Bank OZK
Q4 2008 Earnings Call Transcript

Published: 17 Jan 2009

Operator:

Welcome everyone to the Bank of the Ozarks fourth quarter 2008 earnings release conference call. (Operator Instructions) Ms. Blair, you may begin your conference.
Susan Blair:

Good morning, I’m 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 fourth quarter and full year 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, beliefs, estimates, and outlook for the future, including statements about economic, housing market, competitive, credit, unemployment and interest rate conditions, revenue growth, net income, net interest margin including our goal of maintaining net interest margin at or near the 4.52% level achieved in the fourth quarter of 2008, net interest income, including our goal of achieving record net interest income in each quarter of 2009 non-interest income, including service charge, mortgage lending, and trust income, and BOLI life benefit claims, non-interest expense, our efficiency ratio, asset quality, including expectations for our net charge-off ratio, our allowance for loan and lease losses to total loans and leases ratio, and our other asset quality ratios, loan, lease, and deposit growth, and changes in the volume, yield and values of our securities portfolio. You should understand that our actual results may differ materially from those projected in the forward-looking statements due to a number of risks and uncertainties, some of which we’ll 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 reports, 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:

Thank you for joining us today, we’re very pleased to have you on the call. In the quarter just ended we achieved records in net income and diluted earnings per share for the third consecutive quarter. This helped up achieve our eighth consecutive year of record net income. These record quarterly and annual results are particularly gratifying because they were achieved in the midst of a very challenging and truly extraordinary economic environment. Our success in 2008 was in large part a result of our ability to capitalize on many of the opportunities created by 2008’s dynamic economic conditions while at the same time effectively addressing many of the challenges we encountered as a result of those same economic conditions. The year 2008 was a year of both great challenges and great opportunities all at the same time. In our conference call last January we stated that one of our important goals for 2008 was to get back on a record quarterly earnings pace. We achieved that goal in the second, third, and fourth quarters of 2008. In the quarter just concluded we did this by achieving record quarterly net interest income for the eighth consecutive quarter, improving our net interest margin for the fifth consecutive quarter, achieving record trust income and a record efficiency ratio. We have a lot to talk about today so let’s get to the details. Net interest income is our largest source of revenue. In the quarter just ended net interest income accounted for almost 90% of total revenue compared to 84% of our total revenue for the full year of 2008. The increased dominance of net interest income in our fourth quarter revenue results is due to three factors. First we experienced exceptional expansion in our net interest margin in the fourth quarter. Second primarily as a result of growth in our investment securities portfolio in the quarter we also had good growth in average earning assets. And third our fourth quarter non-interest income was sub par making us particularly dependent on net interest income in the quarter. In each of our conference calls this year we have 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 40.8% compared to the fourth quarter of 2007 and it was up 16.7% from the third quarter of 2008. This was our eighth consecutive quarter of record net interest income. Of course there are only two ways to improve net interest income, you can either expand your net interest margin or you can grow your average earning assets or ideally you can, as we did in the last quarter do both at the same time. In each quarter this year we have benefited from meaningful improvement in our net interest margin which contributed significantly to our growth in net interest income. The improvement in our fourth quarter net interest margin to 4.52% was exceptional, up 105 basis points from the fourth quarter of 2007 and up 70 basis points from the third quarter of 2008. In the quarter just ended our net interest margin benefited from a combination of factors including very favorable yields achieved on a number of new tax exempt investment securities purchased during the quarter, and further improvement in our spreads between our yields on loans, leases, and other securities and our rates paid on deposits and other funding sources. The majority of that benefit came from lower funding costs. In addition we also had good growth in average earning assets in the fourth quarter which contributed significantly to our net interest income. In our last three calls we have discussed that our net interest income results for each respective quarter of 2008 had benefited from our increased level of investments in certain tax exempt investment securities which we expected to be relatively temporary. We also stated that we expected the benefits of these investments would go away as conditions in the credit markets normalized and yields on these securities returned to a more normal level, or as these securities were called away. As we expected our volume of these investments has declined from approximately $290 million at March 31, 2008 to $170 million at June 30, $119 million at September 30, and $85 million at December 31. We expect this portfolio will pay off in full over the next one or two quarters and in fact it has already declined to approximately $60 million so far this month. These investments positively impacted our fourth quarter net interest margin and net interest income but we expect other tax exempt securities that we purchased in the fourth quarter will have a similar positive impact on net interest margin and net interest income in the coming quarters. In the fourth quarter our total investment securities portfolio grew approximately $223 million with purchases of investment securities more then offsetting the $34 million decrease in those temporary tax exempt securities. This growth was primarily due to our purchase of highly rated municipal securities having what we believe are unusually favorable prices and yields due to market conditions at the time of purchase. Over 80% of those securities are AAA rated, 8% are AA rated, 6% are A rated, 3% are BBB rated, and 3% are non-rated. Many municipal bonds in Arkansas are issued with a rating. In addition to our net purchase of securities in the fourth quarter a significant favorable shift in the mark-to-market adjustment on our available for sale investment securities contributed to growth in the outstanding book balance of investment securities. Achieving record net interest income in each quarter of 2009 will again be one of our key goals. To achieve this goal in the coming quarters we will once again need to both achieve growth in our earning assets and maintain our net interest margin at or near the level achieved in the fourth quarter, or hopefully expand it further. We expect to achieve good growth in earning assets in 2009 but you should understand that the current turbulent economic conditions make it very difficult to accurately predict loan and lease growth and the turbulent conditions in credit markets make it very difficult to accurately predict prepayment speeds on existing securities and the potential for purchasing new securities. Therefore understand that the growth projections we’re about to give could be significantly off base because of economic and credit market volatility. With that said we expect loan and lease growth in 2009 of approximately 10% plus or minus. Since we expect current weak economic conditions to continue or even deteriorate further in 2009, we may be more likely to see loan growth in the low side of that below 10%, then on the high side above 10%. In regard to investment securities we have already stated that we are expecting the roughly $85 million of those temporary tax exempt investment securities to fully pay off in the first or second quarters and they appear to be well on their way to doing so. We also expect prepayments from our taxable and tax exempt mortgage-backed securities to accelerate in 2009 and we expect that opportunities to purchase new investment securities will not likely be on as favorable terms as existed in the quarter just ended, particularly in October and November when conditions for purchasing bonds were exceptionally good. Accordingly we expect that new purchased of investment securities in 2009 will roughly offset the maturities cost and prepayments in the investment securities portfolio thus keeping the portfolio at roughly the same dollar volume as at year end 2008. We expect to maintain a favorable net interest margin in 2009. At this point we believe it is reasonable to think that we will be able to achieve net interest margin in 2009 at a level approximately equal to or slightly above the 4.52% level achieved in the quarter just ended. However we should note that significant changes in prepayment assumptions on mortgage-backed securities or a number of other factors could effect our actual results. Let me make a few more comments about growth in loans and leases in the fourth quarter of 2008 which was actually negative bringing our growth in loans and leases for the full year of 2008 down to 8%; this was below our guidance. This quarter of negative growth in loans and leases was due to a combination of factors. First we had several large loan payoffs including two large apartment loans that refinanced. While secondary market long-term fixed rate non-recourse financing is presently unavailable for most types of properties, apparently such financing still is available for certain good quality multifamily projects. Second while we actually closed a number of new loans during the quarter the substantial cash equity requirements on most of the larger credits we originated resulted in little or no immediate funding. In fact it may be several months before the equity contributions are expended and significant loan advances begin on some of those projects. And third economic uncertainty caused a number of customers and potential customers to simply put projects on hold. Accordingly we think our fourth quarter negative loan and lease growth was an exception and not a new norm although we would not rule out the possibility of having one or more quarters of negative loan and lease growth in the future. 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 achieved loan and lease growth of 8% in 2008 and that we are projecting loan and lease growth of 10% plus or minus in 2009. Of course as we have said before current economic and credit cycle conditions are making it harder in some respects to find good quality loans and leases. On the other hand these conditions have led many competitors to withdraw from the market because of liquidity, asset quality, or other problems and there are still good quality loan opportunities and the recent changes in the competitive landscape have given us an opportunity to originate loans with significantly better credit terms and pricing then in recent years. And after several years of having to compete against very aggressive credit terms and pricing these signs have significantly improved credit terms and loan pricing are welcome and they contributed to our improved net interest margin in 2008. Let’s shift to non-interest income which in the quarter just ended included a number of unusual items both positive and negative. We provided extensive detail on non-interest income numbers in the press release so I’m not going to repeat all that data, let me just give you some color on the results and some comments regarding our expectations for 2009. First income from deposit account service charges is traditionally our largest source of non-interest income. This category of income decreased 1.5% for the full year of 2008 compared to 2007 and decreased 3.4% in the fourth quarter of 2008 compared to the fourth quarter of 2007. We believe the decrease in fourth quarter results is attributable to the generally lower level of economic activity in the country. Based on our expectation for continued economic weakness in 2009 we expect service charge income in 2009 to be roughly equal to service charge income in 2008. Mortgage lending income for the fourth quarter was at its lowest level since the third quarter of 2001 and it has declined in each quarter since the first quarter of 2008. Obviously this reflects the generally weak housing market conditions including the effects of negative market psychology and the more rigorous underwriting and appraisal standards now being applied throughout the mortgage industry nationally. Overall it was a very tough mortgage environment in 2008 but with the recent declines in mortgage rates and the federal government’s announced plans to try to engineer a continuation of relatively low mortgage rates there is the possibility of a meaningful boom in refinancing activity in the coming quarters. Who knows how all this will actually play out and effect or mortgage lending income but hopefully we will see mortgage lending income increase in 2009 from the very low levels seen in the fourth quarter of 2008. Our trust staff continued to add new customers and grow existing relationships during the fourth quarter as they have done all year. This has resulted in solid growth in trust income in each quarter of 2008 including record trust income in the fourth quarter. Since a substantial portion of our trust income is based on the volume of assets administered and since equity markets experienced significant declines in 2008 our ability to increase trust income 16.7% in 2008 compared to 2007 reflects very favorably on our team of trust and wealth management professionals. They brought in a lot of new business. We expect that trust income for 2009 will increase 10% to 13% compared to 2008. During the fourth quarter of 2008 we recorded $2,147 million of non-taxable income from death benefits on bank owned life insurance, or BOLI, as it is called. This resulted from the death of a former division president who had retired in October 2006 as a result of health issues and a department head who finally lost a multiyear battle with cancer. As noted in the press release we have not previously received death benefits from our BOLI program which has been in place for over six years and has had a total of 95 individuals insured. Since we’ve not previously recognized income from death benefits on BOLI we consider this as an unusual item of income while at the same time we note that we have 93 individuals insured and thus we will have death benefit claims from time to time throughout the future. The impact on net income of this unusual item was almost exactly offset by the after-tax impact of two other unusual items of non-interest income. First we discussed in some detail in our 10-Q for several quarters our investment securities portfolio includes a bond issued by SLM Corporation or Sally Mae with an amortized cost of $10 million. The estimated fair value of this security has been below amortized cost for a number of quarters which we believe is due to a variety of factors as detailed in our 10-Q. Over time the credit rating on this bond has declined from an A rating to a BBB minus rating. Sally Mae has never defaulted or had a late payment on this bond and we believe there is a considerable likelihood that there will never be a default on this bond which matures in 2015. On the other hand the fair value of this bond has continued to decline. The financial condition of Sally Mae has deteriorated even though it still has $5.3 billion of common and preferred equity capital as of September 30, 2008. Based on the deteriorated financial condition of Sally Mae we would not purchase this security today. Because of these factors we have had significant discussions internally as to whether or not this bond is other then temporarily impaired. The investment accounting and credit professionals in our company frankly have different opinions on this issue. But in keeping with our generally conservative philosophy we concluded in the fourth quarter that as a result of further declines and the financial condition of Sally Mae and further declines in the fair value of this security that this bond should be accounted for as other then temporarily impaired. As a result we recorded a pre-tax charge to non-interest income of $3,016 million in the fourth quarter. This was the first time we have recorded an other then temporary impairment charge for an investment security. In addition we incurred another pre-tax charge to non-interest income of $520,000 in the fourth quarter equal to the difference in our book value of an investment in an entity that provides low and moderate income housing and the fair value of the tax exempt investment securities we received as a result of the planned liquidation of our investment in that entity. Our investment was made in 2003 and qualified as a community reinvestment act investment and also generated certain tax credits. At that time it was understood that on the fifth anniversary date our investment in the LLC would transform into a distribution of these underlying securities. The difference in the value of our investment in the entity and the fair value of the securities we received in liquidation was largely due to the extremely wide credit spreads attributable to unrated securities a year in 2008. We believe the fair value of these securities will likely return to par value when credit market conditions materialize and in fact yesterday, the pricing service, the independent third party pricing service that prices our securities portfolio had already changed the market value on these securities so if the transaction had been recorded yesterday instead of at year end we would not have a loss to recognize. In any event the after-tax impact of these two unusual charges was $2,149 million which offset the $2,147 million of tax exempt income from BOLI death benefits almost exactly. Non-interest expense increased 14% in fourth quarter of 2008 compared to the fourth quarter of 2007. For the full year of 2008 non-interest expense increased 12.7% compared to 2007. Our fourth quarter efficiency ratio of 39.1% was a record quarterly efficiency ratio and our 2008 efficiency ratio of 42.3% was a record annual efficiency ratio. I have said for a number of years that our goal was to achieve a sub 40% efficiency ratio and I’ve also commented many times that to achieve this goal we would have to see improvement in our net interest margin. That all materialized in the quarter just ended. At this point we may not be able to consistently sustain a sub 40% efficiency ratio given the increases in operating expenses we expect in 2009 and we’re estimating that at 10% plus or minus. Those increased operating expenses include higher FDIC insurance premiums for the entire industry. The overall cost of our new headquarters which opened in December and the cost of giving raises at various times in 2009 to our well deserving and very high performing staff. With that said our expectation is that our efficiency ratio for the full year of 2009 will be at or below the 42.3% level of our 2008 efficiency ratio and we will continue to quest to get a point where we can sustain a sub 40% efficiency ratio in the future. Another of our key goals is to maintain good asset quality. Economic conditions nationally have weakened in recent quarters and particularly in the fourth quarter of 2008. That is no surprise to you because you read the same newspapers that I do. This has made our traditional strong focus on credit quality even more important even though most of our markets in Arkansas, Texas, and the Carolinas continue to generally appear to be less severely impacted by this economic weakness then many other markets in the United States there is no doubt that the increase in duration and depth of the global and national recession is having negative impacts almost everywhere and is adversely effecting a number of customers in almost all of our markets. Our most challenged market continues to be Northwest Arkansas which is still wrestling with a significant oversupply of residential and commercial lots and homes in certain price range and submarkets. We have already worked through a number of challenges in that market over the past two years and we expect that we will have to work through more challenges there until economic conditions improve, the excess supplies absorbed and liquidity returns to that market. During the quarter just ended the trend of our various asset quality ratios reflected the weakening global and national economic environment. Our ratio of nonperforming loans and leases to total loans and leases at December 31 was 76 basis points which is up six basis points from September 30. Our December 31 ratio of nonperforming assets to total assets was 81 basis points which is 15 basis points higher then at September 30. Our 30-day past due ratio including past due non accrual loans and leases was 2.68% at December 31, up 174 basis points from September 30. And our fourth quarter annualized net charge-off ratio of 83 basis points was up 56 basis points from the third quarter of 2008. While all of these ratios were still relatively good compared to recent data for the industry as a whole, we acknowledge that deteriorating economic conditions in the fourth quarter did impact our asset quality results more then expected. Notwithstanding the moderate deterioration in our asset quality ratios in the fourth quarter I will repeat what we have said for the past several quarters that in the coming quarters we may see one or more or even all of these asset quality ratios increase somewhat further but we think any such increases if they do occur will not seriously effect our ability to generate a good level of net income or even a record level of net income in each quarter. In support of that statement let me point out that the increases in our various asset quality ratios and provision expense during each of the quarters of 2008 did not prevent us from posting good earnings in each quarter including record earnings in the last three quarters. During the quarter just ended we made an $8.3 million provision to our allowance for loan and lease losses which was our largest quarterly provision ever. With net charge-offs of $4.2 million for the quarter this resulted in a $4.1 million increase in our allowance for loan and lease losses. For the full year of 2008 our provision to the allowance for loan and lease losses totaled $19 million, net charge-offs totaled $9.1 million resulting in a $9.9 million increase in our allowance for loan and lease losses for the full year. This reserve billing increased our allowance to 1.46% of total loans and leases at December 31, 2008 compared to 1.05% of total loans and leases at December 31, 2007. we believe this increase is appropriate and considering all relevant factors including the continued uncertainty regarding economic conditions in general, market conditions in Northwest Arkansas in particular, and our cautious outlook for economic and credit conditions in 2009. After the economic volatility of 2008 and given the considerable uncertainty about economic conditions in 2009 you can appreciate the difficulty in accurately forecasting credit losses for the coming year. Our assumptions for 2009 credit losses are based on our opinion that economic conditions will deteriorate further in 2009 with national unemployment approaching a 9% to 10% level, that economic conditions will continue to decline throughout the first half of 2009 and perhaps the entire year of 2009 before bottoming out, and that any recovery thereafter will be very slow to develop momentum. We just think those are reasonable and appropriate assumptions about the economy given what we are reading in the national media. Given these assumptions we expect that our net charge-offs will increase from 2008’s 45 basis points to approximately 70 basis points of loans and leases in 2009. Given the substantial reserve building we’ve already done in 2008 we expect less reserve building to be needed in 2009 and we’re projecting for budget purposes another 10 to 15 basis points or so in 2009 from the current 1.46% of loans and leases. These are our best estimates based on current information and they are estimates included in our 2009 in planning budget but they are only estimates and of course a number of factors could cause actual results to differ. In our July conference call we provided extensive details regarding some of our practices for accounting for structuring loans, practices we consider to be very sound and conservative. We are not going to repeat all that again but its probably appropriate to summarize a few key points. First we have been very aggressive and promptly conducting thorough impairment analysis on non accrual loans and leases and regularly revaluing the carrying values of foreclosed and repossessed assets. Our general practice has been to quickly write off any identified loss exposure for nonperforming loans and leases and foreclosed or repossessed assets. In addition to the net charge-offs recorded in the fourth quarter we continued our practice of aggressively reevaluating the carrying values of all foreclosed and repossessed assets and we recorded $489,000 of non interest expense during the fourth quarter to write down the carrying value of foreclosed assets to reflect changes in market value. We will continue this practice and if market conditions deteriorate and property values decline further we will make such further adjustments as necessary to keep the value of these assets on our books aligned with current market values. Second we have been aggressive in placing loans on non accrual status when we believe data exists regarding the ultimate collection of payments. Because of this conservative accounting practice at December 31 we had some loans on non accrual status which we’re still making payments including a few loans that were not even past due. Third in regard to two subjects which were thoroughly discussed in our July call, I would just like to remind you that we consider our practices regarding interest reserves for construction and development loans and capitalization of interest on loans is very conservative. If you have any questions about these items I encourage you to listen to the replay of our second quarter earnings conference call held in July and available on the Investor Relations section of our website. In closing we are very pleased with our record fourth quarter results. There were a number of unusual items in our fourth quarter results but they substantially offset each other. Our very strong revenue growth primarily from record net interest income and record trust income, more then offset a higher level of provision expense which was incurred to offset higher credit losses and build our allowance for loan and leases. Both our full year and our fourth quarter 2008 results reflect the higher credit costs and other challenges posed by the current economic environment. But our full year and fourth quarter 2008 results also reflect our ability to capitalize on many of the opportunities created by that same economic environment and thereby achieve excellent revenue growth. We see 2009 as another year of great challenges and great opportunities. Our long-term goal has been to improve earnings on a consistent basis and thereby achieve record earnings in each quarter. We have accomplished that goal in 39 of the last 48 quarters including the last three quarters in a row. That will continue to be our goal in 2009. Now we acknowledge that we’re operating in the most challenging environment in decades but with our very fine staff, good growth in revenue, the significant increase in our allowance for loan and lease losses in 2008, our relatively good asset quality, sound capital position, and abundant sources of liquidity, we think we are in a reasonable position to effectively manage through the challenges and capitalize on the opportunities. We also think it is reasonable to believe that we can achieve modestly improved earnings in the coming quarters and of course any improvement would mean record earnings. That concludes my prepared comments, at this time we will entertain questions.
Operator:

(Operator Instructions) Your first question comes from the line of Matt Olney - Stephens Inc.
Matt Olney:

Did you provide guidance on levels of NPAs and non accruals in 2009?
George Gleason:

We did not, the only thing I said on that is that we wouldn’t be surprised to see one or all of those four asset quality ratios increase. We did give guidance on charge-offs at an expectation of 70 basis points of loans and leases plus or minus. But I think the important guidance and I think it is a very good guidance is within the relevant ranges that we consider plausible for growth in nonperformers and charge-offs we still think that we can generate a good level of net income and very possibly, very probably even record levels of net income in each quarter. We see 2009 as providing more asset quality challenges because obviously in the fourth quarter the economy took a significant step down and that’s effected a lot of people. Read any newspaper in the country and that’s very evident. But at the same time our revenue has grown in a very robust sort of way and our allowance has grown very significantly so we think we’re very well positioned to effectively manage through any challenges that the economy presents.
Matt Olney:

As far as the jump in delinquent credits during 4Q can you give some more details in terms of location.
George Gleason:

That’s primarily due to two credits, and one of those credits is in Texas in the Metro Dallas area. It’s a $20 million credit so obviously that created a 100 basis points of the past dues right there. It’s a credit in which we have about a 65% loan to cost basis. We’ve got I think $20.2 or $20.3 million loaned. The customer has almost $11 million invested cash equity in it. At the time we originated the loan it was a 65% loan to value and 65% loan to cost transaction. In just the last few weeks we’ve had two appraisers reappraise the project and one appraiser on the low side each gave a value range but taking the low value from each appraiser, one would indicate a 64% loan to value currently, one would indicate an 86% loan to value. So if you average those the assumption is 75% loan to value. This customer a very big national player in their sector and has just simply run into problems on a lot of other projects that has rendered them unable to make a payment. They went 30 days past due on the 31st day of December so they just got into the ratio about one day. The equity sources on this deal have also gotten into trouble elsewhere and as a result they are not stepping forward to continue to make payments so the loan went 30 days past due on the last day of the year. Now this, to give you an idea of the conservatism of our practices, we are told by this borrower that all of the other banks which are dozens of other banks that they deal with across the nation on a couple of hundred projects, we’re told that every other bank that they deal with is basically just extended all their loans to June 30, 2009 to give them time to work through this and have agreed to standstill on the loans until mid year 2010 as far as pursuing any sort of litigation and so forth. And that just makes no sense to us. If the customer can’t make a monthly interest payment then we’re ready to move on and we’re not going to extend the credit without them making the required payments and we seem to be unique among the banks this customer is dealing with in that regard. In any event we don’t think this loan is going to become a problem. There are a number of people looking at the property right now to purchase the property from the borrower. Negotiations are in very late stages for a full price buyer who would take the loan over and assume it and recapitalize the project putting in new cash, additional cash into the deal. So our sense is and these things are never done until they’re done, but our sense is that deal works out without ever being a non accrual or nonperformer or requiring any sort of loss. The second loan is in North Carolina. A fantastic piece of property. Our loan to value on that is based on the most recent appraisal is a 42% loan to value. Our loan to cost is 64%. The project has been in our books for a number of years. The customer has 36% cash equity in it. They are vigorously working to revamp that. They are in the development business. They’ve had a significant slowdown in lot sales on other projects apart from ours. Ours is not a lot project, ours is just a land deal and they have a variety of things they’re looking at right now to refinance that. That loan was about 45 days or so past due at the end of the year. So both of these deals have large amounts of cash equity in them. Both of them are actively involved in discussions, negotiations with interested parties that look like they’ll either result in a sale of the property and assumption of our debt and recapitalization of cash by a buyer in the case of the Texas property or a sale or refinancing of the North Carolina property. Now I can’t guarantee you either one of those will work out but at this point they both look like they stand a very good chance of working out. In the worst case scenario ended up with the property on both of them, both of them have been reappraised within either the last few weeks or the last few months and values still indicate that we have a very, very good equity position in both projects.
Matt Olney:

So it doesn’t sound like any of the 4Q charge-offs we saw this quarter were related to any of those projects.
George Gleason:

They were not. The 4Q charge-offs rose because of some interesting reasons that honestly are probably, I know that everybody talks a lot about our big construction and development book but the 4Q charge-offs included some of that as they have for all quarters but the real significant increase in the 4Q charge-offs were not related to that. As you know the automobile sector is under considerable stress and we’ve got a small portfolio of loans where we financed owner occupied automobile dealerships. We put three of those loans on non accrual in the fourth quarter. We had a GM dealership that’s a 60 plus dealership and a been a long, long time relationship in Arkansas with one of our banks. They got their franchise pulled. They’re in one of our small rural communities, they got their franchise pulled. We have a Mitsubishi dealership in South Carolina that the guy simply was not able to be profitable. That dealership is closed. And then we had another dealership here in Arkansas that we put on non accrual in the fourth quarter. The property has been vacated as well. So the stress in the auto sector caused us some distress there in regard to non accruals and some, in the case of the one dealership will have a charge-off on that. The other properties we think we’re in at something like a 60% to 70% loan to value on them. Those should not be issues and we’re working through those things fairly quickly. Another thing that contributed noticeably to our Q4 charge-offs relates to the poultry industry and our real estate book we have loans, probably $10 to $20 million to various people that grow chickens and turkeys and as you know the poultry producers, the big integrated companies are having serious financial problems because of high grain costs earlier in the cycle and low demand for their products so they are producing more chickens and turkeys then they need and their solution to that is they’re cutting back on the number of flocks that they’re giving to people that grow those. So a typical farmer that would grow chickens or turkeys might get four or five flocks a year to grow and he gets paid on how many pounds of product he produces and one of the big integrated companies went to all of our all folks and all of their folks that grow for them and said instead of giving you four or five flocks a year, we’re going to give you three flocks a year because we’ve got to cut down the supply of poultry products in the market because its killing our prices. So when they did that we went through all of our portfolio, I think we had about 10 different growers with that particular integrated processor and we went through all that and did the analysis on them and determined that seven of them were going to be fine, that at three flocks a year which is a historically abnormally number of flocks, that three of them would not be able to survive. So we restructured the debt for those three customers and charged off probably about $700,000, $800,000, of debt that just could not be supported with the [inaudible] that those growers are going to have and we restructured the loans accordingly. Because the loans are restructured we typically don’t report any that are troubled and restructured. The way we do that is in any period when it would be trouble and restructured we put it on non accrual so that also inflated our non accrual ratios. While those are performing and paying now under the new structure and I think they’ll be fine going forward they’re in non accrual because they are troubled and restructured and that’s the way we report troubled and restructured debt. But we just proactively did what we thought we had to do and that is to go in and reduce the debt to the point where these guys could survive in the revenue environment they’re in. So the increase in nonperformers is some of that is due to construction and development lots and so forth and just weakness, some of it is due to this poultry thing, some of its due to just job layoffs that effect the consumer book. It was not reflective particularly of the construction and development portfolio.
Operator:

Your next question comes from the line of [Brant Creese] – Unspecified Company
[Brant Creese]:

On some of the securities that you bought during the quarter could you talk a bit about the yield on some of those and the duration of the securities because it looked like you got a pretty nice lift in the yield on the tax, looks like they picked up about 300 basis points this quarter.
George Gleason:

In the vast majority of those securities are municipal housing authority bonds and the underlying bonds are Jennie Mae, Fannie Mae, Freddie Mac, VA, FA, or USDA rule development guaranteed mortgages. All of the mortgages underneath those credits are guaranteed and that’s almost all of the 80% AAA that I talked about. I think I said 6% or 8% was AA and that was almost all of that AAA and AA. Most of these housing authority bonds are older origination. There are a few of them that are newer but most of them are older originations, 1998, 2000, 2001 originated mortgages and these bonds have been sitting out there for quite a while. Basically what we bought is the pack structure, if there was support tranche type structure. A lot of them are just straight mortgage pass-throughs. And we just found a gigantic aberration in the market in October and November on these things. At that time in October and November a Jennie Mae was trading in the low five’s, Fannie and Freddie mortgage-backed securities were trading in the mid to upper five’s and we were buying, and that’s new origination stuff, we were buying this very seasoned stuff a lot of which was in pack structures and we were buying it to yield a six to a, at deep discounts to yield a six plus yield, probably on average about a 6.25, 6.50 yield to the absolute final maturity. Assuming that there was never a payment on any mortgage and you went all the way, 20, 15, 30 years to the absolute final and with any sort of reasonable prepayment speeds, we were generating yields in the seven, eight, nine’s on some of it. So we just found a situation where you could basically buy Jennie, Fannie, Freddie, FHA, VA, and USDA rule development mortgage product that on a taxable basis is trading in the five’s with yields that tax exempt are six and seven percent. So it’s the exact same credit. So there’s obviously a huge aberration there and you say, well gosh how did that exist and the fact of the matter is there are a variety of factors. The average CMO trader who trades taxed CMOs never looks at anything tax exempt and the analytic sources, are not on Bloomberg and your other analytic sources to just pull all that stuff up and run it, you have to do some manual work on it. The hedge funds and high net worth investors and other folks that buy non-bank qualified tax exempt paper have all had their appetite for tax exempt income dissipated this year because of portfolio losses and other losses and because this is non-bank qualified paper for [TEFRA] tax purposes you have 100% [TEFRA], most banks weren’t looking at it because they say that’s non-bank paper I’m not going to look at it, I don’t want to lose my [interest] reduction for it. Well we did the math on it and the yield on it even with 100% [TEFRA] disallowance for tax purposes was so much better then what you’d get, I’m talking 100, 200 basis points better then what you could get in bank qualified bank paper, we said this is a no-brainer. So we started buying that paper in October and November aggressively confident that we had found a very value oriented type situation and we’re confident we did. I’ll give you an example. We bought some more bonds in one of these same issues we had bought earlier and we bought them just a few days ago and paid $0.89 on the $1 for them and even though they are the exact same credit as a taxable Jennie, Fannie, or Freddie, they are still trading 100 basis points in yield north of that. At one time that’s almost 200 basis points on some of these things. We bought it at $0.89, I think the earlier stuff we bought in October was at $0.76, I think the second piece we bought I think was 13 points higher then the first piece we bought. In the same day we paid $0.89 for some of this paper, we saw some trade away at another transaction at $0.94. So the market has caught on to this and this anomalies like that typically don’t exist very long but we were very fortunate to pick up a couple of hundred million of that product at huge discounts and to give you an idea, December 31 we have $233 million of increase in securities portfolio most of which that was in that type of paper and our discount on that was $29 million so we bought that on average $29 million less then par value. We think that was just an exceptional, really probably once in a lifetime opportunity and there’s still value in it but its not the extreme value that was there and of course the fact that the market between the day that we really started buying that in earnest in October through November the market recognized that were was extreme value there and began to adjust is the reason that we had after-tax $26 million favorable swing in our mark-to-market adjustment from September 30 to December 31. The other reason we had that big mark-to-market adjustment swing is because with the feds action to lower mortgage rates and the expectations that there is a significant refi boom on the way it has increased projected prepayment speeds on our old long-standing Fannie Mae and Freddie Mac mortgage-backed securities portfolio in which we have an $8 million plus discount so as the expectation comes that those things are going to pay off much more quickly then was expected three months ago, that has also contributed very positively to that quarter to quarter mark-to-market swing. Frankly we think that our ability to buy those extremely high yielding and extremely high quality assets in October and November has set us up in a fantastic position to be able to continue a very positive earnings trend throughout what we think will be a difficult economic 2009.
[Brant Creese]:

With respect to the yield then, is that discount being reflected in the yield because if you’re buying them with 6 to 7% yields yet the entire portfolio is yielding close to 10 is that a reflection of some of that discount being accreted into the interest income.
George Gleason:

No. I’ll explain that to you. I’m not quite sure why this is the case but in December I think we recognized $64,000 of discount accretion on the municipal portfolio and if you divide our total discount accretion by $64,000 that’s like a 35 year amortization of that discount accretion so it seems to us that our third party processor who processes our securities portfolio took an extraordinarily conservative view because the average maturity of the bonds, the absolute final maturity, and none of them will reach final maturity, is not 35 years. Its more probably in the 20’s or something. So we are expecting significant potential to accelerate that discount accretion and I’ll tell you we’ve not budgeted that in the guidance I gave today because who knows how that works but we’ve assumed in the guidance I’ve given today, we’ve assumed a continuation of a $64,000 a month discount accretion which is frankly impossible because if you did that the bonds would all be paid off and you’d still have discount on the books. The other thing I would tell you of interest about our discount accretion and to show you our conservative mindset, when we received from our servicer, our discount accretion on our taxable CMO portfolio in December the first run showed $2 million of discount accretion and we’ve only got $8 million on the books and the assumptions that they were running that off of, if you use the [aspill] method of calculating prepayment speed and so forth, and we went back to our third party servicer and said that’s absurd and they just said that’s what the [aspill] method produces and we said we’re not going to report that as income, that’s ludicrous. So we went back and took all of the people who had prepayment speeds on Bloomberg for every bond and calculated a prepayment speed and there are a couple of firms that still have prepay speeds on Bloomberg that haven’t been updated from August because they are effectively out of the business so they had really, really long maturities on those and we took, threw them out because their numbers, actually we threw the high and the low out, and used the others as an average speed and went back and ran a difficult PSA projection on prepayments from the portfolio and accreted the discount and ended up with $1 million. And we said that’s still too high. So went back and redid our prepayment speeds and included in the high and the low number and the high number was just outrageous, unreasonable, and went back and ran it again and came up with $134,000 discount and that’s what we took into income was the $134,000 discount. We think that’s probably a highly conservative number but its based on objective third party data all of the people who are posted on Bloomberg as having prepayment speeds for those securities. What I’m telling you is is the 452 fourth quarter net interest margin number was not impacted by any sort of gimmickry or overly optimistic assumptions regarding discount amortization, it was achieved with the most conservative possible and even overly conservative assumptions on discount accretion. We’re just conservative in the way we do our business.
[Brant Creese]:

I’m still a little unclear of how you got that tax exempt securities portfolio then lifted 300 basis points from the prior quarter.
George Gleason:

I don’t know what else I can tell you. That’s the income off of it. And that’s the discount accretion we took and the rest of it is just coupon yield income. That’s why we’ve given the guidance that we think going forward in 2009 our net interest margin is going to be in or around that 452 level or slightly or higher.
Operator:

Your next question comes from the line of David Bishop – Stifel Nicolaus
David Bishop:

In terms of getting back to the outlook for loan growth next year, in terms of projects you’re still funding out there or segments you’re still funding, what looks enticing our where do you see the growth coming from.
George Gleason:

Well a couple of deals we closed in the fourth quarter are, we closed a couple of retail deals and I know everybody is worried about retail deals but one of these was an existing project that’s already in place and has in place the tenants and so forth. There are several more buildings and pads to be done and basically we’ve got a stabilized project that’s producing good debt service coverage and they want to develop one more pad or one more building at a time and we’re going to let them do that as they get each building 50% leased. So when we did the math on that if they started every building in the project that remains to be built and they had then only 50% each preleased which is probably won’t happen, they’ll probably build one at 50% lease it up and then build another one. But if they started every one simultaneously we’d still have about a 90-something basis point debt service coverage on it. So those are sort of projects you can do. You’ve got to establish property with a good tenant base and a good location and its not fully built out. There are more phases or buildings to be built and you get a good chunk of preleasing on each one and keep building and that makes it a very low risk sort of project. We’re doing some apartment deals with high equity contributions. We used to do apartments with 20% cash down and then it got to be 30% cash and we’re working on, we approved a couple of apartment deals in the 35 to 40% cash range that got closed last quarter. We’re working on one now that’s a 50% cash equity deal so I think we will find retail, industrial, hotel, apartment, I think there’ll be a variety of projects that we can do that have either established income streams on them or sufficient cash equity that it will allow us a very wide margin for error from the economy and still have a quality project.
David Bishop:

Deposit pricing, what are you seeing across your markets there.
George Gleason:

Deposit pricing is coming down sharply. I think our cost, our deposits, or our total cost of funds came down 34 basis points in Q4 from Q3 and the cost of funds is just dropping rapidly. I think its going to continue to happen. I think a lot of people were asleep at the switch and thought that before the fed wasn’t going to go all the way back down, and they kept paying robustly high prices for deposits. Deposits were actually down 37 basis points in Q4 versus Q3 and total cost of funds were down 34 basis points. So we see quite a bit of room to continue to lower our cost of funds going forward and a lot of the craziness is out of the market now. The guys that were doing the crazy high priced stuff seem to be choking on it now.
David Bishop:

In terms of, you alluded to the FDIC insurance premiums, do you have the dollar amount paid this quarter.
George Gleason:

I don’t have that. Its basically going to double. Slightly more then double in the first quarter. As a long-term committed member of the FDIC insurance fund we’re afraid that those costs are going to go up more and more in the future years because it seems like the FDIC is on the hook for a whole lot of loss exposure and a lot of these deals they’re resolving. So we think that’s a long-term upward moving cost item. Its currently running about $290,000 a quarter and it will more then double, so $600,000 plus.
Operator:

Your next question comes from the line of [Stewart Quint] – Unspecified Company
[Stewart Quint]:

Could you update us as to your thoughts on the use for the TARP capital.
George Gleason:

We received $75 million of equity from the TARP infusion. I will say again what I’ve said many times and that is we didn’t need it. We’re well capitalized without it. Obviously we’re very profitable and just had no absolute need for it. On the other hand we believe that it’s a relatively cost effective source of funds and gives us considerable flexibility. We delayed our decision to participate in the TARP really for two reasons. One we wanted to see as clearly as we could what if any strings were going to be attached by the Treasury or Congress or the administration, to receipt of the TARP money that might be offensive and at this point I don’t think that’s going to be a problem at least for the initial guys that got TARP although it will be interesting to see where that develops. And the second thing we wanted to see is could we get enough earning assets in place on the books before we pulled the trigger and made a decision that we could believe that we could absorb the cost of that and continue to put up a positive earning stream for common shareholders over the next few quarters. And certainly the investments that we were able to find early in the quarter put us in an excellent position to do that. With that said what we’re going to use the money for is obviously we’ve already used a chunk of it to buy investments and are continuing to use some of it to buy investments although I think our investment portfolio probably won’t grow much from year-end. I think payoffs will pretty much mitigate any further growth. We hope to use it to support loan growth and we hope that there will be an opportunity to acquire the deposit bases and physical franchise of some failed institutions from the FDIC on cheap terms that would make long-term sense to the growth of our company.
Operator:

Your next question comes from the line of [Dean Armgar] – Unspecified Company
[Dean Armgar]:

I know that there’s been a lot of the BOLI issue and the increase in tax exempt securities, I just wanted to ask about the tax that you showed on the income statement this quarter of only $655,000, could you just elaborate, explain why it was so low and what’s it likely to be going forward given the larger tax exempt portfolio you have.
George Gleason:

The reason it was so low is because we had a big chunk of income from the BOLI. We had a huge amount of tax-exempt income in the investment securities portfolio and the higher level of provision was either for current or deferred purposes deductible and the impairment charges and the loss on the bonds were deductible. So our extra expense and unusual expense items were all deductible. The extra income and the unusual income item being the BOLI were all tax exempt. So that led to a very low lever of tax. We’re projecting an effective tax rate for 2009 in the 25% to 26% range. The Q4 number was a bit of an anomaly just because of the mix of the income and so forth and the mix of the expenses in the quarter.
[Dean Armgar]:

On the loan growth when we talked earlier you mentioned about how you were well positioned, the bank is strong, you’re open for business, a lot of the competitors were impaired, loan terms were coming back to what they normally are, I’m just trying to get a sense of with the situation out there is it you’re being less likely to lend or has the demand gone down or obviously—
George Gleason:

I think demand has gone down and to put some perspective on that just totally a personal comment here, I’ve got three personal friends all very well to do, financially well off individuals that have all put their plans to build a new house on hold just because they’re concerned about this economy and what its doing to their investment portfolios and so forth. There’s much ado in Washington about, oh banks took the TARP money and they’re not lending. Well the economy is contracting and we see it every week in the unemployment numbers and month to month in the employment data and all sorts of other data. The economy is just shrinking and when you have that kind of economic environment people are putting projects on hold and so forth. There are just a variety of reasons that projects that are viable, feasible could be done are not getting done just because people are saying, I’m just going to put this on hold. We were working on a transaction that we spent a lot of time on in the third quarter and was supposed to close early in the fourth quarter that was basically we were going to loan 50% of the cost of acquiring a piece of property and the customer was going to put in 50% plus three years of interest in the deal. If you factored in the interest, we were basically going to be about a 40% loan to cost and the customer just decided to put that deal on hold and is going to try to renegotiate their purchase price on the property because they said in this economy ought to be able to retrade that deal and get a better price on it. We had another deal that we were doing for a very large developer the equity source was a state pension fund and we were within a week of closing that transaction and all of a sudden everything went silent on the other side and it turns out that the state pension fund, their financial advisor for their real estate transactions was a group of guys, I think it was at Morgan Stanley one of the big brokerage firms and in the cost cutting of the brokerage firm they fired everybody in that unit. So the state pension fund no longer had a financial advisor to advise them on the transaction and this thing had been working for three or four months or more and the deal got put on hold and the state pension fund is going to get another financial advisor who will re-underwrite the transaction totally but you have an economy that’s doing strange and negative things like this economy is doing for all sorts of reasons deals get put on hold and don’t get closed unrelated many times to the financial viability of the people who are doing the deals or the financial feasibility of the project. So its just a tough environment economically and I’m not telling anybody anything they don’t read every day in The Wall Street Journal.
Operator:

Your next question comes from the line of Brian Martin - Howe Barnes Hoefer & Arnett
Brian Martin:

The OREO this quarter its about 40% of nonperforming, could you give a little color as far as what’s in that just as far as future potential write-downs if need be. Is it large credits, is it small credits, is it real estate, is it--
George Gleason:

Obviously its OREO so its all real estate by definition and there’s not anything particularly large in there. There are quite a few houses in there. There are a very small handful of lots. There’s some raw land in there. There’s a convenience store in there. Its just a mish mash of things that you acquire. We’re continuing to sell that stuff. The oldest piece of OREO we got on the books today is a July 2007 piece so its eight months old and the vast majority of it was put in there within the last three to six months. So we’re selling a lot of that stuff. We’re moving pieces of it every month and getting good values for it. It just takes time to sell stuff.
Operator:

Your next question comes from the line of Kevin Reynolds – Unspecified Company
Kevin Reynolds:

I was curious if you could give a break down of the loan portfolio by state as of year-end and then also any update or thoughts on branch expansion. Do you put things on hold with the serious recession our there going forward or are there opportunities now to actually open new stores as some of the competitors peel away.
George Gleason:

On the statewide distribution and this is distribution by the state in which we originated the loan, where our offices are we’ll give you in the 10-K Annual Report, you’ll get the distribution by location of collateral on various parts of the portfolio. But Texas accounts for a little over 29% of the portfolio, North Carolina just under 5%, and Arkansas 66%. And on the deposit side, Arkansas is just under 87% of deposits and Texas is just over 13% of deposits. So Texas is continuing to grow both the loan book and the deposit book and Arkansas is continuing to have a little shrinking percentage wise and North Carolina is pretty much holding its own. On branch expansion I think we’ve got two branches that we will open next year, one is in downtown Little Rock, and another company we bought the old Federal Reserve building downtown because we don’t have a branch in the main city part of downtown Little Rock. Our downtown branch is sort of on the edge of the downtown area. We’ll open that probably in the second quarter and then late in the year we’ll open one branch in Allen, Texas. And we do have an operation center building that’s nearing completion in Ozark, Arkansas but its not a branch. We’re only going to add two branches next year and we’ve got that branch on the periphery of downtown Little Rock. We’re going to run the two branches downtown dual for a while. We will see what the business volume at our existing branch is and if that branch is not sufficient after we open the other branch to justify continuing one branch we would close one down there and sell that property. Very small expansion, you’re right. With the economy as weak as it is and all the challenges that the industry is facing and our economy is facing we just think its not the time to go out and build a bunch of new branches.
Kevin Reynolds:

As you talked about Texas, roughly its approaching a third of the loans originations there with oil prices falling as they have, I know you’re not a big energy lender or not in the Houston or down along the coast, what do you hear on the ground in Texas as far as the psychology today versus three months ago, six months ago and is it something that’s starting to become worrisome to the average person on the ground in Texas.
George Gleason:

I think the Texas association with oil and gas is overstated. Now certainly there’s a significant oil and gas business in Texas, but its not near the preponderance dominant piece of the economy like it was 20 or 30 years ago. That’s become a highly diversified state and because of Texas very pro business environment, low cost of living, and favorable climatic and other environmental conditions, you’ve had massive numbers of companies move their national headquarters to Texas. You’ve had many that hadn’t moved their national headquarters move substantial regional headquarters. If you just look at the list of Fortune 500 companies where they’re headquartered and look at that 20 years ago versus today you’ll see Texas having massive gains in that regard and significant diversification. Probably 20 years ago I would guess that almost every Fortune 500 company in Texas was either an oil company or an oil services company. That’s a broadly diversified economy down there. Certainly the Texas economy, even the Metro Dallas economy is probably one of the best in the country has had some setbacks but along with everybody else in this economic slowdown. But its still I think pretty good. I’ll cite you a couple of statistics in support of that. Of course we don’t know what the last state in MSA level unemployment data was but in November when the national unemployment level was 6.8% North Carolina was high at 7.9%. Arkansas was low at 5.7% and Texas was even lower at 5.1%. I was looking at an article in Fortune magazine about a month ago, December 22 issue of Fortune, and they projected home prices for Dallas, Irving area and the Fort Worth, Arlington area, Dallas, Irving next year is projected that home prices are going to decline 1.2%, Fort Worth Arlington 0.4% decline. Little Rock is projected to decline 1.6% and Charlotte 5.9%. You never like to see home prices decline or unemployment rise but if you look at those numbers for unemployment and you look at those numbers for home prices nationally there are not many places that are better to be then where we are in Arkansas and Texas, and Texas is better then Arkansas and Arkansas at this time is better then North Carolina. So that goes back to the comment early in the call it’s a challenging economy nationally. Its gotten so deep so long now in this economic slowdown that no place is immune from it. But I’d still rather be in Texas and Arkansas and don’t feel too bad about being in North Carolina as opposed to a large number of other places in the country. I still think we’re in relatively good shape as things go.
Operator:

Your next question is a follow-up from the line of Matt Olney - Stephens Inc.
Matt Olney:

I know that you mentioned in the past that the loan balances in the market in Northwest Arkansas will continue to contract, could you give us an idea of what we should expect in the 10-K with the loan balances in that area.
George Gleason:

I don’t know that data. I wish I could. I’m confident that they did [inaudible] quarter. I do not know the magnitude. I would tell you that we’ve commented for several quarters that we have been building our allowance for loan and lease losses, doing a little reserve building because of uncertainty about the economy in general and Northwest Arkansas in particular is the way we’ve said it and we’ve said it that way for very specific reasons that we think there are more issues to come up there. We did in the fourth quarter we reappraised a large number of the pieces of collateral that support a lot of our loans up there and these are loans that are performing loans, they’re paying, they are typically not past due but we also know that if they became nonperformers we might have some exposure on them or we were concerned we might have some exposure so we went through in the fourth quarter and paid for reappraisals on a number of those properties. That was one of the factors that led to a further increase in our allowance for loan and lease losses and again these are predominantly performing loans but we know if they became nonperforming in that market with the stress that is there that you would have some losses on them. So what we did is did that and when we did that that suggested we probably ought to keep building the reserve and we have set aside specific reserves for those loans even though they are performing and paying and not past due and very likely will never become past due in many cases. But that resulted, our unallocated allowance at September 30 was $7.2 million and our unallocated allowance at December 31 was $6.7 million so our unallocated allowance actually dropped $500,000 even though we built the reserve of $4 million and change in the quarter. But the reason for that is we allocated several million dollars to, kind of in our head we sort of, it was in unallocated but we thought we’re going to need that for Northwest Arkansas and we allocated it specifically based on reappraisals of that market. So its still a challenging market but I think we’ve got a good handle on what we’ve got there and are continuing to work through it pretty well.
Matt Olney:

So based on the results of the reappraisals recently and just your overall opinion how has the market changed in Northwest Arkansas the last three months since we last spoke.
George Gleason:

Continued to decline moderately.
Matt Olney:

Any more so then the other markets you’re in.
George Gleason:

I would say probably yes. Probably slightly more so then other markets and its just, there’s just the continued disequilibrium of supply and demand up there and what’s ironic about that is the unemployment rate in November in that market was 3.9%. It’s the lowest unemployment rate of any of the major markets that we’re in but and we’ve talked about that its still creating jobs albeit very slowly but there is just such a tremendous oversupply that its just taking a long time to work through it and the longer it takes to work through it the more damage is being done to prices. I mentioned in my remarks that we reevaluate our OREO and foreclosed assets every quarter and we took almost $500,000 of additional [write-downs] because of changes in value, considerable piece of that was in Northwest Arkansas. It’s a tough market up there.
Matt Olney:

Revisiting the TARP discussion after paying the deferred dividend and accounting for the warrants and the other expenses what kind of effect do you think the TARP capital will have on your bottom line in 2009.
George Gleason:

I think we’ve got that factored in in our guidance. The cost of it for the first five years is going to be about 6%. I had originally thought it was going to be more line 8% or 9% but when we priced out the warrants and allocated the discount on the warrants between the preferred stock and the common stock warrants and so forth you’ve got your 5% interest you’re paying on the preferred and about a percent of discount accretion related to that discount which is roughly equivalent to the value of the warrants using the [inaudible] valuation model. So its about a 6% cost and we think with the robust growth in our earning assets and the robust growth in our margin which I’ve already talked about which we think is sustainable and can be even possibly improved further that we’ll absorb that cost of the preferred stock. We’ll absorb higher credit cost next year and still be in a position to put up very good to record earnings on a quarter to quarter basis. And I will comment, we’re talking a lot about credit cost and I said we’re expecting budgeting about 70 basis points of credit cost, we’re of course budgeting growth in the allowance for loan and lease losses for 10% estimated growth in the loan portfolio and I commented that we expect they’ll probably because of deteriorating economic conditions probably be a little more reserve billing next year of 10 to 15 basis points, if you do that math on that that’s $22 million or so in estimated allowance, in provision. And we had $19 million this year. So even though we’re projecting a much higher level of credit losses next year it really doesn’t knock our provision expense up that much because this year we raised our allowance from 105 to 1.46% of loans so we had a big reserve building this year and that means that even with noticeably higher credit cost and charge-offs next year that it really doesn’t raise our provision expense very much.
Operator:

Your next question comes from the line of Andrew Stapp - B. Riley & Company, Inc
Andrew Stapp:

Could you tell me what the percentage of construction loans to total loans was at year-end.
George Gleason:

It was 34.4% construction and land development, that’s up 1.6% from September 30. That pretty much was offset by a decline in multifamily from 4.9% of the portfolio at September 30 to 3.0%. I mentioned in the prepared comments that we had a couple of large apartment deals pay off that went secondary market on us in Q4.
Andrew Stapp:

Do you have any leads to sublease your former headquarters.
George Gleason:

We do, we’re in pretty late stage negotiations with a potential tenant who would take all of the building other then the retail branch space in it and we’ve got two pretty firm prospects that are each potential takers of a floor in the building and it’s a three-storey building. So if our whole building user fell through, the two other potentials if we could land both of them, we would have about 80% of the space other then the branch space leased. And I will tell you we didn’t put any revenue from that in the budget so we’ve assumed that’s a zero revenue item and it’s a [debt] cost to carry for the full year of 2009. So if we get something in there that would actually reduce our occupancy expense. We show rental income on facilities as a credit in the occupancy expense line item.
Andrew Stapp:

Salaries and benefits came in lower then I expected, anything going on there.
George Gleason:

We just don’t want to overcharge you for what we’re doing down here. Nothing unusual there at all. Obviously I would have loved to have had that come in a whole lot higher because we had a lot more income to pay bonuses with. We didn’t achieve our target level of income that would have triggered us paying our general cash bonus program so I wish that could have been otherwise but it is what it is.
Andrew Stapp:

Do you hold any trust-preferred securities.
George Gleason:

We have a $1 million trust preferred security that’s an insurance trust preferred. We at one time had a pretty good portfolio of bank trust preferred securities and those things ran up in value and we sold them and booked a pretty good profit, decided that the risk reward ratio was no longer favorable and we sold them, we booked that income about two or three years ago and the only one we kept was this insurance trust preferred and it’s a pooled $1 million trust preferred and its performing, paying, there’s not deferment on it. Looks like its going to keep performing and paying so we don’t think that’s an issue.
Andrew Stapp:

The first $20 million loan that you mentioned went just beyond a day beyond 30-days past due, I presume that’s construction loan, was it commercial or residential oriented.
George Gleason:

It’s a land, big land piece right near downtown Dallas. It’s a PUD so you would expect that to be apartments, retail, condo, office, it’s a multiuse building.
Operator:

Your next question comes from the line of Joe Fenech – Sandler O’Neill
Joe Fenech:

I don’t want this question to come across the wrong way because what I think you’ve been able to do in the securities portfolio is certainly very impressive, you’ve been able to do it successfully for a long time but my concern is with the lack of visibility and predictability of some of this stuff. I know things are very volatile but speaking for myself I was shocked at the margin expansion you put out this quarter and I feel like I have no way of projecting whether or not you can sustain that so it makes modeling your earnings very difficult. If you look at your stock today I know the group is down now but you’re down almost 8% and you handily beat consensus. It doesn’t seem on the surface that you’re getting paid for the perceived risk you may be taking in the investment portfolio in an area frankly that doesn’t seem connected to your core banking business.
George Gleason:

Our business is to make money for shareholders. And we basically have a deposit gathering franchise that gathers the deposits and makes loans and investments with those deposits and whether or not our earning asset book is all loans or a mixture of loan and deposits is going to be based on the relative risk and rewards of each scenario. For example when we found this anomaly between tax exempt mortgage-backed securities and taxable mortgage-backed securities in October and what caused that was there were a bunch of hedge funds and other investors that were having to liquidate large portfolios because of problems in their business and liquidity issues and because they were having to liquidate these large portfolios you had a bunch of this product being put on the market and the normal buyers weren’t there. Banks wouldn’t look at it because it was non-[BU] paper and CMO traders didn’t look at it because they don’t have the analytics and a CMO trading desk just never looks at it. So it was just an anomaly. And we looked at it and said, my gosh this while its non-bank qualified 100% [TEFRA] paper its AAA you can look at the analytics, you can look at the performance of these portfolios, you can look at the age and seasoning of them, you can look at the demographic to the market, this stuff is easy to underwrite from a credit perspective because you’ve got a ton of data on it and I’m getting yields that are a lot bigger then I can get on loan yields with lots less risk in a liquid instrument. Why would I say well gosh I’m a bank, I oughta just take deposits and make loans when I can make more money buying these couple hundred million dollars of securities then I’d make buying loans. So if market doesn’t give us any credit for it, to heck with the market. We’re going to make money, we’re going to build capital, we’re going to build shareholder value, and as I compound that income year after year, I’ll get credit for it. We’ll get credit for it as shareholders. So if the market doesn’t see that as legitimate earnings for some reason or not then the market is saying how you got to go do something that’s got a higher risk and a lower margin and bypass a slam dunk opportunity for something that is lower risk and a higher margin and we’re just not going to do that, we’re going to make money for shareholders and do what it takes to make money for shareholders.
Joe Fenech:

But if you look back over the past three years of the big investment banks, I’m certainly not comparing you to them but with the proprietary trading activities and none of seem to know what the heck was going on and no one really cared as long as the party kept going, now we look back, we’re all shocked at what’s happened and in retrospect we probably shouldn’t have been shocked. So again, I’m not trying to make a comparison between you and them but I guess in the environment that we’re in the concern is in areas that lack visibility is that it all works until it doesn’t work.
George Gleason:

Number one, and I say this in all due respect and I like you, we’re friends, but you are making a comparison now I’m going to make the contrast. You have a Lehman Brothers, a Bear Stearns, and a Morgan Stanley and a Merrill Lynch and all these guys that number one are not very good credit guys. They’re just deal guys. And number two they’re funding this with a combination of short-term commercial paper and bank debt so they’re funding their balance sheet with highly volatile borrowings. We’re funding this with retail deposits, FHLB advances, you’ve got the Federal Reserve back up, you’ve got broker deposits, there’s a litany of well developed deposit sources that we have and if you look at our cost of funds, you’ll realize boy those are well developed deposit sources and they’re doing this with cheap cost of funds and a stable diverse source of funds. So number one, we don’t have the liquidity issues that those guys had. Number two we are credit people and those guys are deal guys and we’re looking at the credit on this and I’ve been doing credit for 30 years and this is good credit. And these are great yields and great returns on that credit. Number two the stuff we’re buying at $0.70 and $0.80 and $0.90, they were probably buying some of the same stuff, and when the stuff was issued it was coming out at 106 and 107 cents. This stuff was par or premium paper when it was originated and we’re buying it at deep deep discounts and we’re buying the good stuff and I don’t know who’s buying the garbage that they had on their books but this is high quality good credit stuff. We’ve underwritten credit, we’ve understand the credit, we’re funding it with stable funding sources so while you’re not making the comparison I’m going to be very quick to make the contrast and that is what they were doing and what we’re doing is totally different. And if somebody doesn’t see that and understand that then they probably ought to not be underwriting financials. I want to make one other thing, and again we’re friends and so forth, but I noticed in your research report on us that you treated the OTTI charge on the security as a one-time item and you treated, or took the BOLI out rather as a one-time item and treated the OTTI charge as a recurring item.
Joe Fenech:

I’m happy to explain that. The OTTI charge we perceived to be as part of the ongoing activities of the company. We counted all the benefit over the years from the income earned so to speak from those securities and I liken it to when companies want us to exclude large one-time provision expenses where we counted the income for when those loans are performing, we’re also going to count the cost from the other side of the equation. So that’s our rationale for excluding the OTTI charge.
George Gleason:

Well you included the OTTI charge—
Joe Fenech:

I’m sorry, the reverse, that’s the rationale for including the OTTI charge as part of co-operating earnings.
George Gleason:

But I would argue with you that the BOLI benefits ought to be included on the same basis as the OTTI charge simply because if you’re going to follow your logic the cost of carrying that BOLI has been in my earnings for seven years and at some point we’re going to get those death benefits, and I’ve paid the cost on it for seven years and I’ve got the benefits and using your analogy on the OTTI charge the BOLI ought to be treated the same way. We view our $0.54 earnings number as a core number. So just a philosophical difference and I appreciate and I understand where you’re coming from but I would note that I philosophically disagree with the way you handled that. Friends notwithstanding that.
Operator:

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.
George Gleason:

Thank you very much, we appreciate you guys phoning in on the call today and your interest and support for our company. Thank you very much. We look forward to talking with you again in about 90 days. Have a great day.

Bank OZK Q4 2008 Earnings Call Transcript

Other Bank OZK earnings call transcripts:

Bank OZK
Q4 2008 Earnings Call Transcript