Prosperity Bancshares, Inc.
Q3 2009 Earnings Call Transcript

Published: 16 Oct 2009

[Operator:]

Good day everyone and welcome to today’s program. At this time all participants are in listen-only mode. Later you will have the opportunity to ask questions during the question and answer session. Please note this call will be recorded. I will be standing by if you should need any assistance. It is now my pleasure to turn the call over to Mr. Dan Rollins.

[Dan Rollins:]

Thank you. Good morning, ladies and gentlemen. Welcome to Prosperity Bancshares’ third quarter 2009 earnings conference call. This call is being broadcast live over the internet at prosperitybanktx.com and will be available for replay at the same location for the next few weeks. I’m Dan Rollins, President and Chief Operating Officer of Prosperity Bancshares. Here with me today is David Zalman, our Chairman and Chief Executive Officer; H.E. Timanus, Jr., Vice Chairman; and David Hollaway, Chief Financial Officer. David Zalman will lead off with a review of the highlights of our recent quarter. He will be followed by David Hollaway who will spend a few minutes reviewing some of the recent financial statistics. Tim Timanus will discuss our lending activities including asset quality. Finally, we’ll open the call for questions. During the call, interested parties may participate live by following the instructions that will be provided by our call moderator, Shannon or you may email questions to [e-mail]. I assume you’ve all received a copy of the earnings announcement we released earlier this morning. If not, please call Tracy Schmidt at 281-269-7221 and she will fax a copy to you. Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for the purposes of federal securities laws and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Prosperity Bancshares to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in Prosperity Bancshares’ filings with the Securities and Exchange Commission, including its Forms 10-Q and 10-K and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements. Let me turn our call over to David.

[David Zalman:]

Thank you, Dan. I would like to welcome everyone to our third quarter 2009 conference call. I am delighted to report another quarter of solid performance by our team. Among our successes this quarter are the operating earnings increase to $29.3 million or $0.63 per diluted share. That’s compared to $24.6 million or $0.53 per diluted share for the same period in 2008. This represents an increase in earnings per share of 18.9%. For comparison purposes, I’ve excluded the loss on the Fannie Mae and Freddie Mac preferred stock that we recorded during the third quarter of last year. GAAP earnings for the third quarter of 2008 were $0.33 per diluted share. The $0.63 was an increase of 18.9% over the $0.53 in the same quarter last year. Our third quarter net interest margin was 4.08% compared with 4.15% for the same period of 2008 and 4.04% for the second quarter of 2009. Our non-performing assets increased 3 basis points to 29 basis points of average earning assets from 26 basis points in the same period last year and from 26 basis points at the June 30, 2009. Our Tier 1 risk based capital ratio is 11.85% at quarter end. Our total risk based capital ratio is 13.01% at quarter end and our Tier 1 leveraged capital ratio is 6.09% for the quarter ending September 30, 2009. That’s compared to 5.81% for the quarter ending June 30, 2009, a 28 basis point increase in one quarter or a 19.3% increase on an annualized basis. Our efficiency ratio improved to 44.6% from last year’s 49%. Our loan loss reserve increased to 1.39% from 1.05% for the same period last year. Our allowance for loan loss has increased 39% over the past year to $47.3 million compared to $33.9 million for the same period last year. Our earnings momentum continues to be very strong. This is especially true when you take into consideration the additional $16.5 million in provision expense over last year for nine months and an additional $10.2 million in FDIC insurance expense over last year for nine months. These two items alone have increased our nine month total expenses by $26.7 million above last year’s level. A little bit about loans

[David Hollaway:]

Thank you, David. Net interest income for the quarter ended September 30, 2009 increased 33.9% to $77.4 million compared to $57.8 million for the same period last year. The increase was primarily due to a 35.7% increase in earning assets. Non-interest income increased $2.1 million or 16.2% to $15.2 million for the three months ended September 30, 2009 compared to $13.1 million for the same period in 2008. The increase was primarily due to an increase in service charges on deposit accounts related to the Franklin transaction. Non-interest expense decreased $5 million or 10.9% to $41.2 million for the three months ended September 30, 2009 compared to $46.2 million for the same period in 2008. However, last year’s numbers included the $14 million impairment writedown on the Fannie Mae and Freddie Mac preferred stock so excluding the impairment, non-interest expense increased $9 million or 27.9% and was mainly attributable to the increase in staff and general expenses related to the Franklin transaction. Deposits at 9/30/09 were $7.1 billion, an increase of $2 billion or 39.4% compared to $5.1 billion at 9/30/08 and if the deposits from the Franklin transaction are excluded, deposits increased $480 million or 9.4%. The bond portfolio metrics at 9/30/09 reflect a weighted average life of 3 years and an effective duration of 2.9 years and the projected annual cash flows approximately $1.2 billion. With that let me turn the presentation over to Tim Timanus for some detail on loans and asset quality.

[H.E. Timanus:]

Thank you, Dave. Non-performing assets at quarter ended September 30, 2009 totaled $21,920,000 or 0.64% of loans and other real estate as compared to $19,587,000 or 0.57% at June 30, 2009. This represents a 12% increase. The September 30, 2009 non-performing asset total consisted of $8,816,000 in loans, $366,000 in repossessed assets, and $12,738,000 in other real estate. Approximately $3,767,000 or 17% of the September 30, 2009 non-performing assets are at this time under contract for sale. Obviously there can be no assurance that any of these contracts will necessarily close. Net chargeoffs for the three months ended September 30, 2009 were $2,549,000 down 28% from $3,526,000 for the three months ended June 30, 2009. $7,250,000 was added to the allowance for credit losses during the quarter ended September 30, 2009 compared to $6,900,000 for the quarter ended June 30, 2009. The average monthly new loan production for the quarter ended September 30, 2009 was $77 million compared to $76 million for the second quarter ended June 30, 2009. Loans outstanding at September 30, 2009 were $3,406,000,000 compared to $3,451,000,000 at June 30, 2009. The September 30, 2009 loan total is made up of 40% fixed rate loans, 26% floating rate loans, and 34% variable rate loans. I will now turn it over to Dan Rollins.

[Dan Rollins:]

Thank you, Tim. While I’m sure everybody would like to hear us drone on for hours more, I think we’re ready to turn it over to questions. Shannon, can you assist us with that?

[Operator:]

[Operator Instructions] Your first question comes from Ken Zerbe – Morgan Stanley.

[Ken Zerbe:]

Dan, maybe you can comment a little about what you guys are seeing in terms of additional FDIC assisted opportunities within the Texas market and I guess as a follow on to that, if you were to get another deal done, how would you feel about substantially lowering your loan to deposit ratio from here given it’s already at the lowest in the industry, and would that be a hurdle for another deal?

[Dan Rollins:]

I think David and I will probably both take a stab at that. I think opportunities in Texas for FDIC, we believe there’s going to be opportunities out there, the FDIC is doing their part and we think they’re doing a fine job of trying to keep everything together on their side of the aisle. When those opportunities present themselves, we want to be prepared to look at them. Remember, we value core deposits above all else so the core deposits is where the value is in a commercial banking franchise such as ours. It’s not on the asset side of the aisle. As we can all see today, assets aren’t selling at par. Assets are at discount and a problem for banks. So core funding is where the key strength and the key value in banks are. However, as you know, most banks today the FDIC is marketing outside of a very few that we’ve seen are being sold as whole banks so you’re getting assets with the deposits. In the Franklin transaction, let’s go back and walk through that. Remember Franklin had $3.7 billion in deposits at the time we took them over and we said at that time we were going to immediately run off the brokered funds. We had no need for those brokered funds. We didn’t want those brokered funds, and what we valued the most out of the Franklin transaction was the core low cost sticky funding and if you look at our performance in the past year, I think you can see that the Franklin transaction has been very beneficial to us in the fact that even though we only have $300 million or $400 million in loans in those locations that we’ve acquired and we’ve made a little bit since then, we’re still sitting on $1.6 million or $1.7 million, I don’t need to tell you the exact number, of deposits that are out of the Franklin transaction, yet our earnings have been [inaudible] greatly from that. We’ve got $1.533 billion in deposits left out of that, and I think that’s where we thought we would be all along. So we have allowed the high cost non-core funding from the Franklin franchise to run and we’ve maintained the low cost customer-based relationships that are in those locations and then we can invest that money into low risk securities and make money on it and then our goal would be to continue to grow the balance sheet on the asset side. That’s the challenge in front of us, to grow loans to improve our margin and be more profitable. But our process today, it wasn’t but just a few years ago in 2003, we were at 37% loan to deposit ratio. David, do you want to tag onto that?

[David Hollaway:]

First of all, I would say we do have a very low loan to deposit ratio and again, it’s not our goal to stay at this ratio, but whenever you get $2 billion of deposits piled onto you without virtually any loans, it’s not something that you can just do automatically. It’s not something that we would want to do automatically. As Dan said, we’ve been in this situation before. In the 80s we bought a lot of failed banks and all we really got were deposits and our loan to deposit ratio was probably in the 30 something percent range. It took us about 4 or 5 years to get up to the 65% or 70% loan to deposit range and I have no fear that we’ll do that again, but at the same time, you’ve got two factors going against you right now. Probably where most banks are getting rid of… I don’t know if they’re getting rid of, they’re just paying down construction loans. If you look at our construction loans, this quarter we lost, or we paid down $49 million, so we did grow if you take that out of the equation. But whenever you have a slower economy, you’re not going to have a 20% growth factor tier but I can assure you that within a reasonable period of time, and again that’s not a year or two years, we’ll be back to the 65% or 70%. Moving on to the opportunities, I think you asked a question about what kind of opportunities that we’re seeing out there with the FDIC. I guess most people are aware, we spent a lot of time and bid very vigorously on the guarantee deal. We didn’t get it so it took a lot of our time and efforts during the quarter working on that deal. There’s still a lot of deals out there. The difference is there’s probably not as many big deals out there like the guarantee transaction was. I think what you’re going to be seeing, what we’re seeing, is a lot smaller deal, but again the FDIC is giving you some options now. We’re taking some of the small deals where they may have two or three at one time in a certain regional location and letting you pool those together and make a bid on that so we will probably look at making some bids on some of these FDIC transactions. They probably for the most part won’t be like Franklin. They will probably all for the most part have large share agreements with them. Having said that, I think Sheila Bair spoke recently and said that we’re going to have maybe 400 banks. Who knows? But there’s going to be definitely a lot of opportunity for us and so we’re not going to just jump at the first thing. We’re looking at them but again, if we do it, we’re going to try to make good money off of them. I don’t know if that’s answering your question or not.

[Ken Zerbe:]

It absolutely does. The other thing I was just wondering about, have you seen any change in business demand for loans? Obviously commercial loans are down again this quarter but [inaudible] on the margin.

[Dan Rollins:]

There’s virtually no organic loan opportunities going on right now. I think most of the loans that we’re seeing, we’re taking from other players that are not focused on external items, they’re focused on internal items. We’re seeing very little market expansion type business going on out there.

[David Zalman:]

We are seeing many opportunities that we didn’t see two years ago because we just weren’t competitive when the market, I’d say went a little crazy. People weren’t requiring personal guarantees, not requiring the money down, giving terms and conditions that extended into Never Never Land. You could go to what we call the shadow banking market and get all these done. They would patch them and sew them. That’s not out there anymore so we really are getting some very good opportunities to see these kind of loans, and these loans are usually bigger than some of the loans that we’re used to seeing too, so that can help as we grow.

[Dan Rollins:]

I think our loan pipeline is actually looking pretty good again. As David said in his comments, if you look at the loan portfolio at quarter end, commercial construction loans shrank almost $50 million for the quarter. That’s by far the biggest shrinkage in that piece of the business we’ve had now in the last four or five quarters. We’ve been averaging $20 million or $25 million a quarter in shrinkage and we shrank $50 million in this quarter in construction loans and total loan shrank $50 million. So outside of that construction loan shrinkage, we were doing pretty well.

[Operator:]

Your next question comes from Andy Stapp - B. Riley & Company.

[Andy Stapp:]

What was driving the strong reserve build? Was it related to potential problems coming down the road or were you just being cautious in the current environment?

[Dan Rollins:]

Remember, our loan portfolio is very granular and very small and so when you build in your metrics into your loan loss reserve modeling that we all do today, the metrics that are out there are looking at the economic factors and in Texas the unemployment, all economic factors, are still getting worse. They’re not getting better. So I think when you look at our portfolio, I would think that the tell for us would be unemployment. Our borrowers are dependent upon consumer disposable spending and if that continues to contract, that could lead to future problems, but our modeling is all looking at economic factors and the economic factors continue to deteriorate.

[David Zalman:]

Moreso, primarily it wouldn’t be… I don’t know that anybody would think that we were doing our job right or that we would be prudent not building a reserve in these kind of economic times. Even though Texas is probably better than any other state out there, we kind of are putting almost double whatever we’re charging off. We’re putting about the same amount in building reserve, and I think you will see that probably through the end of the year, maybe next year that will change, but I think it will be prudent and our model would suggest that just because of the economics that Dan’s referring to that we do build, and I think it’s the only prudent thing to do in these kinds of times. It wouldn’t look good if we showed a $30 million income I think for the end of the quarter and put less in provision than what we charged off, especially in these kind of times.

[Andy Stapp:]

Your CRE non-performers are up quite a bit. Can you talk a little bit about what was driving this as well as how much heartburn commercial real estate gives you?

[Dan Rollins:]

I think the same answers that we’ve been giving for the last couple of quarters, when you look at CRE and Tim and I are both fumbling pages here, but when you look at CRE, we had a couple of bigger items that were there last quarter. Those items are still there this quarter. Then couple of smaller items have kicked on there with it. I think overall we continue to look at the big picture item on where we are and when we look at the big picture for looking forward, I think we’re still, David, you might want to comment, but I think we’re still looking at 25 to 75 basis points in total non-performing.

[David Hollaway:]

I’m sure somebody will ask that question, but I think two things that I would comment on with regard to the loans and the chargeoffs. From what we can see, I think that things do look better, but again I’m going to be say cautiously optimistic but having said that, I would still I think that we’ve told most of the market that our non-performing assets would run in the vicinity between 25 and 75 basis points. I think that still holds true for the next quarter and I would still stay the chargeoffs where they were probably less this quarter than last quarter. Again, it’s still hard to look past two quarters so I’d still say that for the next quarter you’ll probably still see chargeoffs kind of where we’ve been, really.

[Dan Rollins:]

Specifically, last quarter, CRE, we had 3 credits in the CRE category over $1 million, and as we’ve said many times before, when a credit problem of that size comes on, it’s not as quick to be resolved as smaller credits. When you look at the total number of credits, we had 108 credits on the non-performing list last quarter. We have 108 credits on there this quarter. Those are not the same 108 credits. About 60 of them were there at the end of last quarter and 3, the 3 larger CRE pieces that were there last quarter, are still there, and now there’s another $1 million plus item that’s kicked into that category in this quarter. Thankfully in the numbers that Tim gave, and I don’t remember exactly what you said, Tim, but the numbers that Tim gave of what’s in the process of being resolved now, two of those larger CRE pieces are in that category of under contract and ready to resolve out.

[David Hollaway:]

In round figures it was $3.8 million. You would also have to say though in the earlier stages when all this started maybe in September of last year too, a lot of the non-performing were like residential home loans and our experience with those are those move in and out pretty quick. You go through foreclosure, you foreclose on them, and you can sell them a month later. The problem with a lot of these commercial deals, a lot of the people feel that are companies that they feel like they have an equity stake in it and most of the time when you try to foreclose, they don’t let you foreclose or they declare bankruptcy and that just takes you 180 days down the road before you can really get anything done and get the court to give it to you.

[Dan Rollins:]

Thankfully the foreclosure laws in Texas are not onerous on us so we’re able to move pretty quickly and I think that our process has not changed at all. We talk about what’s in here, the 108 items that are in here, remember this is a snapshot in time. I would venture to say, and we don’t track this in numbers, but I would venture to say that during the quarter we probably had 30 or 40 other items that kicked into the non-performing category and was resolved during the quarter so it never made it onto the final quarter end report. So we’re pretty aggressive and pretty fast on what we’re trying to do to work through that.

[Andy Stapp:]

Could you discuss what you see as far as opportunities for further, that interest margin expansion?

[David Hollaway:]

A big picture discussion of net interest margin, I don’t know that if you’re looking over the next 3 to 6 months, I would say that the opportunity is that the margin should be pretty stable going forward in the very short term, and again, obviously there’s opportunities on the deposit side and the repricing of our deposits, but then the counterweight to that is if we don’t put the loans on the books and net grow the loans, it’s probably going back into the security portfolio and the yields that you get today, because we need to stay shorter, not go long and take extension risk. We’ll lose yield on that side. So when you build that all in, I think over the short term, the 3 to 6 months, that margin should be pretty stable.

[Dan Rollins:]

From a deposit repricing standpoint you have to remember we bought the Franklin franchise last November and we maintained all of their existing retail deposit rates in place on their CDs. We had the right under the FDIC rules to reprice some things. We ran off the broker deposits but we maintained existing contract rates on all of their CDs. We’re coming up on a one year time period and a large majority of that business was less than one year in term so we’ve basically been through a one year repricing time on that Franklin side so the ability to continue to reprice deposits downward on the Franklin side is dwindling. There’s still some opportunity there but it’s not near what it’s been for the last couple of quarters.

[Andy Stapp:]

Last question then I’ll get back into the queue. Did you have 89 day delinquencies at quarter end?

[Dan Rollins:]

Yes, let’s say, that’s a good news story for you. If you look back over the last starting in December, December 08, 30 to 89 day numbers were $39.8 million, in March that number increased to $42.5 million, in June it improved to $34.2 million, and in September, 39 to 89 past due numbers was $23 million.

[Operator:]

Your next question comes from Joe Stieven - Stieven Capital.

[Joe Stieven:]

My question was just sort of addressed on the CD funding but let me ask you two macro questions. Number one, what do you see competition doing on the deposit side as guarantees go and things like this. So let’s talk about CD funding just from a macro perspective. Number two, and Dave this is really addressed to you, with the fact that you guys have become such a well-respected company, there’s a proposal out for essentially full mark to market accounting on the loan portfolios which is a disastrous proposal. What type of thoughts do you guys have? I know the ABA has come out very strongly against it. I’d just sort of like to hear your thoughts on it and what you think is going to happen.

[David Hollaway:]

First of all, I’ll address the competition for the CDs. Today it’s much, much better in CD pricing then it’s been. A year or two years ago, I don’t know why our customers stayed with us quite frankly. Some of them, you could go to Washington Mutual or Guarantee or Franklin, almost every bank we bought or went under, Downey, and you could get 200 basis points more than you could. So that’s helped tremendously. I would say even right now today, we’re probably paying a little bit more than we have to for our CDs and some of our deposits and again, it’s just primarily probably, not a whole lot, but a lot of our customers stuck with us when we weren’t paying the most, now we’re probably paying a little bit more than we have to, and it’s just kind of a reward to the customers. Now having said that, when we bought the Franklin bank, we got about $2 billion in deposits and we felt that we would have probably $700 to $800 million loss on that. We’re doing better than that. I think we’re probably about $1.5 billion, $1.65 billion. $1.533 billion . So we actually kept more of that money than I thought so and having said that, they have a real rate-sensitive client base so what that tells me is that we’re probably somewhere in the middle, that we kept more than we thought we were. Number two question was on the mark to market. I’ll just say that it would be a disaster. I would have to tell you if there was a mark to market I don’t know how you could do it because when you make a loan, today for example, if you had to go sell your loans today and there’s nobody to buy them, you might get $0.50 t $0.75 but nobody’s going to pay you for the full risk and in the good boom times, there will be a big premium because there’s no fear in the market. I don’t think it’s something that they can do. It would be disastrous. If they put up the last thing that happened in mark to market back in March when all the other stuff happened, and they did this, it would be a complete disaster. I don’t even think that the regulators will allow it. In listening to Sheila Bair, she even comments on most of her, when they ask her about it, that it would be a complete disaster for banks to mark to market because there is not really a mark, there’s not a readily available market for it at any given time. It’s just not a tradable market, so I don’t know how you can mark something to market when you don’t have a readily marketable way of selling the loans.

[Operator:]

Your next question comes from Terry Mcevoy - Oppenheimer & Co.

[Terry Mcevoy:]

I think it was on the last call you mentioned the potential for some of the larger US banks that were headquartered outside of your state to possibly look to divest their Texas operations and I didn’t hear that mentioned earlier in the call. Do you still see something like that potentially happening.

[Dan Rollins:]

I think we’ve seen one of those transactions. The guys out of St. Louis have divested their 15 or 16 offices. Certainly there’s been talk of Citibank wanting to do something in Texas. There were other players that were in the game. A quarter ago Colonial was marketing their offices in the state of Texas. There are several other players that are out there that are still talking. I think that’s still one of the opportunities that are out there as people are trying to find things that they have that can help either shrink their balance sheet to preserve capital or generate some capital for them. We continue to look at all opportunities.

[Terry Mcevoy:]

Then as I look at the yield on loans, it was down about 18 basis points this quarter, a little bit more than last quarter. Is that a function of the rolloff of construction loans, and it looks like you added some 1 to 4 family mortgages, or is there anything beyond that this last quarter?

[Dan Rollins:]

No, I don’t think there’s anything special in there. Rates are down. I think that as we continue, speaking of one of those parts that you just brought up, we have put on some 1 to 4 family, the jumbo home loan market as you know is very disrupted on the secondary market and many of our higher net worth customers, we’re happy to put those onto our balance sheet here for them, so that’s where some of that’s come from.

[David Hollaway:]

This isn’t factual, but I guess probably the answer, you answered the question, I think a lot of those construction loans probably had a higher rate on them then regular standard commercial and when you drop $50 million a quarter, that’s probably the reason for the decline right there.

[Dan Rollins:]

Are you sure it actually went down 18 Terry? We’re not seeing that number.

[Terry Mcevoy:]

I thought it went from 479 to 461 but I’ll double check from the press release.

[Dan Rollins:]

That’s the bond portfolio.

[Terry Mcevoy:]

Okay, I’ll double check. Directionally it was still down. I might be off on the numbers.

[Dan Rollins:]

That was the bond portfolio number. The loans is in the sixes. It only dropped four basis points on the loan side, 638 to 634.

[Terry Mcevoy:]

My last question, the CRE growth this last quarter, could you just talk about where that growth is coming from, the types of deals you’re doing, and maybe in what part of the state.

[Dan Rollins:]

We’re doing transactions all over the state. I don’t know that we’re seeing any growth more or less than any of the markets proportionally. I think we’re probably similar. Houston represents 40% or 50% of our market and so we’re seeing 40% or 50% of our opportunities there. The types of credits that we’re doing are no different than what we’ve been doing. It’s the smaller owner operated, owner occupied, could be a doctor’s office, could be a dentist’s office, could be a veterinary clinic, could be a multitude of whatevers in there. It’s all just smaller credits that are customers that we take care of.

[David Hollaway:]

We are getting though some opportunities at some bigger loans. We haven’t funded many of them but we have two larger loans from larger banks that we should be funding this quarter right now and again it’s just an opportunity where the times have changed and we’ve got an opportunity to do them. In one case, it’s probably something, this company had a loan and it’s in a residential development. You would think nobody would want to make a loan on a residential development right now but this is probably one of the best areas of Houston and where we might have a $20 million or $30 million loan, we probably have over $100 million in collateral and a really good area where homes are still selling and doing very good. We’re not running away from any one category either if the borrowers are strong and there’s a market for it at the same time.

[Operator:]

Your next question comes from Bain Slack - Keefe, Bruyette & Woods.

[Bain Slack:]

Just wanted to on the bid for Guarantee, I wonder if you could just entertain a theoretical scenario that Prosperity had gotten that deal. How would that have played out with regard to the two markets?

[Dan Rollins:]

I think our intention all along would be to focus on Texas. I think our plan would have been to as quickly as possible partner up with someone and divest the California piece, just like we did with the Franklin piece, run off the high cost, non-core funding, consolidate the offices in Texas that were closer to our offices and move down the road from there. The Texas piece represented about $7 billion or $7.5 billion in deposits when they were marketing it and our belief was that a big part of that is hot, non-core expensive deposits that we don’t have a need for, so we would have expected to have seen that shrink over the next couple of years just as the Franklin bank did.

[Bain Slack:]

I guess I’d read somewhere that you had 4 or 5 investors to split capital and if necessary… is there any sort of color you can give on these investors? Are they current shareholders or outside and are you all still working with them for other deals because other deals might be smaller and maybe you don’t need them.

[David Hollaway:]

We’ve kind of commented to the market that we’re really not, I think some people have asked us why don’t we raise capital and again we kind of made a commitment to existing shareholders that we really were not going to raise capital unless we really needed capital for a particular deal and even in our bid with Guarantee, I don’t know that we necessarily needed the capital the way that we bid the transaction. On the other hand, we thought it would look good politically if we did raise some capital and I think we really started on a Thursday afternoon, this was a kind of come over the wall type of situation. That was to some of our existing shareholders and some non-existing shareholders. Basically in a day and a half we were trying for I think was it $200 million and we got commitments for over $375 million so it was a good response, but again it was contingent upon us getting the deal and we didn’t get the deal and I think everybody understood that. It would have been raised at the market price. There wasn’t a discount to it.

[Dan Rollins:]

It was purely contingent capital, 100% dependent upon successfully being the winning bidder on the Guarantee transaction.

[Bain Slack:]

Last question, you talked a little bit about CRE and your book, again it looks very granular out there, but we’ve heard in the Fed reports about potential CRE problems in Texas in general and I think David you noted that at the higher level loan size that there might be some issues. Any anecdotes or anything there that you guys are seeing that could cause concern on sort of… as it trickles down or is it just so much at the larger end that it doesn’t concern you guys?

[Dan Rollins:]

I think there’s always concern. I’ll let David jump in. Let me give you some specific numbers. This quarter we’ve been putting out some average numbers for you guys. Average commercial real estate credit on our books is $406,000 this quarter. It’s actually down a little bit from last quarter. Average construction loan is down from 300 something down to $238,000 for the average construction loan for us and that’s the two biggest pieces. The average loan on the whole portfolio is $101,500. So very low average loan size, even on the commercial real estate side, a $406,000 loan. That would be considered very, very small for most of the folks in our peer group today, but having said that, I think all of us continue to watch the economy. We continue to see, Tim and I live close to each other, we continue to see the strip centers that have been built now going on two years that are less than 50% full. I think we continue to have some concern that there’s some big items out there that are going to have to have a day of reckoning.

[David Hollaway:]

I think some of the commercial real estate deals that we have are larger than the $400,000 that Dan’s talking about for the most part, but most of those loans did come from one or two of the banks that we actually purchases that really focused on commercial real estate. That’s primarily what they did. And it does take longer to get the deal done because usually it’s a fight in bankruptcy and it just takes a while to get out of those things, but quite frankly I really thought that the commercial real estate loans, it would be worse than they are right now today. I really thought that we would see more pressure and I’m trying to ask myself the question why aren’t we seeing more pressure from that commercial real estate, especially with so much rhetoric and stuff coming from the Fed and everybody else, and I think it’s because unlike anybody else, like in the 80s when you had a bunch of banks failing, us especially would buy the deposits of the banks and we would give all the loans back to the FDIC and in today’s market, the way it works is you have a loss share agreement and you’re almost in agreement with the FDIC for 5 years and they’re not having to throw all those loans back into the market which is collapsing the market, and I think that’s what’s really helping the economy and the overall market in commercial real estate. And if they continue doing that and they can continue finding buyers who are willing to participate in the large share agreement I think you'll see, I don't think it's going to be as bad as they all think it is.

[Operator:]

Your next question comes from John Rodis - Howe Barnes Hoefer & Arnett Inc.

[John Rodis:]

Just one question on I guess operating expenses on the salary line item, expenses were up about $1 million [inaudible] quarter. Can you just talk about that real quick?

[Dan Rollins:]

Yes. I mean I, you know, after these past few quarters, you know, we've been [inaudible], you know, expense reduction mode from Franklin. But, you know, as you can tell from our numbers by the end of the second quarter I think we were where we needed to be. And now we're, we've kind of flipped around in how we look at things. And that expense that you see is just our general overall operating expenses and things that we're doing internally, you know, having such a good year. You know, we're doing some things on the salary line to, in preparation to reward our people as we go forward. So, you know, another way to ask that question is you see our efficiency ratio as something less than 45. And so I find it hard to believe we can go down much lower at this point. At this point, you know, we've got to run our business and reward our people and reward our customers. So the expense level if anything, you know, could trend up a little bit and just depends on top line revenues. But I think that's a more normalized overall general expense run rate than, you know, what you're see in the past of course now that we've gotten it down to this level.

[John Rodis:]

So is there, I mean has there been any new hires or anything in there? Or is it just generally [inaudible].

[Dan Rollins:]

There’s a couple of new hires in the group. You know, I think if you look at total headcount total headcount's down 30 give or take. So total headcount's down. But absolutely we've been able to hire some folks. I think that's one of the bright spots we would want to talk about. We've hired a couple of people in the central Texas market. We've hired a couple of people in the north Texas Dallas Forth Worth market. We've hired a couple of people here in the Houston market. They've come from a multitude of different players that are again not customer-focused today the way these lenders would like to be. And they decided to come over and join our team. So that certainly helps. And certainly when you hire folks, you know, it takes a while for them to be able to generate enough business to pay for themselves. But I, you know, I think a big part of this, John, is just the normal processes that we go through.

[Operator:]

Your next question comes from Christopher Marinac - Fig Partners, LLC

[Christopher Marinac:]

Dan, would risk-weighted assets have changed much this quarter? Would they have gone up commensurate with the balance sheet?

[Dan Rollins:]

I don't think so. Are you seeing something that we're not seeing?

[Christopher Marinac:]

Yes. See, I was going to make the point that when you look at tangible capital relative to risk-weighted, you've built a lot of capital just in the last couple of quarters. And I'm curious as that continues to accumulate into future quarters. Is there any point where the excess is enough that you feel deemed to do something with it?

[Dan Rollins:]

Yes, no. I think that's a true point. If you're looking at tangible capital with risk-weighted assets, you know, risk-weighted assets are close to the same proportion as they were last time. Certainly we want to build loans as building loans puts, takes money out of a 20% risk-weighted bond portfolio into 100% risk-weighted loan. But, you know, that's a longer moving, slower moving process. You know, we're not going to grow loans, you know, $300 million or $400 million in a quarter. We're not going to go buy shared national credits. Remember, we don't have any shared national credits on our balance sheet. So I think you're exactly right. If you're looking at tangible capital on a risk-weighted asset basis I think we probably are pretty strong.

[Christopher Marinac:]

And a separate question just had to do back with you point on the small CRE loans. Are you seeing anything on the cash flow at the [poverty] level, what the cash flow is changing?

[Dan Rollins:]

Yes. I'm glad you brought that back up. One of the, you know, Bain asked that question here asking kind of the same question. You know, remember, we stress test all of our CRE on a regular, ongoing basis. We cash flow stress test it. We valuation stress test it. We rate stress test it. And those are the things that we're looking at that allow us to continue to look out and allows, I think does it to continue to be comfortable that we're in the 25 to 75 basis point non-performing range. And we don't see, you know, big issues coming up in front of us.

[H.E. Timanus:]

Dan, I don't have the numbers in front of me. So correct me if I'm wrong. But when we stress test we stress test our loan the value right now on most of our commercial real estate overall the whole portfolio. Again, this may not be accurate, but I think it's probably around the 50% range. I'd have to get with [Chris Bagly] on our loan to value. Do you remember, Tim?

[H.E. Timanus:]

Yes. It might be a little higher than that.

[Dan Rollins:]

On a relative basis it's low. And that's after they stress it, what, going up [inaudible] there's so much…

[Dan Rollins:]

Yes. You're looking at what is the total outstanding to the total appraised value at the beginning. And because we require so much equity in the deal, you're right. Our loan-to-value is very low in the portfolio to start with.

[H.E. Timanus:]

Even after stressing them and a [rate] increase in an income-down scenario.

[Dan Rollins:]

That's correct.

[H.E. Timanus:]

I think the bottom line is, you know, there's certainly no guarantee as to how our portfolio is going to perform in the future. But it's clear to me that one of the reasons we don't have the same level of problem that you see out in the general marketplace is the discipline of our underwriting to begin with. I mean we got down payment. We looked at cash flow closely when we made these loans. And we simply haven't had as many go bad. That may change tomorrow.

[Dan Rollins:]

Chris, we're obviously not immune to the ills that are out there. But, you know, I think by and large remember over half of the CRE book is owner-occupied. So, you know, we feel very good about our credit quality.

[Operator:]

(Operator Instructions). Your next question comes from James Margard - Ranier.

[James Margard:]

Could you comment a little bit just on the competitive landscape on the deposit side and the liabilities side that you deferred to suggesting that CD rates, you know, are kind of sticky on the upside? Is the competitive landscape in general also, is capacity kind of leaking out or is it building? Are the larger banks becoming a little more aggressive, less aggressive, more accommodative or not? And also it appears in the smaller bank [ends], are you seeing many banks contrary to your situation that are under significant stress?

[Dan Rollins:]

I think, you know, you asked several pieces of that. But we compete with all of the different players. Because of the customer base that we've attracted and that we like, you know, I would tell you that we're competing with a lot of community banks out there in the market every day in addition to the bigger guys. The bigger guys continue to pay. You know, they've got their marketing specials. And they see, you know, this special or that special. But there's strings attached. You know, it's not so far off the chart. You know, again what David was saying was earlier a year ago when we bought Franklin, again let me remind everybody, it was November 7 a year ago. We closed on the Franklin transaction on November 7 which was a Friday. And on Saturday they were running full-page ads for 4.25 CDs which was a full one or 1.5 more than we were paying in any market we were in. That spread has narrowed greatly for rate competition across the board, whether it's the big guys that need the funding or there's smaller community banks that are fully loaned up that are stressed on the funding side that need the funding. You know, some of that has gone away. But part of the other issue there is is back then wholesale funding was a lot more expensive today. You know, we're hearing many of the banks that are stressed, you know, basically singing the praises of the wholesale funding window by lowering the funds rate to darn near zero. It's, you know, you've got banks that were not funding-stressed that are able to fund for less than they can go fund it on the retail deposit side. So, again, that comes back to us and our customer-focused and relationship-based deposit funding. You know, we've never really gone after what we would call, you know, an individual's investable funds to put in some high-rate CD. We like to have their operating money, their checking account, their rainy day savings account, just everyday folks that, money that people keep on hand.

[David Hollaway:]

I would add, Dan, that, you know, for the most part, Jim, this is probably the most rational time for banking that I've been in a long time. And I guess it's because a lot of the guys that we're paying the higher rates have been knocked out. But for the most part almost everybody is behaving pretty good. You know, once in a while as Dan said you get some of their smaller community banks that may have other issues with their loan-to-deposit ratio where they need something and they're, you know, they're really paying something off of the beaten path or maybe some credit unions. But for the most part almost everybody is really good behavior. And everybody's become very disciplined. And it's been a very good market. You know, I think it's going to stay like that for a while, I really do. And, again, a lot of times when customers would move just because of right we're seeing customers come to us because of stability. A lot of customers, unbelievable to me, are coming to us because we didn't take TARP money. I hear it over and over again, on the loan side and on the deposit side. They just - I got an email from one of the lenders the other day that just said that basically he sent the email from the person who was making the loan. He said, "I'm not a customer of yours but we know you didn't take TARP money. We looked at the stability of the bank and we're going to do business with you and move our accounts just because of that." And that's happening over and over again.

[James Margard:]

So, again, the assumptions for net interest margins near term is probably kind of steady, conceivably maybe widening a little bit mainly because cost of deposits continues to edge down a little bit. But the return, the pricing of loans maybe nudges down a little bit too. Is that sort of a fair assumption?

[Dan Rollins:]

I think the asset return, the rates we're getting on all assets continues to nudge down. And I think deposit pricing can continue to nudge down a little bit. Deposit pricing, on average - I don't remember exactly, David - was it 125 or 126, our weighted average cost of deposits only, not other borrowers' money. It's in the mid 120s. In reality there's not a whole lot of room there. So, yes, I think we want to be able to maintain the margin where we are. We'd like to see expansion but I think it's more likely that we're going to be able to hold.

[Operator:]

Your next question comes from Matt Olney - Stephens Inc.

[Matt Olney:]

I think you've answered most of my questions, but looking just at the construction book you mentioned the decline is balancing during that third quarter. It looks like the sequential charge [offs] net in that book declined the third consecutive quarter and MPAs in the construction book were pretty flat from last quarter. So my question is do you think within the construction book you've probably seen the worse this cycle will give you?

[Dan Rollins:]

I'm taking a breath.

[Dan Rollins:]

Let's all say our prayers here.

[Dan Rollins:]

We had the same conversations before we even came into this meeting with our chief credit officer and our chief lending officer. And we'd like to jump on and say we're through with it and it's going the other way but, again, when we all looked at ourselves in the eye we said it's hard to look past two quarters. And for the most part we're going to say we're going to stick with where we're at. But maybe I'll say cautiously optimistic.

[Matt Olney:]

Fair enough. And last question, David, you mentioned in prepared remarks that we could see more reserve bill going forward again in 4Q. And if we assume a similar reserve bill next quarter I think eventually we get to a reserve the loan ratio around 1.5%. So beyond 2009, is there a certain reserve-to-loan level where you say enough’s enough? I feel good about my reserve coverage regardless of how the national economy is doing.

[Dan Rollins:]

Well, first of all, I have to answer the proper way and say that we have to look at our methodology.

[Dan Rollins:]

3.5%, 4%, David? What number are you looking at? I'm kidding.

[Dan Rollins:]

No, you're exactly right. I think, again, still it's hard to look past two quarters. But I would say there is going to become a point in time and probably next year where if things stay where they're at that we probably won't be provisioning as much as we're doing right now.

[Operator:]

Your next question comes from John Pancari - Fox-Pitt Kelton

[John Pancari:]

Can you talk a little bit about what you did with the bond portfolio this quarter? Obviously it looks like some reinvestment of excess liquidity sitting on the balance sheet but also your borrowings were up. So can you just talk a little bit about that? Thanks.

[David Zalman:]

Yes, John, this is David Zalman. Again, we stuck with just our normal stuff. I mean, again, the yields are down. We hit a home run when we did the Franklin deal because we invested almost all of the $2 billion at that time. And we knocked the cover off the ball on that and I think our gain in our bond portfolio right now is what David, about $140 million or something like that. I want everybody to remember that because when the interest rates go up 300 basis points in about six months and we have a loss in that portfolio that they remember we did have a $140 million gain at the same time. But again, most of that is in held to maturity. The stuff that we bought, again, is basically the same kind of stuff, probably a little over three year average life, a little under two, three-year duration for the most part. That's kind of what we're sticking with. I think going forward right now we may even at least shorten the duration more. You may see it as buying even some shorter duration stuff just because we think that rates are going to eventually going to have to go up when this thing turns around. So that’s why probably we're always cautious. If you just look at the deposits repricing and you compare that to reinvesting, it almost looks like your margins have gone up a lot. It's really not because what we're reinvesting in and staying shorter offsets a lot of that.

[Dan Rollins:]

Plus you've got, in the next 12 months you've got over $1 billion. You probably have to reinvest and you're just looking opportunity during that time.

[David Zalman:]

Yes, and I don't even know that we'll stick with the three-year average life or three-year duration. We may try to bring it down shorter than that too. In the current environment that cause, you don't get as much yield on that either.

[John Pancari:]

And just separately on the capital side, I know you've mentioned, Dan, in a couple meetings the capital generation, the TCE generation you've seen has been in the 20 to 30 basis point range on a quarterly basis.

[Dan Rollins:]

Yes, that's definitely still there. And I think if you just kind of continue to project out going forward you can see we roll out well over six before the end of next year, pushing seven.

[John Pancari:]

So you still feel good about that.

[Dan Rollins:]

Absolutely. The earnings momentum, that's purely a bunching of earnings momentum. I think the earnings have been, our earnings momentum and the quality of what we believe is just core. As David said on his remarks, this is plain vanilla. This is we take deposits and we make loans. We make - we're conservative in our underwritings. We're conservative in our deposit pricing and that allows us to be profitable even with a 50% loan-to-deposit ratio. And the excess provisioning and the excess FDIC cost, so we feel very good about the quality of the earnings that we're producing.

[John Pancari:]

And then one last question - the increase in the deposit service charges in the quarter, does that level look like it's sustainable or is it something impact that that it could come off?

[Dan Rollins:]

Yes, I think as we look at it today, projecting it forward, I would use it as a stable number going forward. I know there are some changes out there through the regulatory.

[Dan Rollins:]

[Inaudible] the political wins.

[Dan Rollins:]

Yes, the political wins and some changes and we're looking at that. But when you throw it all in I think using that number as a stable run going forward I think is pretty good.

[Operator:]

Your next question comes from Jennifer Demba - Suntrust Robinson Humphrey

[Jennifer Demba:]

Question for you on potential FDIC transactions, David, is there any thought to considering transactions outside Texas?

[David Zalman:]

Got to be careful - when I said that last time I told the world that our stock went down 10%. But I would say right now we don't have an interest. Somebody asked earlier in the phone call what our plans were if we got the guarantee deal. And when we were bidding on that we almost had somebody on the side take the California stuff. I don't think we want to be in California. I don't think we want to be in New York. But to get maybe a bigger deal we may have to look at it, this bank that's adjoining to us maybe in New Mexico or Oklahoma or Colorado, in this area, down in Louisiana, Arkansas, Florida. We probably are going to - probably will look at something like that, if it's a reasonable deal and we can make money on it.

[Dan Rollins:]

It's got to be big enough to be worth our while. It's got to be enough size to generate income to make it worth our while.

[David Zalman:]

That's right. And a lot of people say, well, if you jumped over to Oklahoma or New Mexico, that's going to be another [statement]. But we're eight miles from the Oklahoma border right now.

[Dan Rollins:]

We're four miles from the Louisiana border.

[David Zalman:]

Four miles from the Louisiana so Texas is such a big state. Going an extra 10 or 15 miles is not that big of a deal really.

[Dan Rollins:]

I still like the company plane. If Southwest Airlines can get me there, that's okay.

[Operator:]

(Operator instructions) Your next question comes from Andy Stapp - B. Riley & Company.

[Andy Stapp:]

I'm sorry. I thought I got out of the queue but all my questions have been answered.

[Operator:]

And it does appear that there are no further questions at this time.

[Dan Rollins:]

All right, thank you, ladies and gentlemen. We certainly appreciate everybody participating. Sorry we've run so long today. We appreciate the support of our company and we look forward to seeing and visiting with all of you all down the line. Thank you all very much.

[Operator:]

And this does conclude today's teleconference. Thank you again for your participation. You may now disconnect and please have a wonderful day.