Marshall & Ilsley Q2 2008 Earnings Conference Call Transcript

Marshall & Ilsley Corporation (MI)

Q2 2008 Earnings Call Transcript

July 16, 2008 12:00 pm ET

Executives

Dave Urban – VP and Director, IR

Greg Smith – SVP and CFO

Mark Furlong – President and CEO

Analysts

Kevin St. Pierre – Sanford Bernstein

Terry McEvoy – Oppenheimer

Tony Davis – Stifel Nicolaus

David George – Robert Baird

Ken Zerbe – Morgan Stanley

Greg [ph]

Steven Alexopoulos – JPMorgan

Heather Wolf – Merrill Lynch

Brian Forum [ph]

Presentation

Operator

Welcome to the M&I's second quarter 2008 earnings conference call. My name is Jacob and I'll be your conference operator today. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded for replay purposes.

It's now my pleasure to introduce Dave Urban, Director of Investor Relations for M&I. Sir, you may now begin your teleconference.

Dave Urban

Welcome to M&I's second quarter 2008 earnings conference call. The presenter for today's call will be Greg Smith, our Chief Financial Officer, who will review the second quarter financial results. At the end of our prepared remarks, Greg and Mark Furlong, our Chief Executive Officer, will be available for your questions. Before we begin, let me make a few preliminary comments.

If you have not read our earnings release, you may access it along with supplemental financial information from the Investor Relations section of our website at www.MiCorp.com. Also, before we start I would like to mention that comments made during this call contain forward-looking statements concerning M&I's future operations and financial results. Such statements are subject to important factors, which could cause M&I's actual results to differ materially from those anticipated by the forward-looking statements. These factors are described in M&I's most recent Form 10-K and M&I's other SEC filings. Such factors are incorporated herein by reference. For a reconciliation of any non-GAAP financial measures mentioned in this presentation to the most comparable financial measures calculated in accordance with GAAP, please refer to M&I's website at www.MiCorp.com. And now, I will turn the call over to Greg.

Greg Smith

Thank you, Dave. And thank you everyone for taking the time to join us today. By now you've had an opportunity to see our press release and supplemental financial information. In addition, we've included detailed credit quality slides on our website as we have in the past. You may want to have these printed out and available for a credit quality discussion later on this call. Our second quarter results reflect a challenging operating environment that confronts banks, although we continue to view a number of our core businesses as remaining strong. The important items to focus on to understand our quarter include, our aggressive steps to address exposure to the Arizona, West Coast of Florida, and corresponding construction and land development businesses; the impact of certain one-time expenses and good core operating trends in the bank and wealth management. As we discussed earlier this month, continued detailed reviews of our construction and development portfolios led us to incur further provisions and charge-offs this quarter. We will discuss our credit quality trends in more detail shortly.

Before turning to our results, just to reiterate other key messages from our July 3rd conference call, we continue to have one of the highest capital bases among domestic banks, both in terms of tangible common and regulatory ratios. We expect to return to profitability in the third quarter. We expect loan loss provisions and net charge-offs to remain elevated in comparison to our long-term average, but we expect the loan loss provision to be significantly less than this quarter’s levels. While we cannot predict whether or not the housing crisis has reached the bottom, we do believe the actions we have taken adequately address the current exposure embedded in our housing-related construction and development portfolio.

Now turning to our results. As noted in our press release, we reported a loss of $1.52 per share for the second quarter. In the same quarter last year, we reported earnings of $0.68 per share from continuing operations. As I discuss aspects of growth in our banking business from this point on, I will highlight organic growth for the combined franchise in an effort to give as clear a picture as possible of the underlying bank trends. Any balance sheet discussion comparing second quarter of 2008 with second quarter of 2007 will be adjusted for our acquisitions of Excel and First Indiana.

Now, for some additional insights into the quarter. First, the net interest margin. Our net interest margin increased by 5 basis points on a linked quarter basis to 3.14%. During the second quarter, our margin was positively impacted by the decline in interest rate, but was negatively impacted by non-performing assets by 4 basis points. We estimate the negative impact of non-performing assets to be 10 basis points over the second quarter of last year. We manage our interest rate risk position to be near neutral over a one year period, and we realized a benefit as certain short-term liabilities continued to reprice downward in the second quarter.

Despite this quarter’s margin improvement, we continue to expect that the net interest margin will experience slight compression over time. Like the industry in general, we expect to be challenged by competitive loan and deposit pricing, the movement of new and existing deposits into lower spread, higher yielding products, and higher wholesale funding spreads. There continue to be many variables that impact margin making it difficult to project this one data point with a high degree of accuracy.

Now moving on to our Wealth Management segment. Our Wealth Management businesses continued to show strong performance during the second quarter. Revenues for the quarter were up 14% compared to the same quarter of 2007 and on a linked basis were up 4%. Year-to-date 2008 revenues exceed 2007 by 16%. During the second quarter, our trust revenues were up over 14% compared to the same quarter last year, driven by growth in our outsourcing and securities lending businesses, as well as sustained expansion of our personal and institutional business lines. In our brokerage business, we are beginning to see good revenue growth from the addition of new financial advisors during the past several quarters, with revenue growth over 12% in comparison to the same quarter last year and 11% on a linked-quarter basis.

In spite of turbulent equity markets, assets under management grew to $25.4 billion compared to $24.6 billion a year prior but contracted from 25.8 billion at the end of the first quarter. Assets under administration reached $106 billion dollars versus $104 billion a year ago.

Brokerage customer assets remained stable at approximately $9 billion. Overall sales pipelines remained strong, and continued improvement in our investment performance is attracting new opportunities with institutional investors and retail platforms. Our private banking business continued to add new relationships with solid growth in both loans and deposits.

Moving on to other fee income components. Service charges on deposits for the second quarter were $38 million. On a linked-quarter basis, this is growth in excess of 6%. In comparison to the prior year, this is growth of nearly 26%. Mortgage loan closings for the second quarter were $933 million, which was down approximately 33% from first quarter and consistent with national trends.

A couple of comments on Capital Management. With a period end tangible common equity ratio of 7%, M&I remains one of the most highly capitalized domestic banks. Our regulatory capital ratios remain well above any regulatory thresholds. We did not repurchase any shares this quarter and it is unlikely that we would in the coming quarters. Nonetheless, we will continue to evaluate future buyback activity in light of market and economic conditions.

From an expense standpoint, total non-interest expense amounted to $380 million in the second quarter. This is a $65 million increase from the first quarter. The most material sources of this increase in expenses can largely be described as follows. As we indicated on the first quarter call, our expense base last quarter benefited from a $12 million litigation reversal related to Visa. As we noted on our July 3rd call, we increased our reserve for unfunded commitments by $20 million. In addition, we incurred incremental expenses of approximately $8 million, which we do not expect to repeat.

Although our reported efficiency ratio is 59%, when we adjust it for the non-recurring items, it is approximately 55%. Please note that ORE and other credit related expenses account for 3.7 percentage points of our efficiency ratio, implying an efficiency ratio adjusted for credit of 51.3%. On this basis, our prior quarter was 49.8% and the 2007 second quarter was 50.9%. As we have noted before, we are updating many of our internal systems and continuing to expand in markets outside Wisconsin this year in a disciplined manner. Nonetheless, particularly in the current operating environment, M&I will continue to be very focused on maintaining our historical expense discipline.

Now moving on to our credit quality trends. As we discussed earlier this month, M&I like other banks, has experienced continued deterioration in the national residential real estate markets during the second quarter. In addition, we have noted some stress among our consumers with conventional non-accruals picking up but with home equity remaining stronger than the overall bank. On the positive side, our commercial lending portfolio has maintained its strong credit quality profile with 49 basis points of non-performing loans.

As we discussed earlier this month, we realized net charge-offs of 401 million this quarter, and we provided $886 million for loan losses, which is $485 million in excess of net charge-offs. Our quarter-end allowance was 2.05% of period end total loans.

Our underlying market assumption in taking these charges and provisions is that the prevailing economic and national residential conditions will last through year-end and well into 2009.

With regard to our loan loss provision, our loan loss provision this quarter exceeded previous quarters as the residential real estate market continued to deteriorate. We saw further stress in the estimated collateral values and repayment abilities of some customers, particularly among our small and mid-sized local developers and generally the consumer segment. With these issues and the related loss factors this was an appropriate time to strengthen our allowance. As we look forward, we expect to continue taking aggressive steps to resolve our non-performing loans, the proceeds from which will be redeployed in our business.

As in prior quarters, the largest proportion of the charge-offs over 70% were associated with the Arizona, west coast of Florida, and correspondent portfolios. As shown on slide ten, the charge-offs by business were $132 million for Arizona, $68 million for the west coast of Florida, and $85 million for our correspondent business.

Discussing our non-performing loan trends. During the quarter, our non-performing loans increased $254 million, which includes the impact of $77 million in larger construction and development non-performing loan sales. As we noted on our earlier conference call, we have moved aggressively to identify potential non-performing loans and the associated loss content. This is supported by the following. 20% of our non-performing loans are past due less than 30 days. One-third of our non-performing loans are past due less than 90 days.

We have already realized partial charge-offs of $386 million against our non-performing loans, representing a 27% haircut, which is up from 18% last quarter. Within our loan portfolios, we continue to focus on our residential related construction and development categories. These loans are in both our commercial real estate and residential real estate portfolios depending on the underlying collateral. As of quarter end, we had $661 million in construction and development loans on non-performing status, representing 63% of our total non-performing loans.

As shown on slide 11, of these non-performing construction and development loans, two-thirds are in the Arizona, West Coast of Florida and correspondent businesses. Clearly, our issues remain concentrated in these businesses. To provide a little more granularity on our mid-sized local developer portfolio, the following may be helpful. Our largest non-performing loan is less than $35 million and is to a mid-sized regional residential developer in the Midwest.

We have 30 loans greater than $5 million on non-performing status. Only seven of these are in excess of $10 million with our largest being the only one greater than $15 million. We have seen further deterioration in the residential land portfolio during the second quarter. This portfolio is shown in slide 17 and 18. M&I has $2.3 billion in residential land loans to individuals and developers. $1.5 billion or 66% are located in Arizona. The bulk of the Arizona loans nearly 70% are in Maricopa County. The loans in these portfolios are relatively modest in size. We continue to refresh both FICO scores and LTVs for the Arizona portfolio. Individual FICO scores have declined slightly, but remain around 714. LTVs have moved higher and are approximately 115%.

Residential land accounts for $219 million of non-performing loans, of which 55% are based in our Arizona business unit. This level of non-performers and the underlying LTVs have factored into our allowance build this quarter. As we have noted before, our residential land portfolio is almost entirely zoned, entitled and improved, and largely related to individuals.

With regard to conventional mortgages, we have noted deterioration as individuals are feeling increased economic stress. As we’ve noted before, we maintained our underwriting discipline through the cycle, have never originated sub-prime loans and have avoided many of the more risky loan products. Nonetheless, during the quarter, our non-performing residential loans have increased to $121 million or 2.1% of the portfolio. Within the residential portfolio, we have seen some deterioration in many of our markets, with the Arizona market being most notable. We continue to aggressively monitor and manage this portfolio. To provide further granularity on our Arizona residential portfolio, the average loan is around $300,000 and the average non-performing loan is slightly higher. The average refreshed FICO score on this portfolio is 716. The average updated LTV is approximately 90%.

Just a couple of comments on our consumer loan trends, as the overall consumer portfolio has maintained its non-performing loan levels below those of the overall bank. As of quarter end, only 106 basis points of consumer loans were on non-performing status. As we’ve noted in the past, our credit quality experience with this portfolio has benefited from our historical practice of selling much of our production as we did in 2005 and 2006. Looking forward, we expect consumer non-accruals, including both residential and home equity, are likely to trend up reflecting continued consumer stress, although we expect that our ultimate losses will remain better than industry averages.

The Franklin relationship. This relationship has performed according to the terms of the debt restructuring agreement and was returned to performing status during the first quarter. During the second quarter we received another $30 million in principal payments reducing our outstanding accruing balance from $199 million at March 31st to $170 million at June 30th. The non-accruing portion has been reduced from $4.2 million to $3.6 million. We continue to monitor its performance and underlying portfolio closely.

In terms of the future, we continue to expect to see non-performing loan and real estate owned balances to remain elevated, as we have noted before. It is important to remember that most construction credits are complex and it will take time for us or any lender to work through them. We will continue to evaluate the opportunity for further sales of non-performing assets and weigh that opportunity versus the cost of keeping those assets for a period of time.

Sometimes the best resolution will be to take the underlying property to maximize our interest, which will cause increases to REO for a period of time. As we anticipated, our REO increased this quarter to $207 million, which is up from $178 million in the prior quarter. Like our loan portfolio, our REO is also very granular. The largest REO property is an $18 million Florida-based multi-family property. We have four additional commercial properties over $5 million. We continue to expect that REO balances will increase going forward and view this as a natural progression as we gain control of projects and move toward ultimate resolutions. We will continue to aggressively manage our REO balances.

A few final comments on credit quality. Our loan portfolio and non-performing loans remain granular. Stresses in the national housing markets will continue to affect us and we will continue to address them proactively. We have and will continue to take aggressive steps to resolve our non-performing situations and believe that we have recognized as much loss as possible this quarter. Nonetheless, with the housing market continue to deteriorate beyond our current expectations our losses could continue.

Our non-performing loans continue to be concentrated in the housing construction related components of the commercial and residential real estate portfolios, particularly in our Arizona, West Coast of Florida and correspondent businesses. Although we are not immune from consumer deterioration, we believe our residential and consumer portfolios will continue to perform better than the industry as a whole. We expect that the commercial multi-family and non-residential commercial real estate portfolios will continue to perform well. We remaining committed to returning M&I to a level of solid credit quality.

Changing focus to the organic balance sheet growth trends compared to the same quarter in 2007. Second quarter 2008 average loans were $49.9 billion, which is $4.9 billion or 11% higher than the second quarter 2007 average. C&I loans increased on average by $1.9 billion or 15%. For the remainder of 2008, we expect the C&I loan growth rate to be in the low-single digits. Commercial real estate increased on average by $1.5 billion or 10% in comparison to the same quarter last year.

To repeat comments we’ve made before, we continue to see softness in construction and development activity. This has translated into slowing new construction in all of our markets, with our Arizona and West Coast of Florida markets most impacted and less investor activity in construction projects with multi-family and medical office being least impacted. Retail has softened as many retailers have cut back expansion plans. Office is in relative balance in most of our markets although dramatic job losses could impact this segment in the future. Together these factors lead to our expectation that commercial real estate growth for the remainder of 2008 will be relatively modest, which is consistent with 1% linked quarter growth posted in the second quarter.

On the deposit side, there's really only a couple of things to note as many trends remained consistent with prior quarters. We continue to open net new DDA accounts in the community division each month, although growing DDA balances has been more challenging as customers have opted to move excess liquidity into higher rate products. Nonetheless non-interest bearing deposits increased $200 million compared to the first quarter of 2008, which is ahead of our DDA trends last year. Reflecting recent deposit market dynamics, the increased level of high priced competition has caused our bank issued deposits to be relatively flat in comparison to the second quarter of 2007 as we have maintained our pricing discipline.

A few final comments. As we passed the mid-point of 2008 and to reiterate comments made earlier, we expect our financial results to reflect the benefits of the aggressive credit steps we have taken. Similarly our strong capital position, high level of allowances to loans and good growth in many of our businesses and regions will enable us to return to profitability in the third quarter. Although we are not prepared to suggest that we are at the bottom of the housing cycle, we are confident these steps have enabled us to realize all the loss content. Hence that is currently identifiable in our portfolio.

As you are aware, every economic cycle brings its own set of challenges. This economic cycle has been marked by a challenging and volatile interest rate environment, wider funding spreads, competitive pricing pressures on most loan products, and a dramatic downturn in the national residential housing markets.

On the other side of the equation are the positives we have witnessed and continue to believe will be part of our future at the bank such as solid expansion in all of our bank markets, expansion of our Wealth Management businesses, a smooth integration of First Indiana into M&I, and overall reasonably well contained expense growth. As we move forward in this challenging economic cycle, we will continue to benefit from the strength of our capital position, the dedication of our employees and the diversification of our franchise. It is the combination of all of these factors that provide us with the confidence of continued future growth and return to profitability.

This concludes our prepared remarks. Mark and I are available to answer your questions. Operator, you may now open -- operator?

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions). Our first question from Kevin St. Pierre.

Kevin St. Pierre – Sanford Bernstein

Yes, good afternoon, gentlemen. I was wondering if you could tell me of the 401 million in net charge-offs, what percentage or what’s the breakout between realized losses versus write-downs of non-performing loans?

Greg Smith

Well, when you look at how we’ve taken some of the charge-offs, what we’ve really been looking at is a combination of what we’ve taken our loan sales as well as what we’ve taken with appraisals and valuation, I think the important thing to take note of, of course, is the fact that our partial charge-offs have gone up from 386 million, a two 386 million from 178. So right there you’ve got a net increase in partial write-downs of roughly $200 million.

Kevin St. Pierre – Sanford Bernstein

And you pointed out that that 386 is 20% of unpaid principal of non-performers, could you tell us what portion of that 386 is in construction and development loans?

Greg Smith

Well, yes, we’ve obviously got back and looked at the detail, and as you would expect, when you come to the higher balance items, you are going to see more of the charge-offs allocated toward the larger construction and development credit. So you guys think that the largest component to that is against that. It’s probably in the 80 to 90% realm on the construction and development portfolio.

Kevin St. Pierre – Sanford Bernstein

Okay, thank you very much.

Greg Smith

Sure.

Operator

Thank you, sir. Our next question comes from Terry McEvoy.

Greg Smith

Hi, good afternoon, Terry.

Terry McEvoy – Oppenheimer

Hi, good morning. I’m just wondering if the large quarterly losses, could any of your internal expansion plans on hold, be it new branch openings or some of the reinvestments or investments you’ve been making in the banking platform?

Greg Smith

Jerry, all of the various investments that we are looking at it at the end of the day are relatively modest in size as well as capital commitment. So, like we said, we are certainly going to continue to be disciplined as we look at our expense base, but at the same time any of those expansion plans are relatively modest and we’ll be sticking to this.

Terry McEvoy – Oppenheimer

And just a second question, on goodwill, was there an impairment test conducted in the second quarter? And if so, obviously the results were neutral, but I just wanted to make sure that happened?

Greg Smith

Terry, we conduct our goodwill impairment test early in the third quarter based on our June 30th balances, our June 30th results. Any of the preliminary indications on our goodwill impairment testing at this point are coming back just fine.

Terry McEvoy – Oppenheimer

Thank you.

Greg Smith

Thanks.

Operator

Thank you, sir. Our next question or comment comes from the line of Tony Davis.

Greg Smith

Hi, Tony.

Tony Davis – Stifel Nicolaus

Good morning, Greg. Just trying to assess the timing of this deterioration that you are seeing, looking at the change in Arizona land loan LTVs implies about I guess a 35% cumulative decline in (inaudible) original ways as of mid year. I just wonder what that decline would have looked like maybe in March, number one? And secondly, can you give us some color I guess on your thinking about the rest of the year?

Mark Furlong

Yes, this is Mark. Every one of the projects is in different stages, so the weakness in a developer shows up the different times depending on what they have sold out and still it’s too simple to say, gee, they are all at the same point and the same project, you are in different projects in the market. So I’d just say that this is just kind of a normal migration of the relationships. And it’s hard to manage, but there are lot of relationships that are doing just fine. Certainly those that have migrated, there is nothing special third and – first and second quarter than just the passage a time. When they look out the rest of the year though, that’s a little more difficult to predict. We think we’ve done a good job of pulling in into this evaluation as much as we can estimate accurately about what was going on into the third quarter. And so we think that part is we’ve substantially dealt with, but just hard to tell where the housing market goes at this point in time the next six or seven months. So we think we’ve done a good estimate, and based on the things we know today, but too difficult to be too predictive of the last six months of the year.

Tony Davis – Stifel Nicolaus

All right. Just a quick follow-up here. Outside the Florida and Arizona construction, just a color here on 30 to 89-day past dues you are seeing, say, in and Southeast Wisconsin and Saint Louis twin cities (inaudible) market?

Mark Furlong

Not a big change. As you saw in our supplemental data, we had a couple charge-offs in the C&I side, but it’s very isolated. It’s not pervasive as not in any one market and I don’t think there will be a wholesale deterioration in that – in the C&I business by any means, which is the modest deterioration and very isolated. So the markets we are still strong, all those markets still have relatively low unemployment and the business that we are still doing well, we have a fair amount of export business. So those customers are doing relatively well, certainly they are customers that have raw material issues, they certainly have price increases, they have the best lawn. But by and large, when most of your customer base is privately held, they run their business with a longer-term thought process. And so therefore, they generally have an over-extended and they have a business they are trying to pass through the generation. So it just means little more modest in terms of cash distributions and little more modest in terms of expansion because their aspirations are they run a business for several generations. So I would say that businesses are in pretty darn good shape and I’m not really surprised given unemployment still very low down the market.

Tony Davis – Stifel Nicolaus

A follow-on question, the correspondent portfolio, I just wonder if you could give us a feel there about the largest market exposures here graphically and kind of what your loss rate was there in that particular portfolio last quarter?

Greg Smith

Tony, in terms of the correspondent business, it’s a rather diversified footprint in that business. The footprint, there is certainly some Florida, there is certainly some California, and you see that when you look at the credit slides whether it’s in the geographic distributions or in the footnotes related to those. Across the board the correspondent business is one of the businesses where we have obviously seen the deterioration and taken the aggressive steps whether it’s with charge-offs or with the – or in identifying non-performers as well.

Tony Davis – Stifel Nicolaus

Okay, thanks guys.

Greg Smith

Thanks.

Operator

Thank you. Our next question comes from David George.

Greg Smith

Hi, David.

David George – Robert Baird

How are you doing? Couple of quick questions. One, on capital, you did for Tier 1 in the release, I’m coming up with around 8%. I guess first of all, is that the right number? And then secondly, I know you expected return to profitability in Q3, how should we think about the dividend in this kind of marginal capital allocation? Obviously you are blessed with the good tangible number, but the Tier 1 is kind of in line within (inaudible) kind of walk us through capital and kind of your thoughts over the near-term?

Greg Smith

Sure. First of all, just with the Tier 1, we came in at 7.9 at the end of the quarter. And I think earlier we had mentioned we expected 8% there and just a couple of fluctuations on the last day of the quarter. And we are very comfortable with where that ratio is, particularly given that we have a lot of capacity to build that capital ratio, given that we are really – almost 100% of our Tier 1 capital is common equity today. In terms of the dividend and our comments about returning to profitability, we feel very confident that we will return to profitability in the third quarter and as well as really the fourth quarter. In terms of the absolute dollar of earning, I would expect we would cover the dividend as we go forward here, but certainly as the housing markets continue to fluctuate, I’d have to say there is no promise that we would indeed, but we feel that that’s the most likely outcome. I guess one final comment just as we stay on the capital topic is, there is no plan to issue capital today. We’ve gone through a number of scenarios, we’ve gone through a number of stress tests as we look at our capital base, and we really at this point just don’t see that as being on our upcoming calendar.

David George – Robert Baird

Thanks, Greg, appreciate it.

Greg Smith

Thanks, David.

Operator

Thank you, sir. Our next question comes from Ken Zerbe.

Greg Smith

Hi, Ken.

Ken Zerbe – Morgan Stanley

Hi, how are you guys?

Greg Smith

We are good.

Ken Zerbe – Morgan Stanley

First question on expenses. Just went through the math here, if you take the 380, back out the 20 million increase from under reserves and then the 8 million of incremental, you get to about 352, I believe. Is there any other item that’s in there that we should be backing out or is 350 roughly a good run rate?

Greg Smith

In terms of how we’ve looked at the expenses and the items we adjust for, I’m just going to talk about the comparison between the first quarter and the second quarter. There was obviously the Visa litigation, which we talked about. There is the unfunded commitments where that was about $20 million. In addition, as we looked at possible other exposures, there was that incremental 8 million that we backed out. So that gets you to a number that was around 353. But as we look at the incremental costs related to credit items, whether it is loan sale commissions, whether it was an aggressive review of ORE balances and even some legal bills etcetera, that would be tied to those ORE balances. We really looked at a core operating expense run rate that was more in the 325 to 330 area. So that’s how we got down to those numbers.

Ken Zerbe – Morgan Stanley

Got it. So maybe you remain elevated is -- is continues to go on that at least for the short-term?

Greg Smith

Yes. And the important thing for us as well as the investment community to take a look at is to understand the expense discipline of this franchise. We would want to normalize for those credit expenses so that we can understand that the core expense growth is relatively modest.

Ken Zerbe – Morgan Stanley

All right. The other question I had just on NIM, may I ask to give your comments about slight compression over time due to a number sort of larger macro factors it sounded like. Is there any reason to believe that your NIM experience is going to be different than sort of the average of your peers? Is that what you expect with the steeper yield curve that over the short-term, call it 12 to 18 months, are probably going to be seeing some NIM expansion?

Greg Smith

Ken, I can create a scenario where we would see an expansion. We also continue to see that on both the loan and deposit side, things are very competitive out there. So, would we generally go in the trend of the industry? Sure. We have the same underlying macroeconomic factors. At the same time, we are cautious in terms of how we look at NIM today given what we see.

Ken Zerbe – Morgan Stanley

Okay. So, probably near-term flattish going forward. Okay. All right, thank you very much.

Greg Smith

Thanks, Ken.

Operator

Thank you, sir. Your next question is from Greg [ph].

Greg Smith

Hi, Greg, how are you?

Greg

Good morning, just a couple of questions. One, I was wondering if you could provide any color on your 30 to 89-day past due trends or any information regarding close classified credit sized loans, I mean, any color there?

Greg Smith

Greg, we typically don’t comment on those. Certainly, as you go through any period of economic stress, the overall trend year-over-year certainly is going to be up, but we don’t typically comment on that on a quarterly basis.

Greg

Okay. And then the other question would be loan growth. In terms of the categories, it looks like the majority of the loan growth is coming through C&I and home equity. And (inaudible) get some color there, whether you are seeing any activity related to unfunded commitments where people may be drawn down on the unfunded commitments or kind of existing line versus maybe new relationships that you are able to cultivate?

Greg Smith

It is across the board. I wouldn’t look at so much as increased utilization. There is a small uptick on utilization this quarter. I wouldn’t really look at it that way though. In terms of the C&I growth, when I just think about the geography, it is in the core Midwest markets. It is Wisconsin, it is Minneapolis, it is St. Louis, a little bit of it is in Indianapolis as well, when we look at across the footprint. When we think about the sectors where we are seeing that loan growth, we are really -- as you would expect at this time, we are seeing some of it in the agricultural type areas. We are seeing some of it with medical related entities. And of course, at this time of the year in the Midwest we always seem to have an increase in loan balances from those types of companies that are involved in highway, street, bridge construction and repair, and then those balances in those categories typically come down in the third quarter as those borrowers get paid out. If you look at it from the other side where the contraction is, the contraction is really in a place you would like to see it in this piece of the cycle, which is in categories related to auto dealers.

Greg

Okay. So you are seeing a slowdown there and also contracting constructing portfolio?

Greg Smith

Yes, now what I was just commenting now was on the C&I side. When you look at the components of our commercial real estate growth, those components you do see a contraction in our combined commercial land and construction and development categories with growth as much in our multi-family area as anything else. Those are really I think are the highlights that you should take away from the commercial real estate side. Those would be the two important ones.

Greg

Okay. If I can, one follow-up question. On deposit service charges, can you comment as to whether that was related to commercial account analysis activity? We’ve seen some people comment that the lower credit rate that is being given on this commercial account is resulting in higher service charges?

Greg Smith

Sure. When you look at the linked quarter growth, that’s a component of it. A component of it is also going to be on the community side. Now, let me be careful when I say community that is both business banking as well as retail. And you really see it in all three categories, whether it is the larger commercial, some of the business banking, and you also see an increase in deposit service charges coming from the retail side.

Greg

Okay, great. Thank you.

Greg Smith

Thanks.

Operator

Thank you. Our next question is coming from Steven Alexopoulos.

Greg Smith

Hi, Steve, how are you?

Steven Alexopoulos – JPMorgan

Good morning everyone. Greg, I just wanted to confirm when you said that you thought u might cover the dividend with earnings, were you saying for the third quarter or were you saying longer term?

Greg Smith

No, we are talking third quarter, Steve.

Steven Alexopoulos – JPMorgan

In terms of the reserve over the next couple of quarters, do you think you will continue to add to that, or at some point, do you think you might start to draw that down?

Greg Smith

Well, we will see what the overall trends in the national housing market are. I would expect as we go through this part of the cycle and given where we are in the cycle, the reserve would remain in the area it is in today. As some point, we certainly hope that the credit trends and the housing trend would support that coming down, but right now I certainly wouldn’t expect that. It really depends on where we are in the construction and development cycle.

Steven Alexopoulos – JPMorgan

In that, just a final question. If we look at the residential land loans to individuals in Arizona, with LTVs over 115%, are the borrowers there still building on their lots, are they walking away? Just any color you can provide on what this borrow behavior is, that would be helpful?

Greg Smith

You know, I think the real way to look at that is the pace of those projects is slow. Do you have cravings that are continuing to move forward and they are on their expected timetable, you bet. But on average, they are moving slower. Do you have borrowers who walk away? Yes, you have got some of that. But fundamentally I just consider a slower process as opposed to anything else.

Steven Alexopoulos – JPMorgan

Your sense is that they are continuing with the projects?

Greg Smith

On average, on average.

Steven Alexopoulos – JPMorgan

Okay, thanks.

Operator

Thank you, sir. Our next question or comment is from Heather Wolf.

Greg Smith

Hi, Heather. Heather, you might be on mute. There we go.

Heather Wolf – Merrill Lynch

Is this better?

Greg Smith

Yes.

Heather Wolf – Merrill Lynch

It’s the headset, sorry about that.

Greg Smith

No problem.

Heather Wolf – Merrill Lynch

You did mention loss severity levels of about I think 27% on your C&D book. Have you guys -- is that what the appraisals are coming back at right now? Are you guys further haircutting that in case there is more deterioration in house prices?

Greg Smith

First of all, that 27% is against the entire book of non-performing loans, not just C&D.

Heather Wolf – Merrill Lynch

Okay. Can you give us that number on C&D?

Greg Smith

I would rather not put that out there, I would tell you that the C&D haircut is going to be higher than the 27%.

Heather Wolf – Merrill Lynch

And can you just talk qualitatively about how much you are haircutting your appraisal values when you did the partial charge-off?

Greg Smith

What you really need to do these days because of the volatility and appraisal prices is use appraisal prices as your data point as one of the many data points as you go through that process and we look at the appraisals. There may be instances where the appraisal is what we use. There are going to be other instances where we would assume that there is going to be a haircut to that appraisal value. It really becomes a project-by-project type analysis, and that’s been really important for us as we build up the provision – as we build up the allowance. So, that is one data point as we look at it as is local activity based on how we can draw on it as well as what the dynamics around that project, individual projects are.

Heather Wolf – Merrill Lynch

Okay. And then just a quick follow-up on that. On the $8 million of one-time expenses, can you just talk vaguely about that is?

Greg Smith

Oh, absolutely. In terms of the largest component of those $8 million, we went back and took a look at our auto leases and that is a very small portfolio overall. But given the dynamics we see with gas prices today, we have taken a very aggressive approach on how you might look at SUV residuals in that, and that it will be an item that actually flows through expenses. That is probably the largest component of that $8 million though, but it is – yes, it’s a very small exposure.

Heather Wolf – Merrill Lynch

Okay, great. Thanks very much.

Greg Smith

All right, thanks a lot.

Operator

Thank you. The next question comes from Brian Forum [ph].

Greg Smith

Okay. Hi, Brian, how are you?

Brian Forum

Hi, guys, how are you?

Greg Smith

Fine.

Brian Forum

I am just trying to understand the loans to individuals and how you ultimately get paid back there. Are these -- the land loans to individuals, are they building a house and then selling it and so you get paid back at sale? Or are they building house and then moving in and you get paid back when they get a permanent mortgage, or are they selling the land to homebuilders?

Greg Smith

It is more your middle alternative there, where they are buying a piece of land and they are planning on building a house on that piece of property?

Brian Forum

And then are you providing the permanent mortgage or is someone else providing the permanent mortgage?

Greg Smith

That is going to depend on the situation.

Brian Forum

Okay.

Greg Smith

At the end of the day, that becomes the borrower’s decision.

Brian Forum

I mean, when we compare this portfolio versus peers, is it fair then to compare with peers who have one-time close portfolios or is the product somehow different?

Greg Smith

Think of it about it half as being a one-time close product. So you got a little bit of both.

Brian Forum

Okay. And for the most part it is all land where houses being built or there is a significant component of those [ph] lands where the idea is to sell the land to someone else?

Greg Smith

I wouldn’t think about it as land to sell to somebody else. The important thing to take away with this portfolio is that this is a portfolio where the intent of the individuals is to build a home on it. To our best efforts, it is not a flipper portfolio, which I think is really the second half of your point there.

Brian Forum

Okay. And then on the home equity portfolio, can you remind us how much of that is brokered and again specifically brokered secondly and as opposed to the, I guess, first lien portion of your home equity loan portfolio?

Greg Smith

In terms of brokered versus our own product, think of it as half and half. Similarly, when you think about the loans versus lines [ph], it is about half and half.

Brian Forum

Okay. And the brokered piece, does that end up being the most of the out of footprint exposure?

Greg Smith

The brokered footprint is – I’m sorry, the brokered component is very much the out of footprint exposure. And just keep in mind that that portfolio was performing quite well and that portfolio had a higher concentration only on the loan side.

Brian Forum

Okay, got it. And then the last thing just if I could, just to make sure I am looking at this right, if you had $400 million of charge-offs and $964 million of NPAs last quarter, does that mean the net addition to NPAs is running at about $700 million per quarter?

Greg Smith

If you look at the loan sales we have had, you look at the charge-offs, you can come to that conclusion this quarter, but you got to keep in mind how aggressive we have been in moving loans to non-performing this quarter and with one-third of our

Non-performers being past due less than 90 days. I think there is a real (inaudible) there about what we’ve tried to do.

Brian Forum

And that is one-third of the stock of that non-performers or one-third of the (inaudible)?

Greg Smith

That is one-third of the current dollar amount of non-performers.

Brian Forum

Okay. Great, thank you.

Greg Smith

Okay. Operator, are there any other questions?

Operator

(Operator instructions)

Greg Smith

Okay, everybody, well, thank you very much for your time. We appreciate everybody’s interest in M&I. Thanks. Have a good day.

Operator

Thank you, sir. That does conclude today's conference call everyone. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!