Banner Corp (BANR) 2012 Q2 法說會逐字稿

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Banner Corporation's second quarter 2012 conference call and webcast.

During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today, July 26, 2012.

I would now like to turn the conference over to Mr. Grescovich, President and CEO of Banner Corporation. Please go ahead.

Thank you, Erin, and good morning, everyone. I would also like to welcome you to the second quarter earnings call for Banner Corporation.

Joining me on the call today is Rick Barton, our Chief Credit Officer; Lloyd Baker, our Chief Financial Officer; and Albert Marshall, the Secretary of the Corporation.

Albert, would you please read our forward-looking Safe Harbor statement?

Certainly. Good morning.

Our presentation today discusses Banner's business outlook and will include forward-looking statements. Those statements include descriptions of management's plans, objectives or goals for future operations, products or services, forecasts of financial or other performance measures, and statements about Banner's general outlook for economic and other conditions. We also may make other forward-looking statements in the question-and-answer period following management's discussion. These forward-looking statements are subject to a number of risks and uncertainties and actual results may differ materially from those discussed today.

Information on the risk factors that could cause the actual results to differ are available from the earnings press release that was released yesterday and our recently filed Form 10-Q for the quarter ended March 31, 2012. Forward-looking statements are effective only as of the date they are made and Banner assumes no obligation to update information concerning its expectations. Thank you.

Thank you, Albert.

As announced, Banner Corporation continued our improving performance again in the second quarter, reporting a net profit available to common shareholders of $23.4 million or $1.27 per share for the period ended June 30, 2012. This compared to a net profit to common shareholders of $7.2 million or $0.40 per share in the first quarter of 2012 and a net profit of $224,000 or $0.01 per share in the second quarter of 2011.

Looking into earnings before preferred stock dividends, discount accretion and changes in fair value, Banner's net income improved to $0.68 per share for the second quarter of 2012 compared to $0.42 in the first quarter of 2012 and $0.02 per share in the second quarter of 2011.

The second quarter core performance provided unmistakable evidence and confirmed that through the hard work of our employees throughout the Company, we are successfully executing on our strategies and priorities to strengthen our franchise and deliver sustainable profitability to Banner. And our return to profitability for the last five quarters further demonstrates that our strategic turnaround plan is effective and we are building shareholder value.

Our operating performance again this quarter showed improvement on every key metric when compared to the quarter a year ago. Our second quarter core revenue increased 8% when compared to 2011. Our net interest margin expanded to 4.26% in the second quarter of 2012 compared to 4.09% in the second quarter of 2011 and our cost of deposits decreased to 48 basis points in the most recent quarter compared to 80 basis points in the same quarter of 2011.

These improvements are reflective of our super community bank strategy, that is reducing our funding costs by remixing our deposits away from high-priced CDs, growing new client relationships, and improving our core funding position. To that point, our core deposits again increased in the most recent quarter and increased 9% compared to June 30, 2011. Also our non-interest-bearing deposits increased 25% from one year ago. It's important to note that this is all organic growth from our existing branch network. In a moment, Lloyd Baker will discuss our operating performance in more detail.

Clearly, improving the risk profile of Banner and aggressively managing our troubled assets has been a primary focus of the Company. Again this quarter, we continued making excellent progress on that objective. Our non-performing assets have been reduced another 21% compared to the first quarter of 2012 and 61% compared to June 30, 2011. The most problematic part of the portfolio, our non-performing loans, has reduced 27% from the first quarter of 2012 and 59% from June 30, 2012.

In a moment, Rick Barton, our Chief Credit Officer, will discuss the credit metrics of the Company and provide some context around the loan portfolio, along with our continued successful execution in aggressively managing our problem assets.

Although we have made excellent progress reducing troubled assets, we recorded a still large $4 million provision for loan losses in the quarter. As a result, the coverage of our allowance to non-performing loans again increased and is now 169% at June 30, 2012, up substantially from 80% in the second quarter of 2011.

While credit costs remain elevated in the second quarter and above our long-term goal, Banner's reserve levels are substantial, and our capital position and liquidity remain extremely strong. At the end of the quarter, our ratio of allowance for loan and lease losses to total loans was 2.5%, our total capital to risk-weighted assets ratio improved to nearly 20%, our tangible common equity ratio improved to nearly 11%, and our loan to deposit ratio was 94%.

In the quarter and throughout the preceding 27 months, we continued to invest in our franchise. We have added additional commercial and retail banking talent to our Company in all of our markets and we have invested in new sales and credit training programs to further develop our bankers and integrate Banner's new credit and sales culture. These efforts are yielding very positive results as evidenced by our strong customer acquisition.

Also, Banner received significant recognition from a well-known survey agency, J.D. Power & Associates, that Banner Bank was rated number one of all banks for customer satisfaction in the Pacific Northwest, and we ranked in the top 10 nationwide.

Finally, our persistent focus on improving the risk profile of Banner and our successful execution of our strategic turnaround plan has now resulted in five successive quarters of profitability. Although further improvement in core performance is a primary focus for Banner, our confidence in the sustainability of our future profitability has convinced us to eliminate nearly all of the valuation allowance against our deferred tax asset. This gain was partially offset by the net loss of fair value adjustments as a result of changes in the valuation of financial instruments carried at fair value. While the elimination of the DTA allowance is clearly a watershed event for our Company, our improving core performance is significantly more important in the long term.

I'll now turn the call over to Rick Barton to discuss the trends in our loan portfolio and our credit metrics. Rick?

Thank you, Mark. My comments this morning will be brief and mirror those made during our first quarter call.

Our quarterly results again showed solid progress in the Company's credit quality metrics. I would like to highlight and comment on several of them.

Net charge-offs declined for the seventh consecutive quarter. When compared to the linked quarter, they were down by $1.1 million or 17% to $5.3 million.

Total non-performing assets declined to 1.73% of total assets, a reduction of 51 basis points when compared to the first quarter and 275 basis points from a year ago. The quarter-to-quarter dollar reduction was $19.9 million or 21%.

Reduced non-performing loans accounted for most of the quarterly reduction in non-performing assets. They decreased by $17.5 million or 27%. A good chunk of this improvement, $8.3 million, came in the residential construction and land portfolios where non-performing loans are now just $8.6 million. Other portfolios showed more modest improvement, except for the consumer portfolio, where non-performing loans increased by $300,000 to $2.8 million. New non-performing loans during the quarter totaled only $6.4 million, the lowest new quarterly total since early 2008.

REO decreased modestly by $1.9 million or 7% during the quarter. This slowdown in REO liquidation was not unexpected to us as the remaining REO portfolio is very granular. Our team did dispose of $7.8 million of REO during the quarter, realizing a gain on the sale of almost $600,000. Residential construction and land remaining in our REO are only $800,000 and $11.2 million respectively, with both categories declining during the quarter.

One to four-family real estate in the REO portfolio grew by $1.1 million during the quarter to $7.7 million, and now makes up 30% of the REO book. This is reflective of decreased housing values and the fact of life that there will be additional foreclosure activity by all lenders during the next several quarters.

Classified loan totals decreased by $26.4 million during the quarter to $167 million, a reduction of 14%. Total delinquent loans decreased to 1.65% of total loans from 2.45% in the linked quarter. Loans 30 to 89 days past due and [non-accrual] showed significant improvement during the quarter, decreasing to $5.5 million, and the largest non-performing land exposure remaining in our portfolio was paid in full.

The loan reserve continues as a source of strength for the Company. Our riskiest portfolios, residential construction and land, continued to shrink, as already discussed. Coverage of non-performing loans continued to increase during the quarter and stands at 169%, up from 126% last quarter. The reserve to total loans dropped by 2 basis points to 2.5% and is still very strong from a historical perspective. We feel this level of reserve is warranted, as we have said before, because the economic environment remains challenging and fragile and as levels of classified and non-performing loans in the portfolio continue to remain unacceptably high.

The second quarter was another positive step in returning our credit metrics to acceptable levels. Our focus on this task remains strong and will continue to be so until this job is completed.

With that, I'll turn the mic over to Lloyd for his comments.

Thank you, Rick, and good morning everyone.

As Mark and Rick have already indicated and as reported in our press release, Banner Corporation's operating results for the quarter and six months ended June 30 reflected further progress during the quarter and, perhaps more importantly, continuation of the significant progress that has been occurring over the past two years. That progress has resulted in much improved credit quality, strong revenue generation, increasing operating profitability, and now five consecutive quarters of net income, including $25.4 million of income in the current quarter and $34.6 million for the first six months.

Of course, I'm emphasizing the continuing nature of this progress to confirm our belief that this profitability is the predictable result of our improved operating fundamentals and our conclusion that sustained profitability is clearly expected going forward. Our confidence in that conclusion of sustained profitability of our earnings, coupled with our improved risk profile, led us to the two substantial, although largely offsetting, adjustments to the significant accounting estimates reflected in the current quarter's financial results. Specifically, the reversal of most of the valuation allowance for our net deferred tax assets and the large fair value charge associated with revaluing our junior subordinated debentures.

I will discuss those estimates in a little more detail later. However, as Mark has noted, the real highlights for the quarter were the continuing trends that supported these decisions. So, first, I will spend a few minutes reviewing those trends.

Rick has already addressed the improved credit quality metrics thoroughly, but as a recap, the continuing trend of improving credit quality has resulted in lower levels of loan loss provisioning, collection costs and expenses related to real estate owned, and has also significantly contributed to our improved net interest margin as the drag from non-accruing assets has been substantially reduced.

Our provision for loan losses for the second quarter was $4 million compared to $5 million in the preceding quarter and was well below the amounts recorded in earlier periods including the $8 million provision in the second quarter a year ago. As a result, our provision for the first six months of 2012 was $9 million compared to $25 million in the first six months of 2011.

In addition, our expenses related to real estate owned were further reduced during the quarter and were $4.6 million less than a year ago. While these credit costs remain above long-term acceptable levels, they have been consistently declining for a number of quarters and we expect that this extended trend of improving asset quality will result in further reductions in credit costs in future periods.

The first quarter of -- excuse me, the second quarter of 2012 was also highlighted by the continuing trend of increasing revenue generation that we have been commenting for more than two years now. As has been the case for all of this period, the continuation of this trend of year-over-year increases in core revenues was again driven by significant improvement in net interest margin and resulting net interest income, as well as solid deposit fees revenues fueled by growth in core deposits.

However, for the first half of 2012, our results also reflect substantial increase in revenue from mortgage banking operations, which were more than three times greater than a year earlier. As a result, for the quarter ended June 30, 2011, our revenues from core operations, which includes net interest income before provision for loan losses plus other non-interest operating income, but excludes the fair value adjustments, so, revenues from core operations increased to $52.3 million compared to $50.4 million in the immediately preceding quarter, a new quarterly record and $3.7 million or 8% greater than the second quarter a year ago. Revenues from core operations for the first six months of 2012 increased to $102.7 million, a 7% increase compared to the first six months of 2011.

Our net interest margin was 4.26% for the quarter, a 14-basis-point increase from the preceding quarter and 17 basis points stronger than the second quarter a year ago. The year-over-year margin improvement again reflected a meaningful reduction in our funding costs, as well as further reductions in the adverse effect of non-performing assets.

For the first six months of the year, our net interest margin increased to 4.19%, an 18-basis-point expansion compared to the same period a year -- last year. As a result, for the second quarter of 2012, Banner Corporation's net income was $42.3 million compared to $41.1 million in the immediately preceding quarter and $41.1 million in the first quarter a year ago. Despite the adverse impact of very low interest rates and weak loan demand on asset yields, for the first six months of 2012, our net interest income was nearly 3% greater than the first six months of 2011.

Deposit costs decreased by another 4 basis points during the second quarter and were 32 basis points lower than a year ago, reflecting further changes to the deposit mix as well as additional downward pricing. These are trends that have been dramatically contributing to our improved margin and increased net interest income for a number of quarters.

In addition, our funding costs were significantly reduced during the quarter as a result of the repayment of the $50 million of senior notes that we had issued three years ago under the FDIC's Temporary Liquidity Guarantee Program. While these notes provided valuable backup liquidity at the turbulent time when they were issued, including the FDIC guarantee fee, they were costing a little more than 3.375% annually, so the maturity of those notes had a very positive impact on our funding cost.

As a result of the lower deposit and borrowing costs, our average cost of funds decreased by 11 basis points compared to the preceding quarter and was 37 basis points lower than the second quarter of 2011. Similarly, for the first six months of 2012, our funding costs were 35 basis points lower than for the same period in 2011.

Of course, the very low interest rate environment continued to put downward pressure on asset yields, however, net interest margin further benefited from the significantly decreased levels of non-accruing loans and REO as compared to earlier periods, which offset some of this pricing pressure.

As a result, the yield on average earning assets hit 4.76%, actually increased by 4 basis points compared to the first quarter, although, reflecting the rate environment, it was 19 basis points lower than the second quarter of 2011. The yield on loans was 5.44% for the second quarter, which also was an increase of 4 basis points compared to the first quarter, but was 16 basis points lower than the second quarter a year ago.

The adverse margin impact from non-accruing loans decreased to 8 basis points in the current quarter compared to 13 in the preceding quarter and 23 basis points for the first quarter a year ago. In addition, the collection of previously unrecognized interest on certain non-accruals that had been acquired at a deep discount added 5 basis points to the margin in the current quarter. These same factors also positively impacted the yield for the year-to-date period. However, reflecting the lower rate environment, for the first six months of 2012, loan yields decreased by 21 basis points compared to a year ago.

So, now, for my quarterly disclaimer, while the continuing reductions in non-accruing loans and other non-earning assets, including REO that we have achieved will be helpful to our net interest margin in future periods, the yields on performing assets should continue to decline in the current rate environment. And although we expect further reductions in non-performing assets in the current quarter, we will also have less opportunity to reduce funding costs in future periods. As a result, further improvement in our net interest margin will be much more dependent on growth in the earning assets going forward.

As noted in our press release, for the second quarter, loan balances again decreased slightly compared to the preceding quarter, primarily as a result of the impact of refinancing activity on residential mortgage loan prepayments, payoffs on some commercial construction loans as a result of completion of projects, and further planned reductions in land development loans. However, we did experience an expected seasonal rebound in agricultural loan balances and modest growth in commercial real estate and one- to four-family construction loans. Unfortunately, reflecting the continued economic uncertainty, demand for commercial business loans and consumer loans and credit line utilizations remain disappointing.

Total deposits were nearly unchanged compared to the prior quarter-end. However, reflecting a normal seasonal pattern, non-interest-bearing deposits increased by $33 million, and more importantly, increased by 25% compared to a year earlier.

As a result of growth in transaction and savings accounts and planned reductions in high-cost certificates of deposit, core deposits now represent 66% of total deposits. And as I've noted before, we're not just adding balances but instead continue to see solid growth in the numbers of accounts and customer relationships, which has significantly contributed to the increased deposit fee revenues that was very evident in the current quarter and the first half of the year as total deposit fees and service charges were 10% and 11% greater, respectively, than for the same quarter and six months a year ago.

Also, as I noted before, revenue from mortgage banking activity continued to be very strong during the quarter, with mortgage banking revenues increasing to $2.9 million for the second quarter compared to $2.6 million for the first quarter and just $855,000 for the second quarter of 2011. Year-to-date mortgage banking revenues were $5.5 million, more than three times the level a year ago. And the very low rates currently available in the market have caused application activity to remain high, which will continue to positively impact revenues for at least a few more quarters.

Expenses related to real estate owned, while high, declined, reflecting the reduced number of properties owned and fewer valuation adjustments. Although we expect these real estate owned expenses and other credit costs to remain elevated for a little longer, we do expect that they will continue to decrease over time as additional problem asset resolution occurs.

Similar to recent periods, for the second quarter and year to date, other operating expenses were reasonably well-behaved, although compared to a year ago, increases in compensation expense, which in part reflect the increased mortgage banking activity, as well as a sharp increase in health insurance costs, offset a portion of the decrease in real estate owned expense and FDIC deposit insurance costs.

Now returning to the accounting adjustments, the solid performance for the Company has clearly demonstrated some key trends that we have been highlighting for a number of quarters, and for more than a year now, in net income that we have been reporting. As a result of the continuous improvement in operating performance that we have achieved over an extended period and our conclusion that it is likely that sustained earnings will continue for the foreseeable future, we elected to reverse the valuation allowance against our deferred tax asset in the current quarter.

This decision is reflected in the $31.8 million tax benefit that we've reported for the quarter and six months ended June 30, 2012. In addition, under the accounting guidance, the remaining $7 million of the allowance will be utilized to offset our income tax provision for the remaining two quarters of 2012.

Further, as I have indicated in the past, the facts that support this decision regarding the DTA valuation allowance also logically lead to a significant adjustment to the fair value estimate of the junior subordinated debentures issued by the Company. Therefore, we recorded a $21.2 million charge related to the increase in the estimated fair value of those debentures. This was partially offset by increases in estimated fair value of similar trust preferred securities that we own.

As a result, the net fair value adjustment for the second quarter of 2012 resulted in a net charge of $19.1 million compared to much smaller gains in the prior quarter and the same quarter and six month periods a year ago. While the changes to these accounting estimates are large and significant, they should not be recurring in similar magnitude, and more importantly, they should distract attention from the improving core operating results that led to the adjustments.

Finally, as we have noted before, the capital base of the Company and subsidiary banks is substantial and, again, increased during the quarter. At June 30, 2012, Banner Corporation's ratio of tangible common equity to tangible assets increased to 10.92%. Its total risk-based capital ratio increased to 19.76% and its Tier 1 leveraged capital ratio increased to 15.07%.

Further, Banner Bank and Islanders Bank both enjoy similarly strong capital positions as well as loan -- as well as reserves for loan losses that are also substantial. This capital strength should allow Banner considerable flexibility with regard to capital management as we move forward.

So with that final thought, I'll turn the call back to Mark. As always, I look forward to your questions.

Thank you, Lloyd. That concludes our prepared remarks, and, Erin, we will now open the call and welcome your questions.

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions).

And our first question comes from the line of Jeff Rulis with D.A. Davidson. Please go ahead.

Thanks. Good morning, guys.

Good morning, Jeff.

Lloyd, kind of a follow-up on that non-interest expense, pretty significant drop at the FDIC deposit insurance cost. Anything one-time in there? Is that sort of the run rate that you'd expect going forward?

Good morning, Jeff. No, there's nothing unusual in that. It is a run rate. It's reflective of the changes in the fee structure that occurred as a result of Dodd-Frank. It's also reflective of smaller asset base, and it's reflective of a specific reduction in the fee charged to Banner.

Okay. And then I guess a simple question on the comp line, was down considerably, and maybe a big Q1. But given the mortgage banking revenue produced, is that a line item that's oddly low going forward?

No, it's not oddly low, it's pretty much a run rate.

Okay, so --

I think the difference between the first quarter and the second quarter is pretty much insignificant there, Jeff.

Okay. And then the -- so I guess, following that up with your comments, we get to expect flat to down expenses over time, the one factor being OREO expenses, you alluded to eventually working that down, albeit elevated in the near term?

Right. REO's expense was just under $2 million for the quarter. We think there's further room for improvement there over time. There's a few expense items that are volume-related, and as we continue to grow and have success, you would expect some of those to go up. But there's other that we would expect additional efficiencies on, so.

Right. Okay.

Again, expense control I think has been pretty solid for a number of quarters now.

Sure. Switching gears a little bit on the, you know, a pretty big bump-up in the shares out. Any comments on the DRIP program or expectations for additional share [creep] going forward?

Yes, Jeff. The DRIP program, as you know, has been an important part of our capital management through this sort of difficult period of time that we've experienced over this cycle. Having said that, we know that we now are very well-capitalized, and our Board of Directors just recently took action to reduce the discount that we offer to purchasers under that program, de minimis purchasers.

We actually haven't done any what we refer to as waiver transactions, so only transactions under the de minimis amount had been occurring for the last couple of years. But we are adjusting the discount on that effective August 1, from 3% down to 1%. Our expectation is, is that will pretty nearly shut that program down.

Got it. Okay. And then last one if I could, if you could just give us an update, Mark or Lloyd, on the sort of the preferred stock outstanding and kind of what your hurdles are there, whether it's capital on hand at the back of the holding company, and just kind of an update on ideas now that the [DTA] is behind you --

Yes, Jeff. This is Mark. As we've said in the past, and I'll repeat what we've said before, prudent capital management is something that we take very seriously, so we are exploring all options in terms of deployment of the capital that we have. One option is obviously retirement of or a repurchase of some of the perpetual preferred, depending on when the interest rate kicks. But there are also other options in terms of deployment of capital, and we're exploring all those.

Okay, I'll step back. Thanks.

Thanks, Jeff.

Thank you. Our next question comes from the line of Joe Fenech with Sandler O'Neill. Please go ahead.

Good morning, guys.

Hi, Joe.

Lloyd, just a question on the remaining $7 million associated with the DTA, are you anticipating any additional [write-off of] the sub-debt, is it offset or is that pretty much behind you at this point and you get the full benefit of the $7 million in the back half of the year?

We don't -- we anticipate write-off of the sub-debt over the remaining life of it, but that's a very long slow process. We don't anticipate any major revaluation of it unless market conditions should change dramatically.

So I don't, you know, there'll be -- the valuation on net debt is influenced by things like the level of LIBOR that we don't have control over. But our anticipation is nothing unusual there and that the remaining $7 million in the valuation allowance will be an offset to the tax accruals over the next two quarters. And then, beginning in 2013, first quarter, we'll go to a normal tax provisioning process.

So there'll be a little bit of an adjustment in the taxes because obviously the $7 million is based on an estimate, we don't know with certainty what the third and fourth quarters are going to look like. But we don't expect much of an impact on taxes for the rest of the year other than --

Okay. So that basically just drops to the bottom line.

Right.

Okay. And then, Mark, with the regulatory agreements behind you, you mentioned other capital management alternatives to the preferred redemption. Could we see something else maybe before we see the redemption of the preferred, or dividend or share repurchase, or is that sort of the next leg after you get the preferred out of the way?

I think we've indicated before, it's kind of a waterfall. The first deployment of capital is obviously reinvestment in the Company and the franchise. The second deployment would be if we have excess capital, that preferred along with its dividend is fairly expensive capital. And then we would look to other alternatives or alternative use of capital such as increasing in dividend, and then any type of buyback would be down the road substantially.

Okay. And then with respect to the allowance, if you're -- if you guys are expecting continued credit improvement from here, that would seem to imply that there's plenty of room to allow that allowance ratio to drift lower, especially since you're resolving these problem loans without taking big charges to do it. So, could we -- is it possible we could possibly see an allowance ratio below 2% at some point in the next year? What do you guys sort of look at as sort of the minimum threshold that we won't see you go below?

Yes, Joe, this is Mark. I think, you know, depending on market conditions and the economy. And I want to be clear on that because there's still some uncertainty out there in terms of where -- what the economic climate's going to be like. But obviously if we have a modest growth economy and it stabilizes to a point where we see that it's not going to deteriorate, that [2%] number is a reasonable number.

Okay, great. Thank you, guys.

(Operator Instructions). And our next question comes from the line of Timothy Coffey with FIG Partners. Please go ahead.

Good morning, gentlemen.

Good morning, Tim.

Lloyd, I wondered if you could walk me through the revaluation of the sub-debt. What was the discount rate and what was kind of the approach that you used?

As you and I think others know from reading our 10-Qs and 10-Ks for a number of quarters, we were previously using a discount rate of LIBOR plus 800 basis points. Based on the changes that were evident in market conditions and in Banner's credit standing and other issues, we settled in LIBOR plus 550 for the current quarter. Applied that to ourselves as well as, I think you know, we have a small amount of assets that are similar institutions, and so we applied it to them as well. And previously, those had been valued at anywhere from LIBOR 600 to LIBOR 800. So, all of those assets now at 550.

Like you said, it was based on market conditions?

Yes. Obviously we have to go out and support that. We work with some consultants on that support it with what market data we can find. There's not an active market in small bank trust preferreds, but there are similar capital instruments out there that give us some indication, and then we apply what we think are appropriate adjustments to those indications.

Okay. And looking at the loan yields, the last four quarters, you know, treaded on a very narrow range. I wonder, going forward, is that sustainable or do you see the low interest rate environment catching up to your loan yields, the average [loan yield]?

Well, this is Lloyd. I can't -- obviously I've been pretty wrong on that. I continue to believe that the rate environment is going to put pressure on those yields over time, and in fact, on a year-over-year basis, that's the case. But what's been occurring with us is very clear that we continue to have reductions that are meaningfully -- in non-performing assets, in REO and the like -- that are meaningfully impacting that and holding those yields up. But this is a very, very, very low interest rate environment. And over time, it's going to take a toll on everyone.

Okay. And then kind of looking at the net charge-offs for the second quarter, I'm wondering, is that seasonal or is it just a product of the diligence that you've been applying to the credit portfolio?

I think it's product of the diligence that we've been providing to the loan portfolio.

Okay. Do you have a feeling if that's sustainable at this level?

I would imagine that as we go forward, Tim, that we would see it continue to drift down.

Okay. Great. Thanks. Those are my questions.

Thanks, Tim.

Thank you. Our next question comes from the line of Kipling Peterson with Columbia Ventures Corp. Please go ahead.

Good morning. Just a couple of questions. First one, do you have a feeling for the percentage of the deposits at zero interest that may be parked there simply because the FDIC is -- has an unlimited guarantee that should it -- should that guarantee go away, would be at risk of moving out of the bank?

Kipling, we're fairly convinced that the insurance issue is a bit of what's contributed to the buildup in cash balances on our business customers in particular, but not as big of an issue as actually they're just accumulating cash. We talked about a fragile economy and yet businesses are making a lot of money but they're not investing it, they're accumulating cash. And in the current interest rate environment, they don't see a lot of opportunity to move it into other instruments and earn a little bit of money.

So, while the insurance issue is out there, I think the bigger question mark with respect to those, what have been referred to by many as surge balances, is what will happen when interest rates go up? And in our case, I think I've made it clear in the past that we would like to see interest rates go up. So while that will adversely impact some of the dollars in that category, rising interest rates would still be a good thing.

And, Kipling, this is Mark. That is why our strategies around client acquisition are so important. And as Lloyd said in his comments, we've made substantial inroads in market share gains for new clients.

That's great. And finally, in reference to what had been known as TARP, if you folks decided this morning to pay off $20 million of the preferred, would you be able to do that without getting any permission from regulators and you just decided that retiring 5% money is a good thing to do, could you do that without getting any permission?

Kipling, this is Mark again. Thank you for the question. We are in constant, as I said last quarter, we're in constant contact with our regulators. We have a very good relationship with them and we communicate with them in terms of capital management on a regular basis. So we'll look at those opportunities as they arise.

So that's a no. You would have to get permission from the regulators to pay off any amount.

Clearly we're not under any regulatory restrictions at this point. That does not mean we don't discuss issues with our regulators.

Thank you.

Our next question comes from the line of Fred Cannon with KBW. Please go ahead.

Great. Thanks, and congrats on making a real breakout this quarter across all the metrics.

Thanks, Fred.

On your expenses, I was wondering if you could size a little bit how much of the non-interest expense outside of REO was devoted to kind of, you know, credit workout at this point in time.

Too much.

Okay. I mean that is --

We're probably spending still in the neighborhood of $600,000 to $800,000 a quarter in legal, related to collection activities.

That's our historical number, Fred, that we've outlined in the past on an annual basis. It's been about 16% of the expense ratio is related to collection costs. And you're starting to see from the peak of the beginning of 2011, that number start to come down. So it's not unreasonable for us doing that number still at a 10% clip.

Okay, great. That's helpful.

And Fred, this is Lloyd. There's another hidden cost there, which is inside the compensation line. So --

That's right. The number, you could accumulate that number at around 10%.

And as we keep reducing the number of problem assets in REO and the like, there's a compensation expense that can be reallocated to other productive uses.

Okay. That's helpful. And just on the loan book, kind of looking for when we get a real turn in growth, one to four-family construction was up I think meaningfully at least in the period. Is that an area where you can -- really we can start to see some growth or is that still -- or it's just going to kind of bounce around for a while?

Well, I think in the short run there is an opportunity to see some growth in that loan category. Fred, this is Rick Barton. Both in the Portland market and the Seattle market, we've had success in making some loans this year. The Portland market, commitments for new construction loans total about $55 million and it's about twice that amount in the Seattle metropolitan market.

We think that there will continue to be an opportunity to do that for the balance of the year as there are certain submarkets where the housing stock, in terms of completed new homes, is almost non-existent, and there's a very small standing inventory of resale homes as well in those submarkets.

Fred, this is Mark again. I think some of the guidance we've given in the past is that portfolio is right now on the res -- between the construction and residential portfolio, about 7.4% on the overall loan portfolio. Under a normalized cycle, we would be okay with that, running up to 10%.

Okay. Okay. Great, that's really helpful. Great. All right, thanks again.

Thank you.

(Operator Instructions). And we do have a follow-up question from the line of Jeff Rulis with D.A. Davidson. Please go ahead.

Hey, Lloyd, I had a quick one on the tax rate for next year. Is there an appropriate assumption you could give when you return to full taxpayer status?

An effective tax rate usually for us is going to run somewhere 32%, 33%. It depends on the level of tax credit investments, municipal securities, things along those lines. So, marginal tax rates of 35%, but effective will be a little lower.

Got you. Thank you. I guess [you just sort of also] gave us the earnings in Q3, Q4 this year. Kidding on that one.

If you want to do that math. But as I pointed out, there's a lot of uncertainty in Q3 and Q4, so.

I got you.

There will be an adjustment to that $7 million number, I'm not sure which direction it will go.

Okay, fair enough. And one quick last one on the mortgage banking business. It has been strong. Maybe just a quick comment on how that's proceeded in Q3 so far this quarter.

Activity continues to be strong, as I pointed out in my comments. The level of interest rates continues to encourage refinance activity. For us it's running about 70%, which is fairly common I think in the market today. So, our volumes here were double what they were -- more than double what they were the first half last year. They're continuing in the third quarter right at the moment. And I don't see why that would change a great deal. We've actually devoted more resources there. The people are doing a great job. The volume of activity is such that there's a little bit more profit margin in that right now than some other times.

Okay, great. Thank you, guys.

Thank you. And I am showing no further questions at this time. I would like to turn the call back to management for any closing remarks.

Thanks, Erin. This is Mark again.

For the second quarter of 2012, our performance continued to demonstrate that we are making substantial and sustainable progress on our disciplined strategic plan to strengthen Banner by achieving a moderate risk profile and at the same time executing on our super community bank model by growing market share and improving our core operating performance. I would like to thank all of my colleagues who are driving this substantial improvement in performance for our Company.

Thank you for your interest in Banner and your questions and for joining us on the call today. We look forward to reporting our results to you again in the future.

Ladies and gentlemen, this does conclude today's conference call.

If you would like to listen to a replay of today's conference call, please dial 1-800-406-7325 and enter access code 4548321.

Thank you for your participation, and you may now disconnect.