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Executives

Mary Gentry - Executive VP IR

Mack Whittle - Chairman, President and CEO

James Gordon - CFO

Lynn Harton - EVP and Chief Risk and Credit Officer

Analysts

John Pancari - JPMorgan

Andrea Jao - Lehman Brothers

Kevin Fitzsimmons - Sandler O’Neill

Jefferson Harralson - KBW

Adam Barkstrom - Sterne Agee

Robert Patten - Morgan Keegan

The South Financial Group Inc. (TSFG) Q2 2008 Earnings Call July 23, 2008 10:00 AM ET

Operator

Welcome to The South Financial Group's second quarter Earnings Call. All participants will be placed on listen-only mode until the question-and-answer session of this conference. This conference is being recorded.

I would like to introduce Ms. Mary Gentry, Executive Vice President of Investor Relations. Ms. Gentry, you may begin.

Mary Gentry

Thank you for joining The South Financial Group's second quarter earnings conference call and webcast. Presenting today are Mack Whittle, Chairman, President, and CEO; Lynn Harton, Chief Commercial Banking and Credit Officer; and James Gordon, Chief Financial Officer. We will then finish up with an analyst question-and-answer session. Chris Holmes, Chief Retail Banking Officer is also with us and available for questions.

In addition to our news release, we have a quarterly financials supplement and presentation slides for today's conference call which are available on the Investor Relations portion of our website. Presentation slides are new for us this quarter and summarize the focus of our comments today.

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. We assume no obligation to update such statements.

Please refer to our reports filed with the SEC for discussion of factors that may cause such differences to occur. Additionally, 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 over to Mack.

Mack Whittle

Thanks, Mary, and thanks for joining us. These are challenging times both for the banking industry and for The South Financial Group. We are facing these challenges head-on and have been working aggressively to address them. We are going to do everything within our power to work through this credit environment and emerge as a much stronger company with a much stronger balance sheet.

I'd like to talk first about the areas receiving our most intense focus, namely capital and credit, where we have seen some progress despite this tough environment. Capital; we entered this credit cycle in a strong capital position and have taken actions to keep capital and reserve level strong as we navigate through this environment. This quarter, we have raised a new capital and increased our reserve levels from 1.72 at March 31 to 1.85 on June 30. With $239 million in net proceeds from the issuance of new convertible preferred, we increased our capital ratios well above regulatory standards for the well capitalized category.

We also made a difficult decision to reduce our common cash dividend to $0.01 per share per quarter to preserve an additional $52 million in annual capital. We believe these actions provide the necessary capital cushion to weather the credit storm, even in an elevated, severe stress situation.

With regard to credit; we are actively and aggressively managing loan problems. In the first quarter, we proactively responded to the credit conditions and as you well remember, we had a sizable increase in non-performing loans. Lynn will discuss later what we see, and we've seen a slowing of the incoming non-performing loans now in the second quarter. Also, we will address problem loans head on, as demonstrated by our pay downs, additional collateral we have taken and loans sales achieved by our dedicative Florida workout team.

In June, we sold approximately $40 million of our problem loans, starting with some of our biggest and quite frankly some of our most problematic. This included three of our seven largest non-performing loans, including the largest. As a general plan, we are working to identify and deal with the most significant problems first, and as I said in the first quarter, denial is not a strategy.

Due in large part to the sale of the problem loans the second quarter net charge-offs increased, but our non-performing loans declined slightly to $224 million at March 30 to $220 million at June 30. These numbers are based on a quarter-to-quarter consistent methodology for determining non-accrual loans. We continued to increase our allowance for credit losses as well. We added an additional $16.8 million in excess of charge-offs and our allowance equals 1.85 of loans on June 30.

At this point, our chief credit weakness remains concentrated in the residential housing markets, primarily in the Florida area. This portion of our loan portfolio continues to face significant stress. In response to that we placed additional resources in Florida to give special attention to these loans.

We continue to aggressively recognize and resolve these related credit issues. However, such measures will take more time given the current real estate environment and the related valuations in those markets. If we are too impatient, when resolving these problems, the problem loans will cost money. So we will have a balanced approach as we move forward with these loans.

Our North Carolina and South Carolina Franchise, while not immune from these same issues are certainly performing much better. Lynn will discuss our credit quality in greater detail including the accomplishments of our Florida workout team later. I'll close with a few summary remarks on our second quarter financial results.

Our net loss to common shareholders was $16.8 million. We added $16.8 in excess of second quarter charge offs to reserves to increase our loan loss reserve to 1.85 from 1.72 at the end of the first quarter. This had an adverse impact on our second quarter results. Our pretax pre-provision operating income was up $4.6 million linked-quarter primarily from the higher net interest income.

A key driver was a 17 basis point improvement in our net interest margin to 3.24 for the second quarter. This gives us comfort that our strategic funding initiatives are beginning to work. After striving to keep non-interest expense under control over the last five quarters, our operating non-interest expense increased in part from loan collection, expense, and monitoring FDIC insurance, advertising, the addition of five new branches in Orlando, plus two de novo branches that we added in the first quarter.

James will discuss a formal efficiency improvement project that we're implementing in this are a little bit later on. In June, we announced the realignment of our corporate organizational structure, which helps us align the company with the way that we've been operating over the last several quarters, and reduces my direct reports. Our Operating Council consists of James Gordon, Lynn Harton, Chris Holmes and myself.

This new structure also enhances our line of business focus with Lynn as Chief Commercial Banking Officer and Chris as Chief Retail Banking Officer. With streamline reporting relationships, we are more focused on customer relationships and funding both of which support our strategic objectives.

We recognize that in this environment, it is important to provide clarity and insight especially in credit. At this point, I would like to turn it over to Lynn to review that.

Lynn Harton

Thanks Mack. Let's start with the credit quality results for the quarter, and then I'll give some additional disclosure on what we are seeing in each individual portfolio. As Mack said, we are focused on aggressive resolution of problem assets. Our non-performing assets increased slightly for the quarter while non-performing loans actually declined by 8 basis points and now stand at 2.1% of total loans.

That charge-offs were high at $47 million, as we continue to realistically value our problem credits and liquidate non-performing loans. Our provision, while down from the first quarter, still exceeded net charge-offs by $16.8 million. As a result, our reserves were strengthened both relative to total loans and relative to non-performing loans.

Several factors drove these results for the quarter. First the inflow of new problem loans fell about 53% relative to the first quarter. Now the inflow of new problems is still high relative to a normal economy, but it is below the various stress level of last quarter.

Additionally as Mack mentioned, we completed the sale of $40 million in non-performing loans during the quarter including several of our largest problems, the vast majority of which were in Florida. While this adds significantly to our losses for the quarter, I believe they are taking some value risk off the table. It is the right approach in light of the uncertainties of the real estate market today.

Our work out efforts, which we detailed for you last quarter, are having a positive effect on our results, and we continue our weekly action planning on every loan that are making problem accounts. As you'll see in the following slides, in our presentation residential construction continues to be the primary stress in the portfolio with rest of the portfolio performing well.

Slide 6 gives the detailed snapshot. At the top of the page, we have got our core C&I and owner occupied portfolio, which totals 39% of our outstanding balances. This portfolio continues to perform well with non accrual percentages, losses, and enhanced dues well within normal ranges. Continuing down the page, you'll note that our completed income property loans at $2 billion or 19% of the portfolio also continue to perform very well. At this point, we have not seen any significant lead over of economic problems in either of these core portfolios.

Residential construction continues to have a majority of our non performing assets. Firstly, I'll note that our home equity portfolio is performing better then expected Additional detail later in the presentation on the under writing statistics for this portfolio will explain some of the reasons for this performance. I do expect losses in home equity to rise over the two to three quarters. However, I continue to believe they will be below industry averages.

The next slide detailed performance of our residential construction portfolio by market. Consistent with the experience of other lenders, there continues to be significant differences in the performance of different areas

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. Florida continues to be almost difficult market with a non-accrual loan rate of 13.18%, up slightly from last quarter.

The majority of our charge-offs are also from our Florida market and as we mentioned, the majority of our loan sales were Florida accounts. Our residential construction outstanding in Florida are down by $77 million and now represent 47% of our residential construction balances, down from 50% in the prior quarter. We previously noted that our North Carolina residential portfolio was performing below expectations due to underwriting issues that we addressed in 2007.

I indicated that we will probably see rising non-accrual loans as we cleaned up that portfolio, but then we believe we will see some positive trends by the fourth quarter of this year. Performance is meeting expectations. With non-accrual loans increasing this quarter the losses, past dues and potential problem levels show moderate improvements.

Some of you have asked about the quality of our South Carolina residential construction portfolio, and particularly our Myrtle Beach exposure. I would start by pointing out that the good performance to-date of our South Carolina portfolio is not an abrasion. South Carolina is performing very well as an area.. Several of our competitors that report separate numbers by state, as well as results from South Carolina only banks continue to confirm that the state is one of the best performing markets in the country for residential acquisition, development construction, as well as for home equity and mortgage lending. We are proud to be a part of that performance. South Carolina is, of course, the core of our footprint, our deepest franchise and 45% of our total loan outstandings.

However, I am not ignoring the probability that the residential market will weaken in South Carolina. We are managing our largest potential problems in South Carolina with the same passion that we are in Florida, including dedicated worker, officers and weekly action planning sessions. As we have in Florida, we will recognize and report problems accurately and in a timely fashion, if they developed.

Moving on to Home Equity. I promise some support for the performance we are seeing to-date from that portfolio. From slide eight, you will see that our home equity originated by our sales force in our geography. We did not use third partied or brokered channels to originate home equity and as you know brokered home equity loans nationally represent the majority of home equity problems.

Additionally, as we note in the summary statistics on slide eight, our origination scores were strong and have actually improved over time in our Line product. We have a good number of first links in our Line product, and our average LTV and utilization numbers also look good. As I mentioned earlier, I do expect current loss rates to increase. But we don't expect the explosion in losses that many have seen.

Turning to mortgage on slide nine where we have seen an increase in problems, I would note the majority of the problems have come from / loans and construction firms, both products which had performed poorly for other banks as well. Both of these products have declining balances as we tightened under writing standards several quarters ago. We have added management resources to this portfolio and we will work through these issues.

Our primary mortgage product which we have targeted strategically to our private banking customer base continues to perform within expectations. It is technically an Alt-A product, but it is fully underwritten with tax returns to validate income, debt to income analysis to verify capacity and asset verification to prove cash to close.

So, in summary, the credit environment continues to be difficult for loans associated with residential construction. Our focus continues to be on executing our key objectives in our lending businesses. At the top of the list of those objectives is reducing non-performers and managing through the cycle. Accordingly, we continue to recognize problems objectively, we are fighting hard to improve the bank's position where possible and we are taking every opportunity to aggressively reduce exposure.

We made progress this quarter but the work continues. An additional objective is to actively improve our mix of business. We have ceased production of indirect order loans in Florida due to the low returns and lack of other relationships coming from that business. We all are, however, continuing to originate indirect order loans in South Carolina where we have several deep and meaningful commercial relationships with our dealer class.

We are increasing pricing for non-relationship commercial borrowing customers and we are reevaluating our position in some existing large corporate relationships where we have not been successful in cross selling other products.

At the same time, we are increasing our focus on our local family-owned business customers and increasing the empowerment and authority of our market presence to service and grow that business. Our Income Property Group also continues to see excellent opportunities due to disruptions in the market.

The net effect should be limited loan growth through the balance of the year, as we continue to focus on increasing our local C&I and our high quality income property businesses while driving down non-core products and relationships.

I would like to now turn it over to James to discuss second quarter results.

James Gordon

Thanks, Lynn, and again welcome to everyone on the call. Since we've already provided some remarks on the second quarter results I'll start with a few deeper comments on the balance sheet and capital actions during the quarter.

First to look at our June 30th capital ratios that's summarized on slide 11. All of our capital ratios are strong and well above the well capitalized requirements above the holding company and the bank level. I'd like to note, if you will recall that we merged Mercantile Bank in the Carolina First Bank in July 2007, so we have only one core subsidiary bank remaining in all of our banking operations, perhaps within Carolina First Bank, although they operate under different names.

We ended June with tangible book value per share assuming conversion of the preferred stock and the common stock of $9.63. Our tangible equity to tangible assets ratio increased to 7.94% primarily as a result of the preferred stock issuance, which contributed $239 million partially offset by $42.8 million negative swing in other [compensated] income and the current period net loss and dividend payoffs.

To provide additional color on our ability to absorb future credit losses, we have provided slide 11 which shows that we have over $600 million in capital reserves in earnings ability over the next 12 months to absorb credit losses as needed or if needed, while remaining well capitalized to both the holding company and bank levels. The over $600 million to loss absorption ability is based on the following key points. First we contributed $125 million as a preferred capital proceeds to Carolina First Bank from the holding company with the remaining proceeds held with their holding company for cash flow coverage.

This builds our bank level ratios and resulted in $269 million of pre tax excess capital on June 30th. Adding to this is approximately a $180 million of pre-tax, pre-provision earnings power to offset pre-tax losses over the next 12 months.

Also approximately, $60 of allowance in excess of 1.25% that is not currently account as Tier 2 capital. We also have approximately $40 million of cash available at the holding company, which could be injected into the bank as needed after covering all preferred and debt service requirements through the end of 2010 at the holding company, and the capital benefit are reducing the balance sheet for those losses should they occur.

We announced our capital plan in May. We included the possibility of issuing up to $100 million in bank levels subordinated debentures, which was included in our plan out of an abundance of caution. However, after closing the preferred offering we've continued to look at our capital needs inline of the current credit environment. Additionally, we have looked at the current terminal in both the institutional and retail sub-debt markets and combine with our capital projections including the above information that we have provided.

We have decided to suspend the offerings at this point. We will actively monitor this and if things change we will be proactive in getting additional Tier 2 capital rate before we need it. Bottom line, we are no longer raising the sub-debt because at this point we don’t think we need it. Now briefly turning back to the income statement, the net interest margin was a bright spot for the quarter. After remaining in a time stable range over the last six quarters and after the Federal Reserve has now suspended rate cuts, we saw the re-pricing lags between assets and funding sources primarily wholesale borrowings, catchup as previously disclosed. This is reflected in the 10 basis point improvement through active balance sheet management involving the overall changes in volume mix and rate in earning assets and liabilities.

This combined with the positive impact to the proceeds form preferred stock issuance and a decrease in the impact of placing loans of non-accrual provided the overall 17 basis point increase in the net interest margin.

Now looking at the remainder of 2008, we expect near term margin pressure to continue, and possibly compressing principally from higher wholesale borrowing costs, given shifts in the higher cost funding to maintain adequate liquidity in this environment, and continued intense competition in pricing of customer funding. The compression is expected to be between 5 and 10 basis points potentially over the remainder of the year.

Turning now to customer funding and liquidity, we've provide on slide 14, a summary of the changes in customer funding by essentially our line of businesses. There is an example of some of the enhanced line of business reporting, we've put in place at the beginning of 2008. Based on period imbalances, you will see that customer retail deposits remained relatively stable over the quarter, where most of the decline is in customer deposits primarily from lower overall liquidity from commercial customers and customers seeking diversification.

Additionally, these same factors combined with seasonal changes in public fund account generally contributed to the decline in customer sweep accounts.

Slide 15 summarizes non-interest categories. We had good growth in service charges on deposits in keeping with seasonal trends, and improvement in mortgage banking income. Most areas continue to show positive improvement linked-quarter and year-over-year.

We continue to focus on the customer fee income through our customer funding in private banking initiatives. As stated earlier, the non-operating gain on investment securities was a result of $3.2 million gain on the liquidation of an investment fund offset by $1.3 million of losses in the corporate bank and other securities portfolio.

We've also been getting some questions on our investment securities portfolio. We have no Fannie Mae or Freddie Mac common or preferred stock in investment portfolio, and our only direct exposure to Fannie Mae and Freddie Macis through our mortgage back securities and other direct debt obligations.

Over the last year, we have a significantly reduced the credit exposure in our overall investment portfolio while reducing equity holdings and corporate bonds. Our remaining equity holdings and corporate bond exposure has now been reduced to approximately $50 million with less than a $1 million unrealized loss at June 30th, 2008.

Now turning to non-interest expenses, we are disappointed with the increase in non-interest expenses, which had been kept in check over the last five quarters. The increases are summarized on slide 16 with approximately half of the increase related to loan collection in monitoring in FDIC insurance reflective of the current credit environment, which are expected to continue over the remaining quarters in 2008.

Specifically, we expect FDIC insurance premium to increase approximately $750,000 per quarter going forward. We have also added approximately $400,000 in new expenses related to the five branches in Orlando, as well as two de novo branches opened in the first quarter. We expect to add an additional $700,000 next quarter for the full quarter impact of the Orlando branches.

The other remaining increases are for increased commissions from fee based businesses, annual salary increases from non executive officers and employee and annual increases in other expenses.

Following the completion of our organizational changes in the current environment, we are initiating a formal project for efficiency improvement through expense savings in revenue growth. We expect to engage outside consultants in the near future and to kick off the project during the third quarter. The project will be focused on improving overall efficiency, improving the customer experience and enhancing the overall revenue stream going forward.

Before I close, I like to make a quick comment on our income tax rate. First the impact of the non-deductible goodwill impairment from the first quarter spreads over each quarter in 2008 rather than being discreet in the first quarter. Given the size of the good will impairment relative to our annual projections of taxable income involved, the effective income tax rate for the third and fourth quarters 2008 could be significantly impacted by changes in those projections and variances with actual results. Therefore the ongoing rate is difficult to project and could vary significantly from the rates utilized in the first half of 2008. Our second quarter results also reflect the deprivation of the first quarterly dividend on our preferred shares. Going forward the preferred dividend will [sell at] approximately $6.25 million per quarter until those shares are converted into common shares. With those comments, I'd now like to turn it back over to Mack.

Mack Whittle

While we did report a loss for the quarter as we expected, we also made progress in this difficult environment. We built our capital and reserve levels. We saw healthy expansion on our net interest margin. The most importantly, we're aggressively are addressing the credit issues and consistently doing so. All of us at the South Financial Group appreciate your support and now like to turn it to questions.

Mary Gentry

This is Mary. We would ask that you limit your questions to one primary question with one follow up. If you have additional questions, feel free to reenter the queue. We are now ready for the question-and-answer session to begin.

Question-and-Answer Session

Operator

Thank you. We invite analyst to participate in the question-and-answer session. (Operator Instructions). Our first question comes from John Pancari of JPMorgan.

John Pancari - JPMorgan

Good morning.

Mack Whittle

Good morning.

John Pancari - JPMorgan

Can you talk little bit about your interest in selling additional non-performers in this market and are you seeing some opportunities still there to complete some sales and is that 30%, approximate 30% mark that you took on the sale here? This quarter representative of what you are seeing in the market right now for the interest in these loans?

Lynn Harton

Yes, John this is Lynn. We are continuing to use loan sales as a strategy, and reducing our non-performers. As you know, when you sell a non-performing loan, you are selling a claim on the asset versus selling the underlying asset of sales. So you do have higher discounts, when you sell a loan versus if you take it through the process, foreclose and actually sell the underlying property. As I mentioned in the opening comments, taking some risk off the table given the uncertainty, we think its right thing to do. And we are actively marketing several non-performing loans as we speak, and we are not doing them in a bulk sale basis. We do it them on a account-by-account basis. And we believe that the marks that we saw in the second quarter, we certainly don’t see the marks getting worse than that. And that we're seeing a little more interesting activity, but my expectation for loan sales in the third quarter would be consistent marks with what was on the second quarter, but not worse.

John Pancari - JPMorgan

Okay, that’s helpful. Then, my follow-up would be in terms of contingent, and I appreciate the detail you gave us here in terms of the credit metrics in the other portfolios, but can you give us a little bit more color, what you're seeing there on the ground or what areas are you most cautious of in terms of contingent in your commercial portfolio, particularly on the income producing commercial real estate properties, and then also in your C&I book?

Lynn Harton

Sure we'll be glad to. On the income producing properties, we're certainly concerned with a watchful eye towards our retail proprieties. That would be the first area to show weakness, we are not seeing that yet, but we're certainly watching and monitoring for that. I would say that the commercial income property piece of the business in total has been very well balanced. You don’t see the big over supply that you saw back in the early 90s great numbers of spec building. So, what we, we think that that's going to continue to hold that performance, continue to hold their home. We are seeing significantly less new construction, which we think is a good thing for that product.

On the C&I side, it would be what you would expect in that companies. They are all tied to housing, whether it's building supply with local realtors, those are the places we're seeing weakness today, but we have not seen it outside of that kind of group.

John Pancari - JPMorgan

Okay, so it's still largely centered in the housing for low let's say.

Lynn Harton

It is today, yes.

John Pancari - JPMorgan

Okay.

Lynn Harton

Along with, the only other piece I'd add is trucking due to fuel cost, we don’t have a large exposure there, but that would be the only other area that we're seeing.

John Pancari - JPMorgan

Okay. Thank you.

Operator

Thank you. Our next question comes from the Andrea Jao of Lehman Brothers.

James Gordon

Good morning, Andrea.

Andrea Jao - Lehman Brothers

Hello.

James Gordon

Hi, good morning Andrea.

Andrea Jao - Lehman Brothers

Hello, good morning. In one of our slide, you mentioned that some of your assumptions or that the balance sheet will not shrink. I was wondering if you were looking to shrink the balance sheet, deliver a little more and kind of talk about your strategy for the liability side given the interest rate environment.

James Gordon

Well, if we shrunk the balance sheet on the asset side, we would obviously begin to lower primarily wholesale borrowings and continue to focus on the customer funding side of the balance sheet, though we would be in the wholesale borrowings side including broker deposits.

Andrea Jao - Lehman Brothers

Got you. But are you looking to term out some of your liabilities and do you have a number in mind for what buckets of assets to decrease if possible.

James Gordon

As far as the buckets of assets, I think Lynn mentioned, we have shut down the origination of the indirect portfolio in Florida, so that will naturally begin to run all. And then, I think anything that falls into the category are not being a core relationship asset primarily on the lending side, where we have not expanded the relationships or do not perceive the ability to do that would be the areas that we would do. And then, obviously given the environment we would be pulling back on the residential construction portfolios particularly in Florida. So all of those would be the areas that we pull back, but we want to stay still at our core business, we'll stay at that and looking to still have good solid production in those areas while pulling back in the other areas. And far as terming out liability, we are lengthening both the broker deposit side and some of the other wholesale borrowing sides to protect liquidity in this environment, and moving less from the shorting it to the longer end, but not year to 18 month range.

Andrea Jao - Lehman Brothers

Okay. So, is it safe to assume a couple of $100 million decrease in balance sheet from now till year end?

James Gordon

Probably closer to flatter then necessarily down, but we keep that as elaborative, as things vary from our forecast and projections on capital on funding needs.

Andrea Jao - Lehman Brothers

Okay. Thank you so much.

James Gordon

Thanks.

Operator

Thank you. Our next question comes from Kevin Fitzsimmons of Sandler O'Neill.

Kevin Fitzsimmons - Sandler O’Neill

Good morning everyone.

James Gordon

Good morning Kevin.

Kevin Fitzsimmons - Sandler O’Neill

So, I guess if I'm looking at over the next few quarters the margin you expect to really come in from here, the balance sheet at best will be flat as you look to take down certain segments. And credit cost, we'd probably assume would remain elevated at least. And so, it seems like the one area that is in your controls is expenses. And can you talk a little bit about where you want to go with expenses? I know previously when you had initiatives, more informal initiatives on the expenses you were targeting like an $80 million per quarter level. So if you can talk about that then secondly just why do you feel you need to bring outside consultants in to do that? It seems like expenses was an issue, I guess it was little more than a year ago, and you really attacked it over a one to two quarter period and got it down so, why do you think you need to bring someone in if you're really gone through that exercise already, thanks?

James Gordon

Both good questions Kevin, and what I would say first on what of we are targeting. First we got to cover, the headwinds on the collection front in the FDIC insurance and really most of that accounts will increase year-over-year. So getting back to kind of that core $80 million kind of run rate is the first step. But then, as far as engaging consultants, what we, well I would term what we have done before was cost cutting. Now what we want do is really look at the efficiency. we will use the same cost cutting measures to try to get to the $80 million in a much quicker, but over the longer term we want to manage the efficiency and focus not only on the expense front, but on the revenue front as well and improving the processes. And we believe that is an opportune time to do that with the headwinds that continue to process on credit and cost by the FDIC insurance premiums that could potentially go up even further given the overall industry.

Mack Whittle

Kevin to your point, it will be a bottoms up process like we have had before, I mean, and it will be a company owned process. So consultant takes different forms and to join this point, we see they are more looking at the processes that we are using and if there a better opportunity to use technology and is there a better way of doing it and are there inherent savings, cost savings in changing that process.

Lynn Harton

So, we will probably only follow engage consultants to do specific area as not a one consultant to be the silver bullet. We would try to use the best in each category that we maybe looking at. So we may use one group for, you know, the lending side, another group for the retail, another for the back officer or so forth rather than one broad reaching consultant.

Kevin Fitzsimmons - Sandler O’Neill

Okay, great. Real quickly, can you guys also provide a little more color on the banks update, and what was the real issue? Was it's only pricing and you just felt that at the end you didn't need it or was there just some other resistance you were running into?

James Gordon

Well, I will say a couple of things, and at the core of it was the pricing. We were, we do not believe that we needed it bad enough to go at it, you know in all costs or any cost approach, and we never allowed the price fall to move up significantly from where we started at. And then, you know, over the last quarter, we really haven't seen, unfortunately with the industry not a lot of good news, and so that the yields on bank paper have continued to move up. It was not anything specific to us.

We never believe that we had to do the sub-debt and in fact if we go back to the original, our original context, the original goal was to get $250 million of capital and we got that, solely by doing the preferred stock and that didn't count what we did on the extra, roughly $100 million over a two year period on the, on cutting the dividend. It was always something that would have been nice to have, but not something that we had to have and certainly not in any price. So, with the turmoil in the markets and the pricing, the way it is now, we're just going to discontinue it and focus on managing credit and capital that we have today.

James Gordon

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Jefferson Harralson of KBW.

Jefferson Harralson - KBW

Hi, thanks.

James Gordon

Hey, Jeff good morning.

Jefferson Harralson - KBW

I was thinking about this chart on page 12, where you guys calculate $609 million of loss absorption potential.

James Gordon

Right.

Jefferson Harralson - KBW

And then, thinking about that in concept of kind of what happened this quarter with the loss rates as higher they are and no real vision are not real, expectations are going to go down soon. You guys reported a net loss of $70 million this quarter, is there, this is going to be more a follow up Kevin is there some more aggressive changes that could be down to stop the capital attrition in the form of expense cutting more aggressively or shrinking the balance sheet more aggressively or maybe branch sales, because if you make this thing back to break even, it will alleviate a lot of capital issues.

James Gordon

Right, no doubt. But, all of these things that we're going to look at are part of this broader initiative. I don’t want to make it sound like that initiative is just about expenses, because it's not. It's about the complete balance sheet and the complete income statement, both growing revenue, controlling, reducing expenses and looking at what we're doing in the balance sheet, so all of those things will be on the table.

Jefferson Harralson - KBW

How about to shrink the balance sheet option? Is there, are there portfolios in their non-core portfolios and they are large enough that you could consider?

James Gordon

We are looking at all aspects of it. I think Lynn pointed out earlier. I mean, anything that’s non-core business, is not core to where we see ourselves going forward is subject to either cutting back on or getting out of.

Lynn Harton

And obviously, right now Jefferson that would have to come from more run off then probably gross sales because of the liquidity in the marketplace for this broad range asset sales. That’s the reason we are allowing for example the indirect in Florida to run off over - it'll have a life in the 2.5 to 3 year range. And that’s pay down, what we saw just for example last month that portfolio alone ran down about 25 million. So if we control production, stick to our basic things, which are serving in a community bank style, building relationships, we believe we can control the balance sheet road then remixed the assets to position us on the other side of this market.

Jefferson Harralson - KBW

Okay guys. Thanks a lot this is helpful.

James Gordon

Thanks.

Operator

Thank you. Our next question comes from Adam Barkstrom of Sterne, Agee.

Adam Barkstrom - Sterne Agee

Can you hear me all right?

James Gordon

Yes, good morning.

Adam Barkstrom - Sterne Agee

Good morning. Hey James, I was wondering page 12, the exhibit there, the one piece I didn’t understand, I was wondering if you could just explain to me that the capital associated with losses to 55, what is that trying to represent?

James Gordon

Well, basically all I'm saying there Adam is, if you write all $550 million assets that freeze up 10% of capital.

Adam Barkstrom - Sterne Agee

Got you.

James Gordon

That’s really saying. So, in reference that would be saying you'd shrink the balance sheet by the 550, so it's somewhere between 550 and 600 depending on how you view that and how you may or may not replace that. Obviously I don’t think we would replace 550 over a 12 month period, if that were to happen which we don’t believe that that necessarily representative of the law. I mean, if you just take the 269 that recover the provision that we booked this quarter for the next four quarters.

Adam Barkstrom - Sterne Agee

Got you, okay. And then Lynn, you had mentioned two things. You had mentioned, I was wondering in the asset sale, if you can give us a little more and may have mentioned this previously and I missed it. But, if you give us a little more detail of what kind of pricing you got there and that was all primarily in Florida, and then in the net new NPA flow, I think it's about $97 million, if you add the loan sale back end, but I was curious if you could give us some detail as to what you are seeing in the net new NPA book?

Lynn Harton

Sure, in terms of the asset sale, because we have got the amount of the charge-offs mentioned that was associated with the sale. I think say it's roughly $0.60 on the dollar, the individual transactions ranged from 47% to 79%. So it's just all about, which kind of property it is. We did as Mack mentioned we try to attack our most problematic ones first.

Adam Barkstrom - Sterne Agee

Hey Lynn, where is that and I just missed it I am sorry?

Lynn Harton

That would be on slide, page 5

Mack Whittle.

Page 5.

Adam Barkstrom - Sterne Agee

Thank you.

Mack Whittle

Of the presentation slide.

Lynn Harton

Of the presentation.

Adam Barkstrom - Sterne Agee

I got you. Thank you.

Lynn Harton

In terms of the net in flow, a little less than what you mentioned there, but again it's roughly half the level of the first quarter, but it is higher than normal. It's roughly twice the level of the fourth quarter. So I mean, in terms of what we see from here, I certainly don’t know where the economy is going and how the real-estate market will play out from here. We think the third quarter is going to be similar to second quarter to potentially slightly better. But, I would say that the fourth quarter and the first quarter of the year are typically difficult ones for real estate developers, and so we have eye on those two quarters, and part of our urgency in dealing with problems now and taking steeper discounts now is in the context of that knowledge.

Adam Barkstrom - Sterne Agee

Why is that Lynn, is that a just a seasonal issue.

Lynn Harton

Sure, yeah, I mean if you think.

Adam Barkstrom - Sterne Agee

Yeah.

Lynn Harton

Exactly.

Adam Barkstrom - Sterne Agee

And if I could one more, and I'll jump off. James on the sub debt issue on, I mean is that something that you think you will revisit here in the near term, assuming pricing improves or is that just, is that kind a put to bet for now.

James Gordon

I will say, we will revisit to market, because you know I will go back to what we have said. The sub-debt in one form or the other has been around since last fall, because even going back to our ratios where, at the end of the third quarter or second quarter it was where we were, lower relative. If you look it our capital ratios and relative to peers and you know the most room, so we just don’t have much in the way of sub-debt. Tier 2 capital anyway, and so I think over time that will be something nice, but only if the surprise is settled back end. I think, in the 10% range, we would do, maybe $50 million to $100 million, if that's what it is, but obviously the yields now are in some cases twice that.

Adam Barkstrom - Sterne Agee

Okay. Thank you gentlemen.

James Gordon

Yeah.

Operator

Thank you our next question comes from Abraham (inaudible) of Morgan Keegan.

Robert Patten - Morgan Keegan

Hey, guys this is Bob Patten, how are you?

James Gordon

Good morning Bob.

Robert Patten - Morgan Keegan

Most of my questions have been answered. On John Pancari's question, I just want to revisit in terms of the loan sale market, can you give us any color, I mean, you said you are doing loans more in a one-off basis, but what in terms of activity compared to six months ago compared to three months ago? We're starting to hear anecdotally that the discussions are picking up and some activities picking up, are you seeing increased interest at this point or do you expect increase interest over the next six months?

Lynn Harton

Yeah. I will say that we are seeing increased interest. The assets spreads are coming closer together, which is why you're starting to see some transactions happen and that’s coming largely, it is coming on both sides of the equation. The bids are getting a little better and the sales prices that banks will and stake are coming down, and so you're having some transactions happened. I would say that again the interest level has definitely higher than it was six months ago.

Robert Patten - Morgan Keegan

And, who are the buyers that you guys are seeing? Are they different, are their funds, is it private equity, is it individuals, is it remission capitals of the world bringing people in.

Lynn Harton

It's all of the above. We are seeing interest in every one of those categories.

Robert Patten - Morgan Keegan

Is there, the fear that the first one to the trough gets taken care, but if you are last with the trough that may not be anything left.

Lynn Harton

I don’t know, you would have to ask them but that's an interesting follow up.

Robert Patten - Morgan Keegan

Okay. Thanks guys.

Lynn Harton

Thanks.

Operator

Thank you. Our final question comes from Andrea Jao with Lehman Brothers.

Andrea Jao - Lehman Brothers

Hello again.

James Gordon

Good morning Andrea.

Andrea Jao - Lehman Brothers

Good morning. Slide 10 increased allowance for credit losses to the 185 basis point area, I was wondering what goes into that you know 185 basis point sort of target that you're putting out there.

Lynn Harton

Well the 185 is not the target, that’s where we actually ended up at June 30. But, what we are more, what I would say somewhat of a target loosely as the stake with coverage of NPLs and 80 basis point range is more of the target. The 185 is where we were actually at June 30th.

Andrea Jao - Lehman Brothers

Are there some underlying assumptions that you can share with us that go into these numbers?

Lynn Harton

Really the …

Andrea Jao - Lehman Brothers

Or an outlook that go into these numbers?

Lynn Harton

The, which we will do give detailed disclosure in the queue relative to any components of our reserve. And the three components would be our underlying historical loss rates, which are viewed over a longer-term period until they move relatively slowly. So, one factor that would increase it as we continue to see increase loss rates on portfolio-by-portfolio basis. That would drive an increase in reserve.

The second piece is our specific reserves on our commercial non-performers. That was up about $7 million, I believe over the quarter so up slightly. And so again, one other thing that would drive increases in the reserve would be increases in non-performing loans, which kind of speaks to James point earlier. Finally we look economic conditions, last quarter we added to the reserve because of appraisal issues in Florida and we disclosed that. So we, that would be the piece that as we look at the economic environment and get more clarity on where that’s going that we might have potential for additional reserves as well, but those are the three buckets and how we approach those.

Andrea Jao - Lehman Brothers

Got you. Thank you so much.

James Gordon

But, if you think about, it's going to be write in the allowance is going to be linked to what happens in non-performing in due course of time. As it goes up, it's going to go up, relatively speaking and as it comes down, it's going to come down. So we don’t see any near term ability to let it be significantly less than then the 185 at this point.

Andrea Jao - Lehman Brothers

Understood.

James Gordon

So

Operator

Thank you. I’d like to turn the call back to Mr Mack Whittle for closing comments.

Mack Whittle

Again, I'd just like to thank everyone for joining us today and if you have future questions feel free to contact us.

Operator

Thank you this concludes today's conference call. Thank you for your participation on the call. You may disconnect at this time. If you would like to replay information that is available for one week you may dial 1800-879-6754 or toll number 402-220-5334. Thank you again and you may disconnect at this time.

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Source: The South Financial Group Inc. Q2 2008 Earnings Call Transcript
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