Bank OZK
Q2 2008 Earnings Call Transcript

Published: 11 Jul 2008

[Operator:]

Good afternoon. My name is Shandra and I will be your conference operator today. At this time, I would like to welcome everyone to the Bank of the Ozarks second quarter earnings release conference call. (Operator Instructions) Ms. Blair, you may begin, Madam.

[Susan Blair:]

Thank you. Good morning. I am Susan Blair, Executive Vice President in charge of Investor Relations for Bank of the Ozarks. The purpose of this call is to discuss the company’s results for the second quarter of 2008 and our outlook for upcoming quarters. Our goal is to make this call as useful as possible in understanding our recent operating results and future plans, goals, expectations, and outlook. To that end, we will make certain forward-looking statements about our plans, goals, expectations and outlook for the future, including statements about economic, housing market, competitive and interest rate conditions, revenue growth, net income, net interest margin, net interest income, including our goal of achieving record net interest income in each quarter of 2008, non-interest income, including service charge, mortgage lending and trust income, non-interest expense, asset quality, including expectations for our net charge-off ratio and other asset quality ratios; loan, lease, and deposit growth; and changes in the volume and yield of certain portions of our securities portfolio. You should understand that our actual results may differ materially from those projected in any forward-looking statements due to a number of risks and uncertainties, some of which we will point out during the course of this call. For a list of certain risks associated with our business, you should also refer to the forward-looking information caption of the management’s discussion and analysis section of our periodic public report, the forward-looking statements caption of our most recent earnings release, and the description of certain risk factors contained in our most recent annual report on Form 10-K, all as filed with the SEC. Forward-looking statements made by the company and its management are based on estimates, projections, beliefs, and assumptions of management at the time of such statements and are not guarantees of future performance. The company disclaims any obligation to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information or otherwise. Now, let me turn the call over to our Chairman and Chief Executive Officer, George Gleason.

[George Gleason:]

Good morning and thank you for joining today’s call. We are very pleased to be reporting our second quarter results, which include records for net income, earnings per share, net interest income, and efficiency ratio. In the second quarter, we generated strong revenue growth even while operating in a challenging economic environment. This allowed us to post record earnings while also building our allowance for loan and lease losses. We have a lot to talk about so let’s get right to it. Net interest income is our largest source of revenue, accounting for approximately 81% of total revenue in the quarter just ended. In our last two conference calls, we stated that one of our goals for 2008 was to achieve record net interest income in each quarter. In the quarter just ended, our net interest income increased 22.4% compared to the second quarter of 2007, and was up 8.5% from the first quarter of 2008. This gave us our sixth consecutive quarter of record net interest income. We continue to believe that achieving record net interest income in each quarter of 2008 is a realistic goal. Our record net interest income in recent quarters is a result of both improvement in our net interest margin and growth in earning assets. In both quarters this year, we have benefited from meaningful improvement in our net interest margin. During the first quarter of 2008, our net interest margin improved 22 basis points to 3.69% compared to 3.47% in the fourth quarter. If you’ll recall, approximately half of that first quarter improvement was a result of unusually favorable spreads achieved on the unexpected addition of a large volume of tax exempt investment securities during the first quarter. The other half of our first quarter margin improvement was due to better spreads between our loans, leases, and other securities, and our deposits and other funding sources. Our second quarter net interest margin improved further to 3.77%, up another 8 basis points from the first quarter of this year. In the second quarter, we continued to benefit from an unusually large volume of these tax exempt investment securities, although we still consider our investment in these securities to be relatively short-term. In fact, we think most will pay off this quarter. We estimate that these securities added about three basis points to our second quarter net interest margin. We also benefited once again from further improvement in our spreads between our loans, leases, and other securities, and our deposits and other funding sources. At this point, we believe it is reasonable to think that we will be able to achieve net interest margin for the remaining two quarters of the year at a level approximately equal to or possibly somewhat above 3.70%. That takes into account what we expect will be a slightly dilutive effect on our net interest margin in the third quarter from our temporary investment in tax exempt investment securities, and I’ll explain that a bit further in just a minute. Excellent growth in earning assets, both loans and leases and investment securities, has also contributed significantly to our record net interest income in each quarter this year. Loans and leases at the end of the second quarter were up 14.5% compared to June 30, 2007. Although our second quarter growth in loans and leases was less than our growth in the first quarter of this year, in the two quarters combined our loans and leases grew approximately 7.5% or roughly 15% annualized. This is in line with our 2008 guidance for loan and lease growth to range from the low teens to the high teens in percentage terms for the full year of 2008 and we reaffirm that guidance. With the slowdown in economic conditions nationally and operating as we are in a much more challenging portion of the credit cycle, one might be surprised that we are continuing to project loan and lease growth from a low teens to the high teens in percentage terms this year. Of course, the economic and credit cycle conditions are making it harder in some respects to find good quality credit. On the other hand, these conditions have led many competitors to withdraw from the market because of liquidity, asset quality or other problems. There are still many good quality loan opportunities and the recent changes in the competitive landscape have given us opportunities to originate many loans with significantly better credit terms and loan pricing than in recent years. For example, the largest new credit we booked in the second quarter was a transaction in which our first mortgage loan was approximately 27% but the total capital structure of the transaction and the customer contributed true cash equity in excess of 73% for the total capital structure. While this is an extreme example of a favorable deal structure, there are many opportunities that seem compelling to us, even in a difficult operating environment. After several years of having to compete against very aggressive credit terms and loan pricing, these signs of significantly improved credit terms and loan pricing are very welcome and if they continue should have favorable implications for future loan growth, asset quality, and interest margin. We’ve already mentioned that our earning assets got a boost in both the first and second quarters from the unexpected and likely temporary addition of tax-exempt investment securities with unusually favorable spreads. These securities provided a nice boost to first quarter net interest income and net interest margin. In our April conference call, I stated that we knew that a portion, and perhaps a majority of these securities would be called or paid off during the second quarter. Many of these securities were in fact called or paid off in the second quarter but we also found other securities of comparable quality in which to invest in the second quarter. As a result, our volume of investments in these types of securities actually increased somewhat further in April and May from the March 31 level before the volume and frequencies, calls and pay-offs began to reduce our outstanding balances through the month of June. As of March 31, 2008, we had approximately $290 million in what we considered to be temporary investments in such municipal securities, and as of June 30, 2008, our total investment in these securities was down to approximately $170 million. The speed at which these securities are being called or paid off suggests to us that most of the remaining securities will be gone by the end of the third quarter. Additionally, the yields on such securities are declining almost every week, so the benefit to our income will continue to diminish. For example, we estimate that the yield on these securities was about 17 basis points accretive to our net interest margin in April, but we estimate that the yields on these securities were actually dilutive to our net interest margin by one basis point in May and six basis points in June. Even though we expect these additional investments will decline in volume and yield during the third quarter, we believe they will still be moderately accretive to our third quarter net interest income in dollar terms, although moderately dilutive to our third quarter net interest margin in percentage terms. If this occurs as expected, our securities portfolio will probably shrink from $768 million at June 30 back toward the $600 million level over the course of the third quarter. Let me shift quickly to non-interest income. We’ve provided a great deal of detail on our non-interest income numbers in the press release, so I’m not going to repeat any of those numbers. Let me just give you a little color. First, income from deposit account service charges in the second quarter was below our expectations and guidance, with most of the deviation attributable to lower income from NSF and ODCs. While it is impossible to prove, we believe this could be the result of the economic stimulus checks received by most taxpayers. Because of our uncertainty as to whether and how this one-time event could affect service charge income in the coming months, we’re not providing guidance on this particular income category at this time. Mortgage lending income for the second quarter reflected the effects of higher mortgage rates and generally weak housing market conditions. While mortgage lending income in the second quarter was down slightly from the first quarter results, there were actually more changes in the mortgage activity than the numbers suggest on their face. Specifically, higher mortgage rates contributed to a reduction in loans for refinancing from $25 million in the first quarter to $16 million in the second quarter. On the other hand, mortgages for home purchases increased from $15 million in the first quarter to $21 million in the second quarter. We view this increase in home purchase financing as somewhat positive. Our trust staff continued to add new accounts and grow existing relationships during the first half of 2008. This resulted in solid growth in trust income in both the first and second quarters. In fact, our trust income growth in both quarters this year has exceeded our guidance, which was for trust income growth in 2008 to range from the low teens to the mid-teens in percentage terms. Given the uncertainty surrounding the equity markets, we’re not changing our guidance for trust income at this time, even in light of the very favorable results achieved so far this year. Non-interest expense increased 13.2% in the second quarter of 2008 compared to the second quarter of last year. This was higher than our guidance, which suggested that this category of expense will grow in the mid- to high-single-digits in 2008. A number of factors contributed to this increase but even with the 13.2% increase in the past quarter, our revenue growth was even better, giving us an efficiency ratio of 42.1% for the second quarter. As we noted in the press release, this is the best efficiency ratio we’ve achieved in any quarter since going public in 1997. Based on our second quarter results, we now expect non-interest expense for the full year of 2008 to be somewhere between 10% and 13% above non-interest expense for the full year of 2007. Another of our key goals for 2008 is to maintain good asset quality. Economic conditions nationally have weakened in recent quarters, making our traditional strong focus on credit quality even more important. Most of our markets in Arkansas, Texas, and the Carolinas generally appear to be less severely impacted by this economic weakness than many other markets. The notable exception is Northwest Arkansas, which is still wrestling with a significant over-supply of residential and commercial lots and homes in certain price ranges and sub-markets. We’ve already worked through a number of challenges in that market over the past 18 months or so, and we expect we will have to work through some more challenges there until the excess supply is ultimately absorbed and liquidity improves in that market. While our ratios of non-performing loans and leases, non-performing assets, past due loans and leases, and net charge-offs have been higher in the first two quarters of 2008 than during the very benign credit environment of recent years, such ratios are not outside the range that we have experienced in the past. Furthermore, our various asset quality ratios at June 30 once again compared favorably with results recently reported for the industry as a whole. In the coming quarters, we may see our ratios of non-performing loans and leases, non-performing assets, and past due loans and leases increase somewhat further. After all, we are clearly in the negative part of the credit cycle and the headlines suggest that the economy is not doing very well. But we think such increases, if they do occur, will not seriously affect our ability to generate an acceptable level of net income. In support of that statement, let me point out that the increases in our various asset quality ratios net charge-off and provision expense during the first two quarters of 2008 have not prevented us from posting excellent earnings, including record earnings in the quarter just ended. While we expect to continue to generate an acceptable level of net income and possibly record net income in the coming quarters, we realize that some investors may be concerned because we are a real estate lender with many construction and development loans and commercial real estate loans. That’s been one of our primary businesses for many years and we think we do it very, very well. In fact, in every one of the past seven years, our combined net charge-off ratio on construction and development loans and commercial real estate loans has been less than our combined net charge-off ratio on consumer loans, commercial and industrial loans, and one to four family residential loans. More specifically, over that seven years, our annual average charge-off ratio for construction and development loans and commercial real estate loans combined has been seven basis points per annum, while our average annual net charge-off ratio for consumer loans, commercial and industrial loans and one to four family residential loans has been about five times that at 34 basis points. We realize that economic conditions are different today than they have been over the past seven years and our combined net charge-off ratios for construction and development and commercial real estate loans will likely be much higher than seven basis points for a while. But we also feel that our combined losses from these lines of business have been and will continue to be relatively favorable compared to industry results because of the significant equity and collateral in most of these transactions. Even when many competitors became very aggressive in recent years on credit underwriting and deal structure for construction and development loans and commercial real estate loans, we maintained a strong commitment to sound loan and lease underwriting, thorough documentation, effective servicing and diligent collection efforts. We think that puts us in a relatively good position in this credit cycle and beyond. Our most recent guidance predicted that our net charge-off ratio for the full year of 2008 will be in a mid-20s to low-30s basis point range. Our second quarter annualized net charge-off ratio was 33 basis points, at the top end of that guidance range, although it was down slightly from the first quarter’s 38 basis point annualized net charge-off ratio. In light of our second quarter results, it now seems likely that our net charge-off ratio for the full year of 2008 will be toward the top end of such guidance range. During the quarter just ended, we made a $4 million provision to our allowance for loan and lease losses. With net charge-offs of $1.6 million for the quarter, this resulted in an increase in our allowance for loan and lease losses to $23.4 million, or 1.16% of total loans and leases at June 30, 2008, compared to $21.1 million or 1.06% of total loans and leases at March 31, 2008. This growth and our allowance for loan and lease losses increased our unallocated allowance at quarter end to approximately 28% of our total allowance, which exceeds our policy guidelines which call for our unallocated allowance to typically range from 15% to 25% of our total allowance. We believe this increase in our unallocated allowance is an appropriate response to the uncertainty regarding economic conditions in general and market conditions in Northwest Arkansas in particular. Let me give you a few additional comments regarding how we structure and account for loans. First, we have been very aggressive in promptly conducting thorough impairment analyses on non-accrual loans and leases and regularly reevaluating the carrying values of foreclosed and repossessed assets. Our general practice has been to quickly write-off any identified loss exposure from non-performing loans and leases and foreclosed and repossessed assets. Additionally, we feel that we have little additional loss exposure from our existing non-accrual loans and leases and foreclosed and repossessed assets as of June 30. Second, we have been very aggressive in placing loans on non-accrual status when we believe doubt exists regarding the ultimate collection of payments. Because of this conservative accounting practice, at June 30 we had some loans on non-accrual status which were still making payments, including some loans which were not past due. Third, the industry’s use of interest reserves in connection with construction and development loans has recently been a subject much discussed. Our impression is that practices vary widely within the industry and we view our use of interest reserves as very conservative. In the majority of our construction and development loans in dollar amount, including almost all of our larger commercial projects, the customer in effect prepays the construction and development period interest as part of their original equity contribution. Let me give you an example of how we do this from a very well structured loan we approved last week. In that case, we were loaning 50% of the costs to acquire a track of land and we are requiring the customer the put in 50% of the costs plus estimated interest for three years. All of the customers’ equity, including the estimated interest, will be paid in at closing so our loan will initially be about 40% of the cost of acquiring the property, and our loan will increase to approximately 50% of that cost as the interest is paid over time. Now, one might characterize this loan as containing interest reserve but in our view, the interest has been prepaid by the customer. In a lesser volume of our construction and development loans where we do not reserve for interest in this manner, the customer typically pays interest out of pocket over the course of the loan with either monthly, quarterly, or semi-annual payments. Finally, construction and development loans in which the bank advances the interest comprise just a small part of our construction and development portfolio. Because of our generally conservative practices in this regard, we do not expect to encounter many situations where a loan becomes a problem because interest reserves are exhausted. Fourth, our corporate policy is to not capitalize interest on loans or extend payment unless the interest is paid. Occasional exceptions are made, typically on small consumer loans or, in the case of larger credits where additional collateral is typically obtained in consideration of capitalizing interest. Thus we believe our practices for capitalization of interest are very conservative and constructive in that our prospects for collection are typically improved as a result of such transactions. As I’ve already said, exceptions to this policy are rare, specifically in the 12 months ended June 30, 2008, there were only 17 instances of capitalization of interest or extensions of payments without collection of interest which resulted in a total of $261,000 of interest being capitalized or deferred. As you can see, this is not a significant amount over a 12-month period. In summary, we believe that our practices for accounting [inaudible] structuring loans are very sound and conservative. Let me close by repeating that our paramount goal for 2008 was to once again return to a record quarterly earnings pace. Having accomplished that in the second quarter, we now want to improve on that level of earnings. We acknowledge that we are operating in the most challenging environment in years but with our good growth in earning assets and the improvement in our net interest margins so far this year, we think we are in a reasonable position to achieve modestly improved earnings in the coming quarters. Now, that concludes my prepared remarks. At this time, we’ll entertain questions. Let me ask our operator, Shandra, to once again remind our listeners how to queue in for questions. Shandra.

[Operator:]

(Operator Instructions) Your first question comes from the line of Charles Davidson. Mr. Davidson’s question has been withdrawn. Okay, your next question comes from the line of Matt Olney.

[Matt Olney:]

Good morning, George and congratulations on very impressive results. George, your delinquent loans were down from last quarter and your total MPAs were almost flat, so how do you reconcile adding significantly to these loan loss provision wins? The loan growth was a little bit slower than we’ve seen historically and does this mean there were some credit downgrades during the quarter but you’re still performing? How do you reconcile that?

[George Gleason:]

Matt, there are credit downgrades every quarter among loans that are still performing and there are loans that were in problem status that moved into OREO and repo and assets that moved out of OREO and repo, you know, off our books. For example, in June we sold almost $1.5 million of the real estate in repossessed assets in the month of June. So there is a constant flow there. As I mentioned in my prepared remarks, the increase in the reserve was primarily in the unallocated category, which means that to the extent that increase was in the unallocated, it’s not the result of any downgrades or so forth. But it just reflects a conservative view of economic conditions in general and market conditions in Northwest Arkansas in particular. So we’re just -- we’re putting a little more in the unallocated because we read the Wall Street Journal every day. I told someone the other day that I was going to see if there was foreign language version of the Wall Street Journal so I could still get it but not have to read the headlines, since I don’t speak any foreign languages.

[Matt Olney:]

In your prepared remarks, you mentioned that the policy, the internal policy for the allowance of unallocated it 15% to 25%. Now, is that an internal policy or is that a policy that regulators and auditors have agreed that it is necessary?

[George Gleason:]

It is an internal policy. Our auditors and regulators have concurred that it is acceptable. I don’t think any one of them has ever said it was necessary and there’s a sense the Suntrust reserve issue came about a number of years ago. You know, there’s been a strong bias against unallocated reserves and we have just always maintained a conservative posture in that we’ve said that we think there’s always some risk in any portfolio that cannot be fully and accurately identified at any point in time, and that there are various and sundry factors that in our view justify keeping some level of unallocated allowance. And you know, in the days when unallocated allowances were very unpopular, and they may still be in the regulatory and accounting mindset, you know, we got strong push-back but gained everyone’s concurrence that that was okay as long as we documented what those intangible sort of general reasons were while we had an unallocated allowance. My guess is that in the environment today, we probably will get less push-back for having an unallocated allowance and frankly, again for headline reasons, what you are reading about the economy, we just felt it was time, a good time to push that up a notch further and have a little more cushion in that unallocated for the future.

[Matt Olney:]

I think you specifically addressed the Northwest Arkansas market for that unallocated portion there, and I think you briefly mentioned in your prepared remarks, a kind of an update in that market. But since last quarter, we’ve had two banks written up by the OCC in that market, as well as a bank failure. Can you give us an update as to what you are seeing in that market, remind us of your exposure, and how those credits are performing right now?

[George Gleason:]

I can. We’ve said really since the fourth quarter of 2006 when we put a number of smaller construction loans to some of our small builders that had one to five type homes, one to six type homes with us, and you know, small groups of lots from one to five or six lots. We put a number of those on non-accrual status in the fourth quarter of 2006 and we liquidated probably three-fourths of that inventory, of course, in the interim period so in almost every quarter we’ve added additional non-accrual assets or OREO or repo items in that market, so it’s been a constant little flow of stuff working through from that market. It’s a very interesting market and I spent the July 4th weekend up there. I went up on July 4th and Saturday and Sunday, the 5th and 6th of July, my market President, his right-hand lieutenant and one of his senior lenders spent both those days with me and we drove and looked at every piece of real estate collateral we have on any loan. I think new used $900,000 as a cut-off in that market. I had lunch Sunday with one of our good customers in that market. We looked at a lot of projects that are competitors have and I came away from that meeting feeling reasonably good about where we are and certainly feeling like our position in that market is relatively superior to what a lot of our competitors have done. It is a market that is stressed, is challenged. It has been for 18 months and the failure of A&B Financial and the regulatory sanctions that have been apparently placed on a couple of other banks because of their exposure in that market I think has had a chilling effect, and hence the comment in my prepared remarks about liquidity being a challenge in that market. And I think there are good transactions that actually can be done in that market even today, but it’s difficult to get something good done because of liquidity concerns and of course, that liquidity issue is making it harder to work out of problems when one encounters problems up there. So it’s a -- it continues to be a stressed market. I don’t think our view of that has changed significantly. The A&B failure certainly has caused some collateral damage, a ripple effect. And I’ll give you an example of how that works so our listeners who may not have been around FDIC receiverships in the past can understand. We had one customer that’s a common customer with A&B and he had several construction loans at A&B and about three to four months before they failed, they ceased funding on those loans. He was not in fault or anything; they just refused to fund and I don’t know whether that was of the direction of the FDIC or they had no longer had liquidity to fund or whatever. So to complete these projects, this customer who had several million dollars of cash marketable securities used his own personal cash and marketable securities to complete those projects. And then, as they became completed, about the same time that A&B was taken over and he started selling the homes that were built as part of these projects, it was a residential development. He started selling off the homes and of course, the bank had only funded part of their obligations but had blanket mortgages on all of them, so the FDIC took 100% of his net proceeds from each sale. So our customer has put in all of his cash to finish the projects, the FDIC’s put in only a fraction but they are capturing 100% of the net proceeds as he sells it off. So it has created a significantly liquidity issue for that customer. And one of the reasons I wanted to go up there was to meet with that customer and understand how we can work with him to help him get through that situation and fortunately, he has millions of dollars of unencumbered income producing property, so he has some flexibility to work through that situation. But it’s created some significant challenges for him. And those sort of challenges on that market I think just make it more difficult to do business up there. But the flipside of that is as I was traveling with my manager, he was sharing with me that we’ve picked up about 2,000 net new deposit customers so far this year in that market and I didn’t talk about deposits in my prepared remarks but our deposit growth in Northwest Arkansas and the Texas markets has been excellent so far this year and we feel that’s a real strong point. It doesn’t get much press in the current environment but our deposit growth on the retail side has been very good so far this year.

[Matt Olney:]

All right, thank you, George.

[Operator:]

Your next question comes from the line of Peyton Green.

[Peyton Green:]

Good morning, George. You moved into the question I was going to ask, but I mean essentially, your non-CD interest bearing deposits and your non-interest bearing both saw pretty significant turns up and lifts compared to the past four or five, or even maybe six quarters. And I was just wondering if you could comment. You also seemed to have achieved the growth with the reduction in your cost of funds for those categories.

[George Gleason:]

Yeah, we’re very pleased about the result that Dan [Rolad] and Tyler Vance and Susan Blair, who oversee our deposit side and our retail guys are doing out there on the deposit front. And that is a very important story and it’s part of and again, because everybody wants to talk about asset quality in this environment, and I certainly understand that. The deposit story is actually a very positive thing that is not getting too much attention but you know, when we were expanding in Texas initially and primarily had lending functions there over the last five years and only in the last year or so have gotten deposits, we used some brokered deposits to fund that growth and deposit competition was so intense in a number of our Arkansas markets for a while that it was actually cheaper to use brokered funds than local funds to fund our normal deposit growth and so forth. But we’re actually rolling off a lot of those brokered funds now because competitive conditions on the deposit side, while still intense, are such that we can get local funds now at a decent increment below the cost of wholesale funds and you know, we’ve been pushing that this year and are very pleased with the results so far. So I think that helps us both on the quality of our liability structure. You know, we don’t mind using brokered funds where it’s cheaper to do so but we would always rather have local deposits because of cross-selling opportunities. Now that we can get those at an equal or cheaper price on the margin, that’s favorable and we are seeing some growth in our non-CD deposits, and that’s helpful too. So we’re reasonably pleased about all that.

[Peyton Green:]

Okay, and then to what degree do you have Fannie or Freddie preferreds in the investment portfolio?

[George Gleason:]

I don’t think we have any Fannie or Freddie preferreds. I think we have one bond and it’s about a $3 million Fannie May bond that matures in February of next year, I believe, so it’s fairly short-term. And then of course our real exposure to Fannie and Freddie is we have a CMO portfolio that’s Fannie and Freddie guaranteed. But the underlying product in that portfolio, of course, is A paper mortgages. These are all prime mortgages. And even better is the whole portfolio is 2005 and earlier originations, so while I guess you could say in some sort of disaster scenario, which I don’t think is probably a realistic scenario that Fannie or Freddie are not there but in a disaster scenario, our CMO portfolio has seasoned underlying A paper backing those CMOs that was originated in the 2005 and earlier period before some of the more aggressive underwriting standards were applied. So in a non-Fannie, non-Freddie existent scenario, again which I think is extremely unlikely, our CMO portfolio is backed by good assets from a time when mortgages were underwritten pretty well and they are all A paper. There’s no sub-prime stuff in it, so we would expect that CMO portfolio even if it wasn’t guaranteed to amortize out in a very orderly manner.

[Peyton Green:]

Okay, great. And then last question -- to what degree do you think there are some pockets of CDs that you can re-price down again in the second half of ’08 versus what you did in the second quarter?

[George Gleason:]

I think there’s quite a bit more room there and that’s why we’ve upgraded our net interest margin guidance to 370 or higher for the remainder of the year. And as I mentioned in my prepared remarks, the -- what we’re calling temporary or considering to be temporary investment in tax-exempt securities, those will actually be dilutive to our margin this quarter, so the 370 takes into account that dilution. If you factored those out or if they are out, you know, we are actually thinking our margin is somewhat higher than that.

[Peyton Green:]

Okay, great. Thank you very much.

[Operator:]

Your next question comes from the line of Dave Bishop.

[David Bishop:]

I could forward you my copy of the Wall Street Journal in Sanskrit, if you’d like that.

[George Gleason:]

Please do so. Thank you.

[David Bishop:]

Yeah, make things a little bit easier here. A question for you in terms of what you are seeing out there in the various markets. I think you talked about Northwest Arkansas but maybe talk about some of the competitive dynamics in Texas and for the Dallas sub-markets there. Obviously that’s a market that everyone wants to bank here. Are things getting unfrothy there at all or are terms and conditions even improving there too as well?

[George Gleason:]

You know, I think the Dallas market is very healthy and the general health of that market is a function of job creation. And last year, the 12 county metro Dallas MSA added 88,000 net new jobs. That was up from 77,000 or 70-something thousand the year before but down from 90-something thousand a year before that. And I understand, someone told me and I don’t know if this is right or not but someone told me it was the highest job creation of any MSA in the country last year. And you know, it’s just a -- it’s a good market to be in. It’s a relatively low cost of living there compared to a lot of other major metropolitan markets. The quality of life is good there. Regulatory governmental burden on business is fairly reasonable, particularly compared to places such as California. So there are a lot of companies that are moving to Texas and the metro Dallas area in particular, with either national or regional headquarters or other major operations because it’s such a business friendly, easy-to-live-in sort of place. There’s not been a ton of speculation there. House price appreciation has been pretty moderate, so the moderate price appreciation has not led to significant amounts of over-building. The lack of speculation is not -- has created an environment where you do not have a lot of speculative real estate positions that have to be unwound and absorbed into the market. So you know, it’s a pretty -- it’s a pretty healthy market compared to the -- probably the majority of other markets in the country. Now, that doesn’t mean that there is not a sub-division here or a sub-division there that either wasn’t well-conceived or got over-built or got ahead of itself but the over supply dynamics there are pretty benign compared to most places. And I would say that’s somewhat true also of Charlotte. It’s been a pretty healthy market as well. So we are -- as I’ve said a number of times, we are just very fortunate to be in pretty good markets, or really good markets in the case of Dallas, Charlotte, and metro Little Rock and you know, if all of our markets were like Northwest Arkansas or we were in one of the severely impacted areas in Florida or California, it would be a tough road to go.

[David Bishop:]

I know we’ve gotten questions on this before, maybe give us an update on the California credits, how those guys -- how their credits are holding in.

[George Gleason:]

Well, you say that like I have a lot of California credits and we don’t have much out there. We do have a large residential development loan that’s just over the Nevada border in California, really strong guarantors. Our loan is about 55% of the cost basis in the project. The customers I think have 45, or maybe even a little more than that equity in the deal. And that is a unique product because of the fact that it’s in a location where, because of the environmentalist limitations on development in that valley, there can only be so many homes developed, and sales have actually been very good out there in the second quarter and I can’t quote you the numbers but I was getting a report from our -- that loan is one out of our real estate specialties group in Dallas and they were giving me a report on that the other day, but sales have been above projection out there and doing very well. So that project seems to be going very well and we have a trio of guarantors on that that have substantial eight digit cash and marketable securities balances on their balance sheets, so in addition to the large amount of cash they put into projects, so that’s going very well. The only other California asset I think we have is we’ve got a real estate developer, owner out of our Fort Smith, Arkansas market that builds small strip centers on out-parcels in front of super targets and Wal-Mart supercenters and that sort of thing and he has a project that we followed him out there and did and I think it’s doing fine, as far as I know. He’s a very solid customer of ours and we have those strip centers with him in a number of different geographic markets because that’s what he does, is travel around the country and he has a little collection of tenants, Dollar Tree and that sort of tenant that he puts in those buildings and does real well with them.

[David Bishop:]

One housekeeping adjustment; it looks like there was a adverse impact from the fair market value adjustments on securities. I don’t know if you have that dollar amount off-hand.

[George Gleason:]

The negative mark for the quarter was $9.1 million that brought our cumulative mark-to-market adjustment to a negative $8.0 million. That’s the equity side of it, yeah. That’s the tax affected equity side of it and you know, I know that makes our capital account move around but we are only marking the market one piece of our balance sheet and it’s the securities portfolio and I think everybody appreciates that in the market conditions that we’ve been in the last several quarters, that these mark-to-market adjustments are bouncing around all over the place. We don’t plan on selling any of those securities. Our intent is to hold them all to maturity and over the course of time, our view is and belief is that that mark-to-market adjustment always works back towards zero, so when it’s up, you always know that’s really not capital you have and when it’s down, you think that’s always capital. That’s just a paper loss; it will come back over time. So we don’t ascribe a great deal of significance to it. In fact, like the regulators when we calculate our capital adequacy and our capital goals here, we exclude the mark-to-market adjustment and I think the regulators do the same thing for their determination of capital adequacy.

[David Bishop:]

Thanks, George.

[Operator:]

Your next question comes from the line of Andy Stapp.

[Andy Stapp:]

Good morning. Great quarter in a difficult environment. Would you happen to have what the percentage compensation of construction development loans to total loans at the end of June?

[George Gleason:]

Yeah, it actually -- construction and development and land development loans to total loans actually went down and that wasn’t anything intentional. It just shifted in the portfolio but it went from 39.5% of the portfolio at March 31 to 35.3% of the portfolio at June 30, so about a $73 million drop in construction and development loans, almost 10% of that component dropped in that three months. And those things tend to -- there tends to be a considerable amount of velocity in those loans because those things get built and lots get sold, houses get sold, development occurs and obviously our homebuilders read the same headlines as everybody else and developers read the same headlines as everybody else and there’s not as much construction and development projects being started now, either on the residential or the commercial side, it seems to us, as there were. Now, we did have an increase in our non-core, non-residential but it went from 22.4% to 25.3%, so that actually went up about $65 million on the commercial real estate side and you know, that reflects either projects that were in construction that became stabilized and completed and moved to the CRE book, or new loans that we originated in the commercial real estate sector that are leased income-producing properties.

[Andy Stapp:]

Okay. And the mix of your construction development loans, would there be any significant deviation from what you reported in your Q?

[George Gleason:]

Andy, I have not had time. You know, we’re out here pretty early with our release and conference call and I have not had time to go through the breakdowns of that, so I can’t answer that.

[Andy Stapp:]

Okay. You noted that you are getting a lot of equity positions in your construction development loans. Would you have an order of magnitude estimate of what the loan-to-value ratios are on a blended basis for your construction development portfolio?

[George Gleason:]

Andy, I don’t have that and honestly, I don’t know that on an aggregate portfolio basis, we’ve got the data to even produce that information. You know, we look at it on an loan-by-loan basis and we have a -- I think a pretty high standard for equity contributions to our projects and we look at appraisal equity but we look even much more significantly at cost equity. Most of our deals have sizing parameters that loan won’t exceed X dollars or the loan won’t exceed X percent of cost or X percent of value. And a lot of our loans, not all of them but a lot of them, are a minimum debt service coverage requirement. So we’ll have two or three or four sizing parameters for a particular loan and the loan is limited to the lesser of whatever those numbers are. And we do have a strong desire for significant cash equity and I mentioned two deals here and one of them, if you counted interest reserves, had almost 60% equity and that, had 50% equity. The other deal was I think a 73% equity component. Those are unusually good transactions but most of our larger transactions would have 20% to 30% all the way down into the 40s as an equity contribution to them. There will be some occasionally that are higher and some occasionally that are lower but kind of 20% to into the 40%-something equity range is where most of our larger transactions are done. And when I say that, I’m not talking appraisal; I’m talking cash equity.

[Andy Stapp:]

Okay. You talked earlier about your unallocated reserve going up. Do you see that continuing to go up or do you think you are sort of capped out where your accounting firm would let you do it?

[George Gleason:]

I’ve not had any discussion with the accountants about it and I’m not aware that our finance guys have had any discussion with the accountants about it. And I think whether that goes up or not is going to depend on how economic conditions evolve and what happens in coming quarters, so we are -- our approach on allowance for loan and lease loss is always the same, and that is we want to try to do the right thing and keep an adequate an appropriate reserve based on economic conditions and portfolio conditions at that time. We want to be very conservative in how we value our problem assets and very realistic in how we look at it. So if the right thing, when all factors are considered is to increase that further, then that’s what we are going to do. If the right thing is to dial that back in the future, then that’s what we are going to try to do. And if you can tell me precisely where the economy is going to go, I can probably give you a pretty good educated guess of where that reserve is going to go but as I mentioned, one of the reasons we dialed it up a notch is we think just -- I mean, you’re reading all the same headlines we are. There just seems to be a lot of uncertainty and nervousness out there in the world and that makes us uncertain and nervous, so we dialed it up a bit to reflect that.

[Andy Stapp:]

Okay. You mentioned that the majority of your construction development loans don’t have true interest reserves. What percent -- I guess some order of magnitude percentage of loans that construction development loans that do have true interest reserves?

[George Gleason:]

And by true interest reserves, you’re talking about where the bank is actually funding those reserves as opposed to the customer put in equity that included the reserves up front? Andy, I don’t know the percentage but it is a very small percentage. I mean, I don’t know that number but it’s -- in the order of magnitude and dollar terms of our portfolio, the majority of, in dollar terms of our loans, have the reserves funded as I’ve described in my first example where the customers equity included whatever equity we though was appropriate for them to put in, plus a component for reserves, and that was paid up front. That’s the majority of them. The situation where the customer just writes a check every month and pays the interest as the loan goes forward is the next largest component, and situations where we are actually funding the cost of the project plus a reserve is very, very rare.

[Andy Stapp:]

Okay, that’s what I needed. And you mentioned you had a common customer with A&B, and that customer’s liquidity being zapped away, does that present any risk to Bank of the Ozarks?

[George Gleason:]

Well, at this point I’m not sure whether it does or not. Because of that, that customer’s credit moved from a -- what we call a moderate risk category to a watch risk category in the second quarter, just simply because that is an issue and all that credit that was with A&B Financial will ultimately be owned by somebody else and you don’t know whether that’s going to be somebody else that’s going to try to liquidate all that credit quickly or somebody else that’s a portfolio sort of buyer that would actually want to work with the customer in the relationship. It’s created some uncertainty, so we downgraded that customer’s relationship to watch status, which in our system is a 5 rating in the -- a 5A rating in the quarter because of that. But as I also mentioned, that customer has millions of dollars of unencumbered real estate that is income producing that he’s got a pretty substantial monthly free cash flow off of. So our thought is that probably all gets worked out somewhat. But at this point it’s a source of concern enough to us that we did downgrade it to a watch.

[Andy Stapp:]

Have the regulators begun to sell the assets of A&B? And if so, are they just sort of dumping in the market at fire sale prices?

[George Gleason:]

Well, I don’t know the answer to that, and typically in past resolutions, and we’ve been a buyer in past resolutions of pools of sold assets. You know, they will typically market those assets on a bid basis and they will divide the loans into what they think are reasonably homogenous or related pools of assets and put them out there and let people submit sealed bids on them and so forth. I would assume, although I don’t really know, I would assume they will do that in this case. So you have all kinds of different buyers. You have -- if we were a buyer, we would be looking at those assets for relationship purposes and so forth. My guess is that those pools are -- contain some pretty challenging assets and I say that for two reasons; we looked at the franchise and did some samplings on some of the pools and found them to be pretty adverse, and our guys there of course, or the FDIC has sent a letter to all the customers apparently that have loans there telling them they need to move their loans because the FDIC I would assume rather get paid off at par and have them go away than have to auction them and take a discount on the assets. So we’ve had a steady stream of opportunities to look at credits that are coming out of that institution and my guys are telling me that their approval ratings on those credits is running somewhere between 5% and 10%, which means our decline rating is running north of 90% on those credits, so there’s a lot of pretty tough stuff in that portfolio, in our estimation.

[Andy Stapp:]

Yeah, not surprising.

[George Gleason:]

No, it’s not.

[Andy Stapp:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Charlie Ernst.

[Charlie Ernst:]

I’ve been a little bit distracted during the call so I’m just going to defer and go read the transcript, but thanks a lot -- good quarter.

[George Gleason:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Joe [Senich].

[Joe Senich:]

George, you referenced earlier the situation with the regulators taking action against some smaller banks in Arkansas over the past few months. You know, if things continue to get worse for the competition here, I know you haven’t historically been an acquirer -- would you be interested in taking on a bank in a distressed situation, perhaps with regulatory assistance, if it comes to that? Or maybe not even a distressed type situation. Maybe just simply an acquisition of a good bank at an attractive price. And then outside of Arkansas, with valuations where they, would you maybe consider a Carolina deal or a deal in Texas? Specifically in Carolina, a deal that maybe gets you that charter so you can branch into those markets? What are your thoughts there?

[George Gleason:]

That’s a very good question, Joe and let me answer that in three tiers. Number one, I would tell you that our paramount focus every day is to come into work, run our franchise very well, and add 50 to 100 customers that day. And that organic growth and internal focus has served us very well and that will continue to be our paramount focus. We have always said that even though our growth in de novo branching strategy and organic strategy is our principal mode of doing business, that we would love to augment that growth with acquisitions that made sense, and certainly an acquisition that let us branch in the Carolinas, or would be one type of acquisition that would make sense, because we’ve got a pretty good little lending operation over there but it’s a loan only operation, as you know. So something like that would make sense and a fill-in acquisition in an existing market would make sense. And these -- this economic environment may provide some opportunities to do that. We’ll look at those deals, we’ll run numbers on them and if they make good sense for shareholders, we have the capability and the confidence to pursue those transactions. If they don’t make good sense for shareholders, then we’re not even going to go close to them. You know, we’re going to look hard at the numbers and be critical in our assumptions and do things that will make sense by creating real value, real economic value for our existing shareholders. And then the third question is would we look at a failed bank type of transactions or FDIC assisted type transactions -- absolutely. Again, if they made sense for shareholders. We looked at the A&B transaction and it didn’t make sense for us. When you melted that franchise down, there was a very small deposit base and with as many competitors as there are in Northwest Arkansas, you know chunks of it are going to get chipped off. And their branch footprint -- I don’t remember how many branches they had but I think it was nine in Northwest Arkansas, and we’ve got 10 up there and eight of their nine were within a couple of blocks of eight of our 10. So their branch network added nothing. There were less than a dozen people probably that we would’ve wanted and one branch that they had that would have been a decent addition to our franchise. So there weren’t human resources there in any volume; there weren’t facilities there in any volume and with as many competitors as there are in the market, we knew that the deposit base was going to be savagely fought over and we’ve already picked up a lot of customers from there and had we bought it, somebody else would be picking up a lot of customers from there. So that deal just -- the cost and complexity of managing this $2 billion institution for the FDIC for 90 or 180 days in our view didn’t make sense. Now, for the guys in Iberia who weren’t in the market and the branch footprint is an excellent footprint -- it’s almost our footprint up there -- that made a lot of sense for the guys from Iberia. It didn’t make any sense for us. But we’ll look at deals we think are helpful and be pretty critical about it.

[Joe Senich:]

George, would it be safe to say, specifically in the Carolinas, with valuations where they are, I’m of the mindset that we might be here for quite a while in terms of for the industry. Is it safe to say that acquisition, acquiring into Carolina is probably the more likely bet than doing something like you try to do in Tulsa, or kind of with the reciprocal branching?

[George Gleason:]

Yes, I would say the only way at this point that we would contemplate being in North Carolina with a full service banking operation is if we acquired something. We have no other plans to do that and I don’t in any way mean to imply or insult my guys in Carolina, because they are doing just a wonderful job for me and we are so pleased to be there and they do a great job in the Carolinas. But our Texas operations are having such favorable results and Texas is so big compared to Arkansas that the opportunities there seem almost endless to us. So we realized that if we just focus on our Texas opportunities for the next decade that that is very significant. I’ll give you a couple of data points on that. Our loans from our Texas office has increased. At March 31, they were 22% of our total loan portfolio and at June 30, they had grown about 1.75% roughly and were 22.8% of our total loans. And our deposit growth in Texas, and I alluded to this earlier, went from 8.5% of our deposits at March 31 to 11.3% of our deposits at June 30. And we’ve opened one more office down there in February in Louisville, Texas and that office is off to a tremendous start, as are our Frisco offices. So we view our future opportunities for expansion and growth predominantly as Texas.

[Joe Senich:]

Great, and then just separately from that, George, when was your last exam from a regulatory standpoint and when is your next one?

[George Gleason:]

Our last exam was just about a year ago and we are due for an exam -- I think it starts August 11. In fact, I had a pre-exam meeting yesterday with the senior state bank department examiner and the senior -- or not the senior, but a senior FDIC person who will not be the EIC for the FDIC on the exam but one of their senior guys who just came with the state bank department individual who will be the examiner in charge on the exam. So we have an excellent relationship with our examiners. It is a very positive, proactive relationship with them and they understand what we are doing, we understand what they expect us to do and every day we run our bank, we run it with the mindset that we do has got to meet their standards and their muster and they know that we are responsive to their comments and suggestions. I don’t anticipate that exam having a significant impact on us at all because I think we are very much on the same wavelength with those guys.

[Joe Senich:]

Okay, and then sorry to hop around like this on you, but last question -- what was the dollar amount of that exposure that you downgraded to the 5, the watch list credit that you share with A&B?

[George Gleason:]

I don’t -- there are a number of credits there, Joe, that are involved and some are related with other parties so the -- I think the credit we downgraded was $8 million. It’s a -- there are two individuals on the credit and one of them is -- it was $9.2 million, and there are two individuals on that credit. One of them is a shared customer with A&B and the other is not.

[Joe Senich:]

Okay. All right, thanks, George.

[Operator:]

Your next question comes from the line of Brian Martin.

[Brian Martin:]

Good morning, George. I’ll keep it short here, since it’s going long here today -- the expenses in the quarter, you talked about those getting increased a little bit relative to your expectations last quarter. I’m just wondering what was driving that as you look forward here.

[George Gleason:]

Brian, as I said in the call, it’s a lot of different things and if there had been one or two specific items, we would have highlighted them. It really was kind of across the board. I mean, it’s everything from utilities and maintenance. We -- you know, obviously we spent more money on loan collection and repo expense. There was a little higher line item in there for valuation adjustments on foreclosed and repossessed assets held in there. Because of the increased volume in the securities side, we added a person that wasn’t budgeted there temporarily to help with that workflow because of the increased volume and the non-performing assets and so forth, OREO, repo, we added another person to work in our administrative processes there. So there’s just various and sundry additions of things across the board. There’s not anything in particular that really did it, but I think it was all money that was well spent. I don’t think we wasted any money there.

[Brian Martin:]

Okay. How about one housekeeping; the risk based capital ratio at quarter end, do you have that?

[George Gleason:]

No. I’m sorry, we’re too early out with our report here to have that information.

[Brian Martin:]

Okay, and how about just lastly, just with the focus, a lot of the focus being on the construction book this quarter, can you just talk about where if any you are seeing stress within that portfolio, as you kind of look by the different categories you broke out in the queue? Or is that -- I guess can you offer any color there, if there is some that you can point to more than another?

[George Gleason:]

Brian, other than the comments I made about Northwest Arkansas, that’s the -- you know, you’ve got a little customer over here and a little customer over there and a customer here and a customer there. It’s just scattered around in general. There’s not any other area I would point to specifically and again, I think our stuff in Northwest Arkansas is doing pretty well on a relative basis.

[Brian Martin:]

Okay, and as far as the non-performings right now -- I mean, if we look at the construction booked as a percent of total loans, can you talk about just the percentage of non-performings that are construction driven?

[George Gleason:]

I don’t have that breakdown data. We’ll -- that will be in our call report data when it --

[Brian Martin:]

Okay. I appreciate it. Thanks.

[Operator:]

(Operator Instructions)

[George Gleason:]

While we’re waiting for Shandra to see if there’s another question, I will mention one thing and this is a personal thing but I’m going to mention it anyway, just because it will save somebody or several of you from calling to ask me about it; I made a gift of stock yesterday, which there will be a form for filed today or tomorrow or Monday, to give some stock to my children’s trust. So if you see a form 4, I’m not selling stock. It was just a gift to our children’s trust and we are constrained by how much we can give each year because of the annual gift exclusions per [donor], so we thought it was an opportune time given our stock price being where it was to give as many shares as possible within that constraint to our kids and grandkids. So if you see that, it’s not a big deal. Shandra, do we have another question?

[Operator:]

Yes, sir, we have a question from the line of Dave Bishop.

[David Bishop:]

Actually, Brian just asked my question, so --

[George Gleason:]

All right, thanks, Dave. Any others?

[Operator:]

We’re showing no further questions at this time, sir.

[George Gleason:]

There being no further questions at this time, let me thank you for joining today’s call and we’ll look forward to talking with you in about three months. Thanks very much.

[Operator:]

Thank you for your participation. This concludes today’s teleconference. You may disconnect at this time.