Guaranty Financial Group Inc. Q2 2008 Earnings Call Transcript

Guaranty Financial Group Inc. (GFG)

Q2 2008 Earnings Call Transcript

July 31, 2008 2:00 pm ET

Executives

Rusty LaForge – SVP & Director of IR

Ken Dubuque – President and CEO

Ron Murff – Senior EVP and CFO

Analysts

Brad Milsaps – Sandler O'Neill

Brian Clark – KBW

Todd Fernly [ph] – Miller Tabak Bank Capital Management

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2008 Guaranty Financial Group earnings conference call and webcast. My name is Lucy, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn your presentation over to your host for today's call, Mr. Rusty LaForge, Director of Investor Relations. Please proceed.

Rusty LaForge

Thank you and good afternoon everyone. Welcome to Guaranty Financial Group’s second quarter 2008 conference call. Before we get started, please note that the presentations and commentary that you are about to hear contain forward-looking statements that are subject to numerous risks and uncertainties as described in our Forms 10-K, 10-Q, and other reports filed with the SEC. You should not place undue reliance on any of these forward-looking statements. Actual outcomes could differ materially from the views expressed today. We may elect to update forward-looking statements at some future point; however, we specifically disclaim any obligation to do so.

Here with me today are Ken Dubuque, President and CEO and Ron Murff, Chief Financial Officer. I want to call your attention to the slide deck, which we posted on our website, guarantygroup.com, and we will be referring to this over the course of the call.

With that, I’ll turn the call over to Ken.

Ken Dubuque

Thanks, Rusty. Good afternoon. Welcome to our second quarter conference call to discuss financial results. Thank you for joining us. We are disappointed in our financial results for the quarter. The results we issued this morning show that for the quarter we had a net loss totaling $85 million, or $2.24 per share, which included a provision for credit losses of $99 million and a $46 million charge to income tax expense to establish a valuation allowance on deferred tax assets.

Unfortunately, those two charges far exceeded otherwise strong increases in both net interest income and non-interest income. In a moment, Ron will discuss all of those results in much greater detail. However, before I turn it over to Ron I want to provide an update on our progress in accomplishing the short-term goals we set earlier this year. In light of the continued decline in housing market conditions and a lack of liquidity in the mortgage securities market, we turned to a short-term strategy focused on what we call the three Cs – Credit, Cost, and Capital.

First, with respect to credit, we saw another substantial increase both in non-performing loans and loan loss provisions during the second quarter, primarily in the homebuilder and single family mortgage portfolios. While we had very few charge-offs in recent quarter, we acknowledge last quarter that charge-offs typically lag a rise in NPA, and we are seeing those charge-offs increase.

However, you should again keep in mind that the make up of our non-performing loans is primarily secured loans, in particular homebuilder loans and single-family mortgage loans collateralized by land, lot, and houses unless the reserve levels have been set based in large part on the value of the underlying property. Collateral values in these loans types, especially California have dropped significantly and newly obtained appraisals are lower than prior valuations.

However, while past performance does not necessarily equate to the future, our charge-off rate from 2001 to 2007 was less than 10 basis points per year on average excluding asset based lending, which we exited in 2006. That charge-off rate was less than half our peer average. This low charge-off history in our lending areas is testament to our underwriting standards, our relationships, our experience, and our understanding of our products, and markets.

The team of lenders and credit staff that we moved into our Group to focus solely on loans that need special attention have worked hard for the past several months. This team is aggressively identifying emerging problem loans, internally classifying them where appropriate, and taking action where appropriate to mitigate risk.

In addition, we launched a major effort to review our lending standards on a go-forward basis, examining every line of business and tightening standards where appropriate. We need to require a higher equity level, demand greater levels of personal recourse with higher pricing including interest rate floors, and we have also tightened covenant structures. We have not extended any new credit in the homebuilding line of business. Finally, we are reviewing concentrations and hold positions.

As to cost, we are now seeing the benefits of our expense reductions efforts. Our compensation expense is down, and overall we have put in place efficiencies that will achieve annual cost savings of more than $22 million. We also continue to limit new hires, including not filling opening positions – open positions. And we expect to identify utilizing an internal task force, an outside consultant, additional ways in which we can operate more efficiently. For example, we are evaluating all our operating units and lines of business through peer comparisons. We are reducing travel expenses. We are reevaluating our non-essential marketing expenses. We are evaluating our real estate and other non-earning assets. We are reducing planned capital expenditures. And finally, we are rationalizing our branch system and de novo expansion plans.

Now, a third important area of short-term focus is capital. We said last quarter that we intended to manage our capital position appropriately by taking the actions necessary to maintain capital ratios above the minimal levels required to be deemed “well capitalized” by regulatory standards. As of March 31, all our capital ratios exceeded these minimum standards, but we had an effort underway at the time to reinforce our capital position.

Soon after our last conference call we were able to announce in greater detail what efforts were underway. Then in late May, we completed a sale of shares of common stock to raise approximately $38 million in new capital, and last week we announced the closing and funding of private placements of preferred stock and subordinated debt to bring the total amount of capital raised to approximately $600 million.

While we are reporting on June 30^th numbers today and our capital ratios continue to exceed regulatory standards to be “well capitalized,” this additional capital raised after June 30^th takes us well beyond those standards. Moreover, the new capital also reinforced our strong liquidity position. Today, excess borrowing capacity is more than $4.5 billion.

We also announced today that in light of the recently closed private placement transaction we terminated our previously announced rights offering. Accordingly, we will be making the necessary filings with the Securities and Exchange Commission to withdraw the registration statement covering the rights offering. Without the rights offering, we feel that we have taken the actions necessary to maintain capital ratios above the minimum levels required to be “well capitalized” in the current economic environment.

In addition to the strong focus on these three Cs, we have also kept in mind another C, our customers. We continue to achieve remarkable results in customer service. Earlier this year, Guaranty Bank ranked significantly above the American customer satisfaction index industry average as well as large banks. We have a number of other examples of distinct customer service including our success in handling a CD bubble in the previous quarter.

We have also recently launched a progressive checking product with free usage of any ATM without requiring documentation. It has been well received. Prior to May this year, we opened an average of around 2500 accounts per month throughout our extensive branch network. In the months since the launch of this product, we are opening nearly double that amount. Also, our effort – follow-up efforts with new retail deposit customers, called onboarding, is receiving excellent reviews.

Moreover, on the commercial side, we are enhancing our capital markets and asset management capabilities to provide more complete service to our customers. Providing cost-effective distinctive customer service is still one of our core strategies.

Given current market conditions, we are still focused on these short-term strategy and we clearly have made significant progress on all of them. And at the same time, we have an attractive franchise with an outstanding branch network in the two fastest growing states in the country, Texas and California, an excellent mix of lending and insurance product, dedicated and experienced management and staff, distinctive customer service with up-to-date technology and back office support.

In a moment I will close our prepared remarks with some final thoughts. For now, I will turn things over to Ron to discuss financial results in further detail. Ron?

Ron Murff

Thanks, Ken, and hello everyone. My remarks today will cover our financial results and some of the items on our balance sheet. If you have accessed our slides, I will be referencing those.

Let’s first go to Slide number three. Ken noted that for the second quarter we are reporting an after-tax net loss of $85 million, or $2.24 per share on a basic and diluted basis, compared to $10 million after-tax net loss in the first quarter 2008 and $24 million net income in the second quarter 2007.

Net interest income was $200 million – was $100 million for the second quarter of 2008, up $2 million from the previous quarter, and up $5 million compared to the second quarter of 2007. Our net interest income increased because of an increase in earning assets, principally loans.

Provision for credit losses was $99 million in the second quarter of 2008 compared to $58 million in the previous quarter, and less than $1 million provision in the second quarter of 2007. Provisions for credit losses increased again principally because of weakness in single-family construction, and an increase in provisioning for single-family mortgage loans. Provisions for single-family construction loans during this quarter was nearly two-thirds of the full provision amount. We also took a $14 million provision on a $40 million commitment to a mid-stream energy company that had $31 million outstanding at June 30, and I will discuss this in greater detail in a moment.

Non-interest income was $41 million for the quarter, an increase of 8% from the second quarter of 2007, principally as a result of increased annuity sales commission and increased fees and service charges on deposits. Non-interest income decreased 2% compared to the prior quarter, principally as a result of weakness in the property and casualty insurance markets.

Non-interest expense was $99 million during the quarter, flat from the previous quarter, but this quarter’s expense included $3 million of severance. Non-interest expense was $5 million higher than second quarter of 2007. Like last quarter, the increase compared to a year ago was driven in large part by increases in many of our direct costs and expense categories because we began to perform many activities ourselves following our separation from Temple-Inland.

And finally, rather than a tax benefit for the quarter we had a $28 million income tax expense as a result of establishing a $46 million valuation allowance on deferred tax assets. In assessing the realizability of deferred tax assets we consider whether it is more likely than not we will be able to realize the deferred tax assets. The terms of our separation agreement with Temple-Inland prohibit us from carrying back any net operating tax losses to periods prior to 2008. Therefore, our ability to realize deferred tax assets depends on our tax planning strategy including holding available-for-sale securities to maturity and our generation of taxable income in periods after 2007.

As I mentioned, the bottom line for the quarter was a net loss of $85 million.

If you will turn to Slide number four, we show our historical and current net interest margin. You can see here that over time we have a stable net interest margin even during times of sharp changes in the Fed funds rate, which is due to our mostly adjustable rate balance sheet. We continue our efforts to increase our net interest margin over time by allowing mortgage-backed securities to continue to run off. And we expect the runoff to benefit our net interest margin. However, if interest rates change significantly, particularly if they decline further, our net interest margin is likely to decline. We reported today that for the second quarter of 2008 net interest margins was 2.54%, compared to 2.49% for the previous quarter, and 2.55% in the second quarter of 2007. Any significant increases in non-performing assets will continue to negatively affect our net interest margin.

In the meantime, we are changing our loan portfolio mix and rationalizing our loan portfolio with the appropriate credit standards, loan pricing, and return hurdles, which we expect to improve our margin. In addition, we continue to add loans in our consumer lending portfolio, which we began offering at the end of 2007, and we expect these higher margin loans to improve our net interest margin over the long run.

On the next slide, Slide number five, we show strong increases in both net interest income, and Non-interest income for the quarter, compared to a year ago, with net interest income increasing 5.3% to $100 million and Non-interest income increasing 7.9% to $41 million. You can see the softness in the property and casualty insurance market reflected here in a slightly lower insurance commission and fee amount. And we have broken out non-deposit investment fees so you can see the strong increases in annuity sales, up 60%, compared to the second quarter last year as well as a 15% increase in deposit fees, compared to the second quarter in the prior year. Overall, total revenue increased 6%.

Now, please turn to Slide number six, which is a summary of our balance sheet. We allowed our balance sheet to decrease from $16.4 billion at the end of the first quarter of 2008 to $16 billion at the end of the second quarter due in large part to intentional runoff in our single-family mortgage portfolio of nearly $100 million and payoffs in our mortgage-backed securities portfolio of approximately $200 million. And we also recorded an additional unrealized loss in our mortgage-backed securities portfolio of another approximately $100 million. In a moment we will look at a slide showing the change in each of the loan portfolios in the last quarter and we will talk more about the securities portfolio.

We utilized Federal Home Loan Bank borrowings slightly less this quarter compared to last while our total deposits remained flat compared to the previous quarter. We have shown a decrease in our level of stockholders’ equity from approximately $900 million last quarter to approximately $800 million, which is caused by the additional unrealized loss on available-for-sale securities net of tax, as well as our net loss for the quarter.

Now, turn to Slide number seven. We show a total of $9.2 billion in total deposits and there is a breakdown of the various categories of deposits. The vast majority of these deposits are gathered through our retail franchise and we have continued to focus on increasing Non-interest-bearing checking accounts. We would consider almost all of our deposits to be core deposits. We don’t have any brokered deposits, which tend to be more transient, and our CDs are almost exclusively held by long-term customers.

On Slide number eight, we have included information regarding liquidity. We have a variety of liquidity sources including operating cash flows, new deposits, ability to borrow from the Federal Home Loan Bank, and a portfolio of assets including mortgage – marketable mortgage-backed securities, which we can pledge as borrowings or so if necessary. Our borrowings from the Federal Home Loan Bank are secured by a blanket floating lien of certain of our loans, and by securities we maintain on deposit at the Federal Home Loan Bank.

We continue to have sufficient readily available liquidity resources, principally borrowing capacity at the Federal Home Loan Bank of Dallas to meet our requirements. Today, we have the ability to borrow an additional $2.2 billion from the Federal Home Loan Bank. Additionally, we have other assets not pledged as collateral on float borrowings, which we could pledge as collaterals with Federal Home Loan Bank or other lenders, including the Federal Reserve, providing additional liquidity that brings the total to approximately $4 billion at June 30. And as a result of the recent capital raise it is more than $4.5 billion today.

Turning to Slide number nine, we show the diversity of our loan mix, and we also show how each portfolio changed since the last quarter. Total loans remained relatively stable with only a $26 million net decrease in total loans outstanding on a more than $10 billion loan book. We sold our single-family mortgage company and servicing assets in 2004 and 2005, and we completed the exit from this segment in early ’06. As a result, that is a runoff portfolio getting smaller each quarter at a rate of approximately $30 million per month. In a moment you will see a slide that shows the vintage and other characteristics of the loans in this runoff portfolio. In our other portfolios like many banks recently, we are limiting loan growth in the short term in order to preserve capital. And this gives us the opportunity to rationalize our loan portfolios with the appropriate credit standards, loan pricing, and return hurdles.

We are continuing to make new loans but at a slower rate than in recent years. You can see here that our single-family mortgage warehouse and multifamily and senior housing portfolios had strong growth during the quarter with greater than $100 million increases in each. Single-family constructions loans declined more than $100 million, which I will discuss in much greater detail in a moment.

In the energy portfolio we have had several loans pay off or pay down during the first half of 2008 as a result of asset sales. Our pace of originating new energy loans in the second quarter was less than the amount of payoffs. And earlier I mentioned the loan to a mid-stream energy company that caused us to take a $14 million provision in the second quarter.

First, I want to point out that our energy portfolio totals approximately $1.3 billion in total outstandings. Approximately $200 million in our outstanding amount of energy loans involves loans to midstream energy companies, which are generally secured by accounts receivable inventory and other assets. These loans have performed very well in the past.

However, we had a $39.5 million commitment with $31 million outstanding in this midstream portion of our energy portfolio that caused us to take the $14 million provision this quarter. The loan is part of a shared national credit that we participate in with nearly 40 of the largest financial institutions in our industry. This loan was to a company that from all available information was profitable and reported solid financials. However, the borrower recently filed for Chapter 11 bankruptcy in a sudden turn of events. We see this as an unusual situation that is not reflective of the general health of our energy portfolio.

Furthermore, the rest of the energy portfolio involves loans primarily to exploration and production companies secured by proven oil and gas reserves. We expect to see growth in the energy portfolio in the third quarter. Now, finally on this slide our consumer loans. While not large by total outstanding amount, we did have strong percentage growth in consumer loans more than quadrupling the total amount of loans in this area following the roll out of consumer lending that was initiated at the end of 2007, which continues as planned and in line with our goals for that initiative.

On Slide number 10, we have shown which portfolios have experienced an increase in non-performing loans, and clearly homebuilder loans and single-family mortgage loans are the primary portfolios where we are continuing to work through the most non-performing loans. The number of homebuilder loans deemed non-performing increased from $182 million to $233 million, which is evidence of the continued weak housing market. In a moment I will take you through a table showing the non-performing homebuilder loans by collateral type and geography.

Single-family mortgage loan that are non-performing also increased from $69 million to $97 million and we will also take a look at that portfolio in more detail in a moment.

The amount of REO shown here has increased from $8 million a year ago and $23 million a quarter ago to $42 million at the end of this quarter. This was a net increase in REO of $19 million net of a few sales. We expect continued migration of homebuilder loans to REO in the coming quarters.

With respect to the other category, we include non-performing loans from all of the other loan portfolios here. The total of other non-performing loans is $34 million, up from $10 million the previous quarter. $31 million of the $34 million here is the $31 million outstanding loan to the midstream energy company I mentioned earlier. Other loan portfolios are still performing well with only $3 million in non-performing loans out of the other portfolios.

If you turn to Slide number 11, you can see the increases by category and allowances for loan losses that track fairly closely with the increases in – of the non-performing loans. The allowance for single-family mortgage loans doubled from $12 million to $24 million.

In the previous slide you may have noticed that the amount of non-performing single-family mortgage loans did not double. The reason for the disproportionate increase in the allowance is because we made the prudent decision during the second quarter considering the continued weakness in housing markets to increase the percentage of the allowance for single-family mortgage loans from 10% to 20% of the outstanding amount of the non-performing loans.

On Slide number 12, we show an overview of how our provision for credit losses has more than doubled from $125 million at the end of the year to $261 million as of June 30. You can see that the provision was fairly large in both quarters this year totaling $157 million. Over the past 12 months we have provisioned $209 million. Annualized charge-offs as a percentage of loans was only 8 basis points in the first quarter and 74 basis points in the second.

Most of the charge-offs taken in the second quarter related to loans to homebuilders, and we anticipate we will acquire the underlying collateral for more of our loans to homebuilders and is likely we will record charge-offs when we acquire collateral on those loans.

On the next slide you can see the increase in our net charge-off level. Year-to-date, our net charge-offs as a percentage of average loans outstanding annualized is 0.41%. You can also see on this slide that our peer group in $10 billion to $50 billion holding companies are increasing charge-offs as well. But more importantly, you can see how we compare to our peers historically since 2004 and before we have fairly – we have maintained – fairly consistently maintained a charge-off ratio below that of our peers and other large holding companies. We have taken a very disciplined approach to credit risk management that has resulted in this historically favorable charge-off ratio.

On Slide number 14, you can see the declining outstanding balance of our homebuilder portfolio, which we report under the name single-family construction loans. This portfolio consists of loans to finance homebuilding activities including construction and acquisition of developed lots and undeveloped land. Our total homebuilding lending – homebuilder lending portfolio at the end of the second quarter of 2008 is $1.2 billion, down from $1.3 billion at the end of the first quarter 2008 and $1.8 billion last September.

Single-family construction decreased because of paydowns and payoffs and because we have exited a number of credit relationships to reduce our risk but also because we foreclosed on some homebuilders loans moving the net amount to REO. It is likely these trends will continue.

This portfolio can further – be further divided into two groups – national home – national builders and regional builders. We now have approximately $140 million in outstanding loans to national homebuilders, some of which are unsecured lines of credit, but are typically governed by a borrowing base of unencumbered assets.

Our regional homebuilder portfolio is down to $1.1 billion in outstanding loans from $1.5 billion nine months ago. It is in this portfolio where we continue to see the most difficulty.

On the next slide, Slide number 15, we have an update to the slide that we presented in previous quarters, which breaks out our regional homebuilder loans by collateral type and by geography. For those that are not looking at the slides, we show that of our regional homebuilder loans approximately 16% are in Northern and Central California, another approximately 19% in Southern California, 10% in Texas, 8% in Florida, 75 in Colorado, 5% in Arizona, and the remaining 35% spread out in other states.

Again, I would direct your attention to the amount of exposure in California where we have seen the most deterioration. We are also seeing weaknesses throughout other areas of the country including Chicago and Arizona, but not to the extent we are seeing in California. We don’t have big exposure in Atlanta or Los Vegas. Relatively speaking, Texas is holding up well, and we continue to monitor it as we do all markets.

We also show the amount of non-performing regional homebuilder loans by geography. You can see that the amount of non-performing loans in the California markets is high. And while the amount of non-performing loans in the Northern and Central California region has dropped from $107 million last quarter to $52 million this quarter, that is primarily a result of both paydowns and moving loans out to OREO, and the total amount of loans outstanding in that regions has dropped from $227 million to $174 million for that same reason.

On the other hand, in other areas of California, primarily the Southern region, the amount of total homebuilder loans declined slightly, primarily as a result of paydowns. The amount of loans outstanding that are non-performing in the Southern region increased from $21 million at the end of the first quarter to $71 million at the end of the second quarter.

On Slide number 16, we have provided an update to the slide we presented in the last two quarters, which details our single-family mortgage portfolio broken down show the different types of single-family mortgage loans in our portfolio, some LTV numbers, current average FICO scores, current delinquency rates by product, and the state of origination of the mortgages.

As I mentioned, our single-family mortgage portfolio is primarily a runoff portfolio at this time. We sold our mortgage origination and servicing business in ’04 and ’05, and since that time we have added very little in single-family mortgages through our correspondent program. After adding only a very small amount of mortgage since 2006 through our correspondent program as a part of our efficiency review we closed down the program earlier this year.

The overall balance decreased from $1.6 billion at the end of the first quarter 2008 to approximately $1.5 billion at the end of the second quarter 2008. As you can see at the bottom of the slide 90% of our single-family mortgage portfolio was originated prior to 2006, and as we have discussed before we have not originated or purchased subprime loans.

We have underwritten option ARMs to the fully indexed rate. The original loan to value on first liens was 71%, and considering the vintage of these loans we expect the current LTVs are less than they were at origination because the home prices went up generally before they may have gone down more recently.

Average current FICO scores on our first lien loans is estimated at 710. The 90 days plus delinquency rate for all our first liens at June 30, 2008 was a little over 7%. Total delinquencies for all first liens was 11.87%. Certainly there has been continued stress on mortgage holders. However, another reason for increases in our delinquency rates is going to be caused by shrinking portfolio since this is a runoff portfolio.

We also believe that borrowers maybe experiencing financial stress as a result of holding second liens on their homes behind our first lien. That is the case severity of loss bound for closure maybe be minimal.

Starting at Slide number 17 we have included a few slides with respect to our mortgage-backed securities portfolio. This first slide is a high level overview, which shows that of our $5.1 billion in securities $3.2 billion, or 63% is categorized as held to maturity, the rest available for sale. And it also shows that $1.4 billion, or 29% are agency securities, the rest non-agency.

On Slide number 18 we have prepared this slide to give an understanding of the type of securities we own. You can see that approximately 82% of the non-agency mortgage-backed securities are traditional option ARMs, 13% are hybrid option ARMs, and the remaining 5% are hybrid ARMs. Also, we show the vintage of our non-agency securities and the geographic dispersion.

The next slide shows the amortized cost and fair values of our mortgage-backed securities as of June 30, 2008. In round numbers the combined agency securities available for sale and held to maturity have an amortized cost totaling $1.48 billion and their total fair value is the same. This is a decrease of approximately $160 million as a result of payoffs.

Of the non-agency securities those held to maturity have an amortized cost of approximately $2.28 billion and a fair value of approximately $1.38 billion for a difference of approximately $900 million. The non-agency securities held available for sale have an amortized cost of approximately $1.35 billion and a fair value of approximately $830 million for a difference of approximately $520 million.

The total difference between the amortized cost and the fair value of all of these securities is $1.42 billion, which is an additional unrealized loss of $350 million compared to the previous quarter. $100 million of the increased unrealized loss was for securities held available for sale. The total unrealized loss on available for sale securities is now $513 million, which is recorded net of tax benefit as accumulated other comprehensive loss on our balance sheet and decreases are book equity by such amount, in our case a total of $334 million to date as of June 30, 2008.

Each of the securities are adjustable rate and backed by single-family mortgages. Each of the private issued securities were AAA-rated at the time of purchase and all but one continue to be AAA-rated today. We have not invested in subprime securities, collateralized debt obligations, or subordinated tranches.

At June 30, the average total delinquency rate of the underlying collateral for our non-agency securities was 20.5%. The average current LTV on the underlying loans was 80% based on current loan balance as a percent of the original appraised value. The average original credit score was 707. These securities do not have an insurance wrapper. Rather we feel that the securities maintain their high ratings as a result of the underlying criteria – underwriting criteria of the underlying loans and high levels of subordination.

On Slide number 20 we show that the subordination level on average for all of our non-agency mortgage-backed securities is 15.7%. And on this slide we briefly explain how we come to the conclusion that our significant subordination level of each security provides protection from credit losses.

In our quarterly credit review of each non-agency security we project credit losses on underlying loans for each security over its remaining life using appropriate assumptions for default rates and loss severity. We determine the extent to which each security subordination level is sufficient to absorb the projected losses on the underlying loans. Our conclusion at June 30, 2008 was that the subordination level for each non-agency security continues to be sufficient to protect our securities from credit loss. We continue to expect that we will receive every dollar of principal and interest that is contractually due and we have the intent and the ability to hold the securities to maturity

On Slide number 21 we have listed for your convenience the non-agency securities in our portfolio that have been downgraded or are on negative watch for downgrade. There are 10 of 45 securities listed, nine of which are on negative watch by at least one of the rating agencies and we also show the one security that was downgraded by Moody’s last week. We have listed for you the amortized cost, fair value, and unrealized loss on each of these 10 securities. And as you can see the security that was downgraded had a $21 million unrealized loss on June 30.

Moving now to efficiency on Slide number 22, Non-interest expense was $99 million again during the quarter which on a run rate of $396 million for the year is about a 6% increase from 2007. This increase is driven in large part by increases in many of our direct cost and expense categories because we began to perform many activities ourselves following our separation from Temple-Inland.

Most important, however, you can see that compensation and benefits expense decreased from $51 million to $48 million this quarter, which is a product of our efficiency efforts undertaken at the beginning of the second quarter. That effort caused severance to increase to $3 million. Looking forward, severance charges, of course, are not recurring in nature, and we expect to be able to maintain this lower level of compensation expense. As Ken, we expect to identify even additional ways in which we can operate more efficiently. We will have results discussed regarding these efforts in future quarters.

On Slide number 23 we have shown our capitalized ratios as of – our capital ratios as of June 30, 2008, all of which exceed the regulatory standards to be deemed “well capitalized.” We have also included pro forma capital ratios as of June 30, 2008 reflecting the capital from the private placements that we closed after the end of the quarter on July 21, 2008. You can see that the new capital infusions strengthened our capital ratios further beyond “well capitalized” standards.

Following the additional capital raised Guaranty Bank’s pro forma regulatory capital ratios would be Tier 1 leverage ratio of 9.5%, Tier 1 risk-based ratio of 11.6%, and total risk-based ratio of 14.6%, all of which further exceeded the “well capitalized” standards of 5%, 6%, and 10%, respectively.

And on our last slide, Slide number 24, we show our pro forma capitalization, including the net proceeds from the sale of preferred stock on July 21. Total stockholders’ equity increases from just under $800 million to approximately $1.1 billion. Book equity per share, including these proceeds assuming conversion of all preferred into – preferred stock into common shares is $10.31 and tangible equity per common share under the same assumption comes to $8.74.

Ken, with that, I will turn it back over to you.

Ken Dubuque

Thanks Ron. Clearly this quarter was another very difficult period for the industry as a whole and Guaranty Financial Group in particular. We stated in previous quarters that we expect the conditions to continue to be unfavorable for the bank throughout 2008, and that this current cycle will not likely end soon. We feel that we have set aside appropriate reserves.

We are still not seeing broad based weakness beyond our homebuilder construction portfolio. We have not seen contagion over the commercial real estate, but we continue to monitor this portfolio as well as all our loan portfolios for potential weaknesses.

While we expect general economic conditions to continue to be unfavorable for the bank throughout 2008 trying to determine when the housing market will improve and homebuilder NPAs will decline is still difficult. We are not trying to predict what the government will do about housing or oil prices or overall stimulus. Rather, we are operating on conservative assumptions on these issues. For purposes of evaluating the housing related assets on our books and stresses that our customers experience we are assuming gas prices will remain high and housing prices will remain low for some time.

On the other hand, for example, for purposes of underwriting new energy loans, we are assuming oil prices could decrease further from their recent highs. Overall, this is very much a part of our focus on credit and our attempt to hit these issues head on. We should take from our high level of provision – you should take from our high level of provisioning this quarter that we are focused on identifying credit issues early and making the best of the assets on our books just as we said we were doing three months ago.

Nonetheless, while the deterioration in the housing and credit markets is clearly significant and could continue it’s important to reiterate that we do not originate or purchase subprime loans. We have very few 2006 and 2007 vintage single-family mortgage loans, which is where the majority of issues have occurred.

We bought standard, structured mortgage-backed securities and lending to homebuilders has been a core competency for us.

Long term, our strategy is to still build our commercial lending franchise, grow our retail franchise in Texas and California, increase the income, provide distinctive customer service, and improve our operating efficiency while maintaining strong credit and risk standards.

During the short term, we remain focused on the three Cs – Credit, Cost, and Capital. At the same time, we continue to provide outstanding customer service. We will show our strength through these difficult times.

In that regard, I want to thank our employees for their continuing hard work and support through this challenging period. Thank you for your attention and for your interest in Guaranty Financial Group. Now, we’d be glad to answer your questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question will come from the line of Brad Milsaps. Please proceed.

Brad Milsaps – Sandler O'Neill

Hi, good afternoon.

Ken Dubuque

Hi Brad

Ron Murff

Hi Brad.

Brad Milsaps – Sandler O'Neill

Just kind of one quick question on the energy credit this quarter, just I know you mentioned in the release that you started with consultants et cetera that to determine kind of the level of provision just sort of you could offer a little bit more color how you arrived – it looks roughly kind of like based on reserve kind of $0.35 on the dollar something like that. Just kind of curious little bit more on your exposure and how you have arrived at that number.

Ken Dubuque

Sure. You are right. In general that’s kind of the calculation. We’ve looked at it from a couple of different ways. We are still analyzing the total value of those assets that are part of the business. As we get more information we will adjust it, but generally the way we have looked at it as we went through the end of June and looked at what was the necessary provision was to use a range based upon sale proceeds or estimated sale proceeds of the business units.

Brad Milsaps – Sandler O'Neill

Did you have any exposure sort of directly? I know you mentioned your secured inventory accounts receivables, others assets, but any exposure in the hedging or derivative side of the business in terms of that company or any others?

Ken Dubuque

No.

Brad Milsaps – Sandler O'Neill

Okay. Alright, thank you very much.

Ken Dubuque

Sure.

Operator

And our next question will come from the line of Brian Clark with KBW. Please proceed.

Brian Clark – KBW

Good afternoon, gentlemen.

Ken Dubuque

Hi, Brian.

Ron Murff

Hello, Brian.

Brian Clark – KBW

I know you guys did go through a lot of those details, I apologize if you have already answered it. I know Ron you went through some of this. With the regional homebuilder loan portfolio with the NPLs at the end of the second quarter can you give us an idea I guess of how much has been appraised and I guess how current the appraisals are in those collateral values?

Ron Murff

Sure. You know continually updating the appraisals that are used in determining our loan loss provision or reserves that are necessary on each of those loans. All of – of those that are nonaccrual they would have all have gone through an appraisal. We update those appraisals periodically once we get information that might cause us to think that the existing appraisal might have changed. So those are continually updated. So those are as fresh information as we have as we have established the reserves at the end of June.

Brian Clark – KBW

Okay. And I guess – and I know you guys have given the allowance, a lot of good detail you have given us in your breakout of how much you’ve put on each category. I guess if you know off hand I guess how much of the reserve is on the NPLs for the original homebuilder NPLs?

Ron Murff

I think we’ll have a little more detail may be when we get to the Q.

Brian Clark – KBW

Okay.

Ron Murff

And show that number, but probably in kind of broad brush round numbers it’s in the –probably in the high 30s almost 40%.

Brian Clark – KBW

Okay. And I will just have one quick question, let someone else get on. On the Slide 15 you show the 181 million in NPLs. There is 233 million on Slide 10 for homebuilders. So is the 52 million to national homebuilders? Is that the plug?

Ron Murff

That is correct.

Brian Clark – KBW

Okay, thanks guys.

Ron Murff

Sure.

Operator

And our next question will come from the line of Todd Fernly [ph] with Miller Tabak Bank Capital Management. Please proceed.

Todd Fernly – Miller Todd Bank Capital Management

I am calling as I was curious what was the reasoning for deciding to exit single-family lending while continuing to keep buying mortgage-backed securities with a similar underwriting?

Ron Murff

Sure. You know as a part of our thrift charter we are required to have almost little over two-thirds of our – about two-thirds of our balance sheet in the housing related assets. As we looked at our options and continued to look at our options in making sure we met those standards and we looked at the compliance issues and all of the other operating risk and other issues that surrounded the mortgage creation business, the mortgage production business, we came to the conclusion that as we needed to meet our – buy assets that would continue to qualify under the QTL, primarily these mortgage related assets. That as we looked at it on a risk adjusted bases considering all our risk, both interest rate credit and operating risk that buying those assets in the form of mortgage-backed securities because of the sufficient or the significant subordination levels that that was a better way for us to go rather than to continue to create the mortgage assets individually.

Todd Fernly – Miller Todd Bank Capital Management

Hi, great. Thank you very much.

Ron Murff

Thank you.

Operator

(Operator instructions) and our next question is a follow-up question from the line of Brian Clark with KBW. Please proceed.

Brian Clark – KBW

Hi. Thanks for taking my follow-up. And maybe Ron you can talk about the net interest margin expanded modestly in the quarter. It looked like it was a pretty stable margin and maybe you can talk about I guess the mix in there that helped the margin and what you think for the second half of the year where the margin may end up.

Ron Murff

Yeah, during the quarter we got a little bit of a help from some of our funding cost decreasing primarily – our funding spreads against – on our Home Loan Bank advances have widened a little bit, so that’s helped us some on the spread line. We’ve continued to add a little bit down in the – in our consumer book which would help on that line. So it’s not any one significant factor, Brian, it would be kind of a combination of a number of things. Our net interest spread line, as you see on that slide, has been pretty stable as we look into history. We are continuing to do what we can to move that number up, but would expect that it would probably – history would be a pretty good indicator of what might happen in the future.

Brian Clark – KBW

Okay. I mean just a couple of quick things to the personnel and expense line down from the first quarter and you guys had talked about the sort of rationalization, headcount rationalization program. So the 3 million non-recurring charge that was the severance charge you had talked about previously?

Ron Murff

Yes. That’s correct. During the quarter – if you look at Slide 22 the comp and benefit lines actually went down 3 million quarter-to-quarter, but we did have severance. All of that line would be severance at 3 million.

Brian Clark – KBW

That 3 million. And as far as the overall headcount, do you have the FTE headcount at the end of second quarter?

Ron Murff

The FTE headcount would be down. We are still winding down some of the – I think we announced at the end of the last quarter when we had the call about 135 total positions. Not all of those have been – have come to their term yet, we are still winding down certain of those operating units to make sure that we wind down things properly. So, I think we have probably seen between 80 and 100 reduction in headcount and will continue to see a little bit more in the early part of this quarter.

Brian Clark – KBW

Okay. So actually may see some more efficiencies come in the third quarter.

Ron Murff

They will be slight, yes.

Brian Clark – KBW

Right, okay. And I guess on the mortgage portfolio I know you guys have gone through a pretty extensive review and I guess obviously the (inaudible) is a concern. Maybe you can expand a little bit about the review you do and I guess your estimates of default and severity you may – the gyrations [ph] you go through to get comfortable with that – that there is an OTTI [ph] out there.

Ron Murff

Sure. As we look at that mortgage-backed securities portfolio, similar to what we’ve talked about in the past, it does – we do use a number of assumption. We look at each portfolio differently. We look at some of the attributes of each of those securities differently. In general I would say default rates as we go forward, we are kind of using similar default rates to what we were experiencing in the last few months. On average that’s probably – that can probably vary from 12% to 24% as we look at the loss severity. Again, it will vary by bond, based upon what we know. As we look at – in our current projections those loss severity numbers would be probably anywhere from on a range of 35% to 45%.

Brian Clark – KBW

Okay. Great. Right, thanks. Appreciate that, Ron, thanks.

Ron Murff

Yeah.

Operator

And at this time we have no further question. I would like to turn the call back over to Ken Dubuque for closing remarks.

Ken Dubuque

We again thank you for joining us on this conference call. Have a great day.

Operator

Thank you for your participation in today’s conference. This concludes your presentation. You may now disconnect. Good day.

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