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Sterling Bancshares, Inc. (NASDAQ:SBIB)

Q2 2008 Earnings Call

July 22, 2008 11:00 am ET

Executives

Downey Bridgwater - Chairman, President and Chief Executive Officer

Zach Wasson - Executive Vice President and Chief Financial Officer

Graham Painter - Executive Vice President of Corporate Communications

Analysts

John Pancari - J.P. Morgan

Brett Rabatin - FTN Midwest Securities Corp

Erika Penala - Merrill Lynch

Jennifer Demba - Suntrust Robinson Humphrey

Brent Christ - Fox-Pitt

Brian Hagler - Kennedy Capital Management

David Bishop - Stifel Nicolaus & Company, Inc

Jon Arfstrom - RBC Capital Markets

William Teichner - Frontier Capital Management Co.

Charlie Ernst - Sandler O'Neill Asset Management

Graham Painter

I'm Graham Painter, Executive Vice President of Corporate Communications. This morning, Sterling Bancshares released results for the second quarter of 2008. To discuss those results with you today our Downey Bridgwater, Chairman, President and Chief Executive Officer; and Zach Wasson, Executive Vice President and Chief Financial Officer.

Before we begin, and I’ll turn the call over to Downey, I would like to remind everyone of the Safe Harbor statement included in today's earnings release. The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements including statements made during the course of today's conference call. These forward-looking statements are based on the company's current expectations and beliefs concerning future developments and their potential effects on the company.

There can be no assurance that future developments affecting Sterling will be those anticipated by the company. Factors that could cause actual results to differ from those projected in the forward-looking statements are set forth in today's earnings release, which has been posted on the Investor Relations page of our website at banksterling.com. On today's call, our speakers may reference certain non-GAAP financial measures, which we believe provide useful information for investors.

If necessary, we will post reconciliations of these non-GAAP numbers to GAAP results on the Investor Relations page of our website. For additional details on these matters and other risks that could affect the company, please refer to the company's most recent annual report on Form 10-K, which has been filed with the Securities and Exchange Commission. Sterling assumes no obligation to update the information presented on this call. I would now like to turn the call over to our CEO, Downey Bridgwater. Downey?

Downey Bridgwater

We recorded encouraging core operating result in the second quarter despite operating in an increasingly challenging nationwide banking environment. The combination of growth in loans and deposits, a stable net interest margin, non-interest income growth and a reduction in our efficiency ratio on both a link quarter and a year-over-year basis, demonstrates the strength and position of our franchise.

Unfortunately however our second results were negatively impacted at the end of the quarter by one large credit relationship, which accounted for $3.7 million in additional provision for the quarter and $20 million in additional non-performing loans. This credit is an extremely unusual situation for us and is not representative of any systemic issue within our overall loan portfolio.

During the second quarter of 2008, we recorded a total provision for credit losses of $8.2 million, an increase of $4.0 million over the prior quarter. As I previously mentioned, this increase in provision was primarily related to the one commercial credit relationship totaling $20 million which has also driven the increase in our non-performing loans. We have committed to fund additional proceeds of $9.2 million related to this borrower in July, increasing Sterling overall exposure to $29.2 million in the third quarter.

We estimated that approximately $600,000 up provision will be recorded in the third quarter of 2008 related to this increased exposure. The borrower is an energy related business and is part of a share national credit totaling approximately $2.4 billion in which Sterling participate with 39 of the largest and most sophisticated financial institution in our industry. As we have mentioned on numerous occasions our Energy Lending Group is the only department within the bank where we have participated in share national credit and it is the one group that constantly generates and participates in larger loans.

Our energy lending portfolio currently represents approximately 10% of our total loan portfolio. The energy industry has been one of the best performing factors in the nation and still is by virtually every measure. Our energy related portfolio and the company’s that we bank have been no exception. However one of our largest energy borrowers has indicated that they file for chapter 11 bankruptcy. As I mentioned our credit relationship with them is part of a shared national credit totaling approximately $2.4 billion and is spread among 40 lending organizations.

All relationship with the borrower begin several years ago and despite their growth and increasing borrowing needs we were allow to remain as a participant in this credit over the year’s due to our energy lending groups long-term relationship with the borrower. Before becoming aware in the last few days, that the borrowers was considering filing for bankruptcy, we had absolutely no indication from the lead bank or the borrower that they were experiencing any financial duress.

It is our belief that the company has significant valuable energy and fixed assets, which should helps to mitigate any significant future losses. Again I cannot emphasize how unusual a situation this is and that it is not reflective of the help of our overall portfolio and specifically our energy portfolio. This loan is the only non-performing loan of any size that we have ever had within energy lending portfolio.

Our energy lending portfolio consists of primarily upstream companies. All of which have proved develop producing reserves as collateral and some also have storage tanks, pipelines and gathering systems as additional collateral as well. We absolutely believe that this situation is not an industry problem, but one strictly isolated to this particular borrower. We are currently evaluating all of our options. We’ll continue to work diligently with our legal counsel to pursue every remedy available to us in our collection efforts in order to resolve this situation as quickly as possible.

Unfortunately this event has clouded what we believe to be a good quarter in terms of underlying operating trends. This additional provision reduced earnings per share by approximately $0.03 for the quarter. Despite the elevated provision we still earned $10.3 million or $0.14 per share during the second quarter. We were also able to maintain a healthy net interest margin and reduced our efficiency ratio both for the quarter and compared to the prior year.

Other highlights of the second quarter include quality loan growth as well as growth in our non-interest income. The economies that we operate in Houston, Dallas, Fort Worth and San Antonio continued to perform admirably based on the latest economic data. However we are mindful of the impact, the challenging housing sector and increased fuel and other material and commodity prices are having on our customers.

The housing industry continues to be an issue across the nation and has slowed somewhat in our markets for lower priced homes, but overall home values have been and remains relatively stable in our local market, increase long-term rates, economic uncertainty and more notably tougher underwriting standards from mortgage lenders have negatively impacted demand over the last six months.

Our exposure to residential construction and mortgages related product is fairly limited. Our total funded loans related to one-to-four family residential construction was approximately a $194 million as of June 30, 2008. This amount includes homebuilders as well as loans to individual constructing there personal residence or second home. Separately our residential mortgage portfolio totaled approximately $259 million at the end of the second quarter.

The residential mortgages that we have are high quality and primarily consist of loans to our local customers and business owners for the personal residence. They have low loan-to-values and are much shorter maturities than typical 20 year, 30 year mortgage. Our total exposure to home equity loans at the end of second quarter was approximately $57 million. As you may know under Texas law, all home equity loans much be originated at or below 80% of the value of the home including all other debt on home.

Commercial real estate continues to perform well in all of our markets. Excluding the energy relationship already discussed, non-performing assets increased approximately $7 million in the second quarter. This increase is primarily related to two used car auto dealer lines that deteriorated during the quarter. Totaling approximately $2.7 million of few smaller credits tied to the housing sector and some older 7(a) SBA related product that we are in the process of working out of the bank.

We anticipated being able to move a non-performing relationship totaling approximately $4 million in the second quarter. However that transaction has been delayed into the third quarter. Our allowance with loan losses to total loans was 1.14% at the end of the second quarter. With the additional provision our allowance ratio increases significantly quarter-over-quarter as well as when compare to the second quarter of 2007.

We continued to emphasize with our bankers the important of serving all financial needs of our customers. By taking this holistic approach we can better serve our customers by providing them with the latest products and services that help make them and their business more efficient, productive and profitable as well as helping the principles and their employees obtain their personal financial goals. As a result of these efforts the banks benefits by being able to diversify our revenue and we are making progress to goals. Non-interest income was up over $800,000 in the first six months of 2008 compare to the last six months of 2007.

Despite the unanticipated increase in non-performing loans brought on by this unusual situation this quarter, we are still very well-positioned take advantage of significant marketplace opportunities. Healthcare, exporting and a very strong energy sector have provided support to our local economy. These economic drivers are expected to continue to produce job growth and economic investment in each of our Texas markets.

Our team has done a great job managing our capital and we are in an enviable position of being able to take market share from the larger banks that are retrenching and focused on shrinking their balance sheet. In short we’re excited about the futures of Sterling.

With that I’d like to turn the call over to Zach Wasson, our Chief Financial Officer to review our financials in more detail; Zach.

Zach Wasson

We appreciate everyone taking the time to join us on the call this morning. Net income for the second quarter of 2008 was $10.3 million or $0.14 per diluted share, down from $13.1 million or $0.18 per diluted share in the second quarter of 2007. We estimate that the increased loan loss provision of $3.7 million in the second quarter of 2008, related to the large non-performing credit impacted our earnings per share by approximately $0.03.

Our ability to generate substantial profits in the face of these increased credit costs reflect our continued efforts to effectively manage the growth in non-interest expense, maintain a healthy net interest margin, produce rational loan and deposit growth and increase our non-interest income base. We are very pleased with our ability to maintain a healthy net interest margin during the second quarter in what has been extremely challenging interest rate and competitive environment for quite some time now.

Our net interest margin was 4.66% for the second quarter of 2008, 1 basis point below were it was in the first quarter of 2008, this despite us having a 225 basis points decrease in short-term rate in the first half of 2008. While some of the irrational deposit pricing from our larger out of state players is anticipated in our markets over the last couple of months; our markets remain highly competitive for deposits; because of this we anticipate slight pressure on our margin over the near-term.

In addition, the large non-performing loan relationship that Downey referenced was current on its interest payments at the end of the second quarter. So, its non-accrual classification will likely impact our net interest margin, negatively by a few basis points in the third quarter. A large contributing factor of our healthy net interest margin remains a very attractive overall average cost of funds on deposits.

Our average cost of funds on deposits for the second quarter of 2008 was approximately 1.42% down from 1.96% in the first quarter of 2008. Our strategy of focusing on small and medium-sized businesses allows us to be able to attract significant non-interest bearing deposits. As of June 30, 2008 our non-interest bank deposits totaled over $1.1 billion, which is approximately 31% of our total deposit base.

We are also encouraged by the positive results from our efforts to manage the growth and expenses, through the establishment of our sustainable cost discipline, throughout the organization. Even though, we have made three acquisitions since the second quarter of 2007 adding approximately $2.5 in expenses, non-interest expense only increased $1 million excluding acquisitions when compared to the second quarter of 2008, to the second quarter of 2007.

Our expense management efforts seem even more substantial when you consider that our quarterly FDIC insurance cost have increased almost $500,000 in that time period. The First Horizon branch network that we acquired in the first quarter of 2008, contributed an additional $375,000 in non-interest expense during the second quarter of 2008.

The integration of the branches has gone extremely well and we are on target with our revenue and expense goals. We continue to have notable non-interest income growth. Non-interest income was up approximately $155,000 quarter-over-quarter and $3.3 million for the over a year ago quarter. Of course the second quarter of 2007, did not have the benefit of MBM Advisors.

In order to provide better insight into our efforts to grow non-interest income, you will notice that on the income statement, our earnings release will detail wealth management fee for the first time this quarter. Customer service fees were up approximately $717,000 in the second quarter of 2008 as compared to the second quarter of 2007. This increase can be partly attributed to the lower earnings credit rate on commercial deposit accounts on analysis, which is a direct result of lower short-term interest rates.

From a capital perspective we’ve remained well positioned. As of June 30, 2008 Tier 1 capital stood at 9.1%, our total risk-based capital was 11.7% and our tangible capital ratio was 6.5%. At the end of the second quarter of 2008, we issued $25 million in subordinated debt that enhanced our already favorable regulatory capital positions. We consider the LIBOR plus 2.5% pricing on the sub debt to be very attractive pricing in this market. The effective tax was slightly over 32% for the second quarter of 2008. We expect our effective tax rate to be at similar levels for the remainder on the year.

With that I would like to turn the call back over to Downey, before we open the call up for questions; Downey.

Downey Bridgwater

Thanks Zach. In summary our underlying operating trends and asset quality remains sound. We’ll work with this isolated credit issue just as we have with other challenges in the past. We’ll continue to succeed by doing what we do best, focusing on quality banking practices delivered by quality bankers.

With that I’d like to open the call for questions.

Question-and-Answer-Session

Operator

(Operator Instructions) Your first question comes from John Pancari - J.P. Morgan.

John Pancari - J.P. Morgan

I want to see if you can help us a little here on the potential loss content of the energy credit; how did you arrive at the $3.7 million required reserves and is that plus that upcoming $600,000; is that’s the total amount of reserves against this credit?

Downey Bridgwater

Based on what we know at this time, yes that’s the total amount of reserve against this credit, and the stores are the basis for our decision is based on conversations with both the borrower and the banker and our relative counsel.

John Pancari - J.P. Morgan

In terms of that’s how you’re getting to that 3.7, is it? I mean is there a level of repayment that you’re assuming here and I am just trying to get an idea of how you’re coming up that number per se?

Downey Bridgwater

Right it’s based on collateral valuations and estimates of everything from liquidating values and values of various other pieces of the company being sold as on going concern or the entire franchise being sold. So I don’t want to really go into a lot of detail as I’m under a confidentiality agreement with the bank group, but we do believe and as I’ve said in my portion of the call that we have significant fixed assets, energy assets that will allow us to exit this credit fairly quickly. I don’t believe this is going to be a long drawn out process and you have some of the largest and most sophisticated banks in the industry in this relationship. It is highly unusual and it blind side the entire group as far as I know.

John Pancari - J.P. Morgan

I know you’ve indicated that your SNCs are largely within the energy books. So, what is your total energy SNCs that you have on balance sheet right now?

Downey Bridgwater

Our energy portfolio was about 10% of our total loan portfolio, so roughly $350 million, $360 million and about 75% of the energy portfolio are SNCs.

John Pancari - J.P. Morgan

In terms of the drivers of the increases in NPA’s extra credit I know you talked about the auto dealer book, what are you seeing in terms of that book? You have these two issues here in the used car dealer? Are you seeing added pressure there that you need to worry about other than in that portfolio and then just give us an idea of how big that portfolio is?

Downey Bridgwater

We have shrunk that portfolio with the last year, so from approximately $80 million down to $33 million, and we are in the process of exiting that whole effort. It’s probably the most challenging lending that we do. It’s used car, floor plain lines, dealer draft lines and so on that we inherited from banks that we’ve applied over the years. We consolidated those into a single group and we have been working them down and ultimately out, so we believe that within a year we’ll be completely out of that business.

It’s just too much potential risk for the type of lending that we do, even though it generates nice fees and so on. We’ve been moving down and out of that and we believe that will be out of completely within a year. These two particular issues, they’re both related to mismanagement on the part of borrowers, one of which is pure fraud.

Operator

Your next question comes from Brett Rabatin - FTN Midwest. Please go ahead.

Brett Rabatin - FTN Midwest Securities Corp

I wanted to ask some of the questions on asset quality, I was curious if you’d give an update on the assisted living facility in Houston, just how that was progressing and then, given the comments about the just a soft market for lower priced housing, I was curious about that $2 million credit that was related to that business that was having some problems last quarter.

Downey Bridgwater

The $4 million credit we talked about, we believe should close near the end of July. In fact, the borrower’s even offer to put another $0.5 million down on the deal, they’ve already paid another 75 on top of that. So we feel very comfortable that thing is going to end up closing here within the next few weeks.

The $2 million, we’re just working down and out of that as I mentioned, some of the homes, we’re foreclosing and selling them, which we’ve had success in getting them out the door. It’s just one of those things we’re just going to have to take our time and work through it and we think we’ll be out of it before the end of the year.

So besides one would large credit, we really don’t see material deterioration on our portfolio, any systemic issues across the portfolio that we do have, but we’re continuing to watch it very aggressively and again outside of this one large total surprise, we’re not seeing material and significant deterioration across the portfolio.

Brett Rabatin - FTN Midwest Securities Corp.

And could you share what’s your saying from a delinquency or a cost five perspective and the others parts of portfolio as far as C&I, CRE what have you?

Downey Bridgwater

You look at our delinquencies and they’re actually improving from the previous quarter, they’re down, both 1 to 30 days or 1 to 29 days and then those that are 30 days and above. So, those are actually improving.

Zach Wasson

30 to 89 day delinquencies went from $32 million down to $21 million, a $11 dollar decrease.

Brett Rabatin - FTN Midwest Securities Corp.

Okay, and then if I understood you it sounds like you think you’ll get out this $20 million, $20 million credit fairly quickly via disposition or what have you, okay and then just lastly I wanted to ask you on the margin; I was curious if the balance sheet management from borrowing usage or what have you if you think that will continue to be a positive factor, it seems like your margin will down 10, 15 basis points in the next quarter you particularly given the debt issuance and then the non-performing loan; are there some offsetting factors that are still with the borrowings or what have you, migration from CDs to borrowing so to speak?

Zach Wasson

In that respect we have somewhat stabilized the CD book, in the 2.75 to 3.25 areas. We continue to have some pricing flexibility on the deposit side, also most of our loan products have already reprised down during the second quarter.

So, we do see some pressure and you identified the subordinated debt that’s probably slightly under two basis points, the non-performing would be slightly under three basis points, but we have some flexibility in the deposit arena and we can always and everyday we fight the battle to correct some price on our loan product.

Operator

Your next question comes from Erika Penala - Merrill Lynch.

Erika Penala - Merrill Lynch

What was the dynamic behind extending the additional $9.2 million in credit to the troubled borrower?

Downey Bridgwater

Yes, we actually agreed to buy a position from of one of the other portion of the position of one of the other 39 banks at a discount. So we were able to take more of the credit, which we felt was absolutely stellar and able to improve our yield significantly by brining over a roughly $10 million portion at an 8% discount, so that would help our yield overall, so that was a strategic thing to do; it was not issuing really more debt to the borrower; only nearly taking out a portion of debt from one of the other 39 banks.

Erika Penala - Merrill Lynch

And I just want to clarify and follow-up with to John’s question on how much you’ve reserved for this credit. Now the $4.3 million is based on either the wholesale of the company so to speak or them whole selling themselves in pieces.

Downey Bridgwater

Yes, it’s based on conversations with the company that took in to consideration various different options. So, that’s how we came to that conclusion based on what we know at this time.

Erika Penala - Merrill Lynch

Okay and in terms of the value of the underlying collateral have you recently reassessed this or is this something that the lead bank does?

Downey Bridgwater

The lead bank provides that for us, the borrower provides that for us, they have consultants that are working on this at this time actually as we speak, so it is underway; we have some cursory information and all of which I can’t really go into detail. I wish I could, but I can't, but there are significant assets in this company, tangible fixed asset as well as energy assets.

Erika Penala - Merrill Lynch

And could you remind us what your average C&I exposure is within your energy book first as what your average C&I exposure is in terms of the loan size, outside of energy?

Downey Bridgwater

I know our energy average size is just under $9 million average of the relationships that we have. As for as the C&I it’s smaller than that, but I don’t have that number off the top of my head; I can call you back with it Erika and let you know. I would guess it would be in the $300,000 to $500,000 range; I just don’t have that specifically, but I’ll let you know.

Erika Penala - Merrill Lynch

Thank you so much for providing the color on the NPAs; I was just wondering if you could provide the same color in terms of a little bit more granularity on that the 90 day delinquency and if some of those relationships are going to migrate into non accrual next quarter.

Downey Bridgwater

Yes we have what we call a special attention report and of the 90 days we are not looking to see any of those migrate to nonperforming at this time. We continue to work them down and out either by getting additional collateral improving our exposure to those credits, improving the terms and conditions, but more importantly discontinue to work the borrower through getting our payments current or getting them out of the bank.

Erika Penala - Merrill Lynch

And is there any rhyme or reason; is it mostly C&I, was any of it housing related in terms of the increase quarter-over-quarter.

Downey Bridgwater

No its spread over our portfolio there is no concentration in any particular industry or year. As I said there’s really nothing that I can point to you to say “oh boy, we’re seeing housing go sideways or we’re seeing some other sector going the wrong way,” that’s not what we are seeing so, this is typical issues that come across our portfolio.

Operator

Your next question comes from Jennifer Demba - Suntrust Robinson.

Jennifer Demba - Suntrust Robinson Humphrey

Downey what we might expect, over the next, one to three quarters in terms of loan growth from you; are you still looking for a high single-digit, low double-digit type rate.

Downey Bridgwater

We talk about 6% to 8% in the loan side and that’s the range that we’ve been looking for and that’s what we expect to do and because we want to be careful and make sure we put quality credits on the books.

The opportunity certainly is coming from larger banks that are allowing us to take market share. Frankly, some of the larger banks in our market are exiting some very, very high quality credits, because they are having to shrink their balance sheets for other reasons, issues they have in other markets. So it’s a pretty good time for us right now. We just have to be selective.

Jennifer Demba - Suntrust Robinson Humphrey

But most of those credits at the larger banks are exiting on the larger end of your typical loan?

Downey Bridgwater

Not necessarily, some are certainly but, we have them right in our overall suite spot, which is in the $1 million to $5 million, $4.7 million range. That’s very, very healthy for us. Now on the energy side there’s opportunities to take much, much more credits from them but we’re maintaining our concentration to 10% of our portfolio. Our energy guys understand that and we’re going to maintaining that concentration level as we go forward.

Operator

Your next question comes from Brent Christ - Fox-Pitt.

Brent Christ - Fox-Pitt

With respect to the problem in energy credit and the size of it, how many other credits do you have a similar order of magnitude in terms of size wise? It seems pretty large relative to your sweet spot; I’m just curious how many others you may have, in that $30 million range or so?

Downey Bridgwater

As I mentioned we have, in our energy lending group that’s the only place in which we have shared national credits at all and it’s where they have consistently either participated in or shared in larger loans from their inception. It’s the nature of the basin; it’s what we have consistently going. So, off the top of my head I’m going to guess we have between 15 to 20 relationships and while their commitments, they are not necessarily all funded but they are ranging from the $20 million to up $35 million; that’s the max that we have. The largest loan we have in the bank is $35 million and it’s 100% secured by cash, but that’s what we have typically in our energy lending group and as I said the average across the number of relationships that we have is just under $9 million.

Brent Christ - Fox-Pitt Kelton

Could you provide any more detail just in terms of what the issues were with this specific borrower that’s causing them to face some financial difficulties, just because everything we hear outside in terms of what’s going on in the energy industry obviously is; it feels pretty positive and I’m just curious why this one borrower maybe facing some more challenges?

Downey Bridgwater

You’re actually right; the energy industry is doing extremely well and we have no issues with any of our energy credits from an economic standpoint. This one particular credit I just can’t go in to the details and all I can say is it is not related to the energy industry. Its trouble, so it’s different than that and I that’s all I can really go into; I’m sorry I wish could give you more color, but we want to be able to maximize our ability to collect under this credit along with other 39 banks, but we’re going to have to keep a low profile on this one.

Brent Christ - Fox-Pitt Kelton

And then just a follow-up to one another previous questions in terms of how you intent to fund incremental loan growth going forward, should it outpace core deposit growth is still the thought that you would continue to rely on some wholesale borrowings to do that?

Downey Bridgwater

Yes, we’ve done that historically and we’re obviously opportunistic with those. Whether its Federal Home Loan Bank advances or an occasional brokered CD we still have a very low percentage of our total deposits, I guess less than $100 million in brokered CDs. We’re very careful about those certainly, but we will use the Federal Home Loan Bank’s and their short-term borrowings primarily overnight because we want to make sure that we keep our funding cost as low as we possibly can, but we’ll match it with the relative growth that we have.

Obviously we want to continue to grow, core deposits and deposits from relationships. We’re still doing that but as Zach alluded to in his section of the call, it’s really competitive. I mean deposit gathering is probably the most competitive I’ve ever seen it, even though some of the larger banks and some of those that have had balance sheet repair issues have really backed off on some of the higher pricing that they’ve advertised on the CDs. It’s still very competitive. We’ll get our fair share, but it’s not going to be easy going forward.

Brent Christ - Fox-Pitt Kelton

And then the last question just in terms of the sequential or lift in customer service fees, is there any changes to your fees structure there or is it really more driven by the changes in interest rates?

Zach Wasson

No, there was no change in our fees structure. This is directly related to a lower earnings credit rate and we are being compensated with hard charges now rather than a wider margin and a higher rate environment.

Operator

Your next question comes from Brian Hagler - Kennedy Capital.

Brian Hagler - Kennedy Capital Management

Zach, on the sub debt, how much was that again and what was the pricing I’m sorry I miss that.

Zach Wasson

It was a $25 million of debt, there’s a five year call on it, 10 year final; the pricing is 90-day LIBOR, that’s 250 basis points and we issued it right after end of the quarter.

Brian Hagler - Kennedy Capital Management

So, was it included in next quarter’s ratios then?

Downey Bridgwater

Yes.

Zach Wasson

It is and you’ll notice our total risk-based capital went to 11.7%. We had been roughly a 100 basis points below the, so this was one of the big reasons that that total risk based capital ratio moved up so much.

Brian Hagler - Kennedy Capital Management

On the troubled credit; I guess Downey, you’ve mentioned the collateral appears to fairly solid, and you’ve gotten indications from the company and I know you can’t say a whole lot, but can you just maybe get a little more specific on what type of collateral we’re looking at here?

Downey Bridgwater

I really can’t go into that. Again these are the specifics that I can’t describe; other than what I’ve described on the call, which are energy assets and fixed assets. As I described on our entire energy portfolio, secured by reserves and various different types of fixed assets, including storage tanks, pipelines gathering systems and so they’re very large. We don’t do any refining; we don’t have any refining as collateral, so it’s really very much bread and butter, simplistic energy type lending, so it’s very conservative and I’ve never had an issue like this in my career.

Brian Hagler - Kennedy Capital Management

And then, just based on what I heard earlier regarding the additional $9.2 million coming on or being funded this quarter, it sounds like you purchased that after the troubles came to light and then you got additional information.

Downey Bridgwater

Absolutely not; our loan committee approved it on the July 1 and we've already executed the documents. The LSTA documents from another one of the member banks, to buy a portion of their exposure as I said at a discount, and then we found out about this thing four days ago. So, this is done completely before we knew anything about it.

Brian Hagler - Kennedy Capital Management

And then finally, do we know how many other of the participating banks were able to get it into this quarter’s non-performing loans or?

Downey Bridgwater

I have no idea. I have no idea, and that’s something just to discuss with each one of them, and once the bankruptcy filing’s out; I’m sure that the list of the participating banks will be on there and that’s the work you have to do.

Operator

Your next question comes from Dave Bishop - Stifel Nicolaus.

David Bishop - Stifel Nicolaus & Company, Inc.

In terms of the energy portfolio; maybe the SNC or the non SNC and when we think about underwriting that, what is the breakeven, price of oil are you are using, or baked in, what's the margin of error there I guess in terms of maybe the proven reserves?

Downey Bridgwater

When we make a loan on energy, and we utilize an assignment of proved developed producing reserves, we use a price deck, a low of $65 a barrel; so it’s significantly discounted. Then you utilize a cash flow over the next 10 years, very we diversified among several different wells, so there is no concentration in any particular well or even any particular field and then that’s discounted back utilizing a 10% present value, then we make sure that our prepayment or our payment, repayment rather of that loan can occur within 48 months or less, so when we update the borrowing banks every six months for our reserve based credit.

So, it is an extremely conservative approach always has been and I have never lost a dime on a reserve based credit in my entire 30 plus year carrier and that’s even back during the 80’s in Texas the banks didn’t really losing money on reserves. They lost money on drilling the rigs and coupling stock and pipe yards and that kind of stuff, which we do not bank at all.

Operator

Your next question comes from Jon Arfstrom - RBC Capital Markets.

Jon Arfstrom - RBC Capital Markets

I’ll just ask one about the credit, more of a hypothetical; it looks like you purchase that it $0.92 on the dollar in early July and then you took another 6.5% mark on it if you were to reserve on it. So, you’re looking at about a 14.5% discount, so I’m assuming that 600 came after the fact right?

Downey Bridgwater

Yes it will be in the third quarter. Lets us put it this way; we’ve agreed to purchase this we’ve already sign the documents and we are bound by those and we hadn’t even to funded it yet. It’ll be funded this quarter and we’ll fund that provision when we fund the loan.

Jon Arfstrom - RBC Capital Markets

Okay and then the reserve against the $20 million suggest about an 18.5% mark if you will and I guess is it, fair to assume that that’s what you think to realizable value will be somewhere in that range of in the 14% to 18% down from par.

Downey Bridgwater

Based on what we know now, yes.

Jon Arfstrom - RBC Capital Markets

Zach, a non credit question; expenses, how much more room do you have on expenses, taking them down?

Zach Wasson

I will tell you this; it’s getting harder to find expenses. We are definitely having to find efficiencies, we are having to leverage into the money we’ve spent in our IT area, but we continue to work on it. We made every week, we’ve got a project and procurement committee that reviews projects and large procurements and we have a vendor task for us that’s going through managing virtually the top 10 relationships in any expense category and discussing with those vendors how we can team up and either learn to use their product more effectively and efficiently or make sure that we are only paying for the services that we need here at Sterling and so we continue or plan to continue to focus on expenses and we are getting a lot of a assistance throughout the system as for as people adopting this sustainable cost discipline.

Jon Arfstrom - RBC Capital Markets

Any expense pressure that you see on horizon; I know that’s looking back and I know two or three years ago we talked about compensation for vendors and pretty intense salary and benefit type, the competition. I’m just wondering if there’s anything that you’re concerned about on the horizon in terms of pressure.

Downey Bridgwater

At this point that’s seemed to level out, because some of the larger franchises who came into our markets to take market share and hire people and buy locations and so on, have really backed off. So we are beginning to see more of a flattening; it’s not cheap, but it’s at least not continuing to increase significantly.

Jon Arfstrom - RBC Capital Markets

And then just a question on how you’re managing the balance sheet at this point. Do you have a view on rates in terms of how you’re managing it and then if you could talk a little bit about some of the spreads that you are seeing on new lending that’s improved at all like it has in other markets.

Downey Bridgwater

Yes, we are seeing some improvement in spreads on lending, it’s not material, but we’re asking our guys to make sure that they continue to ask for the rate, ask for the relationship, make sure they improved the yield not only by getting a little bit better spread on the loan, but also make sure they get all of the problems they can and drive whatever fee income making across the rate relationship. We talk about a holistic approach to our relationships, not just a business but the principles and their family members and so on, so that we can get their personal business too and of course we’re managing our balance sheet in neutrality; Zack will talk to you about it.

Zach Wasson

Yes, as far as the interest rate risk and how it’s calculated or how it’s come out of here at the end of the second quarter we’re still about as neutral as you can get. We did buy a few investment securities during the quarter, but that was to add a little duration to our asset side of the balance sheet. We in our rate forecast are pretty much expecting rates to stay where they are for a while. It’s hard to say how the Fed can do any raising of rates with the state of the banking and financial industries are in at this moment, but in general we’re neutral.

Operator

Your next question comes from William Teichner - Frontier Capital.

William Teichner - Frontier Capital Management Co.

Let’s say you have one of your energy credits that has an oil hedging program and say they have base business which is actually pretty decent, but they hedge. There is a company called SEN Group; I’m not sure if that’s your credit or not, but how do you do due diligence and make sure that everything is okay; that maybe the base business is okay and but they’re doing some hedging or felt that hedging strategy?

Downey Bridgwater

First of all, I can’t speak to any particular borrower and certainly we don’t participate in any hedging activities that any of our energy companies may undertake and if we are in a shared national credit that activity is managed by and monitor by the lead bank always. So, we’re not participants in those types of activities at all and frankly we want to make sure that our loan, whatever it happens to be is well secured by tangible assets and/or reserves energy related assets that have significant value such that if there is ever an issue we’ll be able to exit the credit in a reasonable timeframe.

Operator

Your next question comes from Charlie Ernst - Sandler O’Neill Asset Management.

Charlie Ernst - Sandler O'Neill Asset Management

Back to everybody’s favorite credit, given the suddenness of the deterioration, how comfortable are you that you really do understand the current situation and the current values of loss, what’s your collateral?

Downey Bridgwater

I think, we are as certain as any of the other 39 banks in the credit as to what our collateral values are. I can’t really speak to other relationships that we have and other insides that we have to this particular credit and where these assets reside, but we feel pretty comfortable with the valuations that we have utilized to ultimately determine our relative provision.

Charlie Ernst - Sandler O'Neill Asset Management

Do you have any idea as to the issues that were creating the challenges for the company as to whether those have been stabilized and whether the economic value of the company and the assets of the company have stopped eroding or is there any else you can talk about on that situation?

Downey Bridgwater

Charlie, I wish there was, but I can’t.

Operator

Your next question is a follow-up from John Pancari – J.P. Morgan.

John Pancari – J.P. Morgan

On the other items or the other non-performers that you had talked about, Downey; I’m just trying to an idea on the overall level of NPAs, if you can give us some idea of an outlook here and it looks like some of these other non-performers are certainly near workout.

You indicated that you expect a relatively expeditious resolution of the energy credit and you mentioned that you’re working actively through the SBA stuff as well as the expected resolution of the $4 million credit. So can you give us an idea of; is this amount of outflow that you could see -- could mitigate the upward pressure that just a broader economy could put on their non-performers, any indication there? Thanks.

Downey Bridgwater

I said we’re working on some of these that we expect to go away, that would get paid off on those that were working out of the bank. Obviously there will be some charge offs in future quarters but we expect net of this one energy credit, our non-performers to actually trend towards the positive. We don’t expect it to be stability necessarily but we expect to see some improvement over the near term and that’s again based on our current reviews and what we see in our portfolio at this time.

Operator

Your next question comes from Dave Bishop - Stifel Nicolaus.

Dave Bishop – Stifel Nicolaus

It related to the home builder portfolio. I think you had some commentary that you’re seeing some stress maybe on the lower segment of the housing markets there I mean, remind us what’s your exposure there and how much of that is actually non-performing at this moment?

Downey Bridgwater

Our total homebuilder portfolio is about $154 million and we have three relationships that are on non-performing at this time; the largest of which is the $2 million credit that I referenced, actually it’s down to $1.5 million and we have got two others that are around $0.5 million a piece; one is 400 and some change and one is 500 and some change and they’re selling homes or we’re selling home and we’re getting down and out of these things.

So, we’re seeing positive movement in those three and the others are generally, fairly strong builder’s folks who build a few custom homes, we don’t have the major home builder that a lot of bigger banks have and the type of product that they build is that product that are customers generally buy. They put significant amounts down on their home 50% to 30% and they usually have them on shorter amortizations and our maturities of course are in the there to five year range.

Operator

We have further questions.

Graham Painter

Thanks for joining us today. We appreciate your interest in Sterling and look forward to speaking to you in next quarter.

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Source: Sterling Bancshares Inc. Q2 2008 Earnings Call Transcript
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