba - SunTrust Robinson Humphrey, Inc., Research Division

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

John G. Pancari - Evercore Partners Inc., Research Division

Paul J. Miller - FBR Capital Markets & Co., Research Division

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Ken A. Zerbe - Morgan Stanley, Research Division

Brian Klock - Keefe, Bruyette, & Woods, Inc., Research Division

Arjun Sharma

David Rochester - Deutsche Bank AG, Research Division

Joe Morford - RBC Capital Markets, LLC, Research Division

Stephen Scinicariello - UBS Investment Bank, Research Division

Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division

Marty Mosby - Guggenheim Securities, LLC, Research Division

Operator

Good day, ladies and gentlemen, and thank you for standing by, and welcome to the Zions Bancorporation's Second Quarter Earnings Call. This call is being recorded. And now I'll turn the time over to James Abbott. Sir, the floor is yours.

James R. Abbott

Thank you, Hewey. Good evening. We welcome you to this conference call to discuss our second quarter 2012 earnings. Our primary participants today will be Harris Simmons, Chairman and Chief Executive Officer; and Doyle Arnold, Vice Chairman and Chief Financial Officer.

I would like to remind you that during this call, we will be making forward-looking statements, and that actual results may differ materially. We encourage you to review the disclaimer in this press release -- in the press release dealing with forward-looking information, which applies equally to statements made during this call. A copy of the earnings release is available at zionsbancorporation.com. We will limit the length of this call to 1 hour, which will include time for you to ask questions. [Operator Instructions] I will now turn the time over to Harris Simmons.

Harris H. Simmons

Good afternoon, good evening to all of you. Thank you for joining us today to review our second quarter earnings. We were encouraged with a variety of elements of the quarter's results with the exception of the effects of the current interest rate environment on all banks, while things continue to improve. We're pleased with the significant progress with regard to credit quality, virtually all of the major indicators of credit quality continue to improve and did so in a meaningful fashion this quarter.

We're also able to generate a healthy degree of loan growth, and we can see that continuing in the early innings of the third quarter. And our current expectation is for that growth to continue into the foreseeable future.

Finally, noninterest expense, as related operations were generally stable. We had a slight increase from the prior quarters, which is ascribable to the provision for unfunded loan commitments, which in turn, is primarily due to an increase in loan commitments by about $400 million during the quarter. And I think that help sets the stage for some further improvement in loan growth and will help to stabilize revenue and eventually to help us increase revenue.

Offsetting some of the positive news was a decline in net interest income, which was largely expected due to pressures on new loan yields, compared to maturing reprising loan yields. Additionally, the decline in loans late in the first quarter adversely affected net interest income in the second quarter.

Our guidance has been, for net interest income, to be stable to slightly lower over the course of the year and in the course of the coming year. One of the drivers of growing net interest income will be an improvement in small business lending, which is a-- recently a significant part of what we do.

The smallest differences in our economy are still reasonably slow to emerge from -- with recession. Some of the indicators of their optimism are flagging somewhat and we're not currently expecting strength in this segment in the third quarter. We were still seeing quite a lot of strength from middle market and larger-sized commercialist borrowers, and some improvement in consumer lending as well.

I'm encouraged by the improvement in all the major areas of credit risk. As I indicated the -- first of all, nonaccrual and classified loan inflows dropped significantly in the second quarter, a sign that the balance sheets and cash flows of our customers are improving at a healthy pace. Secondly, the past due, nonaccrual and classified loans, other real estate-owned and TDRs all improved materially compared to the prior quarter. It should support our expectation for continued reduction in net charge-offs.

Finally, net charge-offs declined meaningfully. As you've seen in the release, it fell to an annualized 47 basis points, assisted by both an 8% sequential order decline in gross charge-offs as well as a 19% increase in recoveries.

Based on the strength of our affiliate banks' earnings, which were an annualized $543 million after-tax in the second quarter and the aforementioned continued improvement in credit quality, we remain quite comfortable about our prospects for redeeming the final $700 million installment of TARP preferred stock in the second half of the year. This will result in further earnings per share savings of about $0.26 annually.

So with that brief overview, I'm going to turn the time over to our Vice Chairman and Chief Financial Officer, Doyle Arnold, to review in a little more detail the quarterly performance. Doyle?

Doyle L. Arnold

Thank you, Harris. Good afternoon, everyone. Good evening to those of you on -- in the Eastern Time zone. As noted in the release, we posted net income applicable to common shareholders of $55.2 million or $0.30 per diluted common share for the quarter. As we've done in past quarters, we've also presented to you the earnings in a way that excludes the noncash sub debt amortization costs and the FDIC loan discount accretion. We believe this information is useful to longer-term-oriented investors as we don't expect those income and expense items to be with us in the perpetuity. And on that basis, the earnings available to common were $0.40 per share.

A little more on credit quality. As Harris mentioned, we made strong progress, in the quarter by significantly reducing problem credits, and we expect continued improvement in the second half of the year. As shown on Page 12 of the release, that's one of the tables, page number there in the other upper left corner. Compared to the first quarter, classified loans declined more than 9% as did the nonperforming lending-related assets. Our TDRs declined by more than 8%, and delinquent accruing loans declined by 14%. The rate -- the ratio of nonperforming lending-related assets fell to 2.5%. That's quite a declined from 4.1% just a year ago.

Within the loan categories, as shown on Page 14, it's noteworthy that construction nonaccrual loans have fallen to only $115 million, about half the level of just 6 months ago, and down by 2/3 from a year ago. This is the category that drove about half the company's cumulative credit losses during the last few years, but we're now experiencing a bit of a reversal of fortune there. Problem credits are down, and we're experiencing actual strength in construction origination volumes.

Note that for the first time in about 4 years, C&D lending was not a drag on net loan growth this quarter, as C&D volumes were flat compared with the prior quarter. We've been suggesting for some time now that we thought that, that would happen around the middle of this year. We're wrong on enough things, and I'll take some pleasure in pointing out that we were right on this one. And we do expect, based on what we're seeing, that we may have hit the bottom in aggregate C&D loans outstanding.

As Harris mentioned, we're also pleased to report that annualized net charge-offs fell below 50 basis points of average loans for the quarter, and we expect a similar or further -- even a further decline in the next quarter.

On a related note, the $11 million provision or about $0.04 a share was roughly similar to the prior quarter's provision and was within the band of our expectations. Despite the improvement in our own portfolio credit metrics, we continue to exercise caution with regard to the appropriate level of the loan loss allowance, given the ongoing weakness both in Europe and in as exhibited by numerous U.S. macroeconomic indicators in recent months that have mostly consistently been coming in weaker or below expectations.

Within the noninterest expense line, you'll see the provision for unfunded lending commitments was a positive $4.9 million compared to a negative $3.7 million last quarter. That's a swing of about $0.02 a share, a negative impact on EPS. But the primary reason for the difference was a strong increase in mid-loan commitments for the second quarter. The commitment growth in the second quarter was skewed toward loans that should experience significant draws over the next several months in higher utilization rates. Therefore, while this provision for unfunded lending commitments was a near-term negative earnings this quarter, we're optimistic with the long-term outlook for revenue generation from this factor over the next few quarters.

Moving on to other revenue drivers. We were reasonably pleased with the amount of loan growth, and it was relatively broad-based. Geographically, 6 of the 8 affiliate banks increased loans outstanding, most of them to a meaningful degree. Pricing on new and renewed loans did compress somewhat again this quarter. However, the spread over mass maturity costs of fund is still within the range of historical norms. It's roughly similar to what we saw in 2006, 2007.

Let me take a couple of minutes and run through some growth statistics on a few of the banks as we typically get a few questions about this in the Q&A session anyway.

Starting with Zions Bank, which covers Utah and Idaho, loans grew in the aggregate of nearly $100 million, driven by C&I and term CRE, partially offset by the continued planned decline in owner occupied and construction and development in this market.

California Bank & Trust experienced healthy growth in more than $70 million, which included growth in C&I, municipal, residential mortgage and construction. Again, partially offset by owner-occupied declines and the ongoing reductions in the loans acquired with FDIC from failed banks, which continues to proceed at pace.

Our National Bank of Arizona affiliate experienced strong loan growth of more than $45 million, again with growth in C&I. But there are also some growth in owner-occupied and residential mortgage, partially offset in Arizona by a decline in term CRE.

In Amegy, which is, the preponderance of which is in Houston and some Dallas and San Antonio exposure, experienced growth of more than $30 million, occurring to earning an owner-occupied leasing residential mortgage, partially offset by a decline in C&I construction and term CRE.

Moving into loan growth by product type on Page 11 of the earnings release, I'll highlight a couple of trends. Overall, despite some ups and downs that I just mentioned, C&I loans increased 2% sequentially, and have continued to grow through the first 3 weeks of the third quarter.

Pricing on our C&I production narrowed compared to prior quarters when we're generally holding our credit underwriting standards firm. Although in some markets or product types, there's been some softening in some elements such as extending length of maturity.

Within C&I and owner-occupied loans, both of which are underwritten with the cash flows of the business as the primary source of repayment, we've seen the strongest growth within the mining and energy industries, while construction-related -- while C&I loans related to construction activity and companies within the consumer goods and services interest -- industries have declined.

As we've discussed in the past, the decline in owner-occupied loan portfolio is largely attributable to decisions made several quarters ago as a part of our concentration and risk management efforts to selectively reduce certain aspects of our exposure in our National Real Estate business. Much of this is the SBA 504 loan product. We expect several hundred million dollars of further contraction in this portfolio before it stabilizes, and expect that stabilization will occur some time around mid-2013. This attrition will pressure the overall trend in owner-occupied loans. For a more comprehensive discussion on this, you can refer to the transcript from last quarter's call or our last quarter's 10-Q.

Construction and development loans were flat compared to the prior quarter, and we actually do expect some growth in this category over the next several quarters. As previously booked, new construction commitments began to fund as construction commences. Most of the new construction loan commitments are in Class A apartment buildings.

Single-family residential development project in some markets, particularly, coastal Southern California are strengthening and our commitments are now growing. Although, relative to historical growth rates we have described, demand for such loans is relatively modest at this point. Pricing on the C&D production has been fairly stable over the last 6 months.

Term CRE loans declined modestly, driven by paydowns and pay-offs, while new production volume also increased modestly. Within the category, pricing narrowed at our largest banks.

Multifamily lending continues to be the largest growth category or strongest growth category, up to about 10% annualized growth in the last 6 months. Industrial properties have also enjoyed strong growth, but remain a small element of our portfolio.

Term CRE loans collateralized by hotel and land continue to decline, down about 15% and nearly 30%, respectively, on an annualized basis.

Within consumer lending, residential first mortgages grew nearly 15% annualized in the quarter, and this growth was pretty widespread geographically. Pricing narrowed about 25 basis points on production, but that's approximately in line with industry pricing compression due to the pretty well-publicized decline in longer-term rates.

Turning to the margin. On Page 15, we'll note that the GAAP NIM compressed by 11 basis points, while the core NIM declined by 9 basis points. As a reminder, the core net interest margin address -- adjusts for items such as the sub debt conversion, expenses and accretion on acquired loans as reconciled on Page 16 of the release. About 6 basis points of the core NIM compression was due to the issuance of senior debt late in the first quarter, which was on the books there for all of the second and additional debt issuances in the second quarter. Subsequently, depositing net cash in low-yielding short-duration cash accounts namely, our Fed account, with the anticipation that we will use that cash for TARP redemption later this year.

The loan yield compression of 10 basis points from -- to 5.07% from 5.17% last quarter in both cases, excluding FDIC-supported loans, were attributable to the same factors we've discussed in the past, which are one, adjustable rate loans resetting to lower rates as the repricing index is lower than it was several years ago, generally 5 years ago when the loans were booked; and two, maturing loans, many of which had rate floors are replaced with new loans that lower coupons -- or lower floors compared to loans originated when spread were higher.

Yield on the loan portfolio compressed a bit more than in the prior quarters due in part to the pricing competition on commercial loans and a slight mix shift towards lower-yielding residential mortgage loans held for assessment.

We estimate that the net interest margin will be undergoing pressure due to these forces -- undergoing -- will be on under ongoing pressure due to these forces, assuming a static balance sheet. There are additional factors that drive NIM compression and expansion, of course. For example, in the third quarter, there'll be incremental pressure from the debt issuance during the second quarter, which will be on the books most of this quarter, if not all of it, as well as some added pressure from higher prepayment speeds from longer-term loan products such as residential mortgages or resets to lower rates, on adjustable rate loans.

It's worth noting that Zions' residential mortgage portfolio is about half the concentration of the industry, thereby reducing, but not eliminating prepayment risk. Additionally, while we've talked about this repeatedly at various conferences, I again remind you, we have the smallest relative exposure to mortgage-backed securities of all regional banks.

Potential offsets to margin compression would be loan growth, as we would simply use available cash currently on deposited of Federal Reserve to fund the loans. Some continued reduction in the cost of interest-bearing deposits, which declined 4 basis points this quarter. Also TARP repayment would reduce cash assets by $700 million, thereby lifting the margin itself by about 4 basis points, as well as reducing the drag from preferred dividends, as Harris mentioned earlier.

Finally, our balance sheet remains quite asset-sensitive. We're in upward parallel shift in the yield curve of 200 basis points. We would estimate to have a positive effect on net interest income by more than 10%.

Turning briefly now to noninterest income. On Page 10, there are 2 items worth highlighting. Other service charges, commissions and fees increased about $4 million from the prior quarter. We believe that this quarter's rate was closer to a run rate. The prior quarter's level was low because of relatively low loan origination volume, which as we noted, has increased this quarter. And the increase in second quarter is almost entirely due to the higher origination and lower loan referral volumes this quarter.

Our current expectation is for the second half of the year, new originations based on pipelines that we see should be similar to, or if not, exceed the second quarter's volumes. So this fee income line should remain relatively strong.

Dividends and other investment income increased primarily due to several small gains from various equity investments including private equity fund investments in Amegy, and which in turn, were primarily attributable to the energy sector. Such equity returns are and will continue to be volatile.

Just a few points on capital. GAAP tangible common equity, was essentially unchanged at 6.9%. The common equity Tier 1 ratio increased to an estimated 9.77% from 9.71% in the prior quarter. Regarding Basel III ratios under the proposed rule published a month or so ago, and which is still out for comment, there are several new provisions in that rule, which may reduce our fully phased-in estimate for common equity Tier 1 to a bit below 8%, maybe 7.75% area, as investment bankers would say. It's a bit lower than our previous estimates of around 8.2%, but the changes primarily impacting us relate to unfunded commitments less than 1.5 years receiving a risk weight. The risk weight increasing on past due, nonaccrual loans and some of the change -- changes in the treatment of 1-4 family residential mortgages.

Given some of the uncertainties around what the final rule will look like, we'll probably not going to publish a firm estimate of that common equity Tier 1 ratio fully phased-in until the rules are final, but to give you a bit of guidance, we think something under 8%, probably in the 7.75% area is a reasonable estimate at this time.

Guidance for the next few quarters, and we'll wrap up and turn to your questions. Loan growth, as we have said a couple of times on the call, we expect moderate organic loan growth in the second half of the year, perhaps somewhat stronger than the first half certainly, but perhaps even a bit stronger than that of the second quarter.

Net interest income, we expect to decline somewhat in the second half due to the previously discussed debt issuance and loan yield compression. We do not anticipate purchasing a large quantity of bulk loans or securities to enhance the net interest income in the near term. We have purchased a small amount of securities in an attempt to prevent our assets sensitivity from growing even larger. Philosophically, we continue to view the associated interest rate risk to be asymmetrical, and note that convexity risk can destroy equity just as well as credit risk if rates rise significantly.

Furthermore, with the Basel III rules on AOCI affecting regulatory capital ratios, the costs of convexity risk is even higher than previous rising rate cycles unless we'd like to avoid that.

OTTI on the securities portfolio, in general, it should remain low as fewer banks are failing. More are recovering, including deferring banks resume -- resuming payments of trust preferred dividends. Our models has been quite conservative at predicting failures. Offsetting the trend maybe faster bank prepayments of trust preferred securities, which as we have described before, diverse cash into the senior tranches that we own, potentially improving AOCI and generating fixed income gains, but removes future cash flow from the mezzanine tranches, which potentially results in additional OTTI.

We expect the net effect of these 2 trends to be accretive to tangible common equity over time, although they may not perfectly offset each other in the same quarter. Some of you have inquired about the section within the Fed's Notice of Proposed Rulemaking that disqualifies trust preferred as Tier 1 capital for small banks, as well as the Dodd-Frank required exclusion for banks $15 billion or greater in size. If the rule is adapted as currently as proposed, we believe it probably would result in some increase in prepayments fees, which would theoretically result in higher OTTI, but an improved AOCI mark, which would be net accretive to our capital ratios and book value per share. However, we do not expect all banks to redeem their trust preferred as a result of this rule because for some, given current conditions, it may be for a time at least relatively inexpensive Tier 2 capital even as it no longer qualifies for Tier 1. So to give you more firm guidance there, we'll have to wait for the final rule of the phase-in period and actual observable behavior on the part of these banks.

Noninterest expense in the near-term should be generally stable, perhaps slightly lower driven, again, primarily by credit cost improvement in the credit expense line that we've broken out for you in that section.

Provision expense, we expect to remain low, continued reduction in problem credits and the ongoing improvement in loss severity rates continues to have a potential to result in the negative provision in some quarters, but loan growth may offset this.

And finally, our preferred stock dividends in the near term, I'd remind those of you building your models, that we expect to redeem the remaining $700 million of TARP preferred stock either in the late -- late in the third or in the fourth quarter. This event, when it occurs, will trigger a onetime accretion of the discount related to warrants that was associated with the TARP.

As of June 30, the rate remaining discount was $17 million, which will be recorded as a preferred dividend in the quarter, in which we do repay TARP. The regular TARP dividend embedded in the preferred stock dividend in the second quarter was $12 million from the $700 million of TARP remaining, and that would be eliminated upon redemption. Aside from TARPn effects, the deferred stock dividend would decline slightly in the third quarter due to the redemption of our Series E preferred, which had an 11% coupon and replacing it with the new Series F, which has a 7.9% coupon.

With that, operator, if you would open up the line for questions. We will try to respond to them for the next 30 minutes or so.

Question-and-Answer Session

Operator

[Operator Instructions] Our first questioner in queue is Jennifer Demba with SunTrust Robinson.

Jennifer H. Demba - SunTrust Robinson Humphrey, Inc., Research Division

Just curious with the challenge in growing net interest income over the next several quarters, what the primary levers you see to grow earnings are, exclusive of provisioning going forward.

Doyle L. Arnold

Well, I think the preferred dividend that I mentioned is probably the biggest single change that will occur over the next couple of quarters. Aside from that, it's going to just be continued basic blocking and tackling and striving for loan growth. There are no magic levers to pull. We have to be disciplined about deposit pricing, aggressive about contacting customers and potential customers, but also disciplined after loans, but also disciplined about pricing those loans. I don't think there any silver bullets out there.

Jennifer H. Demba - SunTrust Robinson Humphrey, Inc., Research Division

You sensed that you guys are being relatively more disciplined in terms of loan pricing than some of the competitors you're going up against for the last several months.

Doyle L. Arnold

I would say we've tried to be disciplined, but it's darn hard. And you have to -- at some point, you have to meet the competition for good quality loans for customers you have or being calling on for a long period of time. So I think we're doing what we have to do to retain market share and very selectively grow. We're trying not to discount loans just for the sake of achieving a lot of loan growth.

Operator

Our next questioner in queue is from Steven Alaba (sic) [Steven Alexopoulos] with JPMorgan.

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

I wanted to start, regarding the pro forma Tier 1 Doyle gave, the 7.75% under the new rules. When you look at the rules and think about what you could do between now and when the rule's get adopted, I know they might change. How much worth of room do you think you have to improve Tier 1, right? You might be able to little change where you do a commitment, et cetera. Just wondering if you could band what that might look like.

Doyle L. Arnold

Well, the phase-in period is relatively long, and the biggest single impact is one we've talked about, it's nothing new. It's been in the kind of the proposal, the Basel committee itself without, and that's the AOCI. As it -- and that's, by far, the biggest single impact in the change from Basel I rules to Basel III rules for us. And as we discussed, all the trends in -- that we're seeing in the CDO portfolio would suggest that the AOCI mark should moderate over the next few quarters and through the years during the phase-in period. So there's a lot that can happen between where we are now and the full phase-in rule with regard to that number. Similarly, the deferred tax asset that requires future profitability towards realization, which is much, much smaller than the AOCI mark rule gets smaller as basically as NOL carryforwards are used up. And as we remain profitable, that too should happen. With regard to, I guess, the other thing -- the next bigger ones and one of the newer ones is the change in the risk weightings on basically nonperforming loans. And as those continue to come down, the impact of that number should come down. The 2 that probably are subject to a little more management discretion are kind of what we do in the way with residential mortgages and with unfunded commitments. You certainly don't want to stop making commitments but it -- one might look at the pricing of those commitments that are under a year. And with regard to residential mortgage, we have some unique -- I wouldn't say they're unique, but we have some products here that we think are very conservatively underwritten that get caught up in the full amortization rules that get them into a higher risk weight bucket. We need to look at those products, and how we price of them or design them to see if with some tweaks, they're still good products that have less risk-weighted impact. But we haven't started to do that yet. It's too [indiscernible]. Is that helpful?

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

Yes, that's actually really helpful. Maybe just a quick follow-up. Looking at the core loan yields down around 10 basis points quarter-over-quarter, given the competitive environment, is this the quarterly pressure we should be thinking about? And maybe can you talk about where your loans were added in the portfolio in the quarter?

Doyle L. Arnold

Yes. I mean that's probably reasonably reflective of what we're seeing out there. The -- and we've talked about the kind of the ongoing pressures of -- it's harder to get floors that margins over -- or spreads over indices have been under some pressure. That's -- it's probably realistic to think that, that loan yield will -- that, that's a new benchmark, but that further decline should layer because those can take -- those pressures continue to impact each quarter's new production or resets as in order. Now, I went to quite a lot of detail in the prepared remarks about where the loan growth came from and by loan type and by geography. Was there a specific area that you wanted to focus on? Or if it was a more general question, maybe you can follow up with James afterwards, so I don't repeat all of that.

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

No, I was just thinking, Doyle, on the blended basis is where you're adding new loans into the portfolio today.

Harris H. Simmons

One thing I have noticed, I mentioned the fact that smaller business loans -- I mean, we're just not seeing a growth there, than what we're seeing in some of the larger deals. The larger deals tend to have skimmed the pricing. So I think to the extent that we see a pick-up on the smaller end of the market that, that should incrementally help us grow.

Doyle L. Arnold

And I would just add, Steve, as well on that topic is with -- on the C&I , which is about half of our production volume, the large loans priced about 75 to 100 basis points thinner than the small business loans. So you're getting some difference in quality, maybe a borrower has got a more diversified business model, but pricing is fewer on the pricing side.

Operator

Next question in queue is John Pancari with Evercore Partners.

John G. Pancari - Evercore Partners Inc., Research Division

In terms of your margin outlook, I know you implied some incremental pressure here, I guess along the lines of the loan yield color you just commented on, is it fair to assume that, to help quantify that margin pressure that we should assume that it could be close to what you saw this quarter for the next couple of quarters?

Harris H. Simmons

On the loan yields?

John G. Pancari - Evercore Partners Inc., Research Division

The impact on the overall margin.

Doyle L. Arnold

Well, the floor, the kind of the minimum that we see is about 5 basis points, and that's just due to the rate resets and the expiration of floors. So it's not going to be less than that for the next several quarters. And probably what we saw this quarter is about the upper bound if that's just a guess, that's somewhere between 5 and 10 for the overall weighted average.

Harris H. Simmons

Again, one thing that probably we should clarify here is, is when we're talking about this, we're talking on a static balance basis. So if the balance sheet, if we get loans by $300 million or $400 million in the third quarter, that will have an offsetting effect of that. But on just a static balance basis, we would expect about 5 basis points of yield compression on the loan portfolio in the third quarter, assuming no production whatsoever. So the new production will come on and have an incremental effect.

Doyle L. Arnold

To get to the overall margin, there are a number of things we -- I think for 6 quarters now probably one or more of you have been asking us when are you going to hit the bottom on deposit pricing. Well, we still managed to lower the cost of deposits 4 basis points this quarter and there's probably still a bit more to go. We -- the kind of the buildup of debt and cash associated with stockpiling money to repay TARP is an unusual effect that will go away in, late this quarter or in the fourth quarter when we do repay TARP. So I don't want you to come away with a focus on loan pricing, and get 5 to 10 basis points, and say that's the margin compression. There's going to be margin compression, but it's -- there are offsetting and other factors besides that.

John G. Pancari - Evercore Partners Inc., Research Division

Okay. All right. And then as a follow-up, can you talk a little bit about where you see your normalized loan loss reserve level falling out? I mean you're at 270 basis points right now relative to the loan book. So can you just give us a little bit of color on how much more downside you see there?

Doyle L. Arnold

If I knew the -- what the accounting rules and the regulatory rules were going to be 3 years from now, I'd give you a pretty good idea. But I don't know and none of us knows, and you don't know. So it's a question that has no answer. I know you want to know it, but those who are giving you an answer, I think, are making one up, because I don't know how to answer the question. All I can tell you is that we're going to be cautious, and I wake up every morning and see what's going on in Europe and I -- 6:30 on CNBC, the latest economic indicator comes out, and it's not good. And yet, everything we see in our portfolio says every day in every way things are getting better and better to coin a phrase, or actually steal someone else's -- a 19th century French psychologist. So I don't know the answer to the question. I can't give you a number. Make one up, I won't make it up for you. But I don't see why were going to be different than anybody else, long-term. So whatever you're assuming for other regional banks with reasonable credit discipline, assume the same for us.

Operator

Our next question in our queue is Paul Miller with FBR.

Paul J. Miller - FBR Capital Markets & Co., Research Division

Can you talk a little bit about what kind of activity you're seeing in your regions? Some CEOs -- I would say the majority of the CEOs over the last week are talking about they saw a material slowdown in activity on loan demand towards the end of the quarter. Are you experiencing the same thing? I know you are different, geography wise, but just wondering how do you're -- how do you see it shaping up?

Doyle L. Arnold

I think it seems to be the contrary. We've actually been seeing probably some improvement for the last, the last couple of months, and so far in this quarter. And it's pretty broad-based. So I mean, I think some of the improvement you saw earlier on over the course of the last year was, perhaps, a little heavily weighted toward banks in the upper Midwest, et cetera, where there was maybe a little heavier manufacturing activity. That is probably slowing a little bit right now. And that maybe coloring some of the very recent results, and some things you're hearing from some of those funders. But you're -- in the West, we are seeing a generally, pretty much across-the-board improvement in film [ph] that we saw an improvement in line utilization. For the first time, we're seeing a couple of percentage point uptick this quarter in utilization of lines. And so it's still -- it's hardly -- it doesn't have the strength that we've maybe historically seen, but we think that it's still good for sort of the mid- to maybe and a little higher than mid-single-digit growth here in the second half of the year. So we are not at this moment seeing any slowing.

Paul J. Miller - FBR Capital Markets & Co., Research Division

And can it -- I mean you said you say more broad-based, but well you know California's still struggling a little bit. Were you seeing, also, activity out of California also?

Doyle L. Arnold

Yes, we're seeing good activity in California. We're seeing better growth in a market like Colorado than we've seen in quite some time. We're seeing it, really, in almost every geography with the exception of Nevada, was pretty flat. We're even seeing it in markets like Arizona.

Harris H. Simmons

I'll just go ahead and follow on California. We had over $100 million if you exclude the FDIC-supported loans which declined, and if you exclude that, we actually had over $100 million worth of net loan growth in California. Like Doyle said earlier, it's mostly the coastal regions which is where we, where our footprint is, but it's not a terrible economy.

Operator

Our next question now in queue is Ryan Nash with Goldman Sachs.

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

I guess just first, just given where your pro forma Basel III capital levels should be under the NPR. I understand that this is just a proposal and you could obviously change your stance. But does this at all impact your ability to get out of TARP without issuing equity? And I guess longer-term, when you think about returning capital, do you think this will concern -- this will serve as a constraint in terms of your ability to do so?

Harris H. Simmons

First part of your question was does this impact our ability to exit TARP, we certainly don't think so. And I've reiterated a couple of times on the call our expectation that we will do so probably late third quarter or sometime in the fourth quarter. And there are no new conditions to that other than the ones we articulated at the time we announced the results of our, kind of our capital plan. In terms of capital distributions longer-term, We -- I assume you're talking about share buybacks and dividends and things like that as capital distributions. What I would point you to is that we have -- we have planned to -- a number of things that we want to do over the next 2 years in the way of reducing our cost of capital, and our cost of funding, which when added together -- we suggest that could kind of double the ROE of the company over that time frame. That's our primary focus for the next couple of years rather than massively distributing common equity anyway. We've never talked aggressively about that. And so no, I don't think it has -- certainly it hasn't caused us to have an OMG moment that we've got to do some massive change to our thinking. I'd also say, as I've pointed out in response to an earlier question, there's reason to believe that the size of that change should moderate quite substantially over the next year or 2.

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Okay, that's fair. And then I guess just in terms of the excess liquidity position, with, I guess with talk of the extension of the TAG Program, the Fed potentially on hold until, looks like late 2014 and if we are to get cuts to IOER, should all these things happen, would you consider changing the stance on redeploying some of the excess liquidity in the near term, and, okay, I guess this question may [indiscernible] if you just have the number at hand, how much of the $7.9 billion of interest-bearing cash do guys to the Fed right now?

Harris H. Simmons

Generally -- today, I don't know. But in general the Fed account has been running at $7 billion to $7.6 billion on any given night, kind of in that range. I'm not sure what you're referring to about extension of the TAG Program, and...

Doyle L. Arnold

Well I think, if it were extended, would we change our thinking?

Harris H. Simmons

I think the answer is probably not really. I mean, if you think the real question is, are you going to go out and dramatically lengthen the duration of your equity account and accrue the risk that, that entails at some point down the road when we expect to rise. And I think we're going to be likely to be losing the discipline between now and maybe if line clings a little, but not -- I don't think materially, as we said, Doyle said during his remarks, we change what we -- the risk there is asymmetric. And that we just don't get paid very much for extensions right now, so...

Doyle L. Arnold

You're the first -- I must have missed something. I didn't know there was any recent talk about TAG Program extension.

Harris H. Simmons

There's been some chatter about it, but no...

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Nothing definitive, but I think -- I believe it's something that's being talked about.

Operator

Next question in our queue is Ken Usdin with Jefferies.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Just one follow-up on the liquidity question. I mean, and conversely instead of extending, is there anything that you could do to, kind of, I don't know, just extend some of that cash from staying on the balance sheet in order to save some on NIM and even preserve capital from -- I know it's not a risk-weighting problem, but just from an equity perspective. I mean, I guess the broader question is, if you're not going to be reinvesting it, and some of it hopefully will remix into loans over time, is there anything that you can do to just maximize the capacity of the balance sheet, and how you're earning on it?

Doyle L. Arnold

Well, we've already taken some action by some of our banks to basically work with their -- some of their very largest depositors to -- with their permission, sweep balances off our balance sheet. We've probably gotten $1 billion to $2 billion of that. We've -- for all intents and purposes, probably exited broker deposits. I think there are a couple hundred million left of residual, but they're -- that's down from several billion and it's on way to essentially 0. We continue to price non-relationship CDs at essentially 0, like 5 or 10 basis points. And so if you're -- if that's all you're here for, please don't come here. We give them a little bit more of their checking account or other customer, but we're trying to shrink, and you've seen we have shrunk some of the, the CD portfolio, as well as the money market portfolio. So yes, we're doing everything that we can think of to reduce those excess deposits without actually chasing out of the company good, long-term customers. And --

Harris H. Simmons

We have thought about coaching tellers to be surly. [indiscernible] very posed we can because we, I mean we've recognized that we've got a lot of excess liquidity. We just have a tough time figuring out where to put it about having disproportionate risk, the downside in the rising rate.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Understood. And my second question is just on the RWA question. Doyle, I understand that you mentioned it was mostly related to the commitments and then just small related to mortgage. Can you talk about any impact it had, positive or negative, on the TruPS book and the swap? And how, if anything, in the NPR changes your view around the swap on that portfolio, how it works and your ability to continue to use it?

Doyle L. Arnold

I don't think there was anything in the proposal other than the phase out of Tier 1 qualifying capital for small banks, which I've discussed, one should have an impact on our portfolio over time. It's hard to quantify. That it doesn't have an impact on the risk-weighted, of assets. We -- I think our -- the previous estimates that we published pretty well incorporated what we think are the impact on CE T-1, Common Equity Tier 1 from the AOCI mark there. The swap, the total return swap, we discussed that several times a quarter, and we've reached no firm conclusion. I think the -- we will look at the final rules regarding -- that eliminate the use of rating agency ratings for regulatory purposes and what classified assets look like under that final rule. It's, I think supposed to be out this quarter, and we can -- and it will be a combination of looking at what the risk-based capital ratios look like, what the classified ratios look like and what the -- and the cost the TRS. I will remind you that in the non-hedged derivative income, the bulk of that negative number there is the quarterly cost of that TRS, which is a little over $5 million, pretax. So we haven't made any decisions with regard to it yet, but I think we'll, over the next few quarters as these changes become -- to asset risk ratings tied into classifieds in particular, we'll be looking at the TRS very seriously, as it may -- and I'm not foreshadowing anything. Obviously, we'll have to take a hard look at quantifying all of those impacts.

Operator

Next question in our queue is Ken Zerbe with Morgan Stanley.

Ken A. Zerbe - Morgan Stanley, Research Division

Though it seems like you guys are pretty much well on your way to retain the second half of TARP, can you just give us a rundown when you look at your TARP repayment checklist, what still has to be done, kind of how much progress have you made. I guess I'm thinking specifically of at least the -- and I think it's roughly $50 million of debt that you may or may not have to issue from here, that I don't think you hit your full $600 million. And then based on how much capital's already been paid out from the bank's subs and what you expect in third quarter?

Harris H. Simmons

Yes, we're -- I think you said well on our way to meeting those conditions, and I will agree with that. Yes, there were essentially 3 conditions that we proposed, by the way, and the Fed accepted. One is that we want to issue $600 million of term senior debt as a way to achieve part of the funding. We have issued, as you pointed out round numbers $550 million. We expect to view into this, I think, at $554 million that we've issued. Approximately $558 million anyway. $558 million. We'll be issuing, I think we'll be issuing the rest of that this quarter. The second was that he would get at least $500 million in a combination of common and preferred dividends and redemptions of preferred stock that push in the that we -- that the parent had provided to the subsidiary banks. As of June 30, we were in the neighborhood of $450 million, and I expect to actually to get several hundred million more this quarter. So probably -- and those 2 items were critical to having enough cash at the parent after repaying TARP, repaying the TLGP debt, to have a pretty lengthy time for required funding. The third condition was, I believe it was characterized in our the press release is something like no material deterioration in the condition or outlook of the company. And certainly there's been no material deterioration in the condition as the outlook we proposed that we would give the Fed a -- an updated stress test, just a forward-looking view of capital, which we are in the process of doing and expect to submit in the first half of August for their review. I -- based on everything I've seen, it's -- and expect to see, it will show better results than what we submitted at year-end. So I do believe that by assuming regulatory permission for the preferred stock redemptions that we will be in a position again late this quarter. And if that permission is just delayed due to review in timing, sometime early in the fourth quarter to meet all of those conditions.

Ken A. Zerbe - Morgan Stanley, Research Division

Okay. And if you get several hundred million more of capital from the banks' subs, do you have to raise the 42? Or can you just essentially ask regulators to let you swap the form of capital that's at the holding company?

Doyle L. Arnold

I could -- the plan was to raise $600 million. There's -- in this day and age, there's probably a limited number of things you want to go back and ask the regulators to change. And I'd rather -- I'd -- for that amount of money, I'd rather just march to the drummer that's beating right now and get it done. I mean, we have $50 million more maturing in the fourth quarter.

Our short-term senior notes, if we really want to, we can make it up that way. I'd rather check every box and "get 'er done," as Larry, the Cable Guy would say.

Operator

Next question in queue is Brian Klock at Keefe, Bruyette.

Brian Klock - Keefe, Bruyette, & Woods, Inc., Research Division

Just one real quick question. On a slide there, on Page 15 of the release, I just noticed that securities portfolio yields did expand during the quarter. I guess can you talk about, was there anything that you guys did to sort of extend the duration a little bit there, just maybe you could talk about the...?

Harris H. Simmons

Brian, that was a good question. That was actually mostly a nonrecurring item. There was a security, a trust preferred security a single issue, trust preferred security that came current. So this fits into the same category the CDOs are getting healthier. But these weren't CDOs, this was a single issue, and there was about $1.5 million catch-up on deferred interest that we had not capitalized previously. So we caught up and that won't be as large next quarter. So they'll continue to pay us, but there won't be a $1.5 million catch-up.

Brian Klock - Keefe, Bruyette, & Woods, Inc., Research Division

So they may have exacerbated the [indiscernible] bucket?

Harris H. Simmons

AFS.

Brian Klock - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. So it looks like the ATM HDM may be smaller, but that actually had a yield expansion as well?

Unknown Executive

I didn't research that one because it wasn't terribly significant, but I'd be happy to do so.

Operator

Next question in queue is Josh Levin with Citigroup.

Arjun Sharma

This is actually Arjun Sharma on the line for Josh. Just my first question is one of your peers said that they're going to close roughly 5% of their branches. So do you -- as you think about the environment, are branch closings or infrastructure cuts on the horizon?

Harris H. Simmons

We have closed actually a number of branches over the last 3 or 4 years. And I expect -- yes, you will continue to see some branch closures. We've also opened a handful, but net-net, we're down roughly 45 or so branches, I think, in the last 4 years. So I would expect for the next 12 months that we'll see a handful, but we don't have, by and large, especially outside of the state of Utah, the kind of branch density that some other banks have that gives us quite the same luxury of being able to combine as previously as some banks have been able to. So we're getting to a point where it's getting tougher, but we're still finding some opportunities do that, yes.

Operator

Next question in queue is Dave Rochester, Deutsche Bank.

David Rochester - Deutsche Bank AG, Research Division

Just drilling down into the C&I growth this quarter, did any of the pick-up in production come from your getting more competitive in the larger corporate arena, or was that primarily small business?

Harris H. Simmons

Well, we talked about the fact that small business was generally the remainder of, relatively weaker. So the growth probably net-net or I don't think we've had time to drill down inventory completely, was probably in the more medium-sized to larger commercial activity.

Doyle L. Arnold

That is true, and I would syndicate it if underneath there is a question about syndicated credits or purchased loans. We didn't see any of that. Really, syndicated credit exposure is not materially different than it was last quarter on a net basis. A lot of the C&I growth, or at least acceleration in production came out of Utah and California, and it was relatively stable in Texas. So -- and it was out of the larger corporate -- or not larger, but maybe middle-market is what would be a more fair characterization.

Operator

Our next question in queue is Joe Morford with RBC.

Joe Morford - RBC Capital Markets, LLC, Research Division

Obviously just trying to understand the $11 million provision this quarter. I know you saw a little bit of loan growth, but classifieds were down another 9% and charge-offs were up 20%. Is it really just a subjective factor of wanting to be more cautious given the macro environment?

Doyle L. Arnold

That's pretty much it.

Harris H. Simmons

Well, I think we're just -- we were trying to be pretty conservative. I think we, Joe, our view is there's still quite a lot of risk out there. I mean, we certainly see it and all the things you're hearing from the Fed. The fact that they're even thinking about for the [indiscernible] and et cetera, suggests that, we think -- they think the -- that the world remains a slow place and a risky place. And so we're likely to remain reasonably, conservatively -- we certainly have methodology in place. And we try to assess some of these factors but, which result in our being probably reasonably conservative right now relative to our peers in terms of forward keeping reserves.

Operator

Steve Scinicariello with UBS.

Stephen Scinicariello - UBS Investment Bank, Research Division

Hey everyone, just a real quick one for you. Just given the progress you guys have made in delayering the capital structure this year with TARP and the Series C preferreds, how likely is it that you're going to be able to get at the 8% trust preferreds for this year, or is that kind of more on the 2013 to-do list?

Doyle L. Arnold

Well, the trust preferred was not in our capital plan that we -- as a part of the stress test last year. So and we're far enough along into the year that there's no point in submitting a formal new capital plan because we'll be -- so I think we'll deal with that one and the stress test and capital plan at the end of this year. And I'll remind you, we have that, and we have the call option coming up in September on this -- on the very large Series C 9.5% preferred issue. I think there's a bit over $800 million in that issue which is callable.

Harris H. Simmons

That's September of 2013.

Doyle L. Arnold

Right.

Operator

Next question in our queue is Todd Hagerman with Sterne Agee.

Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division

Just kind of a follow-up, Doyle, as we about -- as we're about to conclude this journey on the TARP fund, if you will, just trying to get a sense, kind of as we look out the next couple of years, a, kind of targeted mix in terms of your capital structure and b, if you can give us a sense with the debt that's has been issued, the preferred, and so forth, as they roll off, just kind of a step function that we should think about over the next couple of years as some of this rolls off, and you kind of reach your targeted mix, if you will, from a capital standpoint, or structure standpoint as you say?

Doyle L. Arnold

Well, Todd, I guess, in the interest of time, I think we've tried to address that in our recent IR presentations. We -- if there is plenty of time, we've put out a pretty comprehensive list of what capital issues are callable, what debt issues mature and basically there's just about everything out there that, except what we did this year with the Series F is now addressable in 2013, '14 or a little bit of it in 2015. There's some sub debt there. So everything on that list that's high cost at the time that comes up is going to be fair game for refinancing or calling and partially replacing. We've also put out some guidance on what our current thinking is about a long-term capital and financing structure. But the long-term has to be revisited just about every quarter in these days as new capital NPRs come out and things like that. But I think it's still reasonably operative that we're going to be kind of 9.5% -- 9% to 10% common equity Tier 1 long-term that we're likely to have a 1.5% -- 1% to 2% preferred, some Tier 2, or which one of, maybe 2% of Tier 2, which was -- includes the sub debt and 2% or 3% of risk rate assets in the form of senior debt. And I can't probably get any more specific now, but we've tried to lay that out and everything we do is in terms of looking at the things that become callable or mature, we're going to try to then figure out what the new issue ought to do and moving toward that longer-term structure.

Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division

No, I appreciate that. And then that's very helpful. I was just getting at the point that I realized you've put a lot of information out there in terms of maturity. It's just really in terms of what the puts and takes as it relates to your debt structure now, I'm just trying to get a, more of a sense of, again, longer-term from a funding standpoint, how much of this really needs to be replaced as opposed to just kind of a burn or run-through rate as we again, as we go through the TARP repayment process?

Doyle L. Arnold

Well, I think that overall -- the repayment of TARP is a net reduction of Tier 1 capital by that amount. There's probably not that much more to reduce maybe a little bit after that, because there's a matter of cash and capital. I think that the bigger opportunity is the refinancing of a lot of the stuff that's substantially lower cost. Look at what our long-term senior debt is costing us on Page 15. It's kind of 11.25%. That's a combination of mark-to-market discounts and new issuance discounts. That -- and look at what we're issuing debt -- term senior debt for it today. It's in the 4 -- it's got a 4 handle on it. There is a pickup there of 6% or 7% potentially on long-term debt over the next few years. Preferred at 9.5%, we could do probably 7%, plus or minus today, so and for -- maybe the 6%s. So it's more going to be replaced not reduced. I think we ought to take that next question now.

Operator

Next question in the queue is Marty Mosby, Guggenheim.

Marty Mosby - Guggenheim Securities, LLC, Research Division

Doyle, just a quick question on the CDO portfolio. There's only really 3 tranches and $72 million of par value that would be left that can have some credit impairment that's already in some trouble. Can you just figure this out, maybe not the next couple of quarters, but in 2013, it seems some of that overhang in the OTI that comes due every quarter to start and work its way out? And that was my only question.

Doyle L. Arnold

Yes. The short answer I think, yes. Unless there is a very sharp deterioration in the, kind of go back in a higher rate of bank failures and deferrals and whatnot, again the only thing that I can see that's going to cause -- could cause a significant pick-up in OTTI temporarily with the significant acceleration of prepayments, which would be generally accompanied also by an improvement in AOCI. So yes, you could see some income statement impact from that. But the capital accretion would more than offset the income statement impact. So in general, again, I -- absent a severe downturn, I think, net-net the improvement's there, and we'll see an end it.

Operator

Our final question comes from Jeff Navarro with Lord Abbett.

Unknown Analyst

Just quick, apologize. You guys have been adamant about the short duration on what the cash being parked there, but given the world we're all having to deal with unfortunately this lower for longer environment, how much pain, I guess, are you guys willing to endure before not to do anything crazy or dramatic, but just kind of on the margin maybe, or is this just how you see the world?

Harris H. Simmons

I'm not going to say never, particularly to what I am seeing on the margin. I mean we've entertained some things that we -- could lead to modest improvement without taking -- I mean the thing that I think -- I think the things that we're going to be willing to endure a lot of torture over are things that are going to have large conventional risk in a rising rate environment. If we defined things with defined maturities with reasonably bounded credit risk, even if we're not originating it, we might do it. We are mindful, for example, I'll just give you one example kind of and then we'll need to cut it off. We are mindful of the fact that the European banks are under enormous pressure to improve capital ratios, reduce funding needs and which means looking at assets to sell, and in this environment what you can sell or your better assets, not your worst assets. So we are looking at things that might be shed by people who are under some degree of stress, and maybe we'll find something there. We've actually looked pretty seriously at a couple of things, but haven't pulled the trigger on anything yet. But I would put that in your on-the-margin kind of comment.

With that, I think, we need to call it a day. James, do you want to -- we appreciate your the indulgence in going over time, and sorry about that for those of you on the East. James?

James R. Abbott

Thank you very much, and I'll be around tonight and please free to e-mail me, and I'll call you back in the order that I receive the email, or you can try to call me, I'll be happy take the call as well. Thank you again for your time. We'll see you sometime throughout the quarter during -- in conference season. Thank you.

Operator

Thank you, gentlemen. Again, ladies and gentlemen, this does conclude today's conference. Thank you for your participation and have a wonderful day. Attendees, you may disconnect at this time.

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