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The South Financial Group, Inc. (TSFG)

Q1 2008 Earnings Call

April 23, 2008 10:00 am ET

Executives

Mary M. Gentry - Executive Vice President, Investor Relations

Mack I. Whittle, Jr. - Chairman, President and Chief Executive Officer

James R. Gordon - Chief Financial Officer

H. Lynn Harton - Executive Vice President, Chief Risk and Credit Officer

Analysts

K.C. Ambrecht – Millennium Partners

Kevin Fitzsimmons - Sandler O’Neill

Andrea Jao - Lehman Brothers

Robert Patten - Morgan Keegan

John Pancari – JP Morgan

Jefferson Harralson - KBW

Philip Gaucher – Del Mar Asset Management

[Barry Cohen - inaudible]

[Peter Collins] - FrontPoint Partners

Michael Rose - Raymond James

Adam Barkstrom - Sterne Agee

Christopher Marinac - FIG Partners

Operator

Welcome to The South Financial Group first quarter earnings conference call. (Operator Instructions) I would like to introduce Mary Gentry, Executive Vice President of Investor Relations.

Mary M. Gentry

Thank you for joining The South Financial Group’s first quarter earnings conference call and webcast. Presenting today are Mack Whittle, Chairman, President and Chief Executive Officer; James Gordon, Chief Financial Officer; and Lynn Harton, Chief Risk and Credit Officer.

We’ll then finish up with an analyst question-and-answer session. In addition to our news release, we have a quarterly supplemental financial package which is available on the Investor Relations portion of our website.

Before we begin, I want to remind you that today’s discussion, including the Q&A session, contains forward-looking statements and is subject to risks and uncertainties which may cause actual results to differ materially. We extend no obligation to update such statements.

Please refer to our reports filed with the SEC for a discussion of factors that may cause such differences to occur. In addition, I would point out that our presentation today includes reference to non-GAAP financial information. We’ve provided reconciliation of these measures to GAAP measures in the financial highlights of our news release and the supplemental financial package on our website.

Now I’d like to turn the presentation over to Mack.

Mack I. Whittle, Jr.

I’d like to focus a substantial portion of my remarks today on credit. As you can see, credit pressures affected by the uncertainties in the marketplace and our desires to be proactive drove our results this quarter. We accomplished several important things.

We increased our reserve roughly by $48 million, while maintaining our tangible capital levels above our targeted levels. Actually, our tangible capital levels rose modestly from the last quarter.

We reported operating losses of $14.5 million and GAAP loss of $201 million for the first quarter, with the difference driven largely by non-cash goodwill impairment charge of $188.4 million related to our Florida banking segment. The goodwill impairment has no impact on cash flows and no impact on our tangible equity or our regulatory capital ratios. James will provide detail on this goodwill impairment in his remarks.

Needless to say, it’s a challenging environment with declines in the credit markets in general, the uncertainty surrounding the depth and the breadth of this downturn. In this environment, we are reporting net charge-offs of $25 million for the quarter and non-performing assets of $2.26 of loans in foreclosed properties. Not good numbers, but truly reflecting the environment.

However, at this point, our credit issues are largely confined to housing-related CRE loans, principally in our Florida markets. Many of you probably read last week the quotes from the Chairman of the OCC in his statement, “denial is not a strategy”. All of these loans had already been identified as higher than normal risk and were already in active management through our special assets process.

However, toward the end of the quarter, they accelerated more rapidly than previously expected to non-performing status, driven by market value declines in Florida, lack of retail sales, specific unforeseen events, investor pullback and new appraisals. CRE non-accrual loans accounted for $135 million, or over 95% of the increase. More specifically, it’s CRE in our Florida markets up $113 million or 84% of the CRE increase.

On Page 9 of the financial supplement, you’ll find greater detail both by product type and by geography. As I said earlier, denial is not a strategy in this environment. To be assured we are not in denial on our credits, we are aggressively and proactively addressing the issues.

We have a team of senior lenders led by Jim Terry, who was former president of Carolina First Bank, to focus exclusively on working out solutions of our problem loans in Florida. Lynn, Jim and I meet weekly for status updates on these individual relationships and the action plan progress. We discuss what happened last week, what needs to happen next week and the milestones along the way with the key progress being reported.

There is no higher priority in the company than to do what we can to influence the positive outcome of these accounts. At the end of the day, we’re not abandoning these markets, which have been strong and will have great prospects for us in the future. We’re going to do what it takes to work through this credit environment and emerge with a strong balance sheet.

Underneath the credit pressures, we had several positive developments in key operating fundamentals. Our customer funding grew faster than loans. Our net interest margin remained stable. We controlled expenses and our tangible capital levels increased. We continue to execute our strategic plan and we made progress on our strategic objectives. I’ll take a few minutes and comment on each of those.

The first two objectives, funding and loan growth, our net interest margin remained stable, down two points to $307. During the last six quarters, the margin has remained relatively stable ranging from $307 to $312.

We also made progress on our customer funding, following the rollout of three new retail checking accounts last fall, successful deposit promotions and a new relationship reward program. Consistent with our plans, average customer funding grew at a linked quarter annualized rate of 7.8%, exceeding average loan growth of 1.9%.

Number three, credit quality, we aggressively identified our problems loans and working toward mitigating the losses within the context of this difficult environment. Fourth, non-interest income, for the first quarter, we experienced the seasonally low deposit service charges that we experienced last year. However, merchant, debit card and Treasury Service continued with strong growth. We continue to expand in our private banking area in new markets.

Fifth, operating non-interest expense remained well-controlled for the fifth consecutive quarter and essentially flat versus fourth quarter a year ago, while absorbing the industry-related cost increases. And finally, capital management, our tangible equity ratio increased to 6.72% and exceeded the well-capitalized levels for all regulatory ratios.

We are committed to maintaining a strong balance sheet throughout this difficult environment. Over the past few years, we’ve made structural changes to our balance sheet, such as taking leverage off by lowering the relative level of securities, reducing our interest rate risk, and building our tangible equity.

As a result of these changes, we entered into this current challenging environment with a higher quality balance sheet, more net interest margin stability, improved interest rate risk management and higher capital levels.

I’ll now turn it over to James, who will review our first quarter results.

James R. Gordon

As Mack indicated, the higher provision for loan losses and goodwill impairment charge overshadowed our other operating fundamentals, many of which showed progress and moved in direction consistent with our overall strategic initiatives. As a result, our pre-tax, pre-provision income remained relatively stable from the year-ago period.

Lynn will cover credit quality in more detail in his following remarks, so I’ll start with the $188 million goodwill impairment charge. Similar to last quarter, we updated our evaluation of goodwill for our Florida banking segment as of March 31, 2008. With the continued market pressures in Florida, towards the end of the quarter our projected cash flows from the segment decreased. This led to a lower estimated valuation for the Florida banking segment based on those discounted cash flows.

We then allocated the fair value to the underlying assets and liabilities, which indicated an impairment of $188.4 million for goodwill, which reduced the goodwill balance for the Florida banking segment to $239.5 million at March 31, 2008. This is a non-cash event and has no impact on capital ratios that use tangible equity or tangible assets since goodwill is already excluded. Therefore, we have considered this charge non-operating.

We have also reviewed the goodwill associated with our South Carolina banking segment, which totaled $116.2 million at March 31, 2008, and our North Carolina banking segment, which totaled $87.6 million at March 31, as well. We deemed that neither were impaired and, therefore, recorded no impairment charge related to those two segments. While we will continue to evaluate the carrying value of goodwill going forward, we do not expect material changes to the impairment going forward.

Additionally, we will continue to invest in the franchise, including Florida, as shown by the Orlando transaction announced earlier this quarter. You can see our other non-operating items in our release, specifically gains from the VISA initial public offering and reversal of fourth quarter litigation costs, net securities gains and net losses on extinguishment of debt.

The margin held up very well, particularly given the margin pressures from the rise of non-performing loans. It was down only two basis points linked quarter to 3.07%. Our net interest income declined from the fourth quarter, principally from the two basis point decline in the net interest margin, lower earning assets and one fewer day in the quarter.

The higher level of interest income reversals associated with additions to non-performing loans above last quarter’s levels brought down the net interest margin by approximately five basis points linked quarter, or over $2.8 million in aggregate for the first quarter alone.

We were able to offset a large part of this decline by improvements in our balance sheet mix and effective management of deposit pricing. We also managed through the 200 basis points of reductions in the Federal funds target rate, while growing customer funding balances with some success in lowering deposit rates.

Bottom line, we were very pleased with this modest decline in the margin, given the headwinds represented by the rate cut and the interest reversals associated with increased non-performing assets. Average loans grew 1.9% linked quarter annualized, primarily from disciplined growth in our C&I portfolio.

Our shared national credits, primarily through our corporate banking group, increased to $683 million at March 31. Our investment securities portfolio totaled $2.1 billion at March 31, or 15% of total assets, within our planned range.

Over 98% of our investment securities portfolio is rated A or higher with over 80% invested in Treasury or agency securities. We’ve added a schedule on Page 6 of our supplement showing the credit risk profile for the securities portfolio. We do not anticipate any material other than temporary impairment charges reported for the portfolio at this time.

Average customer funding balances increased this quarter, up 7.8% linked quarter annualized. Average interest checking balances increased $77.2 million, reflecting progress in our recent retail deposit initiatives.

For the first quarter 2008, average customer funding growth exceeded average loan growth, a key factor for reducing wholesale borrowings and better margin performance. The sense of improving customer funding balances, pricing and mix should positively impact our longer-term margin outlook.

As we indicated last quarter, additional actions by the Federal Reserve to reduce interest rates will continue to put pressure on our net interest margin in the near term since the timing of our deposit repricing lags the Federal Reserve cuts.

Our net interest margin for the remainder of 2008 will face pressure from the following: competition in pricing of customer funding, reinvestment of investment proceeds from accelerating calls in securities, the repricing lag between loans and deposits, the level of non-performing assets, calls and maturities of certain derivative, hedge instruments outstanding and the unusually wide spread on brokered CDs with the LIBOR/swap curves.

To provide a little more color on our balance sheet and repricing, the following are a few details. Approximately $3.5 billion of our loans are indexed to prime. Another $1.8 billion of loans are indexed to LIBOR, which repriced fully almost immediately after the rate reductions. This is offset by $1 billion of received fixed paid prime rate interest rate swaps and floors and $1.2 billion of wholesale funding which reprices almost immediately based on LIBOR of the Federal funds rate.

Also in the second quarter, we have another $1.3 billion of wholesale borrowing, including brokered CDs, repricing on maturity. We also have customer sweep balances as well as about 50% of our money market balances, or approximately $1.7 billion in the aggregate, that is generally based on the Federal Funds Target Rate, re-indexed and moved downward with changes in that rate. In addition, we have approximately $1.3 billion of customer CDs maturing in the next quarter.

Therefore, based on the above, we believe our margin in a given 90-day period should be somewhat neutral to rate changes, but continued consecutive interest rate cuts puts added pressure on the margin each individual quarter due to challenges in quickly moving deposit rates lower. We would hope to see some limited expansion of the margin during the second half of 2008.

Operating non-interest income declined $1.4 million versus the fourth quarter, largely from a $1 million decline in deposit-related fees. NSF and returned check income tends to be seasonally lower in first quarter each year. We’ve seen declines in each of the last three years for the fourth quarter to the first quarter.

For example, down $537,000 linked quarter for the first quarter of 2006, down $400,000 for the first quarter of 2007 and down $925,000 for the first quarter of 2008. Year-over-year, we’ve had double-digit increases for Treasury Services, debit card income and merchant processing income, partially offset by declines in mortgage banking, insurance and brokerage income.

With our strategic initiative to expand private banking, we’ve now added eight private bankers in the first quarter and now have 13 private bankers in total in 11 different markets. Our private bankers seek opportunities to capture the entire customer relationship deposit, lending and wealth management services.

For the fifth consecutive quarter, we have kept operating non-interest expenses under control. Operating non-interest expenses for the first quarter of 2008 totaled $80 million, up $963,000 from the fourth quarter of 2008, and in line with the $79.7 million a year ago. As expected, first quarter 2008 expenses increased from higher FDIC insurance premiums of $613,000 and higher advertising and business development of $417,000.

The decline in other, principally related to lower loan collection expenses, down approximately $343,000 and lower sundry operating losses down $367,000. Year-over-year, we have funded increases of $1.6 million in FDIC insurance premiums, $540,000 in advertising costs, $251,000 in loan collection expenses and other costs associated with strategic initiatives with decreases in other areas.

We look for modest but controlled increases in operating non-interest expenses during the remainder of 2008. However, we continually seek ways to reduce and control expenses. We continue to make disciplined and manageable investments in our franchise.

This quarter we opened two new branches in our Hilton Head market and announced plans to purchase five retail branch offices in the Orlando area from BankAtlantic. The purchase of the branches will accelerate our efforts to grow deposits in the Orlando area and our overall strategic focus on retail banking. Plus, we believe it’s a cost-effective way to immediately expand our presence in Orlando by adding well-located branches. We expect to close this transaction toward the end of the second quarter.

The effective income tax rate for the first quarter was 7.6%, which was driven by the impact of the non-deductible goodwill impairment and management’s projections of annual taxable income. The effective income tax rate for future quarters of 2008 could be significantly impacted by changes in management’s projections and variances to actual results.

We ended the fourth quarter with a tangible equity to tangible assets ratio of 6.61% and ended the first quarter at 6.72%, primarily from an overall positive change in other comprehensive income, including an improvement of $28.9 million in the after-tax unrealized loss on available for sale securities to $1.9 million at the end of March.

At March 31, we have approximately $400 million in excess Tier 1 capital and approximately $100 million excess total capital to remain well capitalized. Although we continue to maintain strong capital levels, we always consider our capital levels carefully, especially given this environment.

Equity and equity-linked securities and various debt instruments are always on the table, specifically Tier 2 qualifying instruments, as we have previously stated. And obviously, we are one of the companies that hasn’t reduced our dividend at this point, and we can’t rule that out and we’ll look at that depending on circumstances as this credit cycle continues.

I will now turn the call over to Lynn for comments on credit.

H. Lynn Harton

Residential commercial real estate is being very hard hit, especially in Florida. We all expected non-performers to increase for the quarter, but just not this much. So the question is, what was the driver of the acceleration we’ve described as occurring in March? We had six relationships in Florida, totaling $77 million, which we chose to move into non-performing status, even though they were either completely current, had interest reserves remaining or were less than 90 days past due.

In normal times, we might have kept these loans in accrual status until they reached 90 days past due. However, these are not normal times. Appraisals, indicated values on the properties, had declined and we knew that. In March, the market deteriorated in terms of retail sales and investor interest and it became apparent that our workout plans, which had been working as anticipated earlier in the quarter, would fall short of expectations.

We had already been working these accounts aggressively for some time, as they had all been identified in our CRE project reviews from last summer and fall. Given these facts and the individual size of the credits, we felt it was the right response to proactively record the asset as non-performing and to deal aggressively with the disposition. As Mack mentioned, we’re dealing with this extraordinary situation in the context of reality, not denial.

Even without these credits, non-accrual loans would obviously be up. However, the acceleration that we experienced in March was due to these accounts. We are on top of all of our high risk accounts in the market and we’re working these accounts aggressively everyday and with our complete focus.

As Mack mentioned, to proactively manage the challenging environment in Florida, we have moved a significant level of additional talent from our line banks in South Carolina and Florida to focus full time on working through these times. In terms of the overall numbers, non-performing assets increased, as we talked about, to 2.26% of loans in foreclosed property from 88 basis points at year-end.

As mentioned, the primary products driving the increase are residential acquisition and development loans, residential construction loans, condominium construction loans and undeveloped land. Our Florida geographies continue to be the hardest hit by the downturn in residential markets, with non-accrual loans increasing by $115 million, 70% of which came from the five accounts mentioned earlier, six accounts I mentioned earlier.

Moving to our other markets, North Carolina saw non-accrual loans increase from $14.6 million to $30.8 million in the first quarter, also due primarily to residential development and construction loans. While I expect non-accruals to increase slightly in North Carolina for the next couple of quarters, I continue to believe the changes in the underwriting and management processes made in North Carolina will lead to improved performance in that market by year-end.

South Carolina non-accrual loans increased slightly from $23.4 million at year-end to $31.4 million at the end of the first quarter. The overall low levels of non-accrual loans, only 69 basis points in South Carolina, continue to reflect our higher C&I concentrations, greater economic stability in the South Carolina market, our longer experience in those markets and our longer experience with customers in South Carolina.

Relatively small increases that did occur in South Carolina were caused by residential construction and condominium loans, primarily on the coast. While I believe it’s reasonable to expect some continuing increases in non-performers on the coast of South Carolina, I believe our South Carolina bank will continue to perform very well.

The remaining increases in non-performing assets were primarily in our mortgage portfolio as non-accruals increased from $5.6 million to $8.4 million during the quarter. Based on current level of past dues, non-performers in the mortgage will increase next quarter, as well. However, these increases will not have a major effect, given the small size of our mortgage portfolio relative to the total.

Turning to charge-offs, as the residential market weakened in March and drove increases in non-accrual loans, it also drove increased levels of net charge-offs. Net charge-offs for the quarter totaled $25 million, up from our level of $14.5 million expen lend for the fourth quarter.

Our geography, the Florida market experienced net charge-offs of $17.4 million, for an annualized ratio of 1.73%. Write-downs of residential A&D, residential construction and condominium loans were the primary driver at the product level.

North Carolina charge-offs totaled $4.9 million, again driven primarily by residential construction and development loans, with an annualized ratio of 1.14%. The portfolio in South Carolina continued to perform well with net charge-offs of $2.6 million or 24 basis points annualized.

Our provision exceeded net charge-offs for $48.3 million for the quarter, as we built the allowance by 46 basis points to 1.72%. There were three drivers for the increase in the reserves. First, specific reserves on non-performing loans were increased by $21 million.

To give some context for the loss content in our non-accruals the combination of write-downs in specific reserves on non-accrual additions for the quarter totaled 30% of the original loan balance. Secondly, due to volatility in land values in Florida, we set up a reserve allocated to our performing land and land development portfolio in Florida.

We arrived at the value used by stress testing the portfolio for theoretical decline in land values by 35% from original appraised values. There are no guarantees that this reserve will be adequate for potential value decline in the market, however, we believe this is a prudent, proactive and appropriate response to the impact that the current market is having on the portfolio.

Finally, we increased our indirect auto reserve slightly due to observed higher losses in the last quarter. As always, we continue to evaluate all components of the reserve as conditions change for the positive or negative.

Looking forward, we continue to focus our energy on managing our housing exposure, particularly in Florida. We are being as judicious, as assertive and as demanding as possible. As Mack mentioned, we are spending tremendous energy to move these accounts to the best resolution possible.

Last quarter, we provided some detail on representative transactions and also provided representative information on some of our largest watch credits. Unfortunately, this information was used to speculate on individual customer situations in a manner that could potentially harm both individual customers and shareholders of the bank.

Therefore, we will not provide any information on representative transactions on this or any other call and any questions regarding any specific transactions, including product type, transaction size or location will cause us to ask the moderator to move to the next analyst. I’m sure you understand the sensitivity of this information in the current environment.

However, I am glad to provide you with an enhanced report of CRE exposure. Since last quarter, we have added the ability to break out condo exposure and we also have improved the definition and accuracy of our other codes. These improvements make it difficult to compare to past disclosures.

However, it is more accurate and we believe that makes it the better information to present. We’ve added net charge-off information by the same categories, as well. As you’ll see on that page in the supplement, commercial real estate represents 77% of our non-accrual balances, with condo and residential A&D being the primary product types. I’ll be glad to discuss these portfolio buckets in broad markets but, again, will not comment on any particular loan.

I’d like to now turn it back over to Mack.

Mack I. Whittle, Jr.

As we manage through this difficult credit environment, we’ll benefit from operating in great markets, fostering a culture of action and knowing our customers and keeping them close to us. And we will continue to focus on executing our strategic objectives. All of us at The South Financial Group appreciate your support.

I now would like to turn it back to Mary Gentry for questions.

Mary M. Gentry

We are now ready for the question-and-answer session to begin

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from K.C. Ambrecht – Millennium Partners.

K.C. Ambrecht – Millennium Partners

While we applaud what management’s trying to do here and scrub the books, we still only get you getting about 35% of the way there, especially with the reserve to NPLs now under 80%. Can you speak to what the regulators are looking at your CRE book, whether they have been in there recently?

Following up on the coastal South Carolina market, it is our understanding that there’s been some condo projects that have been put on watch list but are not reflected in your NPAs and this is indicative of what our concerns are that you have $107 million residential condo book in Myrtle Beach, but you only have $3.7 million in NPAs. Seems like it’s off.

H. Lynn Harton

Well, first, to your first question, we’ve got a great relationship with our regulators. They’re well-informed. They view what we’ve done as being proactive and so I would say there are no issues at all on the regulatory side. In terms of watch loans being in non-performing, that would be normal. Watch loans are watch loans, non-performing are non-performing.

Hopefully the audience can see from our examples here that we are aggressive in putting loans on non-performing, as evidenced by the $77 million that arguably could have been left on performing, but again we knew the situation and we decided to record it the way it should be recorded.

K.C. Ambrecht – Millennium Partners

What percentage of CRE loans ex-completed income properties have some form of loan modification on it right now?

H. Lynn Harton

Well, that would be an impossible thing to come up with. Loan modifications are not necessarily negative in any way. We have built-in modifications. When projects perform, we may drop rates to show that performance. We may extend maturities to give additional time for stabilization of projects, which was part of the intended plan.

So, modifications would not be a negative in and of itself. Not to say that there couldn’t be some modifications in negative situations, but they are not correlated in the way that some people might think.

Operator

Your next question comes from Kevin Fitzsimmons - Sandler O’Neill.

Kevin Fitzsimmons - Sandler O’Neill

Lynn, I understand you can’t comment on specific loans, but can you give us a sense just on the in-flow to the watch list? Because it seems like a lot of these big problem loans were identified and they were on your watch list and then things deteriorated so quickly toward the end of the quarter that, obviously, you decided it was the right thing to do to move them to non-performing.

Are there certain loans that, midway through the quarter, beginning of March, looked fine that may not look fine now that would be proceeding onto the watch list, but maybe haven’t gotten to that point where you would throw it on non-perform?

H. Lynn Harton

We take each market in hand and I’ll give you a feel for why I feel the way I do about each one. If I look at North Carolina first, our watch list at quarter end, relative to year-end, is down 21.6%. Our past dues in North Carolina are down from 1% at year-end to 58 basis points. So, again, we know what the issues are in North Carolina. As we work through the problems, we expect some continuing increases, but those trends and the changes we’ve made are what is giving me confidence in that market.

I’ll look at South Carolina. The watch list is down four basis points, it’s essentially flat. And the watch list is at a low level. So it’s flat. Now, again, where you’re seeing a little bit of deterioration is at the coast. So I would say, we’re going to probably see a little more deterioration in South Carolina, but the underlying fundamentals are great. Past dues were 14 basis points at year-end, 16 basis points at end of the first quarter.

So Florida continues to be the issue. Our performing watch list in Florida was actually down slightly in March by ten basis points, but our past dues were up from $73 to $133. What we are doing in the market is controlling what we can control. Here is what I can control. I can control identification of problems, implementation of action plans and the accurate reflection of the value of the loan.

I can’t control the market and right now in Florida it’s extremely difficult and consequently hard to predict. At this point, for Florida, my view would be we’re late in the eighth inning of identification of problem situations, but we’re probably only in the fifth inning of the market telling us what will ultimately happen with these accounts. We will have some new non-accruals, the question is, in terms of the level, is how quickly we can move out some of the ones we have and so much of that is market dependent.

Kevin Fitzsimmons - Sandler O’Neill

Lynn, you think we’re in the eighth inning of identifying problems and I presume you are talking about Florida residential construction-related type loans.

H. Lynn Harton

That’s right.

Kevin Fitzsimmons - Sandler O’Neill

Can you sleep at night in terms of C&Is? C&I is a bucket you have been a little more active in over the last several quarters. How do you feel about problems migrating over to the C&I bucket based on what you’re seeing these days?

H. Lynn Harton

I feel very good about that. Where we’re going to see some bleed over is in Florida, small business. And we’re seeing some of that, but very manageable. The other portfolios are very strong. I sleep well on that particular question.

Operator

Your next question comes from Andrea Jao - Lehman Brothers.

Andrea Jao - Lehman Brothers

I was hoping to get a little more detail on your outlook with regard to charge-offs for the remainder of the year and when do you think this will peak and when do you think your NPA ratio will peak?

H. Lynn Harton

Again, that is just very hard to predict the Florida market and that really continues to be the driver. I think one call that I listened to, the CEO said it is very easy to see 45 days out. It gets a little cloudier, maybe you see a little bit at 60 days. But beyond that, in Florida it is just very difficult to predict. So I would hesitate to give too much additional guidance on that at this point.

Andrea Jao - Lehman Brothers

Now, with respect to the discounting that you used to take the goodwill impairment, how much of the deterioration with cash flows was driven by projected lack of growth, versus projected higher credit costs? And over what time period, does underperformance in the Florida market last, you think?

James R. Gordon

We basically detail the cash flows for five years in detail and then run it out, at less detail beyond that. The credit particularly in the nearer term, over the next two years, was the primary driver of that. And, with less growth in that same time period, was the substantial change and then beginning to rebound in the third year out, back to more normal levels from where we would have estimated even six to eight months ago and even from the fourth quarter.

But the key driver from the fourth quarter to today was the impact on the cash flows from the credit environment. And that much on the growth side.

Operator

Your next question comes from Robert Patten - Morgan Keegan.

Robert Patten - Morgan Keegan

I’m looking at your commercial real estate non-accrual loans by geography from December 31 and I’m looking at the press release that you just issued. And what I’m trying to get a feel of is at what point you feel charge-offs need to be taken. And if you take, for example, the central Florida market, at December 31, you had $2 million in non-accruals.

This quarter, you have $33 million in non-accruals, but have only taken $0.7 million in charge-offs. And if you go to some of the more toxic markets like south Florida and Tampa, seems to be the same trend here, where a big jump in non-accruals, but not a big jump in charge-offs. So can you give me how you’re looking at this stuff in terms of toxicity?

H. Lynn Harton

First thing we do is, one, gets into the status as we get updated appraisals, and so we let the appraisal drive that. Where we believe there’s certainty regarding the loss, we will go ahead and take the loss. Where we feel there’s uncertainty, for example, in some of these situations I’ve mentioned the appraisal actually would indicate that we are below the appraised value in our loan balance, given what we believe about the situation, we set up a specific reserve.

So in a normal environment, we would be where it’s easier to predict, we would be probably heavier on the charge-offs and less on the reserves. But in this environment, where it’s very difficult and you’re having situations that show you may not have losses, but we think, because of the market, we think we might, we are going more to the specific reserve route.

Robert Patten - Morgan Keegan

But the fact is, is you can’t sell these properties and if there’s no market for this stuff, one, what are the appraisal numbers that these guys are coming up with? And two, why aren’t you shooting first and asking questions later? Because these markets are just crumbling. Every bank we’ve seen report so far has just accelerated deterioration across the board in the Florida markets. And how can you not be taking charge-offs?

H. Lynn Harton

I think we’ve answered that.

Operator

Your next question comes from John Pancari – JP Morgan.

John Pancari – JP Morgan

In terms of your appraisals, can you just give us an idea of how recently have you appraised properties in Florida and what percentage of your portfolio, particularly in residential construction and development in land, has been reappraised more recently?

H. Lynn Harton

I don’t have a specific figure on how much of it has, but we have current appraisals clearly on everything that’s in non-accrual, we have current appraisals on everything that’s in our watch process, which is, we think is the appropriate piece. We also would have current appraisals on everything that is in the renewal process. But I don’t have a specific number on how much that would cover.

John Pancari – JP Morgan

Can you give us an idea of the depreciation in values and real estate values that you’ve have seen on your properties as you’ve done these reappraisals, specifically in Florida?

H. Lynn Harton

It varies dramatically by what you would expect and that is location of the property. We have had some appraisals that have continued to hold up at 100%. We’ve had some that have come in at 80%. We’ve had some come in at 50%. It’s really transaction specific, market specific and you can’t really give any broad sweeping number.

John Pancari – JP Morgan

Does that go for the same thing for your Carolina markets?

H. Lynn Harton

Yes. It goes for the same thing in terms of our appraisal process. We are not seeing the declines in value that we see in Florida.

John Pancari – JP Morgan

How did you come up with 35% assumption of the depreciation in real estate values when you came up with your reserve additions?

H. Lynn Harton

That was a judgment call and that’s basically it. We looked at a 35% theoretical decline and put an additional 10% on that for foreclosure costs and that was how we came up with the number.

John Pancari – JP Morgan

In terms of the charge-offs in the quarter, you mentioned about 51% of the charge-offs were in commercial real estate. What were the remainder?

H. Lynn Harton

I’d break it down this way. As you can see in the charts, $12.8 million were in commercial real estate. There was an additional $2 million that, while they weren’t on these specific commercial real estate loans, they really were part of the commercial really estate segment.

For example, we talked about in the past our Bristol and our mortgage loans that we’ve had as mortgage warehouse loans. So it was a total of, the way I would look at it, $15 million in commercial real estate or commercial real estate related. We had $6 million in C&I losses, which were 60 basis points roughly, more heavily weighted toward North Carolina on the small business side and North Carolina.

We had $2.5 million in indirect losses. As we’ve mentioned before, we are seeing a little bleed over in the Florida market in our indirect loss rate, so the bigger part of that was in Florida. And then $1.5 million in mortgage and consumer. That’s how it would break out by product.

John Pancari – JP Morgan

I know you indicated you are now provided enhanced disclosure around your portfolio. Why now are we just getting the breakout of condo exposure? Was it really a technical general ledger problem? Why now when you’re moving so much of this onto non-performer are we just getting the condo breakout?

H. Lynn Harton

We didn’t have a condo code. It was about a 90-day project to actually change the physical code, put a code in place on the system and then to recode our existing portfolio to get it in there. I knew what our condo exposure generally was by knowing the individual transactions, but we had no systematic way to report.

Operator

Your next question comes from Jefferson Harralson - KBW.

Jefferson Harralson - KBW

The credit question, on the $2.2 billion of commercial real estate loans that are not in that income producing property so your residential and your commercial AD&C portfolios, how much loss content do you think is in that $2.2 billion book?

H. Lynn Harton

Jefferson, I don’t have it broken out in that specific way.

Jefferson Harralson - KBW

What’s the way you have it broken out then, when you think about total loss content?

H. Lynn Harton

As we do stress testing, we do stress it by those individual buckets. So we have not and wouldn’t think it appropriate to disclose the results of our stress tests. Those are designed for worst case scenarios, but we do stress it by those buckets and I would say that would be the right way for you to look at it, as well.

Jefferson Harralson - KBW

It seems the net charge-offs could be high for a decent part of the year and, with your efficiency ratio around 65%, I know you’ve been waiting to fix the cost of funds problem to fix the efficiency ratio issue. But is it time to pull a page out of the bigger bank handbook to go in and say, “All right, let’s do a 5% cost cut and save $15 million over the next year?” Is there those kinds of costs to go get and add this to our pre-tax pre-provision earnings and be able to absorb losses in reserve build?

James R. Gordon

I think we will continue to look at that. I think we’ve tried to, if you look at it, we are flat, even back to where we were at 2006 levels for the most part, on a quarterly basis. And while we will continue to seek ways to control and keep it, we don’t believe there’s that amount to go back and get. And we’ve gone through it over really the last year and found ways to control and to rebalance and effectively invest into the infrastructure and the franchise to doubt it’s significant at this point.

Obviously, if things continue everything is on the table. So I wouldn’t say that we are aggressively pursuing that today, but tomorrow is a different day and we would take advantage of any opportunities in that area.

Operator

Your next question comes from Philip Gaucher – Del Mar Asset Management.

Philip Gaucher – Del Mar Asset Management

I appreciate that you can’t speak to any specific loans in the portfolio. However, I know that you have modified several loans, in particular on some condo projects, effectively pushing out maturities on deteriorating credits. I was wondering if you could comment on this?

H. Lynn Harton

Part of the normal process for any loan would be, there’s nothing unusual in looking at maturity dates, renewing maturity dates, moving maturity dates. You can’t look at that one piece of information in isolation.

Mack I. Whittle, Jr.

As we said earlier, modifications are not necessarily bad. Loans that have a lot of complexities most of the time have modifications during the course of the loan. And they’re not necessarily negative.

Philip Gaucher – Del Mar Asset Management

No, I understand that. Just taken in context with the fact that you haven’t written down much of anything, you have a very large exposure to residential and commercial in Florida and the maturities of the loans are getting pushed out further and further. I’m just wondering if you think that’s an accurate or honest depiction of the credit picture in your portfolio?

H. Lynn Harton

Yes. We believe that the information that we’ve given is completely accurate. We believe we are taking the right actions. We’ve built the reserve. We’ve talked about that. We’ve placed these loans on non-performing. We’ve given the additional information in the disclosure, trying to be as open as we can in this environment.

Philip Gaucher – Del Mar Asset Management

When you modify a loan do you put it into non-performing?

H. Lynn Harton

No. If I’m putting a loan in non-performing, those are just two different things. I don’t even know how to connect those two things.

Operator

Your next question comes from [Barry Cohen - inaudible].

[Barry Cohen - inaudible]

You gave base point changes by geography roughly in your watch list, but do you think you could just make it a little easier for us and just give us the dollar amounts in your watch list. If you have it handy for third quarter, fourth quarter, first quarter, just so we can understand the roll rates from watch list to non-accrual status?

H. Lynn Harton

We’ve not disclosed that and wouldn’t plan to. No other banks really or very few that we are familiar with do, because it’s a judgmental call and different people have different judgments about what a watch loan is. We believe we are pretty conservative. We wouldn’t want to be compared with somebody who’s not.

[Barry Cohen - inaudible]

You do a judgment call on loans that you are concerned about and then they roll or don’t roll into non-performing status and they roll or they don’t roll into charge-offs. And this is just something to help us understand the second derivative math.

James R. Gordon

But also remember non-performing loans stay in the watch list.

[Barry Cohen - inaudible]

Could you maybe talk a little bit about most people around the country are very concerned about home equity product. And there’s been no real discussion about home equity or indirect lending and can you give us a sense on like what’s happening there?

H. Lynn Harton

Our home equity portfolio has continued to perform very well, much better than what we’re seeing reported in other places. I think there’s several reasons for that. One, we centralized that about five years ago, brought it under a very talented individual who came from a larger bank. We never pushed the product aggressively.

So we never did brokered loans, it’s all branch originated. It was not a very aggressively marketed product so we missed a lot of that. We also insured all of our 90% and over LTVs and we have collected on some of that to this point. So I feel very good about what’s going on in home equity and it’s something we are watching. I’ll be honest as well we are watching that for any signs of deterioration. To this point, it’s continued to go well.

[Barry Cohen - inaudible]

Can you give us the LTVs of the watch list which includes your non-performing loans? Either in Florida, because that’s really the epicenter of a lot of what’s going on or in all your geographies?

H. Lynn Harton

I don’t have that number in any rollup fashion. It’s on an individual loan by loan basis.

[Barry Cohen - inaudible]

On the goodwill, it’s a non-cash charge but it does represent future cash flow expectations and that’s how like the stratification of goodwill occurs. There was no real breakout in the presentation about what those expectations were and the discounting methodology so there’s no way of actually understanding the impact to the Florida franchise that went into the write-down. So could you walk us through the numbers for that?

James R. Gordon

We’re not going to disclose that detailed calculation, but fundamentally the decline is all around the credit from, if you look at year-end you’ll see our income statement for the Florida banking segment. That hasn’t significantly changed. The primary change has been in the outlook on credit and the impact on growth in the near term in the next two years.

[Barry Cohen - inaudible]

What I’m trying to understand is this. If I did something really stupid and relatively simple and that’s to take your net charge-offs that you provided us with for Florida this quarter, which I think is a little bit less than $11 million, and I just simply annualize that, and you’re talking about a two-year timeframe for this write-down. You couldn’t get to $188 million in goodwill write-downs.

James R. Gordon

The math is not quite that simple in how you go through the calculation. The change in the cash flows impact the value and that differential doesn’t correlate to the impairment and then you have to go through the whole fair valuing of the balance sheet process to come up with the impairment.

Operator

Our next question is from [Peter Collins] - FrontPoint Partners.

[Peter Collins] - FrontPoint Partners

Could you walk through just the current quarter charge-offs and just give us some the loss content of some of these different buckets in commercial real estate? Obviously the undeveloped land is a little bit different than the other ones, but just give us a loss content of current quarter charge-offs?

H. Lynn Harton

Are you talking about more detail on the supplement page?

[Peter Collins] - FrontPoint Partners

Could you go through the $12.8 million of CRE charge-offs in the quarter to give us a flavor of what marks you took on these portfolios.

H. Lynn Harton

As I mentioned, the combination of charge-off or specific reserve on the accounts that we moved in was 30%, a combination of the two.

[Peter Collins] - FrontPoint Partners

You took a 30% haircut..

H. Lynn Harton

In terms of the entire portfolio, if you will, of additional non-accruals, I don’t have that in front of me broken out by those individual categories. So that would be for the total.

[Peter Collins] - FrontPoint Partners

You’re saying that the general haircut on this quarter’s charge-offs, it’s about a 30% haircut?

H. Lynn Harton

That’s right, including charge-offs and specific reserves on those individual accounts, correct.

[Peter Collins] - FrontPoint Partners

The land portion is down a lot more all over the South. How do you feel about that? Land values are down a lot more than 30%.

H. Lynn Harton

The driver is the appraisals that we’re getting. Some of the land deals were heavier than that. But it’s all driven on individual account basis by the appraisals that we’re getting.

Operator

Your next question comes from Michael Rose - Raymond James.

Michael Rose - Raymond James

Discuss the process that you would use to evaluate the sustainability of the dividend and its current rate.

James R. Gordon

It’s really a function of capital, projected earnings, Lynn’s stress test on the outlook on credit, and a number of factors is what we would look at and what other capital alternatives might be available to us before cutting or eliminating the dividend.

Operator

Your next question comes from Adam Barkstrom - Sterne Agee.

Adam Barkstrom - Sterne Agee

Just curious as to what we’re thinking on the capital front. One of your competitors, Colonial, we saw a capital raise announcement this week and I’m just curious, is that in the thinking here? Are you strategically looking at that as a potential possibility going forward in ‘08?

James R. Gordon

As I said in my talking points, given this environment, you consider that as one of many things that you look at. So we will continue to do that. But in looking at our ratios versus other ratios, we’re starting from a higher base so that changes the timing and your overall thinking is slightly different than if you were at a different place at a different point in time.

Adam Barkstrom - Sterne Agee

Lynn, to follow-up on one comment you made with respect to fundamentals in South Carolina and specifically fundamentals in the Myrtle Beach market and specifically the Myrtle Beach condo market. From the data we’re looking at, the fundamentals look pretty bad there. What are you looking at in that market versus certainly your numbers today, the deterioration in Florida is significantly worse than anything reported in South Carolina coastal markets. Where are the fundamentals strong there?

H. Lynn Harton

The coastal South Carolina market runs from Calabash on the top, down to Hilton Head and Savannah on the bottom. Markets that we are very familiar with. Our third branch, this bank was opened in Litchfield, which is a piece of that market. We’ve all been very active in that market.

We expanded our presence in that market through the acquisition of Anchor Bank, which was the premiere bank on the coastal market of South Carolina. I would say we are dealing with the best developers in that whole coastal market. Will there be difficulties? Yes. Will they be as bad as Florida? No. Will we fare better than other banks in that market? Yes.

Adam Barkstrom - Sterne Agee

Any concerns, in particular, with the Myrtle Beach condominium market?

H. Lynn Harton

Again, we’re not commenting on any specific market. I’ve given you the flavor for the coast and that would hold true for the entire coast.

Operator

Your final question comes from Christopher Marinac - FIG Partners.

Christopher Marinac - FIG Partners

Can you talk about the appraised values that you’ve done? The new appraisals and how much change has come in versus what they originally were?

H. Lynn Harton

Well, again, as I mentioned earlier, it just varies by individual location, individual market, we have seen some appraisals that have come up exactly the same, no deterioration. We’ve seen 20% appraisal declines. We’ve seen 50% appraisal declines. It’s all back to the fundamental key of location and so it’d be really impossible to give a sweeping statement at this point.

Christopher Marinac - FIG Partners

To that point, if you have either considered or done any loan sales, is there a range of pricing that you expect as you look at individual credits to move off?

H. Lynn Harton

Again, it’s transaction by transaction and we are and have been looking at loan sales. But, the value that we would be willing to take in a loan sale would be dependent upon what we believe the underlying value of that transaction to be. So our range of expectations would be specific to that individual situation.

Operator

I will now turn the call back to Mack Whittle for closing comments.

Mack I. Whittle, Jr.

I’d just like to again thank everybody for joining us today and again if you have questions you feel free to follow-up with us. Thank you again.

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Source: The South Financial Group, Inc. Q1 2008 Earnings Call Transcript
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