Bank OZK
Q3 2013 Earnings Call Transcript

Published: 11 Oct 2013

[Operator:]

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Bank of the Ozarks, Inc. Third Quarter Earnings Release Conference Call. Today's call is being recorded. At this time, I'd like to turn the conference over to Ms. Susan Blair. Please go ahead, ma'am.

[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 quarter just ended and our outlook for upcoming quarters. Our goal is to make this call as useful as possible in understanding our recent operating results and outlook for the future. To that end, we may make certain forward-looking statements about our plans, goals, expectations, thoughts, beliefs, estimates and outlook, including statements about economic, real estate market, competitive, credit market and interest rate conditions; including conditions from current political stalemates in the U.S. Congress resulting in possible monetary default by the U.S. government on its monetary obligations; revenue growth; net income and earnings per share; net interest margins; net interest income; noninterest income, including service charge income, mortgage lending income, trust income, net FDIC loss share accretion income, other income from loss share and purchased non-covered loans and gains on sales of foreclosed assets, including foreclosed assets covered by FDIC loss share agreements; noninterest expense; our efficiency ratio, including our goals for achieving a sub-40% and eventually, a sub-30% efficiency ratio; asset quality and our various asset quality ratios; our expectations for net charge-offs and our net charge-off ratios; our allowance for loan and lease losses; loan, lease and deposit growth, including growth in our legacy loan and lease portfolio through 2014 and growth from unfunded closed loans; changes in expected cash flows of our covered loan portfolio; changes in the value and volume of our securities portfolio; the opening and relocating of banking offices; our goals for traditional mergers and acquisitions and making additional FDIC-assisted acquisitions; other opportunities to profitably deploy capital and our goal of improving on our third quarter earnings and the final quarter of 2013 and each succeeding quarter of 2014. 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'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 G. Gleason:]

Good morning, and thank you for joining our call today. We're pleased to report our excellent third quarter results. Let's get right to the details. Net interest income is traditionally our largest source of revenue and is a function of both the volume of average earning assets and net interest margin. Of course, loans and leases comprise the majority of our earning assets. In the quarter just ended, our loans and leases, excluding covered loans and purchased non-covered loans, grew $79 million, bringing our total growth in such loans and leases for the first 3 quarters of this year to $407 million. Our unfunded balance of closed loans increased another $196 million during the third quarter and now stands at $1.13 billion. While some portion of this unfunded balance will not ultimately be advanced, we expect that the vast majority will be advanced. This has favorable implications for future growth in loans and leases outstanding. Despite the intensely competitive environment, we are finding opportunities for good quality, good yielding loans. Because our lending teams are maintaining sound pricing and sound credit discipline and getting so much cash equity in most new loans, we believe that the loans we are originating are of very high quality. During the quarter just ended, we closed our FNB Shelby acquisition, which contributed substantially to growth in our balance of purchased non-covered loans. Such loans increased $368 million from $31 million at June 30, 2013 to $399 million at September 30, 2013. This combined growth of $79 million of legacy loans and leases and $368 million of purchased non-covered loans was partially offset by $71 million in paydowns on covered loans. The net effect of all this was $376 million of growth in total loans and leases during the quarter just ended. Our substantial growth in loans and leases during both the second and third quarters of this year resulted in a substantial increase in average earning assets in the quarter just ended. Specifically, average earning assets were $3.78 billion in the third quarter, up significantly from $3.29 billion in the second quarter. In regard to net interest margin, our third quarter net interest margin was 5.55%, a decrease of only 1 basis point from the 5.56% level in this year's second quarter. Our strong growth in average earning assets, in tandem with only a 1 basis point decline in net interest margin, resulted in third quarter net interest income of $50.6 million, which was a $7.2 million increase from the second quarter of this year. Let me give you some updated guidance regarding loan and lease growth and net interest margin. Specifically, first, we expect good growth in loans and leases, excluding covered loans and purchased non-covered loans, in the final quarter of 2013. Our quarterly results for loan and lease growth tend to vary quite a bit, but we expect that our fourth quarter loan and lease growth will be more or less in line with the average loan and lease growth achieved in this year's first 3 quarters. Secondly, we are increasing our previous guidance for growth in loans and leases, excluding covered loans and purchased non-covered loans, in 2014. Our previous guidance was a minimum of $480 million, and we're increasing that to a minimum of $540 million. This increased guidance for 2014 is based on a combination of factors, including our substantial growth in unfunded balance of loans already closed and our excellent current pipeline of loan requests. Third, we expect some further decline in our net interest margin in the coming quarters. Over the last 4 quarters, our net interest margin has declined from 5.97% in the third quarter of 2012 to 5.55% in the third quarter of 2013. That's a total decline of 42 basis points for an average quarterly decline of between 10 and 11 basis points. We expect a smaller magnitude of decline over the next 4 quarters. More rapid loan and lease growth, coupled with a rapid paydown of loans covered by loss share, will amplify any decline in net interest margin. Conversely, slower loan and lease growth, combined with a slower rate of paydown in covered loans, would be expected to result in a more modest decline in net interest margin. Of course, this guidance ignores the impact of any additional acquisitions on both the volume of our earning assets and our net interest margin. In recent years, our net interest margin has consistently been among the best in the industry and is truly the results of a team effort. Our deposit team has been very effective in improving the mix of our deposits and has steadily reduced our average cost of interest-bearing deposits. They achieved another 1 basis point reduction in our cost of interest-bearing deposits to 22 basis points in the quarter just ended from 23 basis points in the second quarter of this year. In our last conference call in July, we stated that as a result of our substantial growth in loans and leases, we would begin to increase our deposit pricing and marketing efforts in several precisely targeted offices or groups of offices, as needed, to generate the deposits to fund our expected future growth in loans and leases. And we stated our belief that our second quarter cost of interest-bearing deposits would be the low point for this economic cycle. As stated, we did increase our deposit pricing and marketing effort in several targeted markets in July and August, with the effect of generating very nice deposit growth in those markets. While all this happened almost exactly as expected, our deposit pricing and regional banking team did an excellent job in controlling our cost of interest-bearing deposits. And as a result, we had another 1-basis-point reduction in that cost. Perhaps our team can eke out another small increase in our cost of interest-bearing deposits, but our belief is that the third quarter results will either be the low point or very near the low point of our cost of interest-bearing deposits for this economic cycle. We expect that our cost of interest-bearing deposits will increase slightly in coming quarters, as we continue to accelerate deposit-gathering activities to fund expected future loan and lease growth. Let's shift to noninterest income. Income from deposit account service charges is traditionally our largest source of noninterest income. Service charge income for the quarter just ended was a record $5.82 million, an increase of 14.6% compared to the second quarter of this year. Of course, part of this increase was due to the 2 months of service charge income from the former FNB Shelby offices, which amounted to $430,000. But even excluding this service charge income from the recently acquired offices, our third quarter service charge income would have been $5.39 million, still a record, and up 6.2% from the immediately preceding quarter. These deposit account service charge results reflect the great work our retail banking team is doing in growing core customer relationships. Mortgage lending income for the quarter just ended was $1.28 million, a decrease of 23.7% compared to the third quarter of 2012 and a decrease of 22.3% from this year's second quarter. As we all know, mortgage interest rates have increased significantly over the course of the last 2 quarters. And this was evident in our third quarter results. Our total mortgage origination volume decreased 17.7% from $61.6 million in this year's second quarter to $50.7 million in the quarter just ended. Mortgage refi volume has been significantly impacted. In the first quarter of this year, mortgage refinancings accounted for $38.3 million of our originations. The refis declined to $29.7 million in the second quarter and $20.4 million in the third quarter. Mortgage originations for home purchases were $30.3 million in the quarter just ended, decreasing slightly from $31.9 million in the second quarter, but increasing from $21.7 million in this year's first quarter. Trust income for the quarter just ended increased 22.5% compared to the third quarter of last year and 22.5% compared to this year's second quarter. This increase was due to the 2 months of trust income from the former FNB Shelby offices, which amounted to $222,000. Excluding this trust income from the recently acquired offices, our third quarter trust income would have decreased slightly compared to both the third quarter of last year and the second quarter of this year. Net gains from sales of other assets were $2.50 million in the quarter just ended compared to $1.43 million in the third quarter of 2012 and $3.11 million in this year's second quarter. In recent years, such net gains have been a meaningful contributor in every quarter. In most quarters, these net gains have been primarily attributable to gains on sales of foreclosed assets covered by loss share agreements. We expect that net gains will continue to be a significant income item for many quarters to come. As part of our FDIC-assisted acquisitions, we record a receivable from the FDIC based on expected future loss share payments. And we record a clawback payable to the FDIC based on estimated sums we expect to owe the FDIC at the end of the loss share periods. The FDIC loss share receivable and the related clawback payable are discounted to net present values, and such discounts are accreted into income over the relevant time periods. In the quarter just ended, the resulting net accretion income was $1.40 million, a decrease from $1.70 million in the third quarter of 2012 and $2.48 million in this year's second quarter. Of course, this category of income is expected to go down as we collect and reduce our FDIC loss share receivable. The decrease in this net accretion income in the quarter just ended also reflects another phenomenon. As we have more experience with our portfolios of covered loans and as these portfolios become more seasoned, we are increasingly revising upward the projected cash flows on certain loans where we originally expected a loss but no longer expect a loss. These are loans where principal reductions, through regular amortization or unscheduled principal payments or the provision of additional collateral by the borrower or improvement in the borrowers' overall financial condition or other factors, have essentially eliminated the perceived risk of loss. The effect of these upward revisions in projected cash flows is to accrete into interest income over the remaining life of the loan the previous nonaccretable difference and to amortize against accretion income -- noninterest income over the remaining life of the loan or the remaining loss share period, whichever is shorter, the related FDIC loss share receivable. This is one of the reasons for the decline in income from accretion of our FDIC loss share receivable in the quarter just ended. This was also the primary factor in the increase in the yield on our covered loans from 8.93% in the second quarter to 9.49% in the third quarter. Based on the improving risk profile and greater seasoning of many of our covered loans, we expect to identify additional loans in future quarters for which it will be appropriate to upwardly revise our estimates of future cash flows. These are loans in which the perceived unusual degree of credit risk will have been resolved and therefore it will be appropriate to accrete the previous nonaccretable difference into income over the remaining life of the loan and to amortize any related FDIC loss share receivable over the shorter of the remaining life of the loan or the remaining loss share term. Now the net effect of all this is positive for net income since we will have an additional $1.25 of interest income for every $1 of reduced noninterest income related to amortization of the FDIC loss share receivable. Of course, if this plays out as expected, income from accretion of our FDIC loss share receivable will tend to decline in future quarters, with corresponding increases in yields on covered loans. In addition, noninterest income in the quarter just ended included other income from loss share and purchased non-covered loans of $2.48 million compared to $2.27 million in the third quarter of 2012 and $3.69 million in this year's second quarter. This line item includes certain miscellaneous debits and credits related to accounting for loss share assets and purchased non-covered loans. But it consists primarily of income recognized when we have collected more money from covered loans and purchased non-covered loans than we expected we would collect. We refer to these additional sums collected as recovery income. It is likely this will continue to be a meaningful income item for many quarters to come, and because it can be significantly impacted by loan prepayments, other income from loss share and purchased non-covered loans will tend to vary from quarter-to-quarter quite a bit. You will note from our press release that we had $0.9 million of provision expense in the quarter just ended for covered loans. Obviously, that number reflects covered loans where we were not conservative enough in our initial or previous estimates of cash flows. However, if you consider that number in the context of our gains on sales of other assets, including other assets covered by loss share, and our income from covered loans and purchased non-covered loans, you will see that our acquisitions continue to be a very positive impact on income. Let's turn to noninterest expense. In recent conference calls, we have stated that one of our key goals is to get back to a sub-40% efficiency ratio over the next 2 or 3 years and to ultimately achieve a sub-30% efficiency ratio, although the timing and likelihood for achieving that latter goal are much less certain. We believe there are 4 key steps that we must take to achieve these efficiency goals

[Operator:]

[Operator Instructions] And we'll go first to Michael Rose with Raymond James.

[Michael Rose:]

I appreciate the updated guidance for loan growth for 2014. Was there an update for 2015 of these $50 million per month?

[George G. Gleason:]

We've not updated 2015 yet. We will probably get to that in January.

[Michael Rose:]

Okay. And then I wanted to get a sense for the growth in unfunded balances this quarter, which was strong. How much of that came or was contributed from the New York office?

[George G. Gleason:]

Not very much at all. Our New York team has not yet closed a loan. They've had 2 loans through committee that are approved, that we're very, very excited about. They've got a pretty good stack of loans that they're working on. In fact, I spent last Saturday and Sunday with my wife, who's also on our loan committee, in New York. We looked at the 2 previously approved loan committee projects and just validated how pleased we were with those 2 credit opportunities and looked at 5 more opportunities they've got in the pipeline. So we spent 2 days all over the area there looking at those, and they're doing a good job. They're embracing our culture. They're being very careful, as is our nature, and making sure that the applications they bring us comport with our high-credit standards and underwriting standards. So that office is doing very well, but it really didn't contribute anything to our growth in Q2 or to our Q3 -- or our unfunded balances in Q3. We'll see that beginning to kick in, in Q4.

[Michael Rose:]

Okay. So with the increase in the loan growth guidance for '14, does that factor in contribution from the New York office? Or will the New York office be incremental to that minimum growth guidance?

[George G. Gleason:]

It's factored into that minimum growth guidance.

[Michael Rose:]

Okay. And then just one more question, if I could. How much of the cost saves from the Shelby acquisition did you realize in the third quarter and how much do you have left from here?

[George G. Gleason:]

We've got some more room. I will tell you that our Shelby acquisition -- of course, we've got 2 months of operating results on that. And if you exclude the merger and acquisition cost, the extra cost related to it, the operating earnings rates there in August and September were very good. We're not at our 20% ROE threshold yet, but we're running a mid-teens-plus. We're 15% -- in the 15% to 20% ROE range on that acquisition right out of the box. So we're very pleased with the job that the team is doing over there and the way that revamped operation is performing. We do have some more cost saves to get. I had mentioned in the last call that we expected to convert their operating systems in February. We put that on hold because I have asked our IT people to do a complete review of all of our systems and all of their systems from our core banking system to all the peripheral systems, because I want to make sure that we're converting to the best possible system for our company in the future. So over the next several months, we'll be doing a stem-to-stern review of every software program we're running, every hardware piece that we're operating on that, to really make sure that our technology is where we need it to be, when we're a $10 billion and a $20 billion and $30 billion bank. I've told the guys that, certainly, the most convenient thing to do is just convert Shelby and put them on our system. But I'm not interested in convenient. I'm interested in optimal solutions. So we're undergoing that review, and that will delay that. Now, with that -- with those cost saves delayed indefinitely from a conversion of the systems and sort of I've probably embedded that additional cost structure in our system through a large part, if not all of 2014, by delaying that, we've gone back through and looked at other areas to control costs. And we'll get comparable cost saves elsewhere or have already taken action for the most part to get comparable cost saves that will get us what we thought we would have gotten from the consolidation of those operations sooner. But I want to make sure we get this conversion right. They're on Jack Henry SilverLake. I'm not sure SilverLake is where we need to be long term. We're on FIS Bankway. I'm not sure that's where we need to be long term. And until I'm sure where we want to be at $10 billion and $15 billion and $20 billion and $30 billion, we're not going to convert anybody.

[Michael Rose:]

That's helpful. Should we expect any elevated cost related to this review?

[George G. Gleason:]

No, I don't think so.

[Operator:]

And we'll continue on to Brian Zabora with KBW Research.

[Brian James Zabora:]

A question on the kind of the deposit growth you had, how much -- could you give us a sense of how much you generated as far as deposit growth from those markets that you guys [ph] are targeting? And are you expanding that program at all or still focused on maybe a select number of targets?

[George G. Gleason:]

We -- the term we're using is a spin-up. We spun up 5 offices, 4 of them in late July and one of them in August. And we generated in excess of $50 million. We're continuing to pursue that and would expect comparable results. In fact, the first few weeks when you start those efforts, you tend to get very little, the longer that you go forward with in the campaign, tends to gain traction. So we expect to continue with those offices based on the substantial liquidity that we had at the end of the quarter. I think we were sitting on $60 million or $70 million of surplus cash then. Combined with the expected growth in those offices and from a couple of other sources, we probably will not spin up additional offices until sometime in the first or second quarter of 2014. I think we can get the additional growth we need without putting any more offices in play. And minimizing the number of offices in play helps us keep that cost of interest-bearing deposits suppressed.

[Brian James Zabora:]

Great. Now also a question on loan loss provision. It was up -- the non-covered provision was up in the quarter. Just want to get a sense of maybe what's driving that with all the credit metrics seemingly improving from second quarter.

[George G. Gleason:]

Yes. The directionality of the provision expense and the allowance does seem contrary to the credit metrics. And our allowance calculation is very formula-driven. And sometimes when you have formula-driven calculations, you get some results that don't seem to quite jive with some of the other headline numbers. But we had -- 2 appraisals are a large part of that. And we tend to -- and almost every case, I think, I'm sure there's some exception somewhere, but none come to mind. Almost every case where we've got a property that appraises for less than is loaned against it, we tend to reserve or set aside an allowance allocation for that collateral insufficiency, even if it's a performing loan that we never expect will be a problem. And we had a probably less than $3 million loan in Texas and $2 million or $3 million in Arkansas that we got new appraisals on in connection with the normal annual renewal review of those credits. These are performing credits. I don't think they ever are not performing credits. But because the appraisals on those credits came in at less than the amount owed, we ended up setting up $1.6 million allowance allocation. $1.6 million, Greg, $1.7 million?

[Greg L. McKinney:]

$1.6 million, yes.

[George G. Gleason:]

Somewhere in that range, allowance allocation for that. So obviously that popped our allowance and our allowance ratio as a percent of total non-covered, non-purchased loans and leases, up several basis points as a result of that. So I don't think one should read any ominous implications into that. It just simply is the way the formulas worked out. Otherwise, apart from those specific allocations, the allowance percentage would have, as a percent of total loans and leases, non-purchase, non-covered, would have continued to work down in the quarter just ended.

[Brian James Zabora:]

That's very helpful. And then just lastly, the $1.4 million in kind of merger charges, what line items were they? Were they all in other expenses or were they also -- were there some in salary?

[George G. Gleason:]

They were pretty much all in other. They're all in other. Yes. Thank you.

[Operator:]

Matt Olney with Stephens Incorporated.

[Matt Olney:]

Going back to the integration of Shelby, it looks like you've done quite a bit of work on their securities book in recent months. Is this something you're still rightsizing or is this mostly behind you now?

[George G. Gleason:]

We're pretty much done on that. The Shelby securities book pre-acquisition, pre-closing, we worked with them to really move the assets out of the portfolio that we were uncomfortable with, and they did a really good job and were very cooperative in working with our people to adjust that. We had expected to do some more work on their portfolio post-closing on assets that just -- we would've preferred a different asset based primarily on yield. Their book of bonds was almost exclusively short- and medium-term agency, mortgage backs, very, very plain-vanilla securities and they don't meet our normal yield metrics on those securities. So we would have probably, all other things being equal, would have started a process of trying to handpick municipal securities with an equivalent duration profile, but a better yield profile and rolled that portfolio over. But due to the accounting for -- and the limitation on deferred tax debits and the purchase accounting on this transaction, the portfolio, when we brought it over, had about a $10 million negative mark on it. And we, of course, recorded it at fair value, so we put it on our books at the $10 million reduced valuation. But had we sold those bonds, the way the deferred tax debits on this work, we would have not been able to recognize those losses, so that $10 million in nominal loss would have been a $10 million after-tax loss. And when we actually did the math on that, and the reinvestment yield on that, we decided that we would prefer to just let those -- let that portfolio run off over time and have a little lower yield than we would normally strive to get in our portfolio than to liquidate them at that market value price and not be able to take a deduction from their cost basis down to our fair value purchased accounting basis. So the portfolio, that's a very long answer to explain why the portfolio is pretty much going to stay set, we think, as it is.

[Matt Olney:]

George, that $10 million reduced valuation, is that a discount that you're going to accrete in the future?

[George G. Gleason:]

Yes, because it will -- we recorded them at fair value and those were discounts to par, and the bonds will accrete to par over the estimated life of the loan, yes.

[Matt Olney:]

And what kind of duration should we expect on the accretion of that $10 million?

[George G. Gleason:]

It's probably -- I don't know that number, Matt, so I'm guessing, but I would say it's 5 or 6 years. And a pro rata part of that accretion was built into our yield on those bonds in August and September. So it's not going to be anything different than what you're seeing in the Q3 numbers.

[Matt Olney:]

And then, shifting over towards the loan yields. The yields on the originated loans was down, I believe, sequentially around 15 basis points. Can you give us any color on the average yields of some of your newer production of originated loans?

[George G. Gleason:]

Those average yields are probably running in the low 5s, very low 5s, maybe very, very high 4s, type handles and I haven't had time -- Greg and Susan schedule our conference call dates, and I don't know whether they want to go on vacation next week or what. But they scheduled this call really early so I haven't had time to actually break down that data, but just intuitive sense from all of the deals that I'm seeing in committee and that are flowing across my desk, it's very high 4s, probably to very low 5s on an average basis.

[Operator:]

We'll continue on to Kevin Reynolds with Wunderlich Securities.

[Kevin B. Reynolds:]

Talking about a little bit about M&A. Not to rush you into anything, but you've completed this transaction, looks like you're getting some pretty good results right out of the gate. Is there -- how do you feel about doing another live bank deal as you go forward, time-wise? I know that they sort of have to present themselves, and it's not just a volume game, but would you be comfortable going out and doing something, say, in the next quarter or 2 or 3, or do you feel like you need to stay on the sidelines a little bit just to work on this one given its size?

[George G. Gleason:]

No, not at all. In the time that the Shelby transaction was pending, I think I spent 28 days there on 7 or 8 or 9 different trips and had 8 to 10 people with me every time. So we really had everything we needed to do to implement our business plan for Shelby done by the day the transaction closed. And honestly, we were looking at other opportunities and doing due diligence on other opportunities within a week or 2 of announcing the Shelby transaction, which was back in January or February. So we never went to the sidelines because we had one pending. And if we were to somehow miraculously announce an acquisition tomorrow, then next week, we would be looking for another one. So we're constantly engaged and looking. And in the loss share days, we bought 2 on 1 day. Wouldn't have -- wouldn't bother me at all to announce 2 live bank deals if 2 good opportunities presented themselves simultaneously. And we had 4 at one time that were in various stages of conversion process as unconverted, and that wouldn't bother us again. We have the manpower and the capacity to handle multiple transactions at once. And certainly, our only having done one so far this year is not a reflection of we could only do one.

[Kevin B. Reynolds:]

Okay. And for personal reasons, I hope you don't announce one tomorrow. But going back to your discussion about the systems that you're talking about and kind of reviewing that and thinking about where you needed to be longer term, does that -- can we read into that any inference as to how big you might need to be? Is that just a -- is that a function of getting larger and needing more robust systems or just a natural evolution of upgrading technology as you go forward?

[George G. Gleason:]

The standard that I have told our IT guys, and I've been pounding this message with those guys for quite a while, is our company is one of the top performers in the industry in regard to net interest margin, in regard to asset quality, in regard to efficiency, in regard to ROA, in regard to ROE, in regard to our ethics, our integrity, our transparency and openness with the market. Those are all standards of just the absolute highest caliber in the industry. And what I've challenged our IT guys is, is that our technology is good, it's very adequate, but it's not at the elite level of the industry. And our technology-based products are good and reasonably adequate, but they can be better. And what I've challenged our technology team, and I'm so proud of the guys because they've embraced this challenge and they've really taken it to heart, is I want to have the same industry-leading standards, top-of-the-universe standards for technology and technology-based products we have for everything else in the company. So that's where we're trying to get to. It's not that we've got a problem or it's not why we can't grow, we could get to $10 billion or $15 billion and be quite adequate with what we've got. But as you know, our standards here are not, well, adequate or good enough. Our standards are, what's the best we can possibly be and the IT guys have embraced that and made that their standard and they're on a mission to get us there in a cost-effective and safe and efficient way.

[Kevin B. Reynolds:]

Okay. And then I guess one last question, going back to the M&A opportunities out there. If you look back over the last, let's say, 12 months or so, the handful of companies that have been successful acquirers, yours is included in that, obviously, their stocks have absolutely soared and the market has embraced that strategy as a means for growth. I suspect that will probably continue. However, if you look at who your natural competitors are, some of those companies that have been active acquirers are sort of tied up right now with varying stages of integration or pending deals, et cetera. Do you get the sense that, a, sellers out there are starting to look at the same charts and say, rather than just sort of generally thinking about selling, we want to go out and target our own partners and structure that same kind of deal and then take your currency and go along for the ride; and then b, do you get the sense that maybe your buyer -- your competitors for some of those deals are on the sidelines and that may open up a little opportunity for you now that Shelby is behind you?

[George G. Gleason:]

Well, I wouldn't speak on behalf of our competitors. I'd let you ask those guys if they're on the sidelines or not. We have had several potential target institutions that have approached us and said, "We think it's in our best interest to consider a business combination and we would very much like to own your stock, we would very much like to be part of your company, we think we could be a good fit for you and that we would benefit from having your currency instead of our independent currency." Something along those lines, we've had that conversation several times. So yes, I think we are a preferred acquirer and we're going to continue to be very, very disciplined. And I certainly understand that we've been in an environment over the last several quarters where any deal that got announced seemed to have favorable response for the acquirer's stock. And, frankly, I think that's a dangerous environment to be in. And it's probably made me more cautious about doing a deal than not. And, honestly, probably, it's had no effect, honestly. Let me withdraw my previous comments. Really, had no effect on us doing deals, but I would never ever, ever do a transaction that didn't meet our standards for long-term performance and viability just because I knew why we -- our stock will get a 10% or 15% bump if we announce this deal. And if you run a company that way, you're going to have a bumpy ride. You're going to take all the rides up and you're going to take all the rides down because you're just going to suffer from the fads that come and go. And that has never been the way we've run this company. We've run this company with a very disciplined focus on doing things that are incrementally better every day than they were the day before. Just like we're trying to incrementally improve our technology and technology-based products, not because we have to, it's just because we want to get better and we see room to get better. So acquisitions are going to be driven the same way. We're going to do things that we think are going to make our company better and more profitable and generate high ROE numbers for us. And if they won't do that, even if it's a sexy sizzling headline that would get our stock a good bump, we're not going to do it if it doesn't fit our long-term plan. We're very disciplined, as you know.

[Operator:]

[Operator Instructions] We'll go on to Peyton Green with Sterne Agee.

[Peyton N. Green:]

I was just wondering, these are a couple of relatively small questions, but I wanted to be clear. How much of the targeted savings did you realize on the First National Bank of Shelby acquisition? And then how much would you allocate towards the deferred systems conversion? And then secondly, earlier this year, we spoke about the opportunity for you all to grow your leasing business, and I was just wondering if you're having any success there?

[George G. Gleason:]

Okay. Well, let me start with the leasing first, yes, that is a small part of our business. At year end, it was $68 million, it's $82 million at June 30. So that's -- we're on track for a 20-plus percent growth rate there. Scott Hastings does a great job running that operation for us, and Scott has aspirations to grow it more quickly and more effectively in the future as market conditions permit, and he actually thinks it's a pretty good market environment right now to grow that. So we're continuing to add people. Scott is a very disciplined, very deliberate guy and he runs that department in that way. So he'll add another producer or 2 and build some relationships and get those guys profitable and then go get a couple of more, and add them. You could go out and add 10 guys and take a hit to earnings in the process and grow a little faster, but he is growing it in a very incremental and disciplined sort of way. And I think we'll get a good result doing that. Now your other question about cost savings, I would say we already gotten about probably 75% of the cost saves we would have expected to get out of Shelby. And there is an additional chunk of cost savings to be gotten when we do consolidate those operations. And I haven't -- I'm cold on what those numbers are, so I'm not even going to guess at a number, but it's probably 25% or less of the total cost saves from the transaction. And as I said earlier, when we made the decision to delay that conversion, we went and sort of went stem to stern throughout the company because I had communicated a certain level of cost saves in our earlier column when I made the personal decision to pull the plug on the acquisition and do this RFP process, I felt obligated to go find some additional savings someplace. So we did a pretty good analysis. And I think have come up with a series of savings that will be roughly equivalent to what we would have gotten if we had done the Shelby conversion sooner rather than later. And we got some of those in Q3, will get the rest of them in Q4 and then we will have some hundreds of thousands of dollars of additional cost saves at a later date when that operation's converted.

[Peyton N. Green:]

Okay. And then with regard to the covered asset portfolio. I mean, how much expense leverage would you expect to see from that portfolio shrinking and your work out efforts declining over the next 4 or 5 quarters? And did you see any significant amount in the third quarter?

[George G. Gleason:]

Again, we're so early with the call, I haven't broken down and gotten into those numbers, but I do think we're on the cusp of -- I would expect we saw some improvement in that in the quarter just ended and I think we'll see a lot more improvement in that over the next 3 or 4 quarters. I think that can have a significant role in helping us improve our efficiency ratio over the next, between now and December 31, 2014, on a quarter-to-quarter basis. Those portfolios are shrinking, actually, a little faster the last 2 quarters than I would have projected. And our special asset guys working on those portfolios are really resolving a lot of -- some of the more thorny complex things that have been long-term work out resolutions in those portfolios. And I see all that coming across my desk and they're really making a lot of progress on a lot of the more challenging issues and challenging means it takes more legal cost to round it up, and get it in the pen. And we're getting a lot of those in the corral now, and getting them put to bed.

[Peyton N. Green:]

Okay. And then last question with regard to that, I mean, where would you expect that portfolio to kind of bottom out as the core portfolio?

[George G. Gleason:]

Well, as I say, it's run off at a little faster rate the last 2 quarters than I expected. And I think what that reflects is, and you can see this in our last 2 quarters recovery income numbers, there are a lot of banks over there that are refinancing things away that we still think have credit marks in them, and doing them at much lower rates than we have them on at much longer terms. So that is actually speeding the erosion of those portfolios. So I don't really know quite where that plays out. Now you can look in our Qs and you can see the breakdown between what's 415B assets, the commercial loss share assets, and what are 415A assets, the residential loss share assets, and, of course, the residential assets have 6.5 to 7.5 years to go on those. The nonresidential pieces of the portfolio have 1.5 to 2.5 years to go on the loss share time periods on that. So once the commercial stuff all gets worked through, the residential stuff will -- that erosion in that portfolio will taper out over a much longer period of time because we'll be down to the residential 415A assets that have 5 more years of loss share and just by their very nature, I mean, residential secured loans tend to have a longer amortization cycle.

[Peyton N. Green:]

Okay. No, I guess my other question is just kind of longer-term, over a 2- or 3-year period, you might kind of get left with a loan portfolio that's maybe smaller than you would have anticipated that covers a similarly sized branch network. Are you seeing any pickup in the origination business or is it just too competitive as banks reenter the market to lend there -- to grow the loan side of the business or will you do it through the deposit side and buy bonds?

[George G. Gleason:]

Well, we'll do it wherever we can get the appropriate risk-adjusted returns on the assets. Georgia is getting a little better. Georgia accounted for, if you exclude covered loans, purchased loans had accounted at December 31 for 1.91% of our loans. So that has grown at September 30 to 2.36% of the portfolio. North Carolina accounted for 4.15% of our portfolio at last year, and that's grown to 5.47% of the portfolio. Alabama accounted for 16 basis points, that's grown to 51 basis points. So our offices in those states are generating some positive growth and I think that will speed up as conditions continue to improve over there. But [indiscernible] the acquired offices would operate with 75% or 100% loan-to-deposit ratios. We've always modeled those offices from the get-go with the assumption that given the economies there in the markets that we're in, that on average, those offices would operate with somewhere around a 40% to 50% loan-to-deposit ratio, and we would make up the extra need for earning assets first with our Real Estate Specialties Group; second, with our leasing division; and third, when market conditions are right do so, our bond portfolio. So our original assumption of how those offices would work and where they'll end up has not really changed.

[Peyton N. Green:]

Okay. All right, great. And then, have -- I mean, what is the right change in market conditions to start adding to the bond portfolio? Have we seen enough of a rise in certain segments or not really?

[George G. Gleason:]

No. I think we're hundreds of basis points away from all-out glut opportunity. Now, what we're doing, obviously, as treasury rates have bounced around, you have bond funds that have had withdrawals and outflows, and as a result of their outflows of investment funds and the bond funds, they've been forced to liquidate bonds. So in the midst of a forced selling situation, you've got the opportunity to go through bid sheets and pick lists and look at offerings coming from brokers that know what they're doing in the market and find mispriced assets. And we've found a pretty good chunk of mispriced assets in July and August and September. But those honestly just about offset the volume of calls and payoffs in the portfolio. So that's what we're doing now is we're trying to selectively look at 100 secondary market bonds that are hopefully coming from forced liquidation situations where guys are more focused on getting them sold than they are getting the last dollar out of them, and we can pick up a bond that we can get 100 basis points or 50 or 150 basis points more yield than a comparable new issue security that was comparable in all respects might count [ph] for today. So we're looking for those mispriced assets. The chance to do a, say, wow, our bond book is $600 million, and we're going to go to $1.2 billion, I think we're 200 or 300 basis points, or 300 or 400 basis points away from that kind of environment, but we'll get there. It's just a matter of time.

[Operator:]

And Joe Fenech with Sandler O'Neill.

[Joseph Fenech:]

George, you talked about being a $20 billion, maybe even a $30 billion bank over time. So presumably at some point, that's going to mean that you'll be doing larger deals than you've done in the past. So is the appetite there to do a very large deal if it should present itself? And then as you first approach $10 billion, do you fall into the camp that says, if I'm going to go over $10 billion, I'm going to want to blow through it, or is that not something that you think about all that much when you're doing your longer-term planning? In other words, would you be fine sitting at $9.5 billion or $10.5 billion for a couple of years?

[George G. Gleason:]

Well, obviously, there's the lost revenue on interchange revenue from the Durbin Amendment when you cross $10 billion, and obviously you become subject to a number of other regulations and regulatory requirements. Now things such as capital and liquidity stress tests, we're already doing the same caliber of liquidity and capital stress testing that really big banks are doing. So a lot of the stuff that would apply to us if we were a $10 billion-plus bank, we already do just as part of our normal risk management and internal management processes and policies and procedures. But there would be other laws, regulations and so forth that would affect us. So hypothetically, since we're a long way from $10 billion, I'll address it very hypothetically, if we got to $9.8 billion or $9.9 billion and we were just going to go to $10 billion or $10.1 billion, you would probably, at that point, deploy a number of different balance sheet management techniques to keep from crossing that line unless you were going to cross that line in a significant enough magnitude that it's going to be positive for you. You wouldn't want to say, well, I'm going to grow $100 million and as a result of $100 million, we're going to make $1 million, or $2 million or $3 million less than we would have made had I been a $100 million smaller. We're not going to do that. So when we get to that day, we will address that in hopefully a very thoughtful, prudent manner that will maximize the interest of our shareholders. We have no specific aspirations to be any size. As you know, size doesn't drive our business strategy. ROE, ROI, quality of performance and all of those performance metrics that we look at in the company drive our performance and drive our strategy, size is just secondary. Now we're generating about a 2% return on assets, it gets harder to do a whole lot better than that. So if we're going to continue to improve earnings that probably necessarily includes us getting bigger and bigger and bigger over time, but the flip side of that is we have no specific stated ambitions to be any particular size. It's just to get better and make more money. Well, that's really the way we think about it and run the company. Your question about, would we do a larger acquisition? We would do small transactions, we'll do medium-sized transactions, we'll do large transactions, whatever fits our business plan and will generate a high-teens to low 20s ROE, assuming an 8% capital allocation, that transaction's in the strike zone for us regardless of size. So if a $2 billion or $3 billion bank that fit that criteria for us was on the table, we would actively pursue it.

[Joseph Fenech:]

Yes, and the latter part of my question though, I can appreciate the answer on if you were $9.5 billion, that you want to kind of manage around that. I guess I was more asking, if you were $6 billion or $7 billion, would a $3 billion or $4 billion, respectively -- an acquisition of that size be less likely because it takes you right up to that line or at that line?

[George G. Gleason:]

That's such a hypothetical question. I don't think I can give you a good answer to it because it's going to depend on a multitude of factors. And let me just say this, just because it would take us to the threshold or slightly above the threshold, we would not automatically disqualify it or rule it out. We're going to look at it, and if it makes great sense for shareholders to do it, we're going to do it. If it doesn't, all factors considered, including the lost revenue and the additional cost of crossing the line when you consider all the factors, if it doesn't make sense, we're not going to do it.

[Operator:]

And our final question comes from Brian Martin with FIG Partners.

[Brian Joseph Martin:]

You got most everything, just 2 things, George. The M&A activity, you talked about it. Has there been any change in activity as far as opportunities you guys are looking at recently versus a year ago, have you seen a pickup with some of the activity in the market, or have you not?

[George G. Gleason:]

Well, Brian, I will tell you this, they're more deals out there to look at. We're seeing more opportunities than we have time to look at. And that was true in February of 2012, it's true today. So we have periodic meetings of the team of people that we have who work on these opportunities, looking at them, running numbers, running models, evaluating the transactions. And we pick priorities, and we say, here are 13 opportunities and we've only got time to do really detailed tabletop work on 1/3 of that or half of that, we're going to focus on this one first and this one second and this one third. And when we get through those, we're going to take another look at the universe and re-prioritize and go again. So that's the way we do it. There are a lot of opportunities out there and we're a small company with a small team of folks working on M&A. So the opportunities transcend what we can actually do due diligence on and do thorough underwriting on and address, so we just have to prioritize them. That has not changed in, basically, the 7 quarters we've been actively devoting staff resources to this effort.

[Brian Joseph Martin:]

Okay. Perfect. And just secondly, the loan book this quarter, what -- what was -- just what categories were the most changed from the second quarter, when you look at the $80 million and kind of organic growth? Where was most of it coming from?

[George G. Gleason:]

We had about $18 million of growth in the multifamily portfolio and we had about $34 million of growth in the construction and land development, which is not surprising given the magnitude of unfunded commitments. And we had about $18 million of growth in commercial real estate, nonconstruction stuff, and that was offset by some shrinkage in C&I and residential 1 to 4 and some growth in leases. And then our other loan category, we actually had $32 million of growth in other loans that is loans to public entities and loans secured by various sort of miscellaneous types of collateral loans to financial intermediaries and so forth all fall in that category.

[Operator:]

And with no additional questions, I would like to turn things back over to our speakers for any additional or closing remarks.

[George G. Gleason:]

All right. Thank you. With no more questions, that concludes our call. Thank you, guys, for joining us today and we will look forward to talking with you in about 91 days or so. Thank you very much.

[Operator:]

Thank you. And ladies and gentlemen, that does conclude today's call. Thank you, all, again for your participation.