Heartland Financial USA, Inc.
Q3 2008 Earnings Call Transcript

Published: 28 Oct 2008

[Operator:]

Good afternoon ladies and gentlemen, thank you so much for standing by. Welcome to the Heartland Financial USA, third quarter 2008 conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) As remind this conference is being recorded today on Monday, October 27, 2008. I’ll now turn the conference over to [Mr. Scott Exine] of the Financial Relations Board. Please go ahead.

[Scott Exine:]

Thank you, operator. Good afternoon everyone. Thank you for joining us on Heartland Financial USA’s conference call to discuss third quarter’s 2008 results. This morning we distributed a copy of the press release and hopefully you’ve had a chance to review the results. If there is anyone online who did not receive a copy, you may access it at Heartland’s website, at www.htlf.com or you may call Han Hoi at 312-640-6688 and she will send you a copy immediately. With us today from management are Lynn B. Fuller, President and Chief Executive Officer; John Schmidt, Chief Operating Officer and Chief Financial Officer; Ken Erickson, Executive Vice President and Chief Credit Officer. The management will provide a brief summary of the quarter and then open the call up to your questions. Before we begin the presentation, I would like to remind everyone that some of the information that management will be providing today, falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines, I must point out that any statements made during this presentation regarding the company’s hopes, beliefs, expectations or predictions of the future are forward-looking statements and actual results could differ materially from those projected. Additional information on these factors is included from time-to-time in the company’s 10-K and 10-Q filings, which can be obtained on the company’s website or the SEC’s website. At this time, I’d like to turn the call over to Lynn Fuller. Please go ahead.

[Lynn Fuller:]

Thank you, Scott and good afternoon everyone. We certainly appreciate everyone joining us today as we review Heartland’s performance for the third quarter of 2008. I hope you’ve all had an opportunity to review Heartland’s earnings release that we issued this morning. For the next few minutes, I’ll touch on the highlights of our quarterly performance and the opportunities we see in the present financial environment and then turn the call over to John Schmidt, our Chief Operating Officer and CFO and Ken Erickson, our Executive Vice President, Chief Credit Officer, who will provide additional details on Heartland’s third quarter and year-to-date financial results. In today’s earnings release, Heartland reported net income for the third quarter of $3 million or $0.18 per diluted share compared with net income of $6.9 million or $0.42 per diluted share for the third quarter last year. Year-to-date income from continuing operations was $14 million or $0.85 per diluted share compared with $17.2 million or $1.4 per diluted share last year. For the first time in several years these results fell short of prior comparable periods and certainly short of our expectations. However, as I said in the past, we began to take a longer-term focus versus a quarter-over-quarter approach. Given this quarter’s provision expense, we’re pleased to report solid quarter earnings with our net interest margin increasing $2.7 million or 10% over the third quarter 2007. Heartland’s margin has now remained steady at just under 4% for the past five quarters. Obviously our shortfall and bottom-line income, both for the quarter and year-to-date stems from our loan loss provision expenses of $7 million and $14 million respectively. We continue to believe we are adequately reserved; however these are indeed unprecedented times for the banking industry, given of the continued decline in real estate evaluations. The big question everyone’s asking is; where is the bottom and how far out is the recovery? In a few minutes Ken Erickson, our Executive Vice President, Chief Credit Officer will provide more detail on the credit side, including provision expense and non-performers. Outside of the credit issues there are a number of positive developments that point to our company’s underlying strength and potential. As I mentioned, most notably is Heartland’s positive trend in net interest margin. Our margin, now just below 4% has increased in each of the past four quarters. We continue to achieve favorable progress through strict pricing discipline and emphasis on growing non-maturity deposits. Our stated goal this year is to maintain margin at or above the 2007 year-end mark of 3.87%. Another bright spot this year is growth in deposits increasing at an annualized rate of 11%. By design much of this growth is in the non-maturity categories of money market deposit accounts and interest-bearing checking. As a case in point, the introduction of our new transaction account, Cash Rewards checking has resulted in growth of over 5000 net new checking accounts in 2008, a substantial increased over the last year. Fifty percent of these accounts are new customers to our banks with which we intent to build even deeper relationships. Heartland’s stated goal is to have eight products and services per household and at present a number of our member banks averaged five or greater products and services per household. Additionally, as a member of the Cedars network we have attracted new accounts at many of our banks as depositors have come to us seeking additional safety for their deposits. As you know from previous calls, collection of non-performing loans is this year’s highest priority. Even though we have not shown a substantial reduction in non-performance this quarter we are hopeful that progress will be made over the next two quarters. With respect to loan growth we are first and foremost focused on quality, second on profitability, last and volume. That been said total loan out standings have still increased by 5% on a year-to-date annualized basis. Some of our member banks are reporting opportunities to attract high quality credits from other financial institution that have respected the availability of credit. In time such as these capital is king and Heartland is very well positioned in this regard with risk-based capital remaining an excess of 12%. Heartland and each of our member banks remains well capitalized by all regulatory majors. Liquidity is another highly favorable element among our key performance indicators. Our liquidity position continues to increase as a result of attractive deposit product offerings and depositor confidence with the growth and deposits outpacing the growth in loans. The quarter’s income statement reflects a couple of special items. First, is the other than temporary impairment charge of $4.6 million pretax taken on Fannie May preferred shares held in our investment portfolio. Offsetting this charge was the sale of our merchant credit card processing service to TransFirst for $5.2 million pretax. Shortly, John Schmidt will provide more detail on the treatment of these non-reoccurring events. In terms of Heartland’s expansion plans, we have intentionally slowed the pace of new branch office openings. This year we’ve opened two new banking offices and are contemplating the same number for 2009 with an office in [Santa Pain] New Mexico and a possible office to support our new De Nova Bank in Minneapolis in Minnesota. At present, we believe our resources are best focused on ramping up the 13 offices which we have opened over the last three years. These offices represent nearly a quarter of our total offices. Heartland’s current branch network comprised of 60 offices across eight states continues to enjoy solid growth with average earning assets increasing to $209 million or 7% over third quarter 2007. As we discussed in last quarter’s conference call, instead of aggressive branch expansion, greater opportunities for growth are emerging as acquisition candidate service. At this point, Heartland is reviewing the advantages associated with the treasury stock program. Bank regulators are encouraging strong banks, such as ourselves to consider the advantages of the TARP even though our capital levels are well in excess of the required regulatory levels. If we choose to take advantage of the treasuries offer, the additional capital could be used to further stimulate our local economies through increased lending, also the TARP proceeds maybe helpful as we pursue our stated strategic focus on acquisitions which are additive to earnings. As a growing number of banks announced dividend cuts and elimination this quarter, I believe it’s important to share with that you that at this months meeting the Heartland Board held our dividend unchanged at $0.10 per common share payable on December 12, 2008. Well that concludes my comments. I will now turn the call over to John Schmidt for more details on the third quarter and year-to-date financial results. John will then introduce Ken Erickson, who will provide additional color on credit quality and real estate exposures in our major markets; John.

[John Schmidt:]

Thanks Lynn and good afternoon. My comments will again focus on the more substantial changes through Heartland’s balance sheet and income statement in the past quarter from 09/30/08 versus 06/30/08. Ahead of that as Lynn indicated, these are very challenging times and our provisioning is certainly higher than we would like. We are still encouraged by the strong underlying operating characteristics of the company. Looking first at the balance sheet, total loan balances increased by $69 million in the third quarter with a year-to-date growth now totaling $84 million. We feel comfortable in reaffirming our forecasted growth of $100 million in loan growth. Our focus for the coming quarters is two fold; one to both quality credits, two to repay appropriately on these credits. Net chare-offs for the third quarter totaled $7.2 million as compared to the total of $5.2 million for the first two quarters of 2008. Credits originated in Arizona account for over 50% of chare-off incurred by the company in 2008. Net charge-offs for the nine months expressed as a percentage of average loans and leases total 54 basis points. Our core deposits meaning the excluding brokerage CDs increased by $156.6 million from a quarter-over-quarter perspective. Again this quarter, we saw substantial growth in our savings and interest-bearing checking products which increased by $148.3 million since the second quarter. Approximately 55% of this growth reflects the introduction of the new money market account that feature a 5% teaser rate until 12/31/08. This account 52% of which is new money will negatively impact our margin in the fourth quarter. At the same time we are comfortable that we’ll be able to retain a substantial amount of these deposits. We are also pleased to see the $18.3 million growth in prime deposits, which reverse the trend in the second quarter. Moving to the income statement, net income totaled $3 million or $0.18 per basic and diluted share, probably more significance in this is the fact that we again increased our margin to 3.96% for the third quarter. We were able to accomplish this by aggressively moving our certificate our deposit rates down. Especially encouraging is the fact that we are able to achieve this growth in margin even with the current levels in non-performing loans. We feel that we’ve reached an effective floor in the liability side. Additionally as I previously mentioned the introduction of the new money market account will negatively impact margin in the fourth quarter. At the same time we feel we have the ability to see enhanced pricing in the loan side for the foreseeable future. Accordingly we would suggest that our margin will fall to around 3.9% for the fourth quarter but then rebound to at least the current level in 2009. Since our balance sheet remains asset sensitive this could certainly be impacted by additional Fed rate cuts, our ability to grow loans in the level of non-performing loans. While non-interest was essentially flat for the quarter, there was certainly a lot of noise in the individual components. Like many institutions we are forced to write down our $5.1 million holdings in Fannie Mae by $4.6 million, with the remaining balance placed into a trading account. Additionally we incurred a net loss of $247,000 for the quarter in our bank owned life insurance, as depreciation and securities held in the separate accounts fell below the underlying stable value wrap guarantee. Finally on a positive note, we were able to bring the sale of our Merchant Card portfolio to fruition in the third quarter. This six-month effort to sell the portfolio will immaterially affect our ongoing revenue given the negotiated lease sharing arrangements. Total non-interest expense for the second quarter increased by $1.2 million or 4.8% from the second quarter levels. Salaries and benefits increased from the second quarter as we brought on additional staff from Minnesota Bank & Trust. Outside services increased by $448,000 primarily related to legal cost associated with the collection of our non-performing loans and the increased FDIC premium. We are continuing our advertising promotions focus primarily on core deposit generation in the opening of Minnesota Bank & Trust. The tax rate for the quarter was 25.3% and 26.66% for the nine months reflecting the recognition of tax credits in the deal and a higher level of tax-exempt income. We expect our tax rate to be in the 27% range for the remainder of 2008. In closing we are pleased with several expects of the third quarter performance including margin maintenance and deposit growth, at the same time we realized the job one remains the reduction in the non-performing loans. With that I’ll turn it over to Ken Erickson, our Executive Vice President, and Chief Credit Officer.

[Kenneth Erickson:]

Thank you John and good afternoon every one. Non-performing loans ended the quarter at $43.9 million, while it is far from encouraging to see non-performing loans at this level, it is somewhat encouraging to see that the amount of non-performing loan is approximately the same as it was at the end of the prior quarter. $3.4 million of our non-performing loans is made up of the guaranteed portion of government guaranteed loans. Our press release stated that 64% or $28 million of these non-performing loans are to eight borrowers; the largest of these is a $6.4 million Arizona credit that was added to non-performing assets this quarter. This loan is supported by a recent appraisal of nearly $12 million, the developable property is being actively marketed, no loss is anticipated for this loan. The remaining seven credits can be summarize in the following ways; by location in Wisconsin $6.8 million, Arizona $6 million, Montana $4.8 million, Iowa $2.3 million and Colorado $1.6 million. By industry type, the largest is residential condos at $6.8 million, followed by transportation $6 million, commercial real estate $4.8 million, construction $1.7 million, food industry $1.3 million and senior housing $1 million and the expected resolution of these seven credit, the fourth quarter of 2008 I expect a reduction of $8.8 million with the remaining $12.9 million in 2009 or even potentially later. We recorded $7.2 million in net charge-offs in the third quarter, which $6.6 million was recorded at the bank. Of these $6.6 million, $4 million had previously been taken as a provision expense and had them established as a specific reserve for those credit. The unanticipated losses in this quarter were primarily concentrated in three credits. Approximately half of this was attributed to one loan in Arizona in which an expected settlement with the guarantors did not materialize. The other half was about equally led between a Wisconsin and a Colorado customer and both related to reduce relocate values. Also mentioned in our press release, we have generally recognized the charge-off on a loan when the loan was resolved sold or transferred to other real estates. In our third quarter we recognized charge-offs uncertain collateral dependent loans by writing down the loan balance to an estimated net realizable value based on the anticipated disposition value. Due to these unprecedented times in the banking industry and the continued questions regarding sustainable real estate values, we feel this is more prudent. Last quarter I commented that I expected revolution of $9 million of non-performing loans in the third quarter. We exceeded that by $3 million as six smaller credits were either paid off or paid down. The increases in non-performing loans in the third quarter were primarily driven by the following credits. The $6.4 million Arizona credit I mentioned earlier, $1.6 million in Colorado condos, $1.3 million in the Iowa mead industry, $1 million in a Iowa senior housing credits and $1.1 million made up of four different lot loans in Arizona. Also in the second quarter call, I commented that the fourth quarter should see the reduction of an additional $11.4 million of existing non-performing loans. I now expect that number to come closer to $16 million as we obtain ownership of our collateral. That being said, improving in non-performing loans in the fourth quarter, hinges on the continued performance of a $15 million credit. All though it’s delayed performing real estate loan, the borrower and we are still addressing their plans related to this credit. It is believed the borrower still sees there is equity in the project and we’ll take appropriate actions to protect their investment. Other real estate owned increased from $4.2 million to $9.4 million during the third quarter. This increase is primarily the result of that Arizona lot development loan that we took to OREO in the amount of $4.6 million. Expected foreclosures in the fourth quarter, could see this increase by another $12 million. Citizens Finance our consumer finance company, continues to show solid performance for the year. Loan growth for the year is $3.4 million or 8.5%. Net out standings now sit at $43 million. Annualized net losses for this company are 4.09% year-to-date, appropriate for the risk and yield within that portfolio. With that Lynn, I’ll return the call to you.

[Lynn Fuller:]

Thank you, Ken. At this time we’d open the call up for questions.

[Operator:]

(Operator Instructions) Your first question comes from Jon Arfstrom - RBC Capital Markets.

[Jon Arfstrom:]

A couple of questions here; can you talk a little bit about the three credits that drove charge-offs during the quarter. I guess I’m not sure if you want to get into this, it’s nearly gritty on each of these. Can you talk about maybe what percentage of the charge-offs were attributable to those three?

[Lynn Fuller:]

I guess that we had about $2.5 million of charge-off that were above what we had previously identified through specific reserves. $1.3 million of that came in the one credit, where we had anticipated some with the guarantor and the other $1.3 million was just about 50/50 between the Wisconsin business, where we took a further write-down on a commercial real estate project where we see continued decreases in value and the other half is to a Colorado customer.

[Jon Arfstrom:]

And the expected settlement to the guarantor; is that something that’s not likely to happen in the fourth quarter to first quarter?

[Lynn Fuller:]

Not voluntarily; we are pursuing legal action on the two guarantors we have in that credit.

[Jon Arfstrom:]

And then I was writing quickly when you were talking about your $16 million expected decline in non-performing loans from the fourth quarter and then you talked about a $15 million credit that you’re watching carefully, did I pick those two numbers right?

[Lynn Fuller:]

Yes, it is correct. Of the existing loans in there at the end of the third quarter, we should have resolution to approximately $16 million as we see it today. $12 million of that resolution is taking ownership of property and transferring it to other real estate.

[Jon Arfstrom:]

Okay and that was the $12 million you talked about.

[Lynn Fuller:]

Yes, that’s the $12 million; and then on the potential side that would swing back, is we still have questions on one credit of $15 million that I mentioned that is performing at this point in time, but I do view it as a higher risk revenue.

[Jon Arfstrom:]

Okay, but other than that at this point you don’t see any major issue?

[Lynn Fuller:]

Nothing of major dollar size, that’s the largest one that we have that could be a potential problem.

[Jon Arfstrom:]

Just changing gears, John maybe for you. In terms of your money market product, what kind of hooks you put in the client that opens up an account, the 5% rate of interest? I understand it’s a money market type account, but can you do anything like direct deposit or bill payer or any other obligations that a client might have?

[John Schmidt:]

Right now Jon, we’ve redoubled our efforts if you will, to go back and really solidify the entire relationship and that’s done through direct calling obviously as well as some additional incident to the producers to retain those deposits. Shrinks has been there, we can retain it as much as 8% in these type of accounts based on effort such as these. In another circumstances and then some other offerings we certainly have tide-in checking accounts, tide-in ATH deposits, we do not do that in this case.

[Jon Arfstrom:]

And is this primarily consumer or is it commercial as well?

[John Schmidt:]

Primarily consumer.

[Jon Arfstrom:]

And then in your tax and the reviews you’ve talked about western market deposit growth; any ideas of why it would be in the West and maybe not so much into that Midwestern market?

[John Schmidt:]

I think certainly we still see that one of the reasons that ultimately drew us to the West is the population out there. We still are viewed as a very attractive alternative in the west and markets are still very large and our brands out there are very viable. So, I think that’s why we see that in the west. That doesn’t amaze what we’ve been able to do in the Midwest. It just says that’s less consolidated and still the activity maybe not be as great as our overall population growth. I think it’s just a function of market demographics still Jon.

[Jon Arfstrom:]

And then Lynn maybe a question for you; you touched a bit on potential M&A opportunities, what make sense for Heartland? You’ve typically been a de nova company, but just curious what makes sense from your company’s point of view?

[Lynn Fuller:]

Jon the reason that we switched this year, well actually for ’08 we switched our strategy from de nova to acquisition strategy because we just thought the environment was right for acquisitions that we could make some sense out of. There hasn’t been a lot of activity to date, but we are anticipating that that activity will pickup given the TARP program and just the ongoing consolidation of the industry. During the period of time we were seeing acquisitions at 2.5 to 3 times book in the mid 20’s to high 20’s even on multiples of earnings, we just couldn’t make any sense out of those and we’ve always committed to our shareholders that we would not do acquisitions unless they were additive to shareholder earnings per share. So, we just couldn’t make any sense out of acquisitions at those lofty levels, so we did de nova during that period of time. We knew the markets that we wanted to be in. The only way we felt we could access and then make sense out of them and still make sure that our shareholders continue to see increases in EPS was to do it via de nova, that’s no longer the case. We think we are going to see multiples on acquisitions comedown considerably. I mean you are seeing banks trading at well intangible book values lower than I’ve ever seen and quite honestly back in the 70’s we used to see transactions at book value, but I’ve never seen them at sub book. So, this is really a pretty interesting period of time and we think we are going to see some consolidation of the industry and with the advent of the TARP program, we think it’s going to accelerate.

[John Schmidt:]

I think to add to that Jon too, I think the attractive deposit base is one of the key drivers we are looking for now, strong and immature deposits. I think that’s the key in today’s world and something we will be focusing very hard on as far as potential acquisitions. In last months conference call I talked about the markets that we’re interested in, they’re primarily the ones that were already in, where we could get some cost takeouts, economies to scale and build market share with a good solid deposit base. Those will be the highest priority partners that we would seek out.

[Operator:]

Your next question comes from Stephen Geyen - Stifel Nicolaus.

[Stephen Geyen:]

Just a couple of questions, I’m just wondering what you’re seeing in the migration of sub-standard loans or loans in low rated credits; the cost preference despite geography?

[John Schmidt:]

I’m thinking of that Stephen. I don’t think we’ve seen much shift bank-by-bank. Lynn had mentioned on his call the majority of the losses year-to-date or possibly this was John have come from the Arizona market, roughly half of the losses we’ve had to-date. I would say the non-performing assets are still heavily concentrated from a company standpoint in that market as well as Wisconsin, as well as Rocky Mountain Bank, pretty much the same as it has been for the last couple of quarters.

[Stephen Geyen:]

Okay and I can’t find it now in the release, but you gave the pricing of CDs are currently up, what’s going to rollover the next few quarters. I’m just wondering, what you see right now in the market as far as the potential for producing those costs going forward. Given the current market environment, what could you expect?

[Lynn Fuller:]

I can take the first part and then have John respond as well, but we continue to see anywhere between 85 basis points in a percent reduction in the CDs that are coming due and we’re showing on average about $100 million in maturing CDs every month. We’re still able to add to CD out standings and get that kind of reduction. I would anticipate that that may come off a little bit going forward, but at the same time, if in terms of what market we’re in, we are seeing some deposits paying as much as 5% on five years for CD. I think it’s still hard to attract money out that far. Most of the CDs are rolling over 30 months or less, so most of our customers tend to be saying a bit more short term. John do you have anything to that?

[John Schmidt:]

Yes, I think Steve that what we had talked about is that we’re probably seen at least a diminishment in the ability or reprise of CD booked to some extent. So, we’re getting maybe to a flow in some respects and so of that’s going to be driven in part by what is going to go out into the market relative to liquidity needs etc., so where keeping a close eye on that. Again on the flip side what I’d suggest is I think we’re going to see some opportunity on the asset side for enhanced pricing, which certainly would at least balance those two off.

[Lynn Fuller:]

If the Fed continues to ease and markets start to free up, we may see rates kind of settling in this range and if that in fact happens, that could be helpful, but who knows what’s going to happen with the financial markets, whether they will start to settle out or not.

[Stephen Geyen:]

And last question, there was an adjustment probably in the quarter, just wondering if there is any impact going forward?

[Lynn Fuller:]

We see probably one more impact Stephen of probably a lesser extent in Q4. It’s probably immaterial at this point, but we’re certainly keeping our eye on that.

[Operator:]

Your next question comes from John Rowan - Sidoti & Company.

[John Rowan:]

Lynn, my first questions is for you. In terms of, the TARP money, I know you’ve talked about it. If I would assume based off what you discussed, your primary use of receiving TARP money would be acquisitions. Is that correct?

[Lynn Fuller:]

That would be the principle and although I would say that because we don’t have any specific negotiations going on at this point in time, I mean we’ve talked to a lot of banks obviously throughout the years, but we don’t have anything that we can report on right now that’s in process. We’re growing at a rate of somewhere around $200 million per year in assets and when we looked at this, if we took down as an example and I’m not saying we will or we won’t, but if we took down call it $40 million in preferred, we would only have to leverage that 2

[John Schmidt:]

John, I guess just to keep within the spirit of the TARP as well and certainly we’ll look for additional lending opportunities rather, but again as we indicated we grew our loans by $69 million in this quarter, so it’s not like we haven’t been at the party relative to making loans.

[John Rowan:]

But could we stay on TARP for a second. If you guys do take TARP money and have you said how much you have been pre-qualified for or no.

[Lynn Fuller:]

We know that our maximum potential would be as short as $79 million.

[John Rowan:]

And even if you did leverage 2

[Lynn Fuller:]

Do we have the potential low demand?

[John Rowan:]

Yes

[John Schmidt:]

Really that’s going to be a function in the economy, John. We have a lot of assets in place if you will, we’ve talked about that for a long time, if I could talk about that on the call today. We have three de novo that are effect de novo in place that are still growing. So, that suggests we have a lot of engine that’s trying to warm up, if the economy start to return to a normal pace. So, I think that’s the potential, but again as Lynn indicated we are very focused on acquisitions, we always have been. A third of our growth has historically come from acquisitions, so it still play for us as well.

[John Rowan:]

One last on the TARP program, would you consider buying deposits from a sales institution?

[John Schmidt:]

Absolutely; if it’s out in Timbuktu, probably not. We want it to be added to our current footprint and to market that would be attractive to us, but just to buy deposits for the second buying deposits wouldn’t make much sense, but as John said in his comments, when we look at acquisitions we are looking very much of the deposit trend and the value of those deposits because we really see that as the franchise value of our institution.

[John Rowan:]

John, the FDIC insurance premiums, you said they were going up and you say what they were this quarter and what you see them going through on a quarterly run rate?

[John Schmidt:]

I can tell you that we were looking to see about $2.8 million on an annualized basis in ’09.

[John Rowan:]

But you don’t know what it was this quarter?

[John Schmidt:]

I think it was round about $1.7 for the year, $1.4 rather; about $490,000.

[John Rowan:]

Of the increase?

[John Schmidt:]

No that’s total

[John Rowan:]

Okay. For the quarter

[John Schmidt:]

Yes

[John Rowan:]

And then Ken, I just wanted to touch base on the $16 million that you expected to write those NPL and liquidate down through REO, you guys talk about talking charge-offs before you moved into REO and I just wanted to find out, of that $16 million what have you already taken charges-on; potentially you took in the third quarter and what you’re collateral back at $16 million and the potential charges-offs in the fourth quarter.

[Ken Erickson:]

That charge-offs John, did you say $16 million in charge-offs?

[John Rowan:]

No, $16 million coming out of NPL, into REO, but I want to know if you guys have charged any of that $16 million down already?

[Ken Erickson:]

Let me scan all the names. Say its 750,000 on one, that’s all has jumped out of me. When I looked at this there’s a total of 25 credits involved in there and as I scan the names there I only see 750 that we took as a charge-off in the third quarter.

[John Rowan:]

So I mean realistically could we be looking at a significantly higher charge-off in the fourth quarter.

[John Schmidt:]

No, not on those credits.

[Operator:]

Your next question comes from Jeff Davis - Wolf River Capital.

[Jeff Davis:]

Good afternoon, two part questions and related first is does the recent drop in commodity prices impact the Ag portfolio. I’m going to propose it by assuming not this year, but maybe thoughts on next year and then secondly, Lynn and John in terms of TARP and maybe for the focus for those who don’t get TARP money or offer TARP money which you have clearly not going to be in that gap, is what are you hearing from the regulators informally? Has the MO then going to be like what we read about Nat City were Dugan told Peter to go find an M&A partner quickly, so that some of these more challenged institutions have cleared out quickly or are they going to have more of a regulatory full variance, where they’ll allow it to linger for years so?

[Lynn Fuller:]

Jeff, this is Lynn. I don’t believe they’ve really shared that with us. They have shared that they’d like strong institutions to be able to acquire the weaker ones, so that FDIC doesn’t have to take them out and end up liquidating them. So, I think that’s clearly one of the motivations, but your other question, I don’t know the answer.

[John Schmidt:]

I think that’s at higher level than we’ve been that Jeff maybe…

[Jeff Davis:]

Yes I was just asking you to speculate, that’s okay.

[John Schmidt:]

I’m sure some of that’s going on, we haven’t seen all a lot of that, but my guess says that they would be reluctant to share that with us, whether some of the money will be politically driven or not to institutions; I mean I don’t know. I would guess those intuitions that are three rated that are kind of on the bubble, they’ll have to make a decision as to whether they help to safe them or they let them join with somebody else, but again as we think about acquisitions Jeff, that certainly would be part of our target as well.

[Lynn Fuller:]

Commodity, the question on commodity prices, we’ve been watching that. What weren’t coming $8 of bushel down to four. We’re going to be watching that very closely with our Ag clients, although I will say that our Ag customers tend to be very well capitalized, they’ve not over leveraged on farmland like they did back years ago on the 80’s. We’ve seen land sell for as high as 6,500 an acre for good productive land and most of our clients have not participated in purchasing at those levels and if they have its been a neighboring farm where they’ve been able to melt the cost of that into the rest of their land, we’ve always cross collateralize with all the land of our farmers and cross collateralized with their operating lines, but we’ve got a pretty savvy group of Ag clients and my guess is they’ll be very careful to hedge their inputs and their outputs as they have in the past and fuel prices keep coming down that’s certainly going to help.

[John Schmidt:]

They should see some relief from their inputs as well so…

[Lynn Fuller:]

That’s the key. I mean the concern is if corn comes down to four bucks an acre and oil stayed up at the prices, that was going to be a real squeeze, but it looks like both are easy. So I would guess that it would be a manageable situation for those Ag producers that are well capitalized and have good management.

[Jeff Davis:]

Correct me if I’m wrong, but I think you’ve only got one relatively small situation that’s ethanol related, but how does the drop in commodity and drop in oils work through for those financial institutions that have been making loans for ethanol plans and the like?

[Lynn Fuller:]

We’ve only got two and they are extremely profitable, they’re very well capitalized. We’ve had a cash flow recapture on our loans, where any additional cash flow that they were receiving over and above the payments was going to prepay their debt, so I feel pretty comfortable with what we’ve got. I think there maybe some challenges out there for people who are aggressive in that industry. We set early on a limit on the amount of dollars we wanted to have loan to ethanol plants because, we’ve just never been overly comfortable of where that whole thing is going. That being said though with the ones that we’ve done I think have performed very well and it was good management.

[John Schmidt:]

I’d add to that to Jeff, in the commodity prices the high corn prices and the high soybean prices that came over the summer, really came when they’re also wasn’t a lot of commodities available to trade there. I know that our Ag lenders have been very active in working with their borrowers to say these last couple years that have been very profitable in all segments of the Ag market, whether it’s been in meats or dairy or raw crops that they use the cash that they can build over that time to help build a stronger financial position, because other than fuel recently coming down, other input costs appear to be going up from the fertilizer and feed side, but as Lynn have mentioned most of our Ag borrowers are fairly well sophisticated, are good business people and are positioning themselves for those potential increased prices.

[Operator:]

Your next question comes from Brad Milsaps - Sandler O’Neill.

[Brad Milsaps:]

John or Lynn, I was wondering if you could talk maybe specifically about the loss at Summit Bank & Trust this quarter. Just curious if that must be ready to credit and then secondly maybe talk a little bit about what you are seeing in New Mexico and Montana.

[John Schmidt:]

Let me take New Mexico first because its kind of amazing to me both New Mexico and here in Iowa in this region, the tri-state area it’s hard to tell that we’ve got a recession going on, it’s hard to tell that we’ve got the kind of problems in the financial industry across the world that we’re seeing today, but in Arizona clearly as I said before it’s the most challenged market that we are in and Montana’s seeing a slowdown as well. So, I think Denver’s soft, but it’s not treble; it’s nowhere near as tough as Arizona. Wisconsin’s soft, but yet again hasn’t seen the huge declines in property values that we see in Arizona. Ken can address the credits in Denver. We had a couple of real estate transactions that are slow; there is still servicing the debt, but they are slow. Ken do you want to expand on those at all?

[Ken Erickson:]

Yes, I mean that the one I had already commented on that we took, it was about $650 million that we took the charge-off on and expecting lower real estate values. Another one we took a reduction on was some retail condos in the Denver market that we took a few hundred thousand dollar charge-off as we feel that we may be getting that property back and we took it down to what we felt was realizable value. The other losses there have come from reduced real estate values in that market.

[Brad Milsaps:]

So, the loss this quarter of about $1.2 million, you’re saying that’s mostly all credit related even though, I’m looking, if I have my subsidiary data correct here, you only have about $1.5 million of non-performing loan at that location?

[Lynn Fuller:]

Right, the provision expense in the month of September only was $1.2 million at Summit. Including growth of loans to Brad that will also be in that equation.

[Ken Erickson:]

On Summit’s situation I would expect some recoveries on those loans.

[Brad Milsaps:]

Okay and Ken, how much sort of land and development construction exposure do you have at your Montana subsidiary?

[Ken Erickson:]

Montana in the construction land development, we have a total of $36 million. I will tell you that that is the dollars outstanding on the books of Rocky Mountain and actual we participate loan out to our other member banks. So that one $15 million credit I mentioned before, that is not all on books of Rocky Mountain. They would have approximately $4.5 million to $5 million of that and the remainder would be participated to our other Heartland Banks.

[Operator:]

(Operator Instructions) Your final question comes from Brian Martin - Howe Barnes Hoefer & Arnett.

[Brian Martin:]

Hey Ken, I think you maybe just answered this, but $15 million credit is still performing. I just kind of want to get a sense for what market that was in the Colorado and if you guys have had an appraisal on that recently.

[Lynn Fuller:]

Brian, it is in the Montana market. We haven’t a recent appraisal and I guess for the sake of not disclosing anymore about the customer and always trying to be close to the best of not disclosing enough about any particular credit that we can tie it back there or to the market, so I guess I wouldn’t go further on that answer. As far as appraisals in ’08 we had one in year ago at the beginning of the year. We haven’t had ones since December of last year.

[Brian Martin:]

Okay, how about just two last things on the loan side. Maybe you can just talk a little bit the loan pricing you’re seeing that will help a little bit going forward and just kind of the growth in the consumer portfolio this quarter, just what was drive that?

[John Schmidt:]

I think, a general statement on pricing, we’re seeing all of our banks realizing that there is an opportunity to get increased margin with the changes going on in the banking environment. So I believe I would tell you that we do see that marked up just within the last 30 days by most of our commercial lenders. In the deals they are doing we are seeing some better spread than what we are seeing previously.

[Lynn Fuller:]

And maybe a more appropriate pricing is one way to think about it.

[Brian Martin:]

How about more equity, are you getting more equity in these deal or is it just better pricing?

[Lynn Fuller:]

I think we framed it in our discussions Brain that we are looking really for both. It’s solid credits first and better pricing second and then volume third.

[Brian Martin:]

Okay, and how about the growth in consumer in the quarter?

[Lynn Fuller:]

Brain I think in the quarterly we had 1 million of citizens and then 2 million in New Mexico Bank & Trust and then another 1.5 million at Dubuque Bank & Trust.

[Operator:]

Alright thank you and management there are no further questions at this time. Please continue with any closing comments.

[Lynn Fuller:]

Thank you. In closing Heartland’s core financial performance remains solid and to that point two of our largest banks are having their best year on record, that’s New Mexico Bank & Trust and Dubuque Bank & Trust. However, like our peers, regional problems in the real estate area have resulted in increased levels of non-performing loans, provision expense and charge-offs that Ken Erickson referred to. We have allocated additional resources and focused our energies on those markets that are most challenged. We believe that we are properly reserved and are hopeful as Ken said that an improving trend will be evident within the next two quarters. We continue to operate within attractive net interest margin it just under 4%. Risk-based capital is in excess of 12%. We have ample liquidity and a growing loan and deposit base. With the dedicated and capable staff and the potential of accessing capital via the TARP program, we are poised to take advantage of acquisition opportunities which are likely to surface in our industry over the next few quarters and over the next 18 months. I’d like to thank everyone for joining us today and I hope that you can join us again for our next quarterly conference call which will be January 26, 2009. Thanks again everyone and have a great evening.

[Operator:]

Alright thank you ladies and gentlemen. This does conclude the Heartland Financial USA third quarter 2008 conference call. If you would like to listen to a reply of today’s conference, please dial 1800-405-2236 or 303-590-3000, input the access code 11120596. Again 800-405-2236 or 303-590-3000 to input the access code 11120596. HT would like to thank you very much for your participation today. You may now disconnect. Have a very pleasant rest of your day.