Associated Banc-Corp (ASB) 2006 Q3 法說會逐字稿

Good afternoon. My name is Mary and I will be your conference operator today. At this time, I would like to welcome everyone to the Associated Banc-Corp third quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. [OPERATOR INSTRUCTIONS] Thank you.

It is now my pleasure to turn the floor over to your host, Paul Beidman, President and CEO. Sir, you may begin your conference.

Thank you very much. And thank you all for participating in our call this afternoon. You've seen our press release and you can see that we earned $0.58 in the third quarter. Just a couple of comments and then I will open it up for questions.

As you know, one of our key objectives for some time has been to improve the quality of our earnings. And if you look at our third quarter results, I think in many ways, we've really begun to make some significant progress towards that goal. And it is in a couple of key areas.

First of all, in terms of reducing our wholesale funding. As you know, we announced about a year ago an initiative to do that. And as of the end of the third quarter, we have reduced wholesale funds by about $2.4 billion through a combination of selling matured investments and paying them down and growing deposits and the percentages has dropped from 34% down to 23%. And clearly, our margin has benefited from this reduction. It is also benefited from an improved ratio of loan assets to total assets. So those higher yielding assets are coming through and affecting the margin. As you also know, because we have been shrinking absolute numbers of assets, our net interest income has been somewhat muted through the period, but we view this now as having largely completed this initiative, and we look forward to having growth in assets contribute to net interest income in the future.

Secondly, we've seen our deposit growth improve in the quarter. And that's through a whole series of initiatives, but we're very happy with how some of those things are beginning to take hold. I do need to point out, however, that in money market category, there is one large deposit of over $200 million that has come into that bucket from one customer. And the bad news is, it is going to reside there just for a short period of time. The good news is, a large portion of it, I would estimate over half, is going to transfer from the deposit category into our asset management categories.

This is a company that was recently sold, but because of our relationships with them, we're going to get an opportunity to manage both personally and in other ways, fairly large amount of asset management opportunities, as a result of the relationships we've had. So that deposit is going to translate into fee income in the future, which we think is a really great thing. But net-net, we have generated, even taking that out, some meaningful deposit growth in the quarter which we feel very good about.

Thirdly, our core banking fees, ex-mortgages have really been quite strong on a sustained basis. And while they're down slightly in the third quarter, much of it is attributable to mortgages, and to the seasonal nature of our retail commission. And as you will recall, and if you look back over prior year, since we've had the insurance businesses at the size that we currently do, contingency payments are made in the second quarter, and so there has been in prior years, and was this year also, a slight reduction in fee income in that category. But if you look at the thing in aggregate in terms of trustee fees, deposit fees, card processing fees and retail commissions, which are our brokerage and insurance businesses, you can really see some good sustained lifts, there and if you take the mortgage business out, our fees are up about 12.5% third quarter last year to third quarter this year, and look at it over any period of time over the last couple of years, and you can see sustained positive momentum in those important key categories.

The mortgage business has affected us, really, substantively, both in the short term but also almost $12 million in the third quarter last year, with almost a $5 million reversal in MSRs contributing to earnings and only about $3 million in the third quarter this year, with a small MSR expense. So, it remains a volatile factor here, but the core fees that we focus on in terms of quality of earnings really have been showing some sustained momentum there. So we really feel good about how our initiatives in these core areas are chaining the nature of the balance sheet in the business hopefully to sustain those higher quality earnings as we go forward.

Also, as you know, we have been focusing on investing in our attractive markets to also create sustainable growth in our core retail and commercial banking businesses. And in this front, with basically our commercial loans showing no growth in the third quarter, we are not quite as happy and as satisfied around this initiative as we would like to be. And we think that there is opportunity for us to look at ourselves objectively, and find ways to improve our performance in terms of generating core asset growth in what admittedly is a difficult and challenging environment.

You've heard me talk several times about our conscious effort to de-emphasize commercial real estate lending, not from a construction lending point of view, which have short-term and has been a core business for us for some time, but in the sense that we're not matching terms and rates that we believe are too aggressive and unrealistic in terms of -- and not financially sound, in terms of creating the right return on equities of these transactions that we're seeing in this interest rate and competitive environment. And as a result, we continue to see pay-downs in our portfolios at higher rates than we have seen historically.

Having said that, we think that we can do a better job, frankly, in terms of focusing on the opportunities that we have in our attractive markets that we've been investing in, in terms of increasing our C&I lending capabilities. And to that end, we've been looking at how we've been approaching this opportunity and are going to be taking, over the next three to six months, a series of initiatives to improve our performance there, and quite simply they get at changing our business model to some extent to bring more consistency to how we're implementing our strategy across the regions, and to make sure that we're allocating our resources to the right markets, and to the right segments in those markets, to generate the growth. And over the last couple of years, we've tried to balance this implementation and evolve in it, if you will, recognizing the historical position that Associated and the decentralized way in which we have managed relationships. And quite frankly, we've reached the conclusion that in order to get this done, we need to make some decisions to provide greater clarity to the field and to implement these strategies consistently across our footprint.

And while comparing ourselves to peers, we think we can improve, but really, all we need to do, in terms of getting these initiatives to take hold, is to look at the best performance that we have across each of our regions in terms of deposit generation, loan origination, pricing and the like, and bring ourselves consistently across our footprint to that level. And if we do that, we're going to achieve the objectives that we've set out four ourselves. So we feel very, very good about how we've repositioned the Company, its balance sheet, and these core fee businesses to generate quality of earnings. We still think we have opportunity to improve the generation of -- well, improve the value creation from our commercial businesses. Not just in loan growth, but in terms of cash management fees, and core deposits from those businesses as well. So it is not a matter of trying harder, within our model, it is a matter of critically looking at where we are in our evolution, and making the changes that we think we need to make to deliver.

So in a nutshell, that's how we feel about the quarter. And we think there are some very good things going on that position us well for the future, and we still have some opportunities that we can address. Expenses were very well controlled, I think, with our efficiency ratio staying right around that 15% number which is where we want to be. And asset quality in terms of losses and provisions, again, are very, very strong, right around 10 basis points. We did have a tick-up in our nonperforming loans in the quarter, as compared to the prior quarter.

If you go back and look at it over the last 12, 18 months, we've been steadily declining in terms of nonperformers, so if you do a year-over-year comparison, while the uptick to the second quarter is meaningful, certainly, when you look at it to a year ago, it is really only a relatively small uptick because there has been such an improvement in the early part of 2006. And if you look at our history, we believe that we have been certainly able to manage through these levels of nonperformers and we feel pretty good about being able to continue to do that. Our losses are at historic low levels. And certainly in this environment, there is going to be pressure there. And we believe that the reality is, to some extent, that we're going to see those losses increases slightly, just because they're going get to a more normalized level. But we're also very confident in our ability to manage through these nonperformers, and to maintain those losses at historically low levels, as compared to our peers.

Just lastly, when we're thinking about the future and looking out, we will certainly provide much more detail as we normally do at the end of the fourth quarter, and at our call there, about prospects for '07. But when I look at things at a high level right now, as we work through these initiatives around commercial banking, what I see for the fourth quarter are dynamics that are fairly similar to what we're looking at here in the third quarter, generally. And then when we look out into '07, if you make some assumptions that the interest rate environment and the economic environment and the competitive environment are largely going to persist as they are today, we see different levels of potential and performance in each of our businesses.

The wealth management and insurance businesses we believe will continue to contribute at strong rates, and be a strong contributor to, at the margin to growth. Our mortgage business we don't believe is going to be a significant contributor, and certainly it is not right now. We're showing very, very good momentum in key components of our retail businesses and through our in-store system. We've had positive household growth and positive transaction account growth every month this year. And we see those trends continuing. Our corporate banking business has been a strong contributor. When we look at our core commercial businesses, that's where we need to continue to focus on transitioning through these new models, a more consistent approach to delivering credit, and selling a broader array of products to mine the potential in those businesses and we believe that those things are going to begin to take hold early in '07 as well.

So, we're looking at growth trends, when you add all of this up, to come together in the mid single digits kind of an area, and maybe a little better than that. We continue to buy back stock aggressively. And balancing asset growth with that opportunity and looking very critically at return on equity, we will continue to use buybacks as an alternative, if you will, to -- as a positive alternative for our shareholders on a relative basis in terms of making those trade-offs. So generally, that's how we see the world today, and out over the short-term horizon.

I will be happy to answer any questions that you have, and Joe is available, also.

[OPERATOR INSTRUCTIONS] We will pause for just a moment to compile the Q&A roster. Our first question comes from Scott Siefers from Sandler O'Neill. Please go ahead.

Hi, Scott.

I had -- How is everyone doing?

Good.

Good. Paul, you had chatted about the increase in nonperformers, and was just hoping for a bit more color on that, is it one or two loans or just kind of a bunch of little things, I guess, just sort of any commentary you can give there?

Sure.

And then -- well, why don't you go ahead and then I will ask the follow-up.

It is a half dozen loans scattered throughout the region. It is not one pocket. It is not one market. It's, it's a half dozen loans that, for a variety of reasons have deteriorated. We have spent a lot of time looking at these things in detail and we feel pretty good about collateral positions and the like. One point I would like to make, and I went back in history and looked at some data, in the fourth quarter of '04, our nonperformers went up about 20, well, $23 million in that quarter, and since then, our charge-offs have been at world record low levels. We think we're good at this. And -- but having said that it's undeniable that there are pressure -- external pressures being applied to our customers, and the economic conditions, and the interest rate, environment, the price of oil and those sorts of things create those kinds of pressure, so we have to be realistic about it, too.

Okay. And then I guess the next two questions that I've got are sort of interest rate related, just number one, any additional color you could give on the outlook for the margin, and comments on competition and pricing trends? Which I think, Paul, you actually kind of covered a little of those. And then I guess sort of related question, I think you guys are about the only company I cover this quarter that showed any growth in non-interest bearing deposits, and it was pretty robust, unless my numbers are incorrect, so just any comments you had there as to how you generated such good growth?

Let me see if I can remember all of the questions.

Sorry.

Well, if you think about competition and interest rates, I mean things are the way they were. You know, the inversion is normalized a little bit, but it is still the same environment. And we are assuming that it is just going to stay that way. That we don't expect short-term, it would be great, I think we're fairly well positioned if short term rate go down but we're not going to assume that. We're assuming that what we're seeing right now is pretty much what we're going to see, and thinking about credit risk, and how we want to position ourselves on those terms. The competitive environment is exaggerated because of it. Because there is no place to go. Much of the deposit growth is going to come from invested money market accounts and CDs and selling effectiveness in non-interest bearing deposit categories.

Loan pricing is, to some extent, irrational in many ways, where you can generate long-term fixed rate types of transactions, with spreads of two, and less, even, in some cases. That's not good business. So we're going to be disciplined about it. And part of it is the fact that part of it is that we're not aggressively growing low spread loans, and bringing the net interest margin down. We're holding net interest income by being more disciplined and buying back stock, and that's a trade-off both from a risk point of view, and a performance point of view that we think we can make.

Scott, the other comment I would make on the margin is last quarter when Paul was asked this question, he was saying that the margins are going to stay sort of flattish and --

Maybe go down a few points even.

And there would be pressure on it. I would suggest that we feel similarly today, that yes, we had a quarter where it went up a little bit, but that little bit of movement to us is flattish and you can go on both sides of that, so we're feeling pressure, I guess --

Thank you for saying that. That's true. And I was going to go there, that we're very happy with how the margin has performed here in the third quarter, and it beat our expectations a little bit. But the reality is, in this environment, you're going to keep feeling these pressures. Deposit pricing isn't going to accelerate through the next couple of quarters, as it has through the last two, I don't think. There may still be a little bit of a drag in terms of catching up. But we're fighting very hard, hard to manage that. So Joe is right. I mean we can still see a few ticks down, or stable in margin.

You asked about demand deposits. And we are seeing real growth there. Which is good news. Like I said, positive account openings in our small business area, and in our core consumer area, we can do better, I think, in our core commercial businesses around cash management and demand deposit generation. One of the things that drove this in the third quarter was, and I think I've mentioned this before, where we have completely repositioned our consumer checking product offering, and some of this is customer migration. But some of it is real growth, too. And it is hard for me to unbake a cake, but we are generating core growth, and we've seen customers move from non-interest bearing -- or from interest bearing checking accounts at fairly low rates to non-interest bearing accounts, which there is nothing wrong with that, either.

So we look at the fourth quarter as probably pretty healthy. We should continue to grow on a core basis, and if you look at our history, seasonally, our fourth quarter commercial deposits do grow at greater rates just from natural customer behavior, in addition to us trying to sell more effectively. And then in the first quarter, those deposits, those commercial deposits will then go back down to a lower level. So that's how we sort of see it over the next couple of quarters.

Great. Thank you very much.

Sure.

Our next question comes from Terry McEvoy of Oppenheimer. Please go ahead.

Hi, Terry.

Hi. Good afternoon. I noticed your commercial real estate loan balance is down in the third quarter and I know you've addressed this in past calls. Is it more your decision to just stay away from the pricing environment, and what you're seeing, or is it just overall softness, softness in the market?

Well, if you look at our real estate construction, it is up, so the shorter term stuff, it is up, so that to me is a reflection of the fact that the markets are still pretty good. We're getting paid out at rates that are much higher than they have been in the past, both in our community kinds of portfolios, and in our larger ones, because of term and rate, and underwriting. And we're choosing -- we're choosing not to match, because we believe that real estate is a cyclical business, and the returns just don't necessarily, in our opinion, warrant the risk or the value or the deployment of capital. So, we bought back 2 million shares of stock at -- because our loan levels were essentially flat in the third quarter, our capital ratios popped up to almost 680, and we implied in the press release, we're blacked out right now, but we implied in the press release that we're going to continue to buy back stock in the fourth quarter because it is the best use of capital in this environment.

You mentioned earlier that the pressures on earnings should persist into 2007. Do you see yourself as a -- do you see associated as a buyer? Should certain banks really feel the pressure and begin to sell out? And if so, if you have been talking to some other banks, have you noticed that pricing expectations, as margins, et cetera, continue to come under pressure, pricing expectations are coming down at all?

It's crystally clear, when you talk to other financial institutions, that the earnings pressure is there. Unfortunately, that doesn't seem to always translate itself into rational price expectations. So I guess the answer is, is banks are feeling the pressure, certainly, but the expectations for price are difficult to conceptually break through.

We will continue to look for opportunities in markets that are attractive. Either in footprint or adjacent. And only if we can see clearly how our broader product line, or our approach can create incremental revenue and income to support that decision. We we could have done several things here, but haven't in the last bit, and -- but we will continue to look and we will try to be disciplined buyers. And when we look at our position in the world, we want to make sure that we stay a strategically significant company, and we look at our options all the time, in terms of how we want to position ourselves.

The last question on the balance sheet, the treasury stock at cost, 60, almost $65 million, negative, and it has been about a half a million for quite some time. Why did that number change so much in the quarter?

Because that's the 2 million share buyback that we put in treasury. Okay. And we bought it at almost $32 a share.

That's what I thought. Thank you.

Sure thing.

Our next question comes from Eric Grubelich from KBW. Please go ahead.

A couple of questions. One, Paul, you made a comment in your prepared comments about mid single digit growth trend for next year. Were you talking about the loan growth? Or were you talking about earnings growth? I wasn't sure. You had just come off talking about trends in the commercial business side of the bank.

I see. Well, I was trying to just create a very general perception of where we see -- I guess that was the conclusionary kind of a remark summarizing all of the other stuff. I'm not going to sit here -- our long term intermediate growth objectives have been to grow 10% a year for some time. What I'm saying is the environment in which we were in, if it stays the way it is, is going to put pressure on, that and those expectations should be a little more muted.

Okay. Fair enough. Fair enough. The other question I had, actually I got a couple of questions for Joe. Joe, the securities portfolio, are you done there? The average balance seemed like it was a little bit higher than I thought this quarter, so are you pretty much done with the liquidation for the time being?

Yes.

Okay. That's done. Okay. And then the other question was, on the mortgage banking business, pretty low quarter. Was there any issue there with getting -- or having a problem with the lower cost of market hedge on the pipeline, or was it just lousy volume?

All of the above. We had MSR expense, valuation expense, we had a hit from the warehouse. We had a hit from the commitments. And volume was lousy. And the pricing is being pressured.

So except for that, everything is great.

So it is a tough world in that business right now.

What I was just trying to get at, Joe, if you had a low com mark where you couldn't get the benefit until you actually sell the loans, it sounds like you might -- you would naturally claw some of that back next quarter. Is there -- is 4 to $6 million the last couple of quarters and now it's 2.8, do you see it naturally drifting higher? Or is it sort of a run rate?

Well, I would hope it is better than this.

Yes.

No, I don't think it is. I mean I would like to think it is going to be better than that.

Yes.

But it is not going to be to the 10 to $12 million --

No, no, okay. Again, a couple of other banks I follow had that hedge issue where they're going to get it back next quarter, when they actually sell the loans.

Well, we don't hedge, obviously, and again, the number is -- the mark number was $0.5 million.

Yes, I saw that, you had that in the release. Yes.

So it is not a big --

No.

No, the number you saw in the release were the valuation of the MSRs, I'm saying the mark for the low com was $0.5 million.

Oh, okay. So that was not very big either. Okay. All right.

And again, we have to continue to look at the MSR, again, we made a decision last fall with [indiscernible], and we continue to evaluate our position in that continually so we might -- there is a chance we might do something there, too.

All right.

So that would affect it, but that would be not run rate.

Yes. And then just one other question, with regard to the margin. You know, Paul made some comments about indexed money market funds and the natural shift that is going on into that type of product, and CDs that we're seeing with every bank out in the midwest and other locations, I guess, too. Are you -- how are you sort of managing the, the maturity or rollover effect of the CDs right now? How close are you in the portfolio to being close to where the market is?

That's an interesting question. And it may be that we take a slightly different approach than some. I think some banks attempt to try and index that as well.

Right.

We take a portfolio view of certificates, and there is a segment of the base that is less price sensitive and there is a segment of the base that is just absolutely incredibly price sensitive.

Okay.

So our approach is to maximize spread, or maximize return in the lion share of the portfolio, recognizing that it is not a perfectly logical world, and that you can do that. But to have one or two products that are priced competitively, so that you can capture within your own base those customers that are extremely price sensitive, and market to attract some new money, with the attempt then of trying to sell them other products, even though the reality is, in most cases, a certificate investor is a certificate investor is a certificate investor. As a result of this approach, we have been able to increase the overall margin of our certificate portfolio over the last couple of months, which has been a contributor for us, because we stayed very disciplined in the segments that we view as less rate sensitive. If that makes sense.

Does that tie into your comment, I thought you made earlier, that you thought that going forward, at least for the foreseeable future, if the interest rate environment doesn't change, which I think is what your premise was, that that's what we will sort of use in '07, what is going on now works for '07, was that sort of your basis for the comment that you didn't think you would see as much deposit pricing pressure as you saw in the last few quarters? I forget the words you actually used but --

I wasn't trying to say that. If you heard that, let me back up.

I thought you said that deposit pricing wouldn't accelerate as much compared to the last few quarters.

What I was trying to say is that the cost of funds, in our opinion, will begin to start to stabilize, because you're not seeing repeated increases in short-term interest rates, so you're not chasing a number, and almost by definition, competitors can't be raising their rates significantly from where they are. In fact, they can only be coming down if they're rational at all. So -- And then lastly, in that whole dynamic, in fact, I'm glad you asked this, because I know what I'm thinking but I don't really lay it out for you. We believe we've gone through the lion share of the internal disintermediation as a result of this, and we're seeing those trends ween as well. So as rates are going up and customers are churning and they're reaching out for these new rates, then that's disintermediation moving in, and just because it has happened at a large rate, most of the money that is going to move has.

Okay. Because your trend this quarter with the margin is vastly different than most other banks I've looked at.

Right.

And I think with some other banks, the margin compression I thought that might happen next quarter happened in the third quarter.

Right. Well and this is -- I think you're going to see companies start to differentiate their views of this thing more clearly. Our view is not to price up to generate volume that has no value or little value. In the long run, it just doesn't do you any good. We're fighting to maintain pricing discipline on both sides of the equation. And we will forego growth if we don't think the growth is profitable or if it is just a one-off trade or a transaction so that we feel good about our balance sheet. Our net interest income is flat, right? Our asset size has shrunk through the wholesale funding initiative and the fact that our loans are flat. We're not happy with loans flat, and I talked about that, and you can't do that on a sustained basis, so we're going to find ways to grow in this environment that meets our terms. But our margin is holding up. Others can have flat net interest income and be growing loans at prices that are unacceptable that are deteriorating the margin and net interest income stays flat that way, too. So which transaction adds better value? And plus, you take on the risk of the real estate.

Yes. Okay.

But, you know, who's right?

Well, thanks for the answer, Paul. Thanks, Joe.

Oh, if I could, and somebody asked a question earlier, one more think about the margin. If we continue to buy back stock aggressively, that puts pressure on the margin because free funds get deployed against that transaction as well. So it is not just loan pricing and deposit pricing that affects the margin. Lots of these other things do too. But in terms of EPS, it is a clearly positive trade but it could put some pressure on the margin.

Our next question comes from Kevin Reevey from Ryan Beck. Please go ahead.

Hi, Paul. Hi, Joe. How are you?

Good, Kevin. How are you?

Good, thanks. I just wanted to follow-up on Eric's question on the mortgage banking segment. You said that next quarter, that that number, that line item should be higher. Is that going to be from volume? Is that going to be from the valuation side of the equation?

Well, I don't think we said that. We said we hoped it would be, but we saw some pressure on it this quarter, but again, I just -- I highlighted two items totaling about a million dollars for Eric, so by that nature, if the volume stays the same, and the prices stay the same, you would think it would be better, yes.

And do you see any opportunities to kind of eek out cost savings from that business, by right-sizing your staff, if you haven't already done so?

We did so in the third quarter.

And you don't see any more opportunity for more staff cuts, you're kind of -- it is pretty much over?

Pretty much over. But we were -- I would suggest we were pretty aggressive in the third quarter.

And then do you have any IO or option arm loans in your portfolio?

No.

Great. That was all I had.

Okay.

Our next question comes from Heather Wolf of Merrill Lynch. Please go ahead.

Hi, good afternoon.

Hi, Heather.

Just a couple of questions for you on -- I hate to harp on the deposits, but, by our calculations, the banks in the United States have not passed through anywhere near as much as what the fed has raised rates by. How much do you think -- do you think that now that the fed is done, that we will see deposit rates stabilizing? Or do you think that there will be some level of catch-up on the deposit rates?

I believe there will be some additional level of catch-up, because there will still be some disintermediation from lower cost to higher cost, although it will be at a lower level. Commercial deposits, which are very market linked, so even if you generate some new commercial deposits, from a cash management perspective, they will come in on a relative basis at a higher cost, so that could increase the cost, but, okay, you're growing, if the price is acceptable for you. There is still some migration that will occur of maturing certificates into new market rates today, because they were put on the books at an earlier point in time, and rates were lower, but again, much less than occurred this year. We have been through a lot of that. So at a lower level, there'll still be some pressures. The key from my point of view, is to aggressively focus everybody on demand deposits, and to stay very focused on that, so that we're capturing a level of low cost money that can help offset the effects of these other ones.

And what does your gut tell you, the fed raised 425 basis points, what do you think will happen to deposit costs across the industry when all is said and done? Will they also be up 425 or do you think we will stabilize up 200 or up 300?

Yes, I think it will be somewhere in between there, maybe. But there is still a large slug of interest-bearing deposits that we have on our balance sheet at 1%. And that's not going to change. Those customers were there when it was 1%, they were there when it was 3, and they are there today. So you have those things passing through, also. I think bankers are getting smarter about tiering and creating relationship opportunities so you're not just going to pay everybody the highest rate that you offer. Our indexed money market accounts aren't paying at the top of our own markets competitively, but we're growing those products pretty nicely. On the commercial side, you have to pay, because the market is just -- it is much more rational, so you have to pay more consistently. But when you balance it all out, the retail deposits really, in this environment, create continued value for you.

And Heather, I would suggest, I mean I hadn't thought about the question in the way you're asking, but when I think about what we're paying on CD rates, I mean we're paying above 5%, so it seems to me that they have -- that and again, on these specials that have not -- I mean our whole portfolio is above 4, so I think we've passed it along. Our index money market accounts are above 4, so it would seem to me that the banking industry has passed the increases along. I think -- I feel like we have been. And that's part of the reason we're feeling a lot of pressure. Because as customers move to those higher cost deposits, from the lower ones, that's what is causing some of the margin pressure. I don't know if it should go more, but --

Okay. That's helpful. And then just one question on the tax rate. It was higher than I thought. Can you give us little color on why, and what might be a sustainable level going forward?

Yes, really what happened there is that the tax rate has normalized. In the last two quarters, there were, in each of the last two quarters, there were two settlements of prior issues with state and federal tax organizations that as a result of the settlements freed up tax reserves. So when we were in the 20s in the first and the second quarter, those were because of those isolated events. And the rate in the third quarter, around 32.5 or so is about where it normally should be.

Okay. Great. Thank you very much.

Our next question comes from Ben Crabtree from Stifel Nicolaus. Please go ahead.

Hi, Ben. How you doing?

Hi. Good afternoon. A couple of questions. And we've talked about this in the past calls, Paul, you've gone into it a little bit, the competition on the loan side, both in pricing and in terms, I guess I would be interested in if you think the weighting of the competition has changed between terms and pricing, and then in the past, sometimes you've talked about competition coming in from nonbanks, I'm trying to get a sense of whether it is the nonbanks, or obviously, it is everybody, but is it more from the nonbanks, or more from the smaller community banks, in terms of the loan competition?

On the real estate side of thing, the nonbanks are always there. And they just have a different operating model. But in this environment, the banks are very aggressive in many cases -- some are very aggressive. And it is really coming from those sources. And it is as much in the community type banking environments as it is -- in fact more so, it is in the community bank environments than it is in the in the -- from the larger banks. So it's banks.

Right. They're just trying to bulk their balance sheets up for sale, huh?

I don't know. But they're doing things that we're not comfortable with.

And then I know you said that the jump in the nonperforming loans, nonaccrual loans was kind of spread throughout geography, I'm wondering, I guess one question would be, are those kind of legacy associated generated loans or did they come with the acquisitions?

A couple of them came from State Financial.

Okay.

So they're new. And there is a couple then that are ours, and have been ours for some time, and the businesses have come on some more difficult times.

And no particular notable issue as to whether they're relatively new loans or relatively old loans that have just recently gone bad or anything?

No. And in fact if there is a half dozen of them that are noticeable it is mostly established kinds of customers.

Okay. And then one last thing, and obviously, there is a limit to what you're going to say for competitive reasons, but you're talk -- their strategy on the commercial side is, I'm trying to figure out whether or not it is mostly an internal best practices thing you're talking about, or whether you're thinking about aiming at different market segments.

It is both. If you look at Associated's history, and you know it very well, we have been a died in the wool real estate kind of a company. And as a result our loan and deposit ratios haven't been what they should be, there's a whole variety of issues that come from it. We have invested in creating positions in markets like Madison and Minneapolis and the northern suburbs of Chicago more recently and Milwaukee where we have this potential to focus our resources more clearly on the middle market C&I segments where there's large numbers of customers there where you can really compete and really play. And we've been trying to, like I said before, evolve to that, to get ourselves positioned, to balance that the fact that our credit metrics and all of that have been very, very good, managing the system the way we were.

The simple facts are, if are you going to implement a strategy consistently across your footprint, you've got to do it consistently across your footprint. There can't be regionalized views of how it is different between Milwaukee and Green Bay. There just aren't any. Objectively, there are no differences, except the potential. So you got to get your resources deployed. You got to get your model straight. You got to manage credit so that you're controlling the risks. You go the to have pricing discipline. You got to have sales management. And you do it across the whole footprint.

Okay.

That's the whole difference.

Okay. Great.

And Associated Banc has been a very decentralized thing over the years, we are saying, as a $20-plus billion company that is going to get bigger, that we have to have a consistent strategy for how we're going to add value and we're going to implement it.

Okay. Thank you.

Our next question comes from Brad Evans from Heartland. Please go ahead.

Thanks for taking the question.

Sure.

We're just curious if you could give us guidance relative to non-interest expense on a -- looking at the fourth quarter, taking into consideration some of the expense actions you've taken in the current quarter.

Well, to Kevin's question, earlier, the mortgage business isn't really staffed up like our other businesses are. We've done some things there to be more efficient. And we're always focusing on that. We want to maintain our efficiency ratios right about where they are. So I mean that's how we want to think about it. And to the extent that revenue momentum gives you more flexibility to invest more aggressively, then we would choose to do that. And so we should be thinking about a 50% efficiency ratio for us. We're not, at this point, thinking that we should be attacking expenses aggressively to drive it lower. In our commercial initiatives, for example, I mean we're going to be, perhaps, reducing some, but then adding some in other places. So it is a redeployment as much as it is -- in fact, it is not an efficiency play at all, it's a revenue play.

Okay. So effectively not much of a change going forward then from what we saw this quarter?

No. We, a year or so ago, well in '05, we went through a very systemic review of our expenses and we reduced our head count by about 10% through that process, and we continue to look at it under a critical eye, but we are an efficient organization, and I think staying where we are is about the right place to be.

And then most of my questions have been answered but I hadn't heard any discussion about the investment portfolio and taking into consideration the challenges that the yield curve is presenting, should we expect any further restructuring of the investment portfolio going forward?

We're down to, what, about 15%, and we need collateral and that sort of thing, so that is probably about as low as we're going to go. If that was your question?

Yes.

If you think about redeployment and that sort of thing, in this environment, there aren't many places you can go.

Right. Okay. Thank you very much.

Once again, if you would like to pose a question, please press star then the number one on your key pad. Our next question comes from Andrew Marquardt from Fox-Pitt Kelton. Please go ahead.

Good afternoon, guys.

Hi, Andrew.

Most of my questions have been answered, but I did have a follow-up question in terms of the commercial lending issues that you talked about at the onset of your call, that you are going to focus over the next three to six months, can you give a little bit more color on to what specifically you're going to do? Are there going to be any additional costs associated with it? And how long do you think some of those initiatives, once they're kind of implemented, will actually start to take traction?

Well, some are going to take -- in terms of implementation, some are going to take longer than others. In terms of aligning resources to segments, we've got a large number of just outstanding commercial bankers in our system. And frankly, this is putting my decisions that have been made over the last couple of years, and how we've thought about approaching the business under a critical eye to think about how to be more effective and to position our people to be successful. That's what this is about. And we've got the capabilities, if we provide more tools and more focus. So to align these people against the segments correctly, is really going to -- is something we can do relatively easily, and provide better product bundles for them to sell, and better product offerings, and we have a great treasury management and cash management capacity within the Company, and we need to provide our folks with the support and the resources to sell it more effectively.

At the other end of the spectrum, we've got to move a large number of very small loans into a more efficient processing and create a different value proposition for those customers, and that's going to take a little longer, but that is not where the lift comes from, that is where resource and capacity comes from. And frankly, better service and better access to products comes from from that smaller segment. So it is really looking at the whole gamut of our commercial operations, especially on the C&I side of the business. And coming up with a better set of execution plans that we can bring to the table, so that our people can succeed.

Is it fair to think that there should be some incremental spend associated with that, in the near term, to help get that ramped up?

Not significant. Because we have the ability, again, to redeploy.

Okay.

And we're we're looking at our expenses across the entire company, too, to create that capital. So we want to keep our efficiency ratio about where it is. But create -- and our expense levels similar to where they are and create better growth opportunities. So it is not a big investment with the revenue income by any stretch.

Thanks. That's helpful. Separately, can you just remind us what your thinking is in terms of credit quality, in terms of a normal level of losses that one should expect for your [inaudible]?

Well, if you look back over us for 30 years, our averages have -- and it is hard to talk in averages, but our averages are in the 20 basis points range. I don't see us immediately evolving to 20 basis points. We've been at 10 or below for six or eight quarters here. So we don't see us just jumping to 20 any time soon, we think that we've got things under control. But over time, the credit is going to migrate to a more normal level for the entire industry. And we think at the end of the day, even when that occurs, we're going to be better off than most, because of our history, and because of how we have -- if track records mean anything, we've proven that we can manage through a variety of different interest rate environments and economics that that scenario is pretty successful.

Okay. Thank you.

We have a follow-up question from Eric Grubelich from KBW. Please go ahead.

Paul, one more question on credit quality. The part of the commercial portfolio that might be loans due builders, developers an the residential side of the market, how concerned are you about that, given the slow down in housing sales, and the slow down in mortgage banking that is sort of related to it, too, but are you looking a little bit more closely at the trends in the portfolio there? Does anything keep you awake at night?

Well, you're darn right we're looking at it because those trends are out there and they're real and real estate is a cyclical thing banks are involved in it, and it is the thing that kills you if you're not -- if the market does turn. So yes, we're looking at it very seriously. I would like to think, and again, it is a long-standing strength of the Company, that we have built up good solid relationships with high quality builders, developers, and customers. And that we know those customers well, because of the relationships we have. And we have been able to manage that risk well. Part of the reason we have, I think is that we are objective about the environment that we're in. And we believe that this is the place where you need to be a little more disciplined and a little more structured, and frankly, a little tighter. Because of those dynamics, and how they can affect you.

So I mean right now, are you -- there is one part of it's new lending but the other part is existing business. Are you seeing any markets that you go 'whoa' there has been a big slow down here who do we have exposure to that maybe is overdeveloped? I mean do you have people that are looking at those market dynamics to try to get ahead of the knock on the door by the customer saying, hey, I can't pay you now?

Yes, we are systematically going through our portfolios, and looking at that, and evaluating the risk. And thinking about what our strategies are, and we are having conversations every day about how we want to approach new potential pieces of the business. And we're challenging ourselves on those kinds of issues all the time. It is uncertain as to where we're going to end up. But it is unmistakable that loan to values, existing loans, and the value of those properties and the like are going down. So you've got to be realistic in how you look at that. Now, in our construction book, that stuff is fairly short duration, too. And you're dealing with good customers. We have our criteria, depends upon how those -- the properties are leasing up and the like and those category, and we feel like we're dealing with good, solid -- as a rule, of companies, and having transactions that are of short duration. But there is no doubt that the economic environment is going to be challenging.

And then one final question for Joe, on the comp and benefits side of the expenses, the numbers were down this past quarter, I think Paul may have alluded to some cut backs in the mortgage banking, if I understood that correctly, and maybe that was part of it, but the $71 million that we saw for the quarter, does that pretty much reflect everything you thought were you going to save at State Financial by now? And then plus some other things internally?

Yes.

Is that like a good run rate number or is there any -- is there a little bit more of a rabbit you can pull out of the hat there going forward?

Well, it will fluctuate as revenue and that sort of thing fluctuates because compensation components are variable. So there will be some of that. There is always the fun issues around health care costs and those sorts of things that you got to consider, but those things are always there to create variability.

And Eric, I want to make sure that I remind that you the last quarter we had a $3 million health care nonreoccurring expense, that if you take it out of last quarter was about 71 also.

Yes. Okay. You're right.

Yes. So I think it is in the ballpark.

Yes. Okay.

Our next question comes from Peyton Green from FTN Midwest. Please go ahead.

Just was wondering if you could characterize the kind of centralization or standardization of the credit issue, is this going to result in turnover like the retail and consumer initiative did or is this just simply more of a systems process initiative rather than a sales one?

Well, let me be clear on that. It is not centralizing decision making to a point where in your mind's eye you would think about some larger institutions, and that sort of thing. It is bringing more consistency to the process, and less discretion. The lending officers still sit in the region and work with the business bankers in those regions, but it is going to drive that consistency and discipline around the policies that are there, and basically take some of the exceptions and the independent use of exceptions in the region out of the system. So it is not a -- it is not a night and day shift at all, but it is getting serious about making sure that it is truly consistent.

Okay. And then in terms of the investment portfolio, how much cash flow do you all expect in '07? And then, if you chose to reduce it, I mean, how much leeway do you have versus what you need for pledging?

Well, we're pretty much where we need to be for pledging.

So there is no extra is what you're saying?

Well, again, when you're talking about anything of substance, no.

Okay.

No, and again, the duration of the portfolio is 2.25 years so it comes in pretty quickly.

And is there any disproportionate amount that is particularly low yielding or high yielding that you will lose that could cause an opportunity or issue?

Well, no, not disproportionate, but obviously, the portfolio yield is low, and as we start to reinvest the cash flow, we would think we would be picking up yield.

Okay.

So we think that would be a net positive, but it is not -- I mean it is not that big of a deal, because, again, there is no goal in the investment world, but again, you would think we would get positive lift from that process.

Okay. Great. Thank you.

Gentlemen, it appears that we have no more questions.

All right. Well thank you all for your time and for your questions. And we will talk to you all soon.

This concludes today's conference call. You may now disconnect. Have a wonderful day.