Tony Rossi - Investor Relations
George Leis - President and Chief Executive Officer
Stephen V. Masterson - Chief Financial Officer and Executive Vice President
Dave Porter - Chief Credit Officer
Don Lafler - Former Chief Financial Officer
Trevor Morris - UBS
Joe Morford - RBC Capital Markets
Aaron Deer - Sandler O’Neill
Andrea Jao - Lehman Brothers Holding Inc
Analyst for John Pancari - J.P. Morgan
Pacific Capital Bancorp (PCBC) Q2 2008 Earnings Call July 23, 2008 11:00 AM ET
Welcome to the Pacific Capital Bancorp second quarter 2008 finance results conference call. (Operator Instructions) I’ll now turn the conference over to host Tony Rossi with the Financial Relations Board.
Thank you for joining us to discuss second quarter results with the management of Pacific Capital Bancorp. With us today from management are George Leis, President and Chief Executive Officer; Stephen Masterson, Chief Financial Officer, Dave Porter, Chief Credit Officer and Don Lafler, the company’s former Chief Financial Officer and now a consultant to the Finance Department. Management will provide a brief summary of the results and then open up the call to questions.
During the course of the conference call, management may make forward-looking statements with respect to the financial conditions, results of operations and the business of Pacific Capital Bancorp. These include statements that relate to or dependent upon estimates, or assumptions relating to the prospect of loan and deposit growth, credit quality trends, the health of the capital markets, company’s de novo branching and acquisition efforts, the operating characteristics of the company’s income tax refund program and the economic conditions within its markets.
These forward-statements involve certain risks and uncertainties, many of which are beyond the company’s control. Forward-looking statements speak only as of the date they are made. Pacific Capital Bancorp does not undertake any obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.
At this time I would now like to turn the call over to George Leis.
I’m going to provide a brief overview of the second quarter of 2008 then I will turn the call over to Stephen Masterson, our Chief Financial Officer, who will review our financial results in more detail. Following Stephens remarks, I will conclude with a discussion of our outlook for the remainder of this year.
We record a loss of $0.13 per share in the second quarter. This was due to a provision for loan losses in the Core Bank of $43.5 million. Before I proceed, I would like to say that we fully understand that our second quarter results are well below the markets expectations will look typically until our preannouncement. However, much of the information that led to charge-offs in additional provisioning this quarter, was received and analyzed in just the past two days. The preannouncement was now a possibility and we regret surprising the market in this fashion.
Now we will begin by discussing our credit trends. Majority of the credit deterioration in our loan portfolio is located within the home construction portfolio, which represents approximately 6% of our total loan portfolio. However, we’ve also started to see weakness in the economy as having a more pronounced effect on our other portfolios as well. Within the home construction portfolio, we have segmented the problem loans into two groups. We have developed two different approaches to remediation.
The first group consists of the larger relationship that we discussed last quarter. These six relationships with total outstanding balances of approximately $98 million after certain charge-offs, that I will discuss momentarily. We now have workout plans in place with four of these relationships and we are completing the remediation plans with the other two.
We have also deemed four of these loans to be collateral dependent and we further wrote the value of these loans down to positions them for liquidation. This is a more conservative evaluation and reflects the determination that foreclosure maybe a possibility. Once a loan is deemed to be collateral dependent and written down in this fashion. The appropriate accounting treatment is to charge-off the specific allowance against that loan.
We charged-off approximately $12.3 million in allowance against these four loans. Since the effect of this accounting treatment serves to reduce both our loan balance and our reserve balance against those loans, it makes out allowance ratios appeared lower. However, this must be viewed in the proper context. Its important to understand that we have now taken partial charge-offs against many of our larger nonperforming assets.
The second group within the home-builder portfolio consists of builders, were the bank had decided to foreclose on the collateral. The total loan balances among this group is approximately $15 million. We’ve obtained current appraisal data on all of these projects and written the loans down to position them for liquidation. We have also added some additional resources to our credit department that provide expertise in moving swiftly to the foreclosure process. We did stress testing on a number of portfolios in the second quarter and we would like to share the results with you.
In the CRE portfolio, we stress property values by 15%. In the residential real estate portfolio, we stress property values by 33% and finally in the homebuilder and land portfolio we stress collateral values by 35% with March 2008 being the average date of the appraisals used for the test. In each case, we found that the existing allowance in each portfolio covered our potential loss exposure. With respect to commercial real estate, it is also worth noting that the trends in our footprint continue to be stable, although we have seen some signs of occupancy rates coming down from very high levels.
I would now like to discuss our provision for loan losses this quarter. As I mentioned earlier, the provision for the Core Bank was $43.5 million and I would like to walk you through the components of the provision to help provide some additional insight. Approximately, $29.3 million covers the charge-offs for the quarter, which includes $13.7 million related to the homebuilding and land loans, $5.4 million for C&I loans, $4.9 million in residential real estate loans, $2.3 million in small business loans and $2.2 million in home equity lines.
We recorded a nominal charge-off of $300,000 in commercial real estate during the quarter, which reflects the relatively strong trend we continue to see in this market. Approximately, $3.8 million is related to the growth in the loan portfolio and the increase in problem loans during the second quarter. Approximately $10.5 million was added to the qualitative factors portion of the allowance.
The last two items represent an increase in the allowance level of $14.3 million. This increase is allocated randomly across the mix of our non-performing assets. With the provision taken this quarter, our allowance levels have increased to 1.29% of total loan and 46% of our non-performing loans. Given the results of the stress testing that we discussed earlier, we feel confident that our allowance is adequate.
Moving to other items of note, we are clearly seeing the benefits of having a strong capital position in this environment. We had strong loan production in the second quarter that generated an annualized growth rate of 15% for the core bank. Loan growth was particularly strong in commercial real estate, commercial and industrial, homeowner equity and the residential real estate portfolios.
We are also moving forward with our strategy to reduce our reliance on wholesale funding. During the second quarter, our retail deposit campaigns resulted in a net increase of $109 million in our CD balances. We have decided to be slightly more aggressive in our CD pricing to help attract more deposit. However, we are aggressively working to cross-sell other deposit and loan products as well as our Wealth Management Services to the new customers that we have obtain through these campaign. We believe this strategy will enhance the profitability of these relationships overtime.
Now, I would like to turn the call over to Stephen Masterson, for further discussion of our second quarter results.
I will provide our review of our Refund Anticipation Loan Program and our Refund Transfer Program a little later in call. For the next few minutes however, I would like to talk about the results of the Core Bank, which do exclude the impact of RAL and RT. The Core Bank net interest margin increased to 3.74% during the second quarter of 2008 and that’s up from 3.64% during the first quarter of 2008. The increase is primarily attributable to higher volumes at lower interest rates.
Our non-interest income in the second quarter of 2008 was reduced by $4.8 million due to office and CRI investments and related to our mortgage backed securities portfolio. Excluding gains and losses on securities and loan sales, our non-interest income totaled $15.9 million in the second quarter of ’08 compared to $16.5 million last year. The decline was primarily due to a loss on our CRI investments, which I previously mentioned. This was partially offset by an increase in wealth management feels primarily due to the acquisition of R. E. Wacker Associates, the Registered Investment Advisor that we purchased in January of 2008.
Total non-interest expense was $56.3 million in the second quarter of 2008 and that’s an increase of 2.6% from the same period in the prior year. This also represents an increase of 3% from non-interest expense from the first quarter of 2008. So, primary reason for the sequential quarter increase was a $2.8 million charge recorded in the second quarter to throughout depreciation expense on some of our information technology systems.
The operating efficiency ratio for the Core Bank was 71.1% for the second quarter, which is essentially the same as it was in the first quarter. We recognized that the operating efficiency ratio has become unacceptably high, beginning in the third quarter we have implemented tighter controls of discretionary spending, the use of consultants and other items they do not have a direct impact on customer service, more in generating business for our bank.
Turning to our balance sheet, total gross loans in the Core Bank were $5.69 billion at June 30, 2008 which represents an annualized growth rate of 15%. Total deposits in the Core Bank were $4.57 billion at June 30, 2008 as compared to $4.62 billion at March 31, 2007 and $4.72 billion at June 30, 2007. Our growth in CD’s help to offset sequential quarter declines in the other deposit categories. George already discussed our asset quality, so I’ll move on to talk about our capital ratios a little bit now.
At June 30, 2008 a Tier 1 tangible asset ratio was 8.4% compared with 7.6% on March 31, 2008. Our total risk weighted capital ratio was 13.1% at June 30, and that’s compared to 13.2% at March 31. All of our capital ratios continue to exceed the regulatory definition of, well capitalized. Now I would like to provide a brief review of the RAL and RT programs. Through the first six months of 2008, these programs generated $117.9 million in pretax income an increase of 81.3% from the $65 million that we had the same period of last year. Total volume for these programs was 8.3 million transactions, an increase of 25.8% from the 6.6 million transactions that we had in 2007.
During the second quarter we recorded a negative provision for the RAL related loan losses of $6.4 million. The negative provision was due to greater than expected collections and funding from the IRS during the second quarter. During the first six months of 2008, we experienced a loss rate of about 1.01% for the 2008 RAL program. With a modest amount of additional collections we expect to see that loss rate for the full year be at a target rate of 1% or less.
Now I will turn the call back over to George.
Giving the continued weakness in the home building market and the challenging economic environment, we anticipate that our non-performing assets and provision for loan losses will remain elevated until the credit cycle on economic conditions improved. The level of provision will remained the biggest uncertainty with regard to our financial performance over the next few quarters.
However, we do feel comfortable in saying that we believed, we have adequate allowance against the home building portfolio that our remediation efforts are preceding well, and at that the stress testing indicates that we can observe additional clients in-value without incurring additional losses, that our provision for loan losses remained stable or decline, there’re positive trends in loan and deposit gathering along with improved expenses management should help the Core Bank to generate greater profitability in the second half of the year.
The decisive actions we took this quarter, substantially booster the strength of our balance sheet. We remained confident that our allowance position as of June 30, coupled with our strong capital position, will enable us to successfully manage through this challenging credit cycle as we continue to provide quality banking services to our very important local markets.
We would now be happy to address any questions you might have. Steve and I are joined on the call today by Dave Porter, our Chief Credit Officer and by Don Lafler, Finance and Treasury consultant to our company.
(Operator Instructions) Your first question comes from Andrea Jao - Lehman Brothers.
Andrea Jao – Lehman Brothers
Just wanted to get more detail on how thoroughly you have looked at your entire loan book, beyond the most problematic, slighter to the loan book and I believe, you were working with an outside consultant [inaudible] again hoping to get an update and more detail from that?
I think we mentioned in the first quarter that we had a targeted loan review that was focused on the both the larger construction credits that we had in our portfolio. In the second quarter, we did a second step to that which was a independent loan review on basically commercial real estate and construction accounts that we did not review in the first quarter. That review resulted in, actually only a few risk rate changes that we had, that we had not already taken into account. So, we were pleased with the outcome of that particular review.
Andrea Jao – Lehman Brothers
Could you please remind us what's your priorities are in terms of the use of capital? Some banks prioritize the dividend, others prioritized growth. Please remind us what’s your priority are, and what you think the call from your capital would be in coming quarters, especially as you face what’s potentially a strong RAL season next year?
I think to your last point, the capital position of our bank is geared towards preserving it for use in our RAL season. So that goodness, we had such a strong RAL season and Stephen I think that generated $67 million of capital for our company, so, you know Andrea we are looking at all of the sort of uses of capital, ensuring that we are adequately positioned to launch into our 2009 RAL season.
Andrea Jao - Lehman Brothers
What was the tax rate do you us, for the coming quarter?
Each month, each quarter we true up our annualized effective tax rate and there is lot of things to going into that, but it’s basically as if we are doing a tax return for the company and we look at our reductions. The things that we have flowing through, in this case the allowance for loan losses any losses we have etcetera and we true up and create what we call the annualized effective tax rate. In the first quarter you’ll recall that was 37.65%.
This quarter that came down to 34.02% , 34.05% something in that range. I think that’s a good tax rate to use going forward that’s what we are projecting to use till the reminder of the year and that’s part of the reason that you saw the negative tax provision come through in the financials this quarter, because of that difference in the tax rate.
Your next question comes from Aaron Deer - Sandler O'Neill.
Aaron Deer - Sandler O'Neill
I guess a question on the margin. Dave I was wondering if there is any net interest reversals in there and if so, if you can kind of put a number on that in terms of basis points and then I was wondering, given that the widening that we saw this quarter, if in fact that is sustainable given the direction to deposits rates, especially with the deposit campaign that you are undertaking?
I was wondered if moving anything into NPA’s this quarter cause, was cause for taking any interest reversals and if so what those reversals, what kind of impact they had on the margin?
I don’t think we have any of that. To your second point on the net interest margin we did see the increase this quarter it went from 3.64% up to 3.74%. I think if you look at that on a year-to-date basis it’s averaging about 3.66%. We do have a very strategic campaign going on to raise retail deposits as George talked about and we are competitively priced for those products, but we are not priced over market in those products, but we are attractive in the market that we serve.
I think what’s you seeing though is when we receive the new CD’s or we have new customers come in especially if it was some of our existing customers, we saw that they were coming in and some of their older CD’s were maturing that were at higher rates and they’re coming down into some of our new CD’s that were at lower rates based on current markets.
I also think that that part of that - I know that part of that increase was due to some of our borrowings, and our borrowings were coming in at much lower rates than they historically have. As I’ve looked around the banking industry, I have seen most of the banks have an increase in the net interest margin in the last quarter. I don’t think you’re going to see a large increases, sustainable overtime, but I do think you’ll see that mid-range of about 3.66% where we are now, its were we hover as we go forward.
Aaron Deer - Sandler O'Neill
I’m just wondered if you gave the breakdown in terms of the total construction with residential commercials well as in foot and out of footprint?
Total construction out of footprint was approximately, I’ll give you a number, but I may want to comeback and check with you, but I’m going to say about 130 million.
That’s probably where it was at the end of the last quarter.
Right, the balance would be in the footprint.
Aaron Deer – Sandler O’Neill
Then the breakout between residential and commercial?
Continues to be about 45% residential, about 55% commercial
Your next question comes from Joe Morford - RBC Capital Markets.
Joe Morford - RBC Capital Markets
The release talked about seeing some increase problem loans and other portfolios as well. I just wondered if you could kind of detail that a little more about what kind of stress you’re seeing outside of the construction stuff.
I think we addressed some of that in the press release, but we are continuing to follow all the portfolios very closely. We saw a little bit of an up-tick in delinquency in commercial real estate and C&I, however we also saw a little bit of a decline in delinquency in residential real estate and home equity. It’s kind of mixed bag.
Joe Morford - RBC Capital Markets
Given some of those signs and some of the economic uncertainties you are still seeing really strong loan growth, I am just kind of wondering, is this the time to be growing in the quarter, loan portfolio, 15% annualized rates and do you feel that you’re getting underwriting and proper pricing for those credits?
We have this discussion all the time here at the bank and we want to be very prudent in using our balance sheet today obviously. So, good news is that we’ve been able to, for lack of a better word cherry pick the relationships that we are bringing in. We saw the conduit, which just ends at the market on a commercial real estate side and some of our very best customers that we were unable to compete with on the rate and term, we now have an opportunity to do some business with them, so that has been encouraging on the commercial real estate side.
On the C&I side, we are very much making a focus at our bank to diversify out of commercial real estate and so we’re really putting an effort in growing our C&I portfolio, particularly in our adjacent markets strategy. We hired a guy, a team out of Melon First Business Bank to start an office out in the Orange, California area. So we’re looking for that middle market business that is deposit which mature kind of customers, so that’s sort of the area you want to do on C&I.
On the residential real estate side again in our footprint we want to be able to do the very best loans and we’ve actually gotten some -- as Dave was tightening down the underwriting requirements, we’ve also gained some pricing power there. So, yeah we’re looking very hard at that growth number, but we think we’re getting rewarded for the deals that we’re getting. We can certainly cherry pick through the business here, so I hope that answers the question.
Joe Morford - RBC Capital Markets
You kind of touched on I guess Stephen did on the expense side, looking to kind of tighten up going forward. I guess should we be looking for just kind of controlled expenses going forward, are you looking for absolute levels of decline and kind of the core operating level of expenses.
Yes, you know what, Stephen and I have been actually talking a lot about the company and I think with Stephen’s input and monitoring we want to making it a significant movement down. One of the things that we’ve done here, we brought in some consultants again to help us with some of the deposit strategies. Good news is that we learnt from them, but under Stephen’s financial leadership we are going to be extraordinarily aggressive in expense controls, that’s something that I’ve said when I first came here and it’s something that Stephen is going to help us execute against; the Stephen can you.
No, I think that’s very well said and as you know whenever you start focusing on expenses and reducing expenses, it doesn’t all happen overnight, and we will sustain this, we were focused on this for quarters and years to come and we will focus on this continuously and you will see the results in our efficiency ratio in time.
Making that a very much a priority, given all the noise in the market and everything, that’s something that we absolutely have control over, so lets just make serious efforts in lowering that.
Your next question comes from Trevor Morris - UBS.
Trevor Morris - UBS
I’ve got a three part question here in effect and I think at the end of the first quarter you indicated that you felt -- you’re confident that the earnings per share would be better than the prior year, that the EPS for ’08 would exceed that of ’07. What is your position on that today? Second part of that question is what about your stock repurchase program? What’s been you’re experience in the most recent quarter with the stock being somewhat desolated and thirdly has there have been any sign of deposit or nervousness and what have at your bank say versus that of what we’re seeing down here with IndyMac?
Okay, yes I will answer the last question first. With our recent CD campaign we brought in $109 million of CDs, more than half of that is new money, so I am very encouraged. With that said IndyBank did nobody any favor, so do I get phone calls from individuals that are concerned about the banking system or do I get phone calls from large depositors who are afraid, absolutely I get those calls; I think we get a lot a lot of them, but the good news that we’re able to tell our customers is that we’re strong, our capital position is strong and so I don’t see any run or any exit on the bank.
Our bank has a natural cycle of deposits and that sort of runs up towards the end of the year and runs down after income tax payment. So, I see that as the answer to the deposit question.
You had asked about the earnings per share and I’m thinking back to first quarter and the things we did then and I know we talked a lot about our RAL business and we certainly saw our RAL business performing very strong and we continue to see it performing very strong and fully expect that the earnings per share generated by the RAL program will significantly outpace last year and we did talk about at the consolidated bank level to that extents on this well.
At the Core Bank level though given the provision, given the core that we’re working with we didn’t talk about that exceeding last year at the first quarter and we’re not talking about that at this point either.
I think you asked about stock repurchase and I think Andrea asked the question about what’s our view on capital for the bank and I think we are certainly looking at all options, but I think the answer to the question was we want to maintain the capital level in the company to ensure that we have the capital, we’re adequately capitalized as we enter into the RAL season. So, at the board level we’re looking at lots of strategies, but I think the overwriting strategy is to preserve capital to ensure the success for RAL season.
Your next question comes from Analyst for John Pancari - J.P. Morgan.
Analyst for John Pancari - J.P. Morgan
If you could just give us additional color on the securities impairment charges that you took this quarter, was it related to non-agency MBS and just the size of that portfolio?
Hi, this is Stephen Masterson, good morning to you. A little bit of history on the mortgage-backed security portfolio that we have and you may be aware of this, you may not. Back in the fourth quarter of 2007 we permanently impaired that mortgage-backed security portfolio and when we did that it fits in our available-for-sale portfolio and when we did that we had to write it down to its market value, fair value.
Every quarter subsequent to that, we have the mark-to-market, so the losses that you see in that portfolio in Q3 or Q2 which was about $2.8 million was related to the fair value of those and the mark-to-market that we did at the end of the quarter. I can tell you that we do look at that portfolio and we do look at its performance and we look at how we can reposition that investment portfolio for strength in the current market we’re in and the current economic conditions we’re in and which way we are headed. That portfolio I think if you ask the size it’s somewhere between $250 and $300 million.
Analyst for John Pancari - J.P. Morgan
And is that the carrying value on the books-to-date as of June 30.
At this time there are no further questions.
We really appreciate your joining on the call today and we would all talk to you next quarter.