Bank of the Ozarks Q3 2007 Earnings Call Transcript

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Bank of the Ozarks, Inc. (NASDAQ:OZRK) Q3 2007 Earnings Call October 12, 0000 11:00 AM ET

Executives

Susan Blair - Vice President, Investor Relations

George Gleason - Chairman of the Board, Chief ExecutiveOfficer

Paul Moore - Chief Financial Officer, Chief AccountingOfficer

Analysts

Barry McCarver - Stephens, Inc.

Charlie Ernest

Andy Stapp - B. Riley & Company, Inc.

David Bishop - Stifel Nicolaus

Leo Hamid

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Operator

Good morning. My name is Shanda and I will be yourconference operator today. At this time, I would like to welcome everyone tothe Bank of the Ozarks third quarter earnings release conference call.(Operator Instructions) Thank you. Ms. Blair, you may begin your conference.

Susan Blair

Good morning. I am Susan Blair, Executive Vice President incharge of Investor Relations for Bank of the Ozarks. The purpose of this callis to discuss the company’s results for the third quarter of 2007 and ouroutlook for upcoming quarters. Our goal is to make this call as useful aspossible in understanding our recent operating results and future plans, goals,expectations, and outlook.

To that end, we will make certain forward-looking statementsabout our plans, goals, expectations and outlook for the future, including statementsabout economic, competitive, and interest rate conditions, revenue growth,including our goal of accelerating our rate of revenue growth in 2007 as comparedto 2006, net income, net interest margin, including the effects of therelatively flat yield curve and intense competition and our goal of maintainingand possibly improving net interest margin from the level achieved in the thirdquarter of 2007, net interest income, non-interest income, including servicecharge, mortgage lending and trust income, non-interest expense and our goalsfor decelerating our rate of increase in non-interest expense in 2007 ascompared to 2006, and achieving positive operating leverage in the future,asset quality, including the effects of the current economic and housing marketconditions, changes in residential mortgage market conditions, future growthand expansion, including plans for opening new offices, loans, lease and depositgrowth, and changes in our securities portfolio.

You should understand that our actual results may differmaterially from those projected in any forward-looking statements due to anumber of risks and uncertainties, some of which we will point out during thecourse of this call.

For a list of certain risks associated with our business, youshould also refer to the forward-looking information caption of themanagement’s discussion and analysis section of our periodic public report, theforward-looking statements caption of our most recent earnings release, and thedescription of certain risk factors contained in our most recent annual reporton Form 10-K, all as filed with the SEC.

Forward-looking statements made by the company and itsmanagement are based on estimates, projections, beliefs, and assumptions ofmanagement at the time of such statements and are not guarantees of futureperformance.

The company disclaims any obligation to update or revise anyforward-looking statement based on the occurrence of future events, the receiptof new information or otherwise.

Now, let me turn the call over to our Chairman and ChiefExecutive Officer, George Gleason.

George Gleason

Good morning and thank you forjoining today’s call. We are pleased to be reporting record net income for thequarter just ended. While this record was only a slight improvement over ourprevious quarterly record net income, we feel good about this accomplishment,considering the current operating environment.

We are also pleased that ourthird quarter results generally reflect continued progress in achieving our keygoals for 2007.

Earlier this year, we hadstated four key goals for 2007, which are: one, accelerating our rate ofrevenue growth; two, decelerating our rate of increase in non-interest expense;three, maintaining or improving net interest margin; and four, maintaining goodasset quality.

We also stated that we wantedto get back on a record earnings pace by year-end 2007, after pursuing oursignificant deposit, branching, and corporate growth initiatives in 2006.

Let me give you some specificson our recent results.

First, let me discuss our goalof accelerating our rate of revenue growth in 2007. Net interest income, whichtypically accounts for about three-fourths of our revenue, increased 3.1% forthe year 2006 compared to 2005. In the first, second and third quarters of this year,2007, net interest income has increased 4.7%, 7.3%, and 10.7% respectivelycompared to the comparable quarters in 2006. That is exactly the sort ofperformance we had in mind when we articulated our goal of accelerating ourrate of revenue growth in 2007.

As a result, we have achievedrecord net income in each quarter this year. The acceleration in our rate ofgrowth in net interest income to date this year results from a combination of:one, growth in earning assets, and that’s primarily loans and leases; and two,quarter-to-quarter improvement in our net interest margin during the first twoquarters of this year. Our net interest margin actually declined one basispoint in the quarter just ended.

I will discuss our expectationsfor future loan and lease growth and net interest margin in more detail in afew minutes.

Our efforts to accelerate ourrate of revenue growth from non-interest income sources have had mixed resultsthis year. We have seen good progress in regard to income from depositaccounts, service charges, and trust, but it has been a challenging year so farin mortgage.

Income from deposit accountservice charges is our largest source of non-interest income and last year thiscategory of income increased 3.5% compared to 2005. In the first, second and third quarters of 2007, incomefrom deposit account service charges has increased 22%, 20.1% and 21.1%respectively compared to the comparable quarters in 2006.

A number of factors havecontributed to this increase and our growth rate of service charge income in2007. These factors include enhancements made in late 2006 in our processes for applying and collecting service charges,a large increase in our number of deposit accounts from our 2006 deposit growthinitiative, and some small adjustments earlier this year in our service chargefee schedule.

Typically, mortgage lendingincome is our second-largest source of non-interest income. During the year2006, our mortgage income actually declined 3.8% compared to 2005, and duringthe first and second quarters of 2007, despite generally slower housing marketconditions, mortgage income increased 21.2% and 4.9% respectively compared tothe comparable quarters in 2006.

However, during the quarterjust ended, mortgage lending income declined 25% compared to the third quarterof last year and 27.3% compared to the second quarter of this year. Both thedirection and magnitude of this decline were disappointing.

In our view, the third quarterresults were more significantly impacted by factors of market psychology thaneconomic fundamentals. Let me explain what I mean by that.

First, the tremendous mediahype about problems in certain sectors of the mortgage industry seems to havemade many buyers doubt their ability to obtain financing. For our customerbase, which easily financed through various secondary market programs,including a resurgence in FHA lending.

Secondly, the proliferation ofpublicity about housing market conditions nationally appears to have turnedmany buyers into bargain hunters. Clearly many buyers are negotiating harderand many seem to be waiting for market deterioration before they buy.

Now I would love to give yougood guidance on where our mortgage lending income is going but since, at lastin our markets, it seems that conditions are being driven more by marketpsychology than economic fundamentals, it is especially difficult to predictwhen we will return to a more normal environment.

Trust income is anotherimportant source of non-interest income and we are pleased to have reportedrecord quarterly trust income for the third quarter. During the year 2006,trust income increased a very favorable 16.4% compared to 2005. In the first, second and third quarters of this year,trust income increased 7.4%, 11.1%, and 16.3% respectively compared to thecomparable quarters in 2006.

A slowdown in new bond issuancein Arkansas has restrained our growth in corporate trust income so far thisyear. However, we have continued to see good growth in our personal trust andinvestment management business, and we expect growth in these areas to continueto drive overall growth and trust income in the remainder of 2007.

Let me conclude my remarksregarding these various revenue categories by saying that we feel the resultsso far this year reflect good progress in achieving our goal of acceleratingour revenue growth rate in 2007.

Decelerating our rate ofincrease in non-interest expense is another key goal for 2007. During 2006, weinvested heavily in our branching and corporate growth initiatives, whichcontributed to the 15.7% increase in non-interest expense in the year 2006compared to 2005.

In the first, second and thirdquarters of 2007, non-interest expense increased 8.8%, 7.8%, and most recently0.2% compared to the comparable quarters in 2006. Clearly this reflects that weare on track so far in accomplishing our goal of decelerating our rate ofincrease in non-interest expense in 2007. In fact, our results have been even better than weexpected as our absolute level of non-interest expense has actually declined ineach quarter of 2007 compared to the immediately preceding quarter.

While we will strive tocontinue to carefully control non-interest expense, it would be unrealistic toexpect that the aggregate non-interest expense level would decline further, butwe want to continue to grow and expand our franchise and this will requireincreases in non-interest expense as we add new people and new offices andotherwise spend to operating and build our business.

Our goals going forward will befor our growth rate of non-interest expense to be below our growth rate ofrevenue, thus achieving positive operating leverage.

Our third key goal that we setfor 2007 is maintaining or improving net interest margin. Of course, this isclosely related to our goal of accelerating our rate of revenue growth, whichI’ve already discussed. However, net interest margin is so important that wethink of it as a separate goal and I want to talk about it separately as well.

During the first and secondquarters of this year, our net interest margin improved 13 and 11 basis pointsrespectively compared to the immediately preceding quarters. In our lastconference call, we stated that our short-term goal was to maintain netinterest margin at the second quarter level or hopefully improve it slightlyover the next two quarters. We fell slightly short of that goal in the thirdquarter as our net interest margin declined one basis point.

At this point, we have not seena broad-based change in our environment for pricing loans and deposits.Unfortunately, competition continues to be very challenging for pricing bothsides of the balance sheet.

The improvement in our netinterest margin since the fourth quarter of 2006 is primarily due to twofactors. First, in 2007, we had moderated our deposit pricing somewhatfollowing our deposit growth initiative in 2006 and we’ve allowed a number ofhigher cost deposits to roll off our balance sheet in favor of lower costborrowings. And secondly, our loans generally re-price somewhat more slowlythan our deposits and with the federal reserve on hold with interest rateadjustments for the last half of 2006. In the first eight months of 2007, our loan pricingduring the first half of this year started to catch up somewhat with ourearlier deposit repricing.

As we suggested in the lastconference call, we expect that further improvements in net interest marginwill be more difficult to achieve in the near term. At this time, our goalcontinues to be to maintain net interest margin at the third quarter level orhopefully improve it slightly during the coming quarters.

Our simulation model resultssuggest that we are almost neutrally positioned and the recent fed actionshould have little impact on our net interest margin.

The fourth goal for 2007 is tomaintain good asset quality. Our third quarter asset quality ratios were veryfavorable and are consistent with this goal. Our strong credit culture and ourcommitment to good asset quality appear to be serving us well.

At September 30, 2007, ourratio of non-performing loans to total loans and leases was 19 basis points andour ratio of non-performing assets to total assets was 22 basis points. Ourratio of loans and leases past due 30 days or more, including past duenon-approval loans and leases, as a percentage of total loans and leases was 45basis points at September 30, 2007, and our annualized net charge-off ratio was17 basis points for the last quarter.

As of the end of the mostrecent quarter, our allowance for loans and lease losses equaled 564% of totalnon-performing loans and leases.

Our good third quarter assetquality results might lead on to believe that we are operating in a veryfavorable credit quality environment. However, as I have said previously, thecumulative effects during the past two years of 425 basis points of FMOC rateincreases, 50 basis points of course which have now been reversed, higherenergy prices, and slower economic conditions in many sectors among otherfactors are adversely affecting some borrowers.

In all of our markets exceptnorthwest Arkansas, I would characterize business conditions as generally good,although activity has slowed in recent quarters. In northwest Arkansas, aslowdown in residential lot and home sales has occurred and that market iscontinuing to work through the oversupply situation.

The good news for northwestArkansas is that there is by no means a cessation of residential lot and homesales and the area continues to be a growing and economically vibrant marketwhich in due time should resolve the oversupply of houses and residential lotsnow existing in some sub-markets and some price points.

In summary, accomplishing ourkey goals of accelerating our rate of revenue growth, decelerating our rate ofincrease in non-interest expense, maintaining or improving net interest marginand maintaining good asset quality were critical elements in our favorableresults in each of the first three quarters of this year, including our recordnet income in the quarter just ended.

These four goals will continueto be key objectives for the coming quarter.

Now, let me turn our attentionto several other subjects.

Growth in earning assets,primarily loans and leases, is important in achieving our goal of growing netinterest income. Loan and lease growth in each quarter this year has been belowour expectations. Our quarterly loan and lease growth in the first, second andthird quarters of this year were $46 million, $33 million, and $16 millionrespectively.

Over the last four quarters,our loans and leases have grown 13.9%, near the bottom end of our target range.Despite this slower growth in recent quarters, it appears that we have a verygood pipeline for the fourth quarter and we continue to believe that in thecoming quarters, our growth in loans and leases will on average be in themid-teens to low 20s annual percentage range.

Our investment securities portfoliois another source of earning assets and as you will recall during the firstquarter, we were a net seller of investment securities and we have found veryfew investment securities we thought were compelling values this year. This hasbeen the primary factor in the $29 million decrease in our investmentsecurities portfolio so far this year.

As we have said a number oftimes before, we will be a seller of securities when we believe marketconditions are conducive to selling and a buy of securities when we believemarket conditions are more appropriate for buying. We expect to continue tomanage the securities portfolio with the same mindset.

After record-setting depositgrowth in 2006 and very strong deposit growth in the first quarter of 2007, ourdeposits have actually declined in each of the last two quarters. This is notconcerning to us. We have simply been trying to maintain or improve our netinterest margin this year and over the last two quarters, we have allowed anumber of broker deposits and other high cost deposits to run off in situationsin which we could replace those deposits with lower-cost borrowings.

We continue to expect that ourdeposits will grow over time to the extent that deposit growth is costeffective and needed to fund our growth and earning assets, and we expect touse brokered funds and borrowed funds within reasonable limitations whenborrowings are a cheaper source of funds.

Our goals for the comingquarters include continuing to achieve good growth in earning assets, primarilyloans and leases, and maintaining or perhaps improving slightly our netinterest margin from the third quarter level. If we can accomplish these goals,then we have the necessary elements to continue to achieve improvements in netinterest income each quarter, and of course this is critical to our achievingearnings growth.

We have continued our growth inde novo branching strategy in 2007. In addition to our Hot Springs, Arkansas office, whichopened during the second quarter, during the third quarter we replaced ouroriginal temporary office in Frisco, Texas with our second permanent office inthat city and opened a second banking office in Fayetteville, Arkansas. In thefourth quarter, we expect to open our third banking office in Rogers, Arkansas.At this time, we expect to open approximately three new banking offices in2008, including our new corporate headquarters.

Given the fact that 53% of ourtotal banking offices have been open in the last four years and nine months,including the record number of new offices we opened in 2006, we believe we canmaintain good growth rates while opening fewer offices in both 2007 and 2008.

In closing, let me state againthat we are very pleased with our record third quarter net income. Now that wehave once again achieved record quarterly net income, our goal will be tocontinue to improve earnings each quarter. We think this is a reasonable goal.

But given current economic,housing market, mortgage market, competitive and [yield curve] conditions, we arevery cautious in our optimism. Given the considerable headwinds anduncertainties related to business economic and interest rate conditions, wepresently see room for only modest EPS growth in the fourth quarter. We arealso very cautious in our outlook for the first quarter of next year.

The first quarter, as many ofyou know, is always a challenging quarter, as it is usually a soft quarter forincome from deposit account service charges, mortgage income and loan growth,and also typically includes some non-interest expense items unique to the firstquarter.

Here’s the bottom line; we wantto continue to report record earnings each quarter and that is our goal and wethink it’s a reasonable goal, but we should all be cautious in our optimism forthe coming two quarters and until conditions improve.

That concludes my preparedremarks. At this time, we will entertain questions. Let me ask our operator,Shanda, to once again remind listeners how to queue in for questions. Shanda.

Question-and-AnswerSession

Operator

(Operator Instructions) Yourfirst question comes from the line of Barry McCarver.

Barry McCarver - Stephens, Inc.

Good morning, George, and greatquarter. George, just on your last comments there about you said in yourcomments, modest EPS growth for the next couple of quarters. I’m assuming youmean late quarter and how they would move up from compared to the $0.50 you hadin the third quarter. Is that what you mean?

George Gleason

Yes, thank you for clarifying.That is.

Barry McCarver - Stephens, Inc.

Second question, just goingback -- and again, you touched on the difficult environment for gatheringdeposits but in terms of the margins, seeing deposits come down 6% in quarterand running that loan-to-deposit ratio up to 89%, I would have suspected themargin would have been just a little bit stronger than it was. Could you giveus some more specific details on the deposit line? It certainly indicates thatwas a much more competitive environment than what I thought was out there.

George Gleason

We had hoped to see moremoderation in deposit pricing in most of our markets than we have seen. Thathas been very slow to come about and I think still has hopefully a ways to go.We were also surprised when Fed did make their 50 basis points cut. Some of ourcompetitors did not adjust deposits as quickly or appropriately as we thoughtthey should, so that’s part of my comment about being cautious about being ableto improve that margin and also reflected in my comment regarding continued challengingcompetitive conditions out there.

Barry McCarver - Stephens, Inc.

So was there anythingspecifically large in the way of deposits that were running off in the thirdquarter that you just let mature and go, or there was just a little ofeverything?

George Gleason

It was significantly brokerdeposits and other higher cost CDs, were the principal sources of that and yousaw that in the change in the mix of our deposits. For example, last quarterour average CDs were 67.2% of our total deposits and this quarter, on anaverage basis, they were 66.4%, so a decline in CDs in the mix of deposits andthat was the principal source of run-off.

Barry McCarver - Stephens, Inc.

Okay, so the bottom line is itsounds like a flat margin is what we can expect for the next couple ofquarters, all thing being equal, hopefully?

George Gleason

Again, our guidance was we hopeto maintain it at the third quarter level and improve it slightly but generallyflat is our expectation, plus or minus a tad.

Barry McCarver - Stephens, Inc.

And then just secondly, on theexpenses, it continues to be very impressive the way you are holding expensesdown. I am surprised that so much of it is coming out of salaries and bonus. Iknow part of that must be related to commission basis on the mortgage businessand probably some of it relates to some of the hiring you did in 2006. Can youbreak that down just a little bit further so we’ve got an idea of what to lookfor next quarter? And then, in addition to that, I’m assuming you are going tohave some bonus accrual and potentially some catch-up in the fourth quarter aswell.

George Gleason

That’s going to depend purelyon our earnings whether or not we have bonus accruals and catch-up. We have hadfairly nominal bonus accruals in the second and third quarter. I think it was$100,000 we accrued for targeted bonuses in the second quarter, and I think itwas $45,000 in the third quarter.

We want to get back on aprogram of either paying our general cash bonuses or, if we can’t pay thegeneral cash bonuses, we want to get back on a program of paying targetedbonuses to employees who are performing at a particularly high level or makinga particularly significant, noteworthy contribution to the company and wedescribe in our proxy material those two categories of bonuses, if you want torefer to that for more clarification on that.

So I am hopeful that we willhave bonus accruals in the fourth quarter and in future quarters subsequent tothat. But as you know, we have minimum earnings targets that we want to hit inorder to accrue bonuses and obviously we slightly exceeded those earningstargets in Q2 and Q3, allowing us to accrue the $100,000 and the $45,000 inthose quarters, so we have targets for Q4 and Q1 and the other quarters of nextyear, and we’ve got to exceed those earnings targets.

Now, I will tell you if weexceed those earnings targets, I am generally inclined to put a large part, ifnot all of that excess, into bonus accrual because I do want to get back onthat bonus accrual and that’s in part of our mindset in being reasonablycautious in our guidance for EPS growth.

We certainly feel like ourearnings trajectory has been very good in the first, second and third quartersof this year and we are on the path of accomplishing what we want toaccomplish. I think it is prudent to realize that we are in a tough operatingenvironment and not get carried away in ratcheting up future earningsprojections too aggressively.

Barry McCarver - Stephens, Inc.

And then just lastly, samequestion I ask every quarter, George, but nothing in the loan book in terms ofasset quality that has popped up that has you worried anymore than what’s beenthere recently?

George Gleason

And I’ll give you the answer Ialways give you, Barry, is I’m a credit guy by history and I always worry abouteverything but no, I think that the asset quality ratios for the third quarterare very reflective of the condition and quality of our portfolio. We workedvery hard on asset quality.

To give you a little color onthat, I would tell you those ratios are, depending on which ratio you look at,slightly better or slightly worse than the comparable ratios a year ago. Iwould tell you that we are spending more time on asset quality this year thanwe did last year and that’s just a reflection of the fact of what I commentedon in the prepared remarks, but the higher interest rates, higher energyprices, generally slower economic conditions are causing some borrowers on themargin to struggle significantly.

And we sold quite a bit of OREOin the third quarter, including -- we had a number of accounts -- I think wesold five houses from our OREO portfolio in northwest Arkansas and liquidated asmall church and a small retail facility that we moved out of OREO in the quarter,so it’s requiring a lot of work. Our guys are doing a good job. I thinkmanaging problem assets is a strong skill set that we have, as well asmaintaining a strong credit culture and doing a good job of underwriting.

So all those skill sets are provingto be pretty valuable in the current economic environment.

Barry McCarver - Stephens, Inc.

Very good. Thank you, sir.

Operator

Your next question comes from the line of Charlie [Ernest].

Charlie Ernest

Good morning. George, my firstquestion is on your loan growth outlook. The numbers are coming in a little bitlighter, as you pointed out, and I guess there is more concern about theeconomy, yet you still stick with the higher targets. Can you share any colorwith us as to why you still feel comfortable with those higher targets?

George Gleason

I’ll be happy to share thatwith you. I think an important consideration there is that we did enter overthe last year to two years, we’re really entered or ratcheted up our presencein four new markets significantly. Northwest Arkansas is one of those markets.It is not contributing much growth at this time because of the slowdown ineconomic conditions there. Garland County, Arkansas, the Texarkana, Arkansas and Texarkana, Texas area and in the metro Dallas area.

And the metro Dallas market,both our real estate specialties group that’s headquartered in Dallas and ourmore metro Dallas retail offices, of which we opened the second of theiroffices this last month, is providing a significant chunk of growth for us.That was very evident in the third quarter when our percentage of our loans inDallas increased from 11.6% at June 30 of this year to 14.6% at September 30,so I that quarter, Dallas increased or Texas, including our Texarkana officesas well there, increased their contribution to our loan portfolio by 300 basispoints.

As a result, Arkansas loans inour portfolio went from 83.1% to 80.4%, a 2.6% decline, 260 basis pointsroughly decline there in Arkansas. So the Texas economy is very good, the metroDallas economy particularly is very good. We have a large presence there. It isa fairly new presence. Our guys seem to be gaining traction there and I suspectthat we will also see some growth from our Charlotte office and from our metroLittle Rock area offices.

So we feel like there is stillsome really good growth opportunities available to us. Our growth so far thisyear in each quarter has been offset to some extent, reduced to some extent bya considerable number of pay-offs that we’ve experienced. We have an ongoingprogram of pruning the portfolio. We try to move credits out of the portfoliowhen we see signs of financial weakness beginning, when we see deterioratingcredit trends and we talk with management and we talk with borrowers and theyare not providing us the kind of answers and comfort and direction that wewant. We are pretty aggressive in moving loans out of the portfolio.

So as economic conditions haveslowed over the last year or so, we’ve seen a few more credits fall in that categorythan we have seen fall in that category in the prior few years and that’s ledto a little bit more aggressive pruning, and that has tended to provide someheadwind to our growth this year.

Secondly, we have a largeconstruction and development portfolio and for obvious reasons, a lot of thoseguys are carrying less inventory.

So what I would tell you isthere are some headwinds as folks borrow less under their prior -- compared totheir prior borrowing arrangements because they are carrying less lightinventory or less construction inventory, slower economic conditions arecausing a little more pruning than normal of the portfolio, so those areheadwinds.

On the flipside, we’ve gotreally good lending teams, we’re in some really good new markets where economicconditions are good, so that’s the positive things that give us optimism thatwe can continue to maintain a mid-teens to low-20s growth rate, on average.

Charlie Ernest

Can you just comment what theconstruction number was during the quarter at period end?

George Gleason

Yes, I can if I can put myfingers on that. The construction and land development loans at September 30were $597 million. That was 32.9% of the portfolio, up from 32.0% of theportfolio at June 30. And again, as would be evident from the percentages thatI gave you on the state-to-state mix of the portfolio, most of that growthoccurred in our metro Dallas or Dallas real estate specialties group offices.

And what we really like aboutthe product that we originate in those offices is in almost every case, we’vegot lots of equity in those projects. There’s a lot of equity money, a lot ofwealth in Texas and our Texas loan portfolio typically has much higher equitycontributions from the borrowers than we see in Arkansas, so we like that sortof business and I think it’s one reason you’ll continue to see our appetite andour portfolio of Texas loans grow significantly.

Charlie Ernest

How much of that 597 is land?

George Gleason

I could not -- I don’t havethat number.

Charlie Ernest

Okay, and then just oneclarification; you mentioned your operating leverage goal of positive operatingleverage. Was that on an annual basis for the full year or was that sort of ablank quarter goal?

George Gleason

I think that’s an annual goaland you’ll see that number bounce around from quarter to quarter, for variousreasons. You’ve asked questions about bonuses in the past and Barry asked aquestion about bonuses. If we had a particularly robust Q4, for example, wemight make a particularly robust bonus accrual, or if we had some extraordinaryincome from some source, unusual income in Q4 we might use that to buttressbonus accruals and that would actually -- might lead to negative operatingleverage as far as the efficiency ratio goes, but over time our goal is toachieve positive operating leverage.

We still have a longer termgoal of getting to a 40% efficiency ratio and certainly the interest marginenvironment we’ve been in the last couple of years has caused us to not talkmuch about that and not view that as a near-term achievement, but over a periodof several years, we still want to get to a 40% efficiency ratio.

Charlie Ernest

And then my last question is doyou have any -- I know that you said most of your mortgage business is in theconforming space, but do you have any guesses as to about what percentage thatis? It is 90% or 95%, somewhere around there?

George Gleason

It is well north of 90%. Iwould say it is in the 95% plus range. I don’t have third quarter data but lastyear, we originated I think about $10 million of sub-prime or Alt-A mortgages,which we sell immediately, non-recourse. We’ve got them sold when we commit tothem so we are not taking any portfolio risk and that was about 5% of our total$174 million or so mortgage originations last year, so --

Charlie Ernest

Great. Thanks a lot, you guys.

Operator

Your next question comes from the line of Andy [Stapp].

Andy Stapp - B. Riley & Company, Inc.

Good morning. Last year youopened a record number of offices. I’m just wondering if you could give us anupdate on how they are performing.

George Gleason

I would say, as in any casewhere you open 11 offices like we did last year, they are performing with mixedresults. Again, I would tell you our Texarkana, Arkansas and Texas offices, ourFrisco offices are performing well -- let me clarify that.

I would say Texarkana, Texasand Arkansas offices we opened are doing very well. That’s turned out to be avery competitive environment, but the guys are generating good growth and goodadditions in number of accounts and doing well there.

Our Frisco office that weopened last year, we’ve really been sort of slow-balling that and the reasonwas is the office that we opened just a couple of months ago -- a month ago, Iguess, will be our headquarters for that office and right after we opened theFrisco office, they started doing a whole bunch of roadwork right in front ofour facility and access was very difficult. So we decided to not aggressivelypush that office, to just sort of slow play that office until the roadwork gotdone, which I think is all done now, and until we opened this office, theheadquarters office down there in September. So we will begin really in earnestto push that office, so that office has been very slow to develop.

Our Hot Springs offices aredoing very well, particularly on the deposit side, and our northwest Arkansasoffices are, as you would expect from the economic conditions up there, rampingup at a slower rate than what we would have expected because things have sloweddown up there considerably.

The good news, and I think themore important news is that I think all these offices are well-situated inmarkets that have strong, long-term growth potential, so whether or not they’veoutperformed our expectations, as a few have, or under-performed ourexpectations, as a few have, I think the long-term prospects for all of themare very good.

Andy Stapp - B. Riley & Company, Inc.

When do you plan to open yournew corporate headquarters?

George Gleason

That will probably be completedin November or December of next year, so that really has no significant bearingon our ’08 operating results until the last month or two of the fourth quarter.And I would -- but I don’t think while that is a big new facility and it willbring some higher overhead costs, it will also bring some efficiencies and somereductions in cost.

I’ve got folks in two rentedspaces in town now and other office buildings where we’ve just run out of spacein our existing headquarters and we’ve pushed people out to other leased spacein other buildings, and of course that lease cost will go away and offset tosome degree the cost of a new facility.

And our existing facility thatwe are in now, we are not quite sure what we are going to do with that yet. Wewould very much like to keep the retail banking office downstairs. We thinkwe’ll need this facility again in the future and potentially will lease it fora period of time until space is needed in it again, or we think we own it at avery favorable cost basis and if a really good offer to buy it came along, wewould sell it.

So I think through the --either leasing this space or eliminating the cost of the headquarters we’re innow by selling it and eliminating the cost that we are expending for leasespace for other office buildings where we’ve got folks stuck now and achievingsome productivity efficiencies by having all of our people back together andhaving room to do some things that we can’t do right now in our headquartersfacility I think will mitigate a large part of the monthly operating costs ofthat new building with some savings.

Andy Stapp - B. Riley & Company, Inc.

Okay, great. That’s all for me,thanks.

Operator

Your next question comes from the line of David Bishop.

David Bishop - Stifel Nicolaus

Good morning, George. Firstquestion, in terms of loan pricing out there; obviously with the disruption inthe secondary markets we saw with the liquidity issues in the early to mid partof August there, I had talked to some of our management team and some of themhad been hopeful to see an improvement in terms of some of the risk-adjustedpricing out there, maybe some of the conduits, some of the insurance companieshad stopped picking up the phones there. Have you seen any sort of evidencethere as of yet in terms of on the loan pricing side? Obviously loan yields aredown here. I would assume not. I guess I’m somewhat surprised at this stage ofthe credit cycle and to your overall commentary, we haven’t seen that translatethrough yet to loan pricing.

George Gleason

We are beginning to see some ofthat, both in volume opportunities and in pricing, and let me try to explainall that so I can help you understand the nature of the comments that I made.

First, we are seeing someopportunities to do some loan business with folks that would typically not usebank financing. They would typically be Wall Street money that would be provingtheir financing at very low rates and as you said, a lot of those money sourceshave dried up because perhaps they were overly aggressive in the past andthey’ve got some problems and issues that they have to deal with, so they areturning off the spigots.

And customers who might nothave accepted our equity requirements or loan covenant terms or pricing in thepast, we’re getting some shots at some pieces of business from really primo,high-end, high net worth borrowers that we would not have had a shot at eventalking to them about doing their business in years past.

So that is one reason to sortof follow-up on Charlie’s question, I guess, that we are somewhat optimisticabout the high teens to low 20s loan growth rate going forward. I think we aregoing to have some business opportunities that we would not have had a year ortwo ago.

In regard to pricing, we areseeing in some categories of larger commercial credits that are really, reallyhigh quality credit, libor-based pricing and we are seeing that pricing up 20,30 basis points or so where those loans would have been priced a few years ago,or a few quarters ago, actually.

And that is -- I think thataugers well for the growth prospects of our Dallas area offices and ourCharlotte area offices and also the margin prospects of those offices.

That is being somewhat offsetin Arkansas, where we still have 80% of our loan portfolio, where thesignificant slowdown in loan opportunities in northwest Arkansas and the factthat Arkansas is a heavily banked state, seems to be creating even moreaggressive competition, unfortunately, from the top tier players in Arkansaswho were getting loan volume from northwest Arkansas and a lot of that volumehas dried up, so they are becoming more aggressive in trying to steal businessaway in other markets.

So that’s providing somechallenges on particularly good credits in some of these other markets.

So it’s a -- that’s why I saidwe’ve not seen really a broad-based change in competitive pricing conditions.In some instances, it’s gotten better and we are seeing opportunities to get 20or 30 or 40 basis points better yields than we might have gotten a few monthsago, a few quarters ago, and in some instances, we’re seeing unusuallyaggressive competition because the pie of available high quality, particularlylarger loans in Arkansas has shrunk for some lenders and they are trying tomake up for that with aggressive pricing in other markets. So it’s achallenging environment out there.

David Bishop - Stifel Nicolaus

Great color. One follow-up, Iguess; Texas versus Arkansas, you are still seeing good ability there to priceand loan fees in terms of the construction credits and other commercial creditsrelative to Arkansas, where I guess there’s been a little bit more of a legacytype resistance to that type of pricing.

George Gleason

Yes.

David Bishop - Stifel Nicolaus

Okay, great. That’s it for me.Thanks.

Operator

Your next question comes from the line of [Leo Hamid].

Leo Hamid

Good morning. Can you talk alittle bit about whether or not loan growth in the quarter was allowed to acceleratebecause of the FED toward the end of the quarter?

You talked a little bit on theprevious question about seeing opportunities of 20 to 40 basis points higher inprofitability. Did that give you an opportunity to add more loans toward theend of the quarter.

George Gleason

The FED action had no effect onour loan growth whatsoever. Our guys are charged with this general instruction.We are a lending oriented company and I would say lending is our best skill andour guys operate under this protocol, and that’s to make every good quality,good yielding loan you can make consistent with safe, sound, and prudentbanking practices.

The guys have a constant greenlight to make loans that meet our underwriting standards and our pricingstandards and are otherwise documented, serviced and managed in a safe, soundand prudent manner. In our company, there has never been a restraint or alimitation on that. The guys have a constant green light to go do that, so FEDaction had no change in our policies there at all.

Leo Hamid

And then you talked a littlebit about deposit prices and still being relatively competitive, even after thecut. Historically, how long has that taken to bleed through competitively andwhat are you seeing differently this time?

George Gleason

Leo, I don’t know that I canintelligently answer either one of those questions. We are in different marketsto a great extent than we have been in the past. We’ve entered four new marketslast year, so I don’t know that we can give you an apples-to-apples comparisonof what’s happened in the past and what’s happened this time.

I would tell you and justreiterate the comments that I made earlier and that is that I would haveexpected, in response to a 50 basis point FED cut, I would have expected to seea little more moderation in deposit pricing from a number of our competitorsbeyond what I saw. We’ve still got competitors in some markets that are pricingCDs, Susan, in the 550 range?

Susan Blair

560.

George Gleason

550 and 560 APY range and Imean, I just don’t see any need for that. It’s surprising me that we’ve stillgot competitors doing that.

Now, there has been a generalreduction in rates since the FED move. It’s just not been as much or as fast asI would have thought was prudently appropriate by people that are interested intheir bottom line.

Leo Hamid

Fair enough. Thanks.

Operator

Your next question comes from the line of Brian Martin.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Good morning, George. Just aquick question, just on the growth over the last two quarters on the loan side,specifically within the Texas market. I guess, given some of what your commentarytalked about, the northwest Arkansas and Arkansas in general, can you talk --maybe you’ve done this and I’m just not aware of it -- but maybe what yourshort and long-term goals are, as far as kind of your Texas presence? It isspecifically targeted at Dallas? Do you go elsewhere given the growth you areseeing down there? I guess maybe what color you can provide there?

George Gleason

We basically have threestrategies in place that we are pursuing for Texas and one of them is what wecall our real estate specialties group and we have a lending team that islocated in metro Dallas in the Preston Center area there, and these guys havesubstantial experience and contacts and knowledge about larger commercialcredits and we’ve been doing this now for several years there and this officeis the principal contributor of our loan growth in Texas. And I’ve talked at lengthabout this office at various times and this is a very important part of thefuture growth picture of our company.

So those guys are focused onlarger, commercial real estate transactions, including construction anddevelopment lending transactions with very high-end developers and borrowers witha pretty significant customer profile for their customers. That office we wouldhope someday would have 100 to 125 customers that it serves -- very high-endcustomers, including folks that you would find in the top 10 nationally indevelopment categories of different kinds. And that office has been the largestcontributor of our loan growth this year.

The second strategy is what wecall the metro Dallas strategy and it is really a more traditional retail bankingoperation. We have two offices, now both in Frisco, Texas that will fulfill thestrategy and it is a strategy to do in the metro Dallas area, in that nine, 10,11 county area, essentially what we’ve done in Arkansas in the past, and that’sto have a really active lending and deposit retail bank that has a significantcommercial book-of-business associated with it and generates trust prospectsand cash management customers and all of that.

And then the third strategy forTexas is more of a mid-market strategy. We’re in Texarkana, Texas and Texarkanalook a lot like Harrison, Arkansas or Fort Smith, Arkansas as far as itseconomic profile. We’ve got a great guy that leads that. We’ve got great guysleading all three of these units for us and our expectation is that in probably2009 or 2010, we will expand into another Texas city in east Texas from thatoffice and that those guys will develop over time a pretty significant networkof offices in the second-tier Texas cities, below your Dallas, Houston, San Antonio,Austin type markets and your second-tier Texas markets, much as we have in manyof the top 20 cities in Arkansas.

So we are approaching it fromall three of those directions and we think all three of those strategies aregoing to serve us very well. They are all off to wonderful starts and we’vebeen a couple of years in Texarkana, three years on Frisco, and I guess threeor four years now with real estate specialties group and those are alldeveloping very well. We’ve sort of ramped them up slowly and really made surewe understood what we were doing and that everybody was on the same page and Ithink they are poised for fairly significant growth.

As a result, we believe thatTexas will contribute a disproportionately large percentage of our company’sgrowth going forward. Now, we still have some Arkansas offices to open but aswe commented in the first quarter when we made a decision to not open an officein Jacksonville, Arkansas and sold that site and entered into an agreement tosettle the longstanding dispute regarding that branch application. InJacksonville, we made the comment I believe that part of our decision there aswe looked at our opportunities in Texas, we saw those as better than theopportunities for that Jacksonville office and as a result decided to abandonthat effort and we booked a pretty nice little gain associated with abandoningthat effort, in preference for being able to open another office more quicklyin Texas.

We continue to evaluate that onan ongoing basis and there may be one or two or three more Arkansas sites thatas time goes on we elect to sell, part of our mindset for that decision couldvery well be that we continue to think gosh, relative to what we might do witha new Texas office, that one might not do as well as one in Texas.

So we are constantly evaluatingthat and our experience in Texas has been so good that we are just veryencouraged about our prospects there for the future.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Okay, I appreciate the color.Just a couple of other questions here; the variable rate versus fixed rateloans, can you give the breakdown at quarter end?

George Gleason

Yes, at the end of the quarter,48.99%, so we’ll just round that off to 49% of our loans were variable rateloans. That is up several percentage points, I think about four or fivepercentage points from the prior quarter and that again is a function of the factthat most of our growth in the third quarter came from Texas because we find itmuch easier to get variable rate loans in Texas. In Arkansas, there’s just astrong customer desire to have fixed rate loans.

The growth in Texas is alsotending to accelerate the growth in the variable rate parts of our portfolio.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Could you comment about thepercentage of loans that are tied directly to prime, especially given the fedrate cut here?

George Gleason

I don’t have that number handy.We’ll try to put that in the Q or something and give you that number, but themajority of our loans historically have been tied to prime rate as an index,which of course is unfortunate that they weren’t all tied to libor, given whathas happened to the spread between libor and prime recently.

But in our Texas portfolio, forexample, a lot of our loans there, and I would say a growing percentage of ourArkansas loans are becoming libor-based credits but right now, thepreponderance of those loans that are variable are tied to prime rate, so as aresult, we incurred a 50 basis point reduction in the yield on those loans andthat, since our CDs are fixed rate, we’ll have to well over CDs some period ofweeks to offset that reduction in that prime rate. It will take a little whileto catch up with that.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Okay, and just the last thing,the CNI balance at quarter end, do you have that?

George Gleason

Yes, I do. The CNI portfolio atquarter end was 9.5% of the loan portfolio, down from 9.8% as of June 30. Nowthat was essentially unchanged in dollars. We were down $400,000 from $172million to $171.6 million in the CNI book in the quarter, but because of thegrowth in the real estate side of the portfolio that the CNI piece went downpercentage terms by three-tenths of a percent.

Total real estate loans atquarter end were 81.5% of our portfolio, compared to 81.0% at June 30 and 81.6%at the end of last year.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

And maybe one last thing, ifyou have it; you talked about the broker CDs in the quarter. Could you justgive what level you are at there? And then you talked about I guess maintainingsome type of reasonable level there. Can you define or just give a little coloron what you view as reasonable? And I’ll hang up and I appreciate your help.

George Gleason

All right, very good. Let mesee if I can get you that information: total brokerage CDs at September 30 were$253 million and to give you a comparison, at June 30, that number was $356million. So a $103 million reduction in brokered CDs during the quarter.

And as far as what constitutesreasonable, certainly we were not uncomfortable at all at the $356 millionlevel and I actually wouldn’t be uncomfortable at a level higher than $356million, so I don’t think that’s a significant constraint on us.

And really, when I said withinreasonable limits, what I was really referring to principally was borrowing andwe have a policy that we will use our federal home loan borrowing capabilitiesup to a high level. We wouldn’t mind $300-and-something million or so borrowedfrom the federal home loan bank, but we have a policy of always keeping a $75million cushion on those borrowings. We always want to have at least $75million more federal home loan borrowing capacity than we have utilized at anytime, plus we always want to have our full, federal reserve discount, primarycredit borrowing capability intact and we maintain a number of fed funds linesof credit that we also want to have intact.

So the limitations are there iswe have a number of internal guidelines on secondary sources of liquidity thatwe want to maintain at all times for emergency purposes and subject to thoselimitations, we would continue to increase borrowings and brokered deposits.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Okay, thanks very much, George.

Operator

Your next question comes from the line of Andy Stapp.

Andy Stapp - B. Riley& Company, Inc.

Yeah, I just have one otherquestion, if you could just provide the duration of your securities portfolioat September 30?

George Gleason

Modified duration of thesecurities portfolio at September 30 as estimated by our accounting providerfor that FTN Financial was 5.31 years.

Andy Stapp - B. Riley& Company, Inc.

Okay, great. That’s all I have.Thank you.

Operator

Your next question comes from the line of David Bishop.

DavidBishop - Stifel Nicolaus

George, one follow-up, circlingback to Texas: in terms of expansion there, is the cost of acquiring commerciallending talent there still relatively prohibitive and has that raised anyhurdles in terms of is that impeding your growth there or are you sort of happywith the trajectory you are projecting here in terms of your ability to growthere over the future?

George Gleason

Well, talent is not cheap therebut I wouldn’t characterize the cost of it as prohibitive. In fact, we addedanother really high quality lender, a very experienced high level guy that wepicked up from another bank on Monday of this week, so -- and we are veryexcited about that and he is already having some significant conversations withsome very desirable new lending prospects, so we are very optimistic aboutthat.

Certainly, as I’ve said anumber of times, the key to our company’s future success is being able tocontinue to add the talent of the nature and volume that we’ve been able to addtalent in the past, and it is always a challenge in every market to find theright guys and then to hire those guys, and we’ve had a good track record ofdoing that. We are encouraged with the three teams that we have in place in thevarious Texas markets now. We are encouraged by the leadership of those teamsand the growth and potential, and capabilities of those guys.

We are feeling pretty goodabout it. Certainly we are always looking for talent and we just have tocontinue to always look for talent and add good talent wherever we can find it,whenever we can find it.

David Bishop - StifelNicolaus

Great. Thank you.

Operator

At this time, sir, there are nofurther questions.

George Gleason

All right. There being nofurther questions, let me thank all of you for joining the call today and tellyou we look forward to talking with you in about 90 days and we’ll see youthen. Thanks very much. Have a good day.

Operator

That concludes today’sconference call. You may now disconnect.

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