Marshall & Ilsley Corporation F3Q07 (Qtr End 09/30/07) Earnings Call Transcript

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Marshall & Ilsley Corporation (NYSE:MI) F3Q07 Earnings Call October 17, 2007 12:00 PM ET

Executives

Dave Urban - VP and Director, IR

Gregory A. Smith - Sr. VP and CFO

Frank R. Martire - Sr. VP and President and CEO, Metavante Corporation

Michael D. Hayford - Sr. VP and Senior EVP, COO and CFO of Metavante Corporation

Analysts

Scott Siefers - Sandler O'Neill & Partners, LP

Eric Wasserstrom - UBS

Kenneth Usdin - Banc of America Securities

Robert Patten - Morgan Keegan & Company, Inc

Heather Wolf - Merrill Lynch

David Konrad - Keefe Bruyette & Woods Inc

Robert Rutschow - Deutsche Bank Securities

Operator

Welcome to M&I's Third Quarter 2007 Earnings Conference Call. My name is Janice and I will be your conference operator today. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. As a reminder, this conference is being recorded for replay purposes. It is now my pleasure to introduce Dave Urban, Director of Investor Relations for M&I. Sir, you may begin your conference.

Dave Urban - Vice President and Director, Investor Relations

Welcome to M&I's third quarter 2007 earnings conference call. The presenters for today's call will be Greg Smith, Chief Financial Officer of Marshall & Ilsley Corporation and Frank Martire, President and CEO of Metavante. Greg will review the third quarter financial results and Frank will discuss recent business trends at Metavante.

Before we begin, let me make a few preliminary comments. If you have not read our earnings release, you may access it along with supplemental financial information from the Investor Relations section of our website at www.micorp.com.

Also, before we start, I would like to mention that comments made during this call contain forward-looking statements concerning M&I's future operations and financial results. Such statements are subject to important factors which could cause M&I's actual results to differ materially from those anticipated by the forward-looking statements. These factors are described in M&I's most recent Form 10-K and M&I's other SEC filings. Such factors are incorporated herein by reference.

For a reconciliation of the non-GAAP financial measures mentioned in this presentation to the most comparable financial measures calculated in accordance with GAAP, please refer to M&I's website at www.micorp.com

And now, I will turn the call over to our Chief Financial Officer, Greg Smith.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Thank you, Dave, and thank you everybody for taking the time to join us today. By now, you've had an opportunity to see our press release and supplemental financial information. Our third quarter results reflect a challenging operating environment that confronts domestic banks, but we continue to view our core businesses as healthy and having a good growth profile over time.

In this quarter, we have continued to address our non-performing loans and have seen margin diminution. On other side of the ledger, we have seen improved loan growth in many of our markets, double-digit earnings growth in wealth management, strong net income contribution from Metavante and continued expense discipline. Later in this call, I will discuss our credit profile in more detail than we have in the past. Please refer to the credit quality slide available on our webpage to follow this discussion.

Now turning to our results. We reported $0.83 per share GAAP earnings for the third quarter, adding back the $0.02 per share in costs related to the Metavante separation. We are reporting $0.85 per share. In addition, this quarter's $0.85 per share also includes $0.01 per share in previously reported dilution associated with the United Heritage, Excel and North Star acquisitions. In the same quarter last year, we reported $0.81 per share exclusive of a benefit related to a change in accounting for derivatives.

Our earnings this quarter include $13.9 million in pre-tax gains generated through capital markets investments, securities gains and swap repositioning. We undertook some balance sheet repositioning as we prepared to move $2 billion of non-interest sensitive assets off balance sheet later this quarter with the Metavante separation. In addition, we had a $15.5 million increase in our loan loss provision in comparison with the prior quarter and, as I previously mentioned, the dilutive impact of our acquisitions.

Before discussing the more detailed trends in our businesses today, we'll briefly discuss the Metavante separation and our most recent bank acquisitions.

With regard to the Metavante sponsored been transaction, we continue to make good progress on all of our most important timelines. We have received our Private Letter Ruling from the IRS and have received all the appropriate regulatory responses. The shareholder meeting has been scheduled for October 25th and we expect to announce the distribution date after that meeting. The bank continues to be focused on responsible redeployment of the capital generated through the Metavante separation. As we have indicated before, we will prudently invest in our franchise as our top priority. Our next priority is to pursue financially disciplined acquisitions in both banking and wealth management along the same lines as we have before.

Finally, we expect to allocate capital to enhance buyback activity after the separation. We closed the $105 million acquisition of Excel Bank in Minneapolis early in the quarter. This systems conversion for Excel was completed in August with no customer issues. As we've noted before, we do not expect this transaction to have a material impact on 2007 earnings per share. We are encouraged about our progress in working with our new colleagues.

With regard to our pending acquisition of First Indiana, we expect the combination to close either late this or early next quarter. In addition, we have made all the relevant personnel decisions throughout the organization. We look forward to a smooth integration with this attractive partner in the fast growing Indianapolis marketplace.

As I discuss the aspects of growth in our banking business from this point on, I will highlight organic growth for the combined franchise in an effort to give as clear a picture as possible of the underlying bank trends. Any balance sheet discussion comparing third quarter of 2007 with third quarter of 2006 will be adjusted for the United Heritage and Excel acquisitions. If you recall, these acquisitions closed in April and July respectively.

Now for some additional insights into the quarter. First, the interest margin. Our net interest margin contracted by seven basis points on a linked quarter basis to 3.1%. During the quarter, our margin was negatively impacted by non-accrual loans and day count. Before taking into account the anticipated impact of the Metavante separation, our expectation for the net interest margin will continue to be modest margin compression.

We continue to believe margin contraction is more likely than margin expansion. Like the industry in general, we continue to be challenged by tightening loan spreads in the middle market segment, the movement of new and existing deposits into lower spread, higher yielding products and of course the yield curve. These pressures will be somewhat offset during the fourth quarter by the cash the bank is expected to realize from the Metavante separation. This cash will be used to pay down short-term funding and is expected to positively impact margin. On the other side of the ledger, any increase in buy activity will further pressure the margin. There continue to be many variables that impact margin, making it difficult to project this one data point with a high degree of accuracy.

As we move to our fee income discussion, I will turn it over to Frank Martire to discuss Metavante's third quarter.

Frank R. Martire - Senior Vice President and President and Chief Executive Officer, Metavante Corporation

Thank you, Greg. Our results for the third quarter were very solid. Both our core banking and payment businesses continued to execute well despite some signs of spending constraints and financial institutions.

As we expected, organic revenue growth rate accelerated from about 2% during the first half of the year to nearly 7% in the third quarter. Acquisitions added two points to our growth rate for total reported growth of 9%. Growth in the quarter was paced by double-digit growth in our payment business while software license revenue declined slightly.

Profitability was very strong this quarter. EBITDA before transaction costs increased by 19% to $128 million and EBITDA margin expanded by 2.7 percentage points. While much of this improvement can be attributed to cost productivity, volume leverage and advantageous revenue mix, about half of the improvement was due to the benefit of the timing of costs allocated between Metavante and M&I.

Looking ahead, we expect modest acceleration in the organic growth in the second half versus the first. The result will be a full year organic growth rate of about 4% and total revenue for the year of approximately $1.6 billion, which is at the lower end of our original expectation for the year.

We are not ready to give 2008 guidance in any detail because we are in the midst of our planning process. That being said, we expect the banking environment to remain challenging, and to the extent those challenges affect capital spending, it could impact some of our businesses, particularly the software-based business. However, one area that won't directly have a material affect on us is a troubled mortgage industry where we have very little exposure. All that considered, our early read suggests organic revenue growth in 2008 will modestly exceed our 2007 results.

In summary then, we look forward to delivering a solid fourth quarter, closing out a very good 2007 for Metavante and to successfully completing the pending spin transaction.

Before I hand it back to Greg, I want to express my appreciation to the small team of people at Metavante who have been dedicated to working on the spin transaction and to all the Metavante employees who have remained focused on delivering superior service to our clients. In addition, I also want to thank the M&I team for their tremendous support in this exciting time for both companies. Greg?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Thank you, Frank. Now moving on to our wealth management segment. Wealth management revenue increased 22% in the third quarter compared at the same quarter last year. Assets under management reached a record level of $26.6 billion and assets under administration ended the quarter at nearly $110 billion, another record level. Growth in revenues and assets was attributed to continued strong sales results and improved asset management performance.

In September, our Investment Management group was awarded new short-term asset management mandates totaling over $1.2 billion. While a portion of these assets will roll off in the fourth quarter, a large component will remain beyond year end. The impact of our cross sell initiatives provided healthy incremental growth during the quarter. And coupled with our new initiatives such as Cedar Street, our high-end wealth management capability and Institutional Trust, fee revenue has benefited. Additionally, changes in the delivery of our brokerage and insurance business along with productivity gains have positively impacted revenues. Brokerage customer assets rose to $9.4 billion.

Moving on to other fee income components. Service charges on deposits for the third quarter were $29 million, up 5% on a linked quarter basis. This increase is in both our commercial and community divisions. Mortgage loans closings for the third quarter were $1.2 billion, which was down approximately 17% from the prior quarter and applications decreased approximately 31% from the second quarter. As we have shown in previous mortgage cycles, our focus on the production side of the business reduces the volatility of our mortgage revenue stream.

A comment on capital management. We did not buy back as much stock as we expected this quarter, specifically shares related to the SPACES settlement. Although we retired 6.8 million shares in the second quarter through repurchases and the Excel acquisition restructuring, we did not retire the incremental 2.4 million shares issued through the SPACES settlement. To date, we have retired three quarters of the shares we issued. As we noted earlier, we expect to reinitiate our buyback activity during the fourth quarter subject to market conditions after the Metavante spin occurs.

From an expense standpoint, total non-interest expense amounted to $571 million in the third quarter. This is down slightly from the second quarter. This decrease reflects bank level discipline on items such as salaries and benefits as well as lower processing charges tied to the seasonality in Link2Gov's tax payment-related business. These decreases are partially offset by higher cost of equipment and plastic sold at Metavante.

Overall, the bank core operating efficiency ratio decreased from 51.3% in the second quarter to 49.9% this quarter. The second and third quarter efficiency ratios do not include those professional expenses associated with the Metavante separation.

Looking prospectively, the bank efficiency ratio is expected to remain in the area of 50% to 52%, particularly in the current operating environment, M&I will continue to be very focused on maintaining our historical expense discipline.

Now moving on to our credit quality trends. Consistent with prior quarters, we continue to aggressively manage our portfolio even with the higher non-performing and charge-off levels, we continue to remain comfortable with the risks in our portfolio and our underwriting discipline. As we have noted in prior conference calls, we expect -- we expected that net charge-offs would trend to the 15 to 20 basis points range on average. At this point in the credit cycle and given the level of non-performing loans, we expect charge-offs to approximate this quarter's level for the next few quarters, which is higher than what we've indicated in the past. For the quarter, we realized net charge-offs of $26 million or 23 basis points. For the year-to-date period, our net charge-offs are $64 million or 20 basis points.

For the third quarter, we provided $42 million for loan losses, which is approximately $15.5 million in excess of net charge-offs. This excess provision has resulted in our quarter-end allowance for loan losses being 1.01% of total loans.

At quarter end, non-performing loans totaled $454 million, which is up $70 million from the end of the second quarter. Non-performing loans are 1.01% of total loans, up from 89 basis points at the end of the second quarter.

In July, we indicated that we saw some signs of credit trend stabilization. At that time, we observed some large credits move out of non-performing status. In the second quarter, there were some signs that the housing market was stabilizing, but as a third quarter progressed, it became clear the housing market was deteriorating further. Today, we believe it is possible we will see future increases in non-performing loans, some of which is dependent upon changing economic conditions.

As I mentioned earlier on this call, we have provided more detail regarding our non-performing loans on the credit quality slides that appear on our website. Although I will not go through these slides individually, there are a few key trends to identify.

The commercial loan portfolio continues to perform well with 33 basis points of loans on non-performing status. Our non-performing loans are concentrated in the construction-related components of their commercial and residential real estate portfolios. Within commercial real estate, the non-performing loans are concentrated in the commercial vacant land and commercial construction portfolios.

On the residential side, non-performing loans are concentrated in the residential vacant land and residential construction developer portfolios. The residential real estate and residential construction portfolios currently have non-performing loan ratios below 1%.

For the residential mortgage component, those loans currently on non-performing status have a current loan to value of 75%. With regard to the residential construction portfolio, over 95% of this portfolio are projects with individuals.

From a geographic perspective, we have provided information on three specific markets in terms of non-performing loans. The Arizona and Florida markets both have non-performing loan ratios higher than the average of our bank. Kansas also has non-performing loans to total loans in excess of the bank, but Kansas non-performing loans are less than $30 million.

As we have indicated before, the housing slowdown continues to cause stress for some of our borrowers. This continues to be true in all of our markets. To provide a little more granularity on our commercial non-performing loans, the following may be helpful.

Our largest non-performing loan is approximately $22 million and is a Florida multi-family project. We have 50% of this credit. This project has over 300 units and is currently being repositioned for sale. We believe the collateral values on this project are adequate. There are no other projects of this magnitude. More broadly, we continue to expect the multi-family portfolio to continue performing well.

With regard to the residential construction developer portfolio, housing sales continue to slow, resulting in rising builder inventories which have depleted interest reserves and stressed developer liquidity. Each large non-performing loan receives constant focus from senior management, the credit team and the lender. For each of our largest non-performing loans, we have a workout plan in place or being negotiated. We believe these plans will lead to resolutions. Many of the largest non-performing loans were originated in 2005 and the first quarter of 2006. For those 13 non-performing loans in excess of $5 million, we have already charged off $7 million in total.

Looking forward, it is important to remember than most construction credits are complex and that it will take time for us or any lender to work through them. We are working with developers and others toward resolutions. Nonetheless, these resolutions will take time and any new situations may continue to be additive to our non-performers. Sometimes the best resolution will be to take the underlying property to maximize our interest, which may cause OREO to increase for a period of time. As we expected, our OREO increased this quarter to $77 million, which is up from $24 million in the prior quarter. The largest OREO property is $10 million with another two commercial properties over $5 million. Like our loan portfolio, our OREO [ph] is also very granular. We continue to expect that OREO balances will increase going forward and view this as natural progression as we gain control of projects and move towards ultimate resolution. We continue to aggressively manage our non-performing loans with the expectation that net charge-offs over time will trend to our historical average. Again for the next few quarters, we do not expect net charge-offs to vary substantially from this quarter's level at this point in the credit cycle.

Changing focus to the organic balance sheet growth trends compared to the same quarter in 2006. Third quarter 2007 average loans were $44.1 billion, which is $2.5 billion or 6% higher than the third quarter of 2006. Commercial loans increased on average by $848 million or 7%. For the rest of 2007, we expect C&I loan growth to continue its slight moderation, but still post growth rates in the mid to high single digits. Commercial real estate increased on average by $741 million or 5%. To repeat comments we made earlier this year, we continue to see softness in the construction market for residential developers and to some extent throughout the commercial real estate business. This has translated into slowing new construction throughout all of our markets, less investor activity in new construction units and our expectation that CRE growth for 2007 will most likely be in the mid single-digit percentage range.

Fundamentals in the retail, hospitality, office and warehousing segments continue to be positive. The key is to know your customers, work with the best people and maintain your underwriting discipline. We have been fortunate to partner with successful, well capitalized organizations over the years.

On the deposit side, there is really only a couple of things to note as many trends remain consistent with prior quarters. We continue to open net new DDA accounts in the community division each month, although growing DDA balances has been more challenging as customers have opted to move excess liquidity into higher rate products.

We have continued to see the benefits of our bank issued deposit gathering approach with our increase of $1 billion or 4% compared to the third quarter of 2006.

A few final comments. As we move forward, we continue to acknowledge a difficult operating environment for banks. As you are aware, every economic cycle brings its own set of challenges. This economic cycle has been marked by a challenging yield curve, competitive pricing pressures on most loan products, slower absorption of housing in all of our markets, normal movement between deposit products in search of higher yields, increased regulatory costs and competitive pricing pressures in Metavante's marketplace, just to name a few of our challenges.

On the other side of the equation are the positives we have witnessed and continue to believe will be part of our future at the bank such as: solid expansion in all of our bank markets, continued growth in many of our deposit products, expansion of our wealth management businesses, a smooth integration of United Heritage, Excel and North Star into M&I, overall reasonably well contained expense growth and the continued expectation that net charge-offs will remain in their current range for the next few quarters.

At Metavante, the positives continue to be our ability to retain and cross sell into our core customer base, a sustained and continuous effort to make the operations more efficient and several successful acquisition integrations over the last four years.

At both the bank at Metavante, through solid organic growth and acquisitions, we have made strides towards further diversifying both M&I Bank's geographical source of earnings and Metavante's balance of revenue between its core possessing businesses compared to its payments-related businesses, which are now approximately equal. It is the combination of all these factors as well as continued progress towards the completion of the Metavante separation that provide us with the confidence of continued future growth.

This concludes our prepared comments. For the question and answer portion of the call, Frank and I will be joined by Mike Hayford, Chief Operating Officer of Metavante.

Operator, you may now open the line for questions.

Question And Answer

Operator

Thank you. For analysts who would like to ask a question, you will be able to do so during the Q&A. [Operator Instructions]. Your first question comes from the line of Scott Siefers.

Scott Siefers - Sandler O'Neill & Partners, LP

Good morning guys.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Hey Scott, good morning.

Scott Siefers - Sandler O'Neill & Partners, LP

Just had a couple of questions. First, I was wondering if you could chat in a bit more detail about the margin. I would imagine that given the complexity [ph] of you guys balance sheet, you should be pretty well positioned to benefit if the Fed is indeed in a kind of sustained using mode. So I guess the first question is just what, kind of what it would take to get the margin back on on sort of an upward trend. And then the second question is just on the level of the reserve, and Greg, I appreciate the additional color you have given on credit. But I guess my sense would be despite the pretty significant over providing, the reserve to loan ratio continues to kind of stay right around that 1% and the coverage of non-performers looks pretty light. And if non-performers are going to continue to go up, presumably, it would look even lighter. So just any color. And then you've got I guess the big gain coming from Metavante. What would be your appetite to plough some of that back into the reserve and kind of resolve that question once and for all?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Okay, let me go back to the beginning with your question, and hopefully you've got about six questions in there, so --

Scott Siefers - Sandler O'Neill & Partners, LP

Sorry about that.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Let me -- let's go back to the net interest margin first. Well, obviously, there are a couple of answers here. We mentioned in the call that in the middle market, loans spreads are still very competitive. So, clearly, any improvement that we can see in the loans spread will certainly help us on the margin as with any improvement in DDA growth. Us, like many other banks, have found DDA growth a little bit more challenging in here. So those two factors in and of themselves will both be very positive contributors to the margin.

In terms of the margin trend this quarter, think in terms of our -- the interest adjustments from non-performing loans, think of the impact of non-performing loans this quarter having an impact of about 2 basis points. We also had an impact of about 2 basis points from day count this quarter. So I think we'd box the net interest margin question.

In terms of the reserve, think of the loan loss reserve -- well, let me go to the last part of your question. We are going to take the gain from separating from Metavante and put that into the loan loss reserve. Loan loss reserve just doesn't work that way. The loan loss reserve has got to be a reflection of what we think the loss content is in our portfolio. We go through that in a very disciplined manner and we go through that regularly to make sure we are current in our loss estimate. As we've indicated in the past, if we see loss content in any loan on non-accrual status, we will go ahead and take a partial charge-off at that point in time, which is more aggressive than some of our competitors are on that. So in terms of the loan loss reserve, it's got to reflect what we think the loss content is in the loan portfolio.

Scott Siefers - Sandler O'Neill & Partners, LP

Okay. Good. Thank you very much.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Did I get everything?

Scott Siefers - Sandler O'Neill & Partners, LP

Yes, I think you got pretty much everything. So I appreciate it.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

All right, thanks Scott.

Operator

And your next question comes from the line of Eric Wasserstrom.

Eric Wasserstrom - UBS

Thanks. Greg, just to follow up on that last question. Given that the acceleration in NPAs is exceeding the growth in the reserves, I guess I am still a little confused about why that would translate to basically flat credit losses over the next few quarters. Is it just that the loss content of the loans that are going into NPA is somehow different than the ones that have driven the higher than expected losses in the current period?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, again, those loans that go into NPA, if at that point in time we think there is charge-off, we'll take partial charge-off then. So to think loans are on NPA and that hasn't already been reflected in our reserve calculation as well as our loan loss provisioning, wouldn't be right. We have got -- those increases are reflected in what we've booked to date. So we will continue to look at what the loss content is, whether it's in the non-performers, whether it's in the loan portfolio, and that will be what we reflect in the reserve.

Eric Wasserstrom - UBS

Great. And if I can just touch on a different issue, could you -- you talked a little bit about this in terms of the opportunity to pay down high cost debt with cash from the Metavante spin. But after that, could you help me prioritize what your uses of capital would be?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Sure. This is a very consistent message with what M&I has said since long before I was here. In terms of capital utilization, the first priority of capital utilization will be investing in our franchise, whether that is, as we have discussed in the past, whether that is a slight expansion in our de novo efforts, whether that is improvements in some of our systems. We are going through that process now; that is the first priority. The second priority is indeed acquisitions, but sticking to our knitting in terms of what types of acquisitions we'll look at. We continue to consider Gold Bank to been a large deal for this organization. The types of transactions you've seen us announce have been good companies in good markets with good teams. We'll continue to do that, but we'll stick to the same financial discipline of looking for IRRs in the 15% area and wanting transactions to turn accretive sooner rather than later.

Wealth management, we'll also factor into our acquisition strategy going forward. Ken Krei has a built a fantastic team on the wealth management business as has been shown by the growth in that business and as we discussed earlier in the call. And then buy back will be a very important part of our capital utilization strategy going forward as well. As you've heard me say before, Eric, the average bank in 2006 bought back 3% of their shares and we bought back 1 million shares in 2006 and we would expect to buy back at more peer like levels, if not stronger, as we go forward.

Eric Wasserstrom - UBS

And dividend, if I can just ask a last one?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Sure. Dividend is the fourth prong of that capital hierarchy, capital utilization. And historically, our dividend payout ratio has been in the low to mid 30s. With the separation, our dividend payout ratio moved closer to 40% because the bank will be bearing the entire dividend commitment for the companies post separation. The typical bank, it seems over the last few years, to have had a dividend payout ratio in the 42% to 45% range, and I would expect that we would continue to move in that direction.

Eric Wasserstrom - UBS

Thanks very much.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Okay. Thanks Eric.

Operator

Your next question comes from the line of Ken Usdin.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Hi Ken.

Kenneth Usdin - Banc of America Securities

Hey Greg, how are you doing?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Good. How are you?

Kenneth Usdin - Banc of America Securities

All right, thanks. I wanted to ask you to drill down into Arizona and Florida. Obviously, that's where the residential -- well, the developer and the construction portfolios are showing the highest NPA contact. Previously, you guys had talked about Arizona holding up better than the rest of the portfolio, and now it seems that those levels are looking kind of worse than the rest of portfolio. Can you give us some color specifically to both Arizona and Florida? What's happening in those markets for you guys? Are you experiencing the same type of deterioration as we have heard from some other banks in the region? And if not, can you just paint the differentiation between you guys and other banks out there?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Sure. I mean with Arizona -- let me start with Arizona. The NPLs in that market for us crossed the 100 basis points this quarter, and that, as we identified in those slides, that has really been concentrated in the residential vacant land and the residential construction developer categories. A lot of it reflects home building to be perfectly straightforward. And you are seeing lower absorption rates in that marketplace. The interesting thing with Arizona, though, is you are still seeing a decent employment base and you are still seeing decent migration patterns into the Phoenix area. So that gives us some comfort that over time Arizona, like Florida, will continue to see expansion in its population, and a population, population with jobs, will drive housing absorption. So over time, I think we have some confidence. But are we seeing deterioration in that market? Absolutely. That is part of what we see in this part of the credit cycle. I think one of the things that we will benefit from in Arizona is that we have been in this market for quite a while, our lenders have been in this market for quite a while and have a pretty good handle on what the good projects are and who the good people to partner with are. Our franchise there has been there for 21 years and we have learned a lot in that time.

In terms of Florida, the non-performing loans are a little bit more concentrated in some of the commercial real estate, but the commercial real estate that we have in Florida is somewhat associated with multi-family type projects. Of our non-performing loans in the commercial construction and commercial vacant land portfolios, five credits make up the bulk of that, they make up 80% of it. Those five credits all have plans in place on them in terms of how we are addressing them. We continually go through analyzing the loss content on those as well as updating those plans. So we feel the loss content is to date well reflected. Of those five credits, three of them were acquired and then another two actually came through our correspondent channel.

Kenneth Usdin - Banc of America Securities

Okay. Second quick question. Can you tell us what was in -- any non-recurring items in the other expense line this quarter?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

In the other expense -- when you look at our other expense line, you've got to look, Ken, at it relative not just for the second quarter but also the first quarter. And when you look at it relative to the first quarter, it looks a little bit more in line. Are there any non-recurring items in particular in there? Not anything that would be noteworthy. In terms of the non-interest expenses, Metavante, its cost of plastics, cost of equipment sold, those are a couple of the bigger movers.

Kenneth Usdin - Banc of America Securities

Okay. Then last thing is, Greg, you didn't buy back stock this quarter as much so that your capital ratios went up. Can you give us an update on what you are expecting the pro forma post-spin ratio to be and kind of an update on that amount of excess capital that you'd intend to have on hand including the First Indiana deal?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Let me give you some parameters to box that. First of all, we didn't buy back as much stock as we expected. We've had a lot going on. And whether we had a blackout because of what the SPACES pricing period was, whether we had a proxy about to be in the mail or in the mail. We've taken a conservative interpretation as to when it's appropriate to be in the market buying back stock. So all in all, we would have liked to have brought it back.

In terms of our comments on where we expect the capital ratios to go, I think everything we have said in the past still gives a rather appropriate description of where we'll be. I think if, go back to the April conference call, we indicated at year end we expected our capital ratio to be around 9.4%. We currently having not brought back as much stock as we would have planned, there may be a little bit more out there. But really the differential on those shares is only about 2.4 million. So may be there is a small bias to the upside, but I wouldn't want to put any more definition on it than that because I think the 9.4 we said is still roughly in the right ballpark.

Kenneth Usdin - Banc of America Securities

And First Indiana takes a percentage point from that?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

First Indiana will take 90 to 100 basis points.

Kenneth Usdin - Banc of America Securities

Okay, got it. Thank you.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Sure.

Operator

Your next question comes from the line of Michael Cohen [ph].

Unidentified Analyst

Hi. Thanks so much for taking my question and for the additional detail on your construction portfolio. I had a couple of quick questions for you. Can you talk about what you are sort of underlying kind of economic or sort of home price forecast is for Arizona as well as maybe some of the other regions? I don't know if you are aware, but MGIC came out today and gave a forecast that projected 20% declines in Arizona home values. Is that kind of the type of stress you've assumed in your loss guidance -- Phoenix, specifically Phoenix rather?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

We go through a lot of different stress scenarios as we go through our loss guidance. I am not going to get into a individual market-by-market assumption as to what we think home prices are going to do. We could be here all day. But certainly when we look at the Arizona market and we look at the Florida market, we certainly are taking into account what some of the more draconian downside scenarios could be. But we also have a very current sense of value as we look at the markets and as we look at the underlying dynamic. So I understand your question. I don't want to comment going market by market.

Unidentified Analyst

Okay, understood, understood. Can you -- when you said you had a very current sense of value, that would imply that you guys are being fairly aggressive at getting reappraisals on the property. Is that a fair statement?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, absolutely. On the community side, on the residential side, we update our values as soon as we have any indication that a loan's going to start being anything more than about 60 days delinquent. We start reassessing any sense of value and we do that throughout the process. As we do that with loans that may go on non-accrual, we certainly develop a very good sense about where the broader market is. It's a very normal process going through those updates. We will go through that on the commercial side as well. And with and the commercial side, as I mentioned earlier, we put teams around the credits. We have very current sense of values around those as well.

Unidentified Analyst

Great. And kind of within that context, have you -- can you talk about what sort of the change you have seen? Is it kind of severe or in some cases, is it sort of relatively benign?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

I could give you situations and anecdotes covering the spectrum. One of the things that makes us feel particularly good about any of these markets and any of our lending exposure is that we are a secured lender and with any of these -- with any of the properties we have in those, we very much are a lower loan to value type lender. And so far we go through and calculate our losses and go through our loss expectations, we do take the loan to value into account.

Unidentified Analyst

Great. And final question, you gave some excellent data on sort of the origination date of your NPL. Does that imply that if it runs through the first quarter of 2006, does that imply that sort of after 2006, you were sort of less robust in your activity, so there isn't really a whole heck of a lot of -- a whole significant percentage that is relatively new or is that just that some of that stuff hasn't had a change to season yet? How should we think about sort of the post-first quarter of 2006 exposure?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, certainly, it will have more of an opportunity to season. But I think the important thing to take into account is the heights of the real estate market were really 2005, spilling into the beginning of 2006. And based on market conditions at that point in time, these projects that we underwrote were good projects, but markets moved against us. That became more clearer as went into 2006. So as we went through 2006, stressing the assumptions underlying the next series of credit decisions would have changed because absorption rates had started becoming clearer. Absorption rates were going to slow.

Unidentified Analyst

Great. Thank you very much.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Sure. Thank you.

Operator

Your next question comes from the line of Robert Patten.

Robert Patten - Morgan Keegan & Company, Inc

Hey Greg.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Hey Bob.

Robert Patten - Morgan Keegan & Company, Inc

Just a couple of questions that are left. One, can you comment on the general M&A environment? Obviously, you are attuned to this as much as anybody, Greg. Is there more chatter going on now than it has been over the last say 12 to 18 months because of just the revenue challenges? That's the first --

Gregory A. Smith - Senior Vice President and Chief Financial Officer

The investment bankers are chattering a lot these days, Bob.

Robert Patten - Morgan Keegan & Company, Inc

And what is the issue now? Is it pricing or is it balance sheets that are keeping things from really starting to move?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

We continue to see opportunities, but I would say we tend to see things in the same sort of pace that we've seen them in the past. I can't give you a good answer why there is not a big uptick. Certainly people I think more internally focused in terms of their businesses. But in terms of why we haven't seen a tidal wave, I go back to what I've always said for a long time, and I've said on these calls, in general, merger and acquisition activity does tend to be very situation specific.

Robert Patten - Morgan Keegan & Company, Inc

And then I guess in terms of do you guys disclose unallocated reserve?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

We do not.

Robert Patten - Morgan Keegan & Company, Inc

Okay. I guess is there any update on First Indi [ph] in terms are you guys through with your credit diligence sound?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Absolutely. I mean we have gone through, let me put it this way, we are exactly where we want to be at this point with First Indiana. We have gone through our due diligence. As I mentioned on the call, we've made all the personnel decisions, which is quicker than normal. We are working very closely with them as partners. So I would way we are in good shape.

Robert Patten - Morgan Keegan & Company, Inc

So we shouldn't see any catch up provisions by putting loan grading in line with M&I's whatever?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

We will go -- we've gone through their portfolio carefully and we continue to work with them on a daily basis. At the same time, as we get to know their portfolio in even more detail, is there a chance that we wind up moving -- changing the ratings on some of their loans? Yes, absolutely, there is always that chance. But we have been working really closely with them and we are already well in sync with them just because of the type of partnership the two organizations had well before First Indiana even decided to sell.

Robert Patten - Morgan Keegan & Company, Inc

Okay. And last question, in this environment of the Internet, are banks picking up any ability to market OREO properties and other distressed situations versus just going to the local lawyer or accountant? It seems to me that you guys have been pretty consistent in recoveries. Who are the buyers for a lot of these properties and how are you moving this stuff out?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, I mean, these properties we work on -- I mean, again, it's a it's a one-by-one basis.

Robert Patten - Morgan Keegan & Company, Inc

Okay.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

And particularly with the larger commercial type relationships. At this point, we are largely working with the type of buyer you'd expect to see for individual properties. On the residential side, we have got a process that we follow in terms of moving residential property through the pipeline and continue to do that. Largely what we see in terms of pricing is really the local developers tend to be the people who are best buyers as we go to -- if you think about hedge funds or some of the other asset aggregators out there that might want to buy those properties, they tend to then turn around and flip them to the local developers. So you might want to take the middle man out.

Robert Patten - Morgan Keegan & Company, Inc

Okay. Thanks Greg.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

All right, thanks a lot Bob.

Operator

And your next question comes from the line of Heather Wolf.

Heather Wolf - Merrill Lynch

Hi there. How are you guys?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

We're good. How are you?

Heather Wolf - Merrill Lynch

Good. A couple of questions on credit. Can you tell us what the loss severity you are assuming is for the total construction book and maybe how that loss severity compares to M&I's history?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Heather, we have not gone through that level of detail publicly in terms of what the loss severity is. We are in terms of how we look at it relative to history, we are being very cognizant of where the markets are today, and we are reflecting that in what we do. So we do look at the lower absorption rates, we do look at the lower sale prices when we stress the values.

Heather Wolf - Merrill Lynch

Okay. I mean if I do a rough calculation, it looks like the loss severity that you've booked so far looks like it's sort of 5% to 10%. And if you look at the industry average, it's usually at the peak of a cycle kind of 25% to 35%. And I am trying to determine if there is some reason why M&I has maybe always trailed the loss security averages for the industry. Do you have any color on that?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, I think this really goes back to our underwriting discipline when we make the loans and who we really partner with as we enter into these types of projects. And whether it is the personal guarantees, it is the sticking to our loan to values, whether it is requiring cash equity in projects and having the interest reserves to draw on. I think all those things sticking with our discipline are what help us maintain the loss realization at lower than peer levels.

Heather Wolf - Merrill Lynch

Okay.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

I think it's a fundamental franchise question that way.

Heather Wolf - Merrill Lynch

All right. And then can you give us a little bit of guidance on expenses as it relates to OREO? And obviously you've brought a lot of stuff back on balance sheet. Do you expect to have a meaningful increase in expenses as a result of maintaining that real estate?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Certainly with OREO, there is the possibility for increased expenses. As the properties that we have moved into OREO to date, we have frankly taken a aggressive stance with those properties in terms of value. And in terms of expenses, I don't think there is anything material at this point to provide guidance on.

Heather Wolf - Merrill Lynch

Okay. And then just last question -- this might be for Frank -- but I noticed that you guys had tweaked some of the covenants on Metavante's debt, and I am wondering it didn't look meaningful from where I sit, but was there anything in the change in the covenants that could materially impact business going forward?

Frank R. Martire - Senior Vice President and President and Chief Executive Officer, Metavante Corporation

No Heather. They were -- thanks for the question by the way; I was starting to feel unwanted. There were minor changes in -- we are [ph] cash on hand in our credit facilities and stock capabilities. We feel fine, and there were just minor changes, non-material.

Heather Wolf - Merrill Lynch

Okay. All right, great. Thanks so much.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Thanks Heather.

Operator

Your next question comes from the line of David Konrad.

David Konrad - Keefe Bruyette & Woods Inc

Good morning.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Hey, good morning David.

David Konrad - Keefe Bruyette & Woods Inc

A couple of question. The first is just a little bit more color on the expenses. I think you mentioned the seasonality on the processing expenses, but overall, the corporation came in at a efficiency ratio around 60%, which is probably the low that we have seen in the past quite a few quarters. So, I was trying to figure out a little bit when you talk about the bank efficiency ratio moving from a 49 to 50, 52 range, is that the seasonal factors that we are talking about and we should see the consolidated efficiency ratio ease up a little bit or does that have to do with inter company issues at Metavante post spin?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, first of all, for the third quarter, our efficiency ratio bank only was 49.9%. And one of the reasons we made sure to say we expect it to be 50 to 52 is we didn't want people to latch on to the 49. So that's the first thing. I mean we are still pretty much in that 50 to 52 range. In terms of why did it -- why it dipped down, I think we showed great control on the salaries of benefits line, and that is both at the bank and Metavante. In addition, the banking business is difficult right now and some of the production targets that people have for the year are not being met. So we don't have to improve by this much on incentives. So that's helped up provide some discipline there as well.

David Konrad - Keefe Bruyette & Woods Inc

Okay, great. And then just one follow-up question on the OREO. Can you give us any color on loan to values that you might be looking at now that they are a banking property?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, once we bring those over to OREO, we bring them over at what we think the value of that property or what that lending exposure is at that point in time. So we expect they are at fair market. When they come over, although to be fair, once you bring something over to OREO, you want to make sure you consider all the expenses that would be associated with the carry of that property. So we have been -- we are comfortable that we have been pretty conservative in bringing properties over to OREO.

David Konrad - Keefe Bruyette & Woods Inc

Okay. Thank you.

Operator

And your next question comes from the line of Rob Rutschow.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Hey Rob.

Robert Rutschow - Deutsche Bank Securities

Hey Greg, how are you doing?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Good, how about yourself?

Robert Rutschow - Deutsche Bank Securities

Good. Couple of more credit questions. On the OREO, I'm wondering if you can tell us what the prices of the real estate have done for the properties that are in OREO. And then also how long are they -- have they been in OREO? What's the turnover in terms of timing for that?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Yes, I understood the question. And in terms of turnover, I don't have a good number in front of me at the moment, but it's going to hard to give you a real good number on that given how much has just moved into OREO. So we will see that shortly. In terms of any other comments on OREO, again, one other material comment to keep in mind is with the residential portfolio in particular, when we sell properties out of OREO, we tend to see about a 1% or 2% gain on those properties at that point in time.

Robert Rutschow - Deutsche Bank Securities

Okay.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

It's been our historical track record.

Robert Rutschow - Deutsche Bank Securities

Okay. And then I guess M&I is known for working with its borrowers. Have you renegotiated any of the loans that are performing at this point or is there any percentage there?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, first of all, I mean we are -- a renegotiated loan is a rather -- that can be rather defined term. And as we show in our supplementals, renegotiated loans in and of themselves wind up being a rather immaterial number in the asset quality detail in the supplemental and financial information. We'll look at loans in the normal course but nothing noteworthy to talk about.

Robert Rutschow - Deutsche Bank Securities

Yes, I guess I meant not the more strict definition. If you've loosened any sort of payment plans or any of the covenants or anything.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Nothing noteworthy to talk about. I've been through that recently with Mark Hogan.

Robert Rutschow - Deutsche Bank Securities

Okay. And then I guess you also mentioned at the beginning of the call that middle market was still competitive. Have you seen any changes in the terms there in terms of underwriting or any of your competitors?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

In terms of the middle market underwriting terms, again, I don't -- nothing noteworthy to talk about. I think in general you see that overall, banks being more careful on the lending side, but also on the commercial side, you really see companies being a little bit more careful on how much they pull down. Companies aren't building inventories quite as much.

Robert Rutschow - Deutsche Bank Securities

Okay. And I just missed it, what were the assets under management at the end of the quarter?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Assets under management in the wealth management business were $26.6 billion.

Robert Rutschow - Deutsche Bank Securities

Okay. Thank you.

Operator

Your next question comes from the line of David Kanutzen [ph].

Unidentified Analyst

Hi. I recall earlier today by Cross City Company, they mentioned the velocity and severity of loss trends in the late third quarter were surprising, and I was wondering if you've noticed any of that in your residential or consumer credit book.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, in terms of loss characteristics on the consumer side in general, what we have really seen over time is that our delinquencies and losses tend to be better than the banking industry as a whole. And we are continuing to see that at this point in time. So our losses industry wide possibly becoming more severe. Well I think you see that in the net charge-offs going across -- going through the banking industry in general.

Unidentified Analyst

I guess the other question -- or the other part of the question is the velocity, and I think a prior caller question that are loans that are going non-performing I mean 30, 60, 90 due. In the past, maybe it took a few quarters or even years before they actually made it into a charge-off bucket. Are they jumping? Do you see any kind of jump to default on some of your clients as people just capitulate and say that I am over my skis and the situation isn't worth trying to work out?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, I mean you always run the risk of having some of those situations, and some of those situations do exist. Fortunately, so much of our underwriting is really focused on developers or individuals where we already have a relationship. What we've really tried to do is call out the investor component, and that's why we look at our -- when we look at our residential construction portfolio, we can take 96 -- more than 96% of it is to individuals. That is a different characteristic. Now when you move to the commercial side, the commercial real estate, as we walked through on the call, it's going to take longer to work through those types of credits as we go through these cycles. But could have been more complicated, that's why.

Unidentified Analyst

One last question. In the past, everyone has used unemployment as the ultimate predictor of credit trends. And it seems like credit is weakening while employment is relatively firm still. Is there a better input in your mind to model at this point?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, unemployment is still an important component of that. Unemployment is what gives us confidence on the housing market in terms of where they will alternately become a turn in that. On the commercial side, right now businesses are really good and we continue to watch company balance sheets. I think one of the things that's most interesting as we watch the commercial side is the building strength of exports, which is frankly something relatively new as a growth engine for the U.S. economy. So that's one thing that gives us some comfort.

Unidentified Analyst

Thank you.

Operator

[Operator Instructions]. Your next question is a follow-up question from the line of Ken Usdin.

Kenneth Usdin - Banc of America Securities

Hey Greg, a couple of quick ones. Did you sell any NPAs this quarter and do you have plans to in the future?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

Well, I mean let me first answer that in terms of our view on NPAs and selling NPA.

Kenneth Usdin - Banc of America Securities

Well, did you sell any this quarter?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

I will answer that too.

Kenneth Usdin - Banc of America Securities

Okay.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

I'll get to it. In terms of NPAs, our view has been in most cases we are going to be the bank, we are going to be the first... we are going to be the entity that is going to be able to work with the projects and realize the best value. But we have never said that we won't sell NPAs. We did sell one small pool of NPAs this past quarter. It was only about $8 million, they were not relationship-based assets and frankly, we got a good bid for them. So we want ahead and sold them. That's it though.

Kenneth Usdin - Banc of America Securities

And did is that reflected... like did you take a loss that was also in the provision related to those?

Gregory A. Smith - Senior Vice President and Chief Financial Officer

There was a nominal loss associated with those, yes, and that ran through charge-offs this quarter.

Kenneth Usdin - Banc of America Securities

Got you. Hey Frank, Frank or Mike, you had what looked like to be an all-time high EBITDA margin this quarter, kind of a higher than you guys had talked about recently. Can you talk about, is that due to the mix of business that's come on expense control or whatever and is that a new sustainable level that you are expecting to hold on to going forward?

Frank R. Martire - Senior Vice President and President and Chief Executive Officer, Metavante Corporation

Sure Ken. We'll answer that one. I am going to baptize Mike and let him answer the question, okay?

Michael D. Hayford - Senior Vice President and Senior Executive Vice President, Chief Operating Officer and Chief Financial Officer of Metavante Corporation

Ken, we had a great quarter in terms of numbers as Frank referenced. A portion of that was related to some timing of some things moving between M&I and Metavante that gave us a benefit. We had great expense control, we had timing and mix of our product set. But your last point of the question, are we are going to continue to run at that level? We don't expect to run at that level. And again, we don't run quarter-to-quarter numbers; we look to the whole year and we set our goals for the entire year. So we did run a little higher in the third quarter more than we would expect to see in the future.

Kenneth Usdin - Banc of America Securities

I mean can you just remind of what that broader goal is of what you think the company can run at?

Michael D. Hayford - Senior Vice President and Senior Executive Vice President, Chief Operating Officer and Chief Financial Officer of Metavante Corporation

Well you have seen us historically run in the 28 -- 27-28 range. We'd like to be in that range 28-29, be kind of the high end. We don't expect to see north of 30 like we saw in the third quarter.

Kenneth Usdin - Banc of America Securities

Okay. And the last question was Frank mentioned that your revenues are going to come in at the low end of the 160 to 164 guidance this year. I am just wondering what that was due to if it was that your contracts being delayed already, because, Frank, you talked about the potential delay on the industry slowing down. I am just wondering how that's manifesting itself currently versus what you had initially expected.

Michael D. Hayford - Senior Vice President and Senior Executive Vice President, Chief Operating Officer and Chief Financial Officer of Metavante Corporation

I think the largest customer that impacted the fee for '07 is probably more related to the software as a services side of our business where organizations, the banks that we serve, they come under a little distress and challenges in the market. Might we go back to capital projects in '07. So it's been running a little behind where we expected it in '07. I mean the bulk of our business, the processing side, the business we talked about selling last year, bringing on this year is still pretty solid.

Kenneth Usdin - Banc of America Securities

Right. And do you still have some of those contracts that you had signed at the end of last year that's still coming thorough? I mean can you just talk about the pipeline of contracts and your kind of expected pace of conversions of such?

Michael D. Hayford - Senior Vice President and Senior Executive Vice President, Chief Operating Officer and Chief Financial Officer of Metavante Corporation

Yes, we said last year that some of those were coming in the third quarter or the fourth quarter of '07, and that's when they are coming on board. They are continuing to come on board. I think we also shared last year that based on consolidation in the industry, we are losing customers who get acquired and merge into larger organization that the process is in house. So those things are balancing up pretty much as we expected.

Kenneth Usdin - Banc of America Securities

Okay, thanks a lot.

Operator

And there are no further questions at this time.

Gregory A. Smith - Senior Vice President and Chief Financial Officer

All right. Well, thank you very much everybody. Appreciate everybody dialing in for what is likely the last M&I Metavante earnings call. Thanks.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.

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