First Commonwealth Financial Corp (FCF) 2010 Q2 法說會逐字稿

Good afternoon. I would like to welcome everyone to the First Commonwealth Second Quarter 2010 earnings conference call. All participants will be in a listen-only mode. (Operator Instructions) Please note this event is being recorded. At this time, I will turn the call over to Rich Stimel, Communications Manager at First Commonwealth. Rich?

Thank you. As a reminder, a copy of today's earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page and then selecting News on the left side of the page. We have also included a slide presentation on our Investor Relations page with supplemental financial information that we'll reference throughout today's call. With me in the room today are John Dolan, President and CEO of First Commonwealth Financial Corporation, Mike Price, President of First Commonwealth Bank and Bob Rout, Executive Vice President and Chief Financial Officer. After brief comments from management, we'll open the call to your questions. For that portion of the call, we'll be joined by Bob Emmerich, our Chief Credit Officer and John Previte, our Senior Vice President of Investments.

Before we begin, I would like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, its business, strategies and prospects. Please refer to our forward-looking statements disclaimer on page two of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Now, I'd like to turn the call over to John Dolan. John?

Thanks, Rich, and good afternoon. Thank you all for joining us on today's call. With the release of our second quarter financial results this morning, we were pleased to report solid overall performance and continuing progress in resolving the credit quality issues that have so dramatically affected our earnings over the past several quarters. While the credit issues we have been managing and working to clear up did stabilize in the second quarter, the continued economic uncertainties require that we remain cautious. Mike will walk through the credit details -- the credit quality details with you a little bit later, but in general, our second quarter provision for loan losses was significantly lower than both the previous quarters and the provision for the second quarter of last year.

An extensive amount of time and resources have been dedicated to reshaping our risk profile and addressing the exposures of our large credits. In the second quarter, we did not experience any significant deterioration in the credits or collateral valuations. We did recover $3.6 million during the quarter from previously charged off loans as well as releasing specific reserves for a troubled loan that paid off. Credit quality obviously continues to be our top priority, and the changes we've made to the structure of our credit function, the talent we've brought in to lead the team and the refinement of credit policies and guidelines have allowed us to make consistent progress in this area.

So while credit quality remains rightfully the focus of our attention, there is solid performance to report in virtually every aspect of our community banking operations. Revenues continue to grow, with net interest income up from the same quarter of last year, although down from the late quarter. Net interest margin is up 15 basis from the second quarter 2009 and is also up on a year-to-date basis as well. Our gains in net interest margin have been generated from a better deposit mix, improved loan pricing and deleveraging our balance sheet. There was also greater moderation in our other than temporary impairment charges, predominantly resulting from our pulled trust preferred securities for both the quarter and on a year-over-year basis.

On the expense side, we continue to contain cost and prudently manage our expenditures. As I mentioned earlier, our deposit mix is an important focus for us that helped to enhance our net interest margins. Our deposit gathering efforts have generated a 16% increase in transaction and savings deposits from the second quarter of 2009 through the second quarter of 2010, and we continue to run off time deposits of single service household. Our client household growth continues to exceed the market, and a significant portion of this growth comes directly from our Pittsburgh operations. Our modest loan growth for the quarter was a product of light loan demand and our disciplined underwriting standards. We feel that flat loan growth between now and the end of the year is an optimistic outlook.

The uncertainty over exactly where the economy is headed is likely to continue to have an effect on loan demand, as will the customers' willingness to borrow. So, we see real opportunity to win market share in the middle market commercial lending area by building up this infrastructure. Corporate finance will be also be a point of focus. Both areas, we believe, will provide growth opportunities in 2011. From the big picture perspective, economic uncertainties have only led us to place an even greater emphasis on delivering locally as a responsible community bank, and our employees are seeing this through at every level of the organization.

Consumer households are up, as are small business households. Cross-sell activities continue to grow. And the 2010 JDPower and Associates survey showed first Commonwealth making the biggest jump in customer satisfaction rankings of the 28 mid-Atlantic banks surveyed. So, while a lot remains to be done and uncertainty surrounds everything from the economy to the effects of regulatory reform, we still see a very positive trend in performance of our community banking operations. However, our optimism remains cautious. So, to discuss the financial results in greater detail, I would like to introduce Bob Rout. Bob?

Thank you, John. Good afternoon, everyone. This quarter represented substantial progress for us on a number of different fronts. The first area is credit issues, where we saw significant improvement to most metrics. Certainly, there is still a lot of work to be done and more risk remains, but we are becoming increasingly comfortable with our restructured and credit and administration function. The second area is liquidity and funding sources.

Our strategic focus on cash management relationships is not only helping net interest income, it has also contributed to our goal of reducing balance sheet leverage and overall liquidity risk. Over the last 12 months, we have reduced borrowings by $668 million. Part of that derisking strategy includes reducing our exposure in municipal securities for both tax and credit purposes. The other -- the temporary impairment charges on our trust preferred portfolio continues to trend downward over the last couple of quarters, and hopefully that trend will continue. Pretax preprovision continues to improve, and we are encouraged by the performance of our core banking groups in the areas of net interest income, non-interest income and non-interest expense. Net interest income and the net interest margin have had a good run over the past several quarters as a result of growth and transactional deposit accounts, the firming of loan pricing and pretty good asset liability management strategies.

Our asset sensitivity is only slightly positive, and we think that is a good position in this interest rate environment. Loan growth has been declining and actually negative by $161 million on a late quarter. Some of that decline is voluntary as we manage down larger sized credit exposures and implement more disciplined underwriting criteria, especially relating to credit size, geography and types of business. And some of that decline is involuntary, brought by weak borrower demand as consumers and businesses restructure their own balance sheets in a weak economy. And we are seeing some renewed signs of life in the commercial secondary markets that did increase payoffs this past quarter.

Non-interest income, not including security gains and losses showed steady improvements in most categories on a year-over-year and quarter-over-quarter perspective. There is a little bit of noise in these numbers since last year we received a one-time legal settlement of $2.1 million. In addition, this quarter we had to write off $600,000 of accrued rent due from the operators of our food processing plant OREO, with the pending sale of that property to a third party. It doesn't look like we're not going to be paid, or at least not paid voluntarily, anyway. There are some unusual items in non-interest expense. Last year, all banks had that special FDIC assessment. Ours was $2.9 million. This quarter, we had a $2.2 million charge down of that OREO property based upon value determined by (inaudible) agreement. Without those unusual effects, non-interest is flat or improving in most areas.

One area where we are spending more is in technology-based solutions. We believe that there is tremendous opportunity to improve organizational efficiencies, customer service and product deliveries with better technology utilization. Some examples of these initiatives would include cash management, teller platforms, database management, commercial loan risk gradings and profitability measuring. We should also mention that we currently have $67 million of deferred tax assets and $166 million of goodwill on our balance sheet. And as you all well know, in these times, both areas get very close scrutiny every quarter for potential valuation issues.

Positive earnings such as we experienced this last quarter are very helpful in those valuations. Capital levels in all categories for both corporation and the bank remain well above regulatory well capitalized guidelines. We had earnings this quarter, along with our decision to reduce dividends earlier in the year have been helpful in improving those ratios. In addition, we have raised approximately $6.4 million year-to-date through our dividend reinvestment programs. So with that, I will turn it over to Mike Price.

Thanks, Bob. I'll keep my comments brief as the supplemental financial data we have provided for you on our website gives you a wealth of detail on the financial metrics. The good fundamentals in net interest income, non-interest income and non-interest expenses were not overshadowed by credit issues this quarter. I would like to say that our credit issues are behind us, but I won't. The economic environment is still challenging, but we have made significant progress towards the resolution of some troubled credits that have caused pressure on earnings of the last few quarters. I would like to provide some additional details around our credit quality issues.

Total non-performing loans decreased $34 million, or 20% during the second quarter from the end of the first quarter. This was the result of the $34 million charge off on the $40 million condominium construction project in south Florida. The bank received an updated appraisal on an as-is raw land valuation, and we are in the process of exercising our default remedies. We did record an additional specific reserve of $1.8 million on this credit for the quarter.

Looking at the total non-performing loan portfolio, at the end of the second quarter, on page seven of the presentation, we had $133 million, which represents 3% of total loans. The construction loan portfolio represents 37% of non-performing loans, but represents only 9% of our total loan portfolio. In 94% of the construction, non-performing loans are out of Pennsylvania. We've reduced our out-of-state lending practice -- we reduced it earlier in 2009. The percentage of non-performing loans by type shows that 12% of construction loans are non-performing, 2% of commercial real estate loans are non-performing, and 5% of CNI loans are non-performing.

With the charge off of this Florida loan, our two largest non-performing loans are a $45 million line of credit to a western Pennsylvania real estate developer that was placed on non-accrual status in the fourth quarter of 2009 and a $13 million participation loan secured by a condominium development in Missouri and personal guarantees that was placed on non-accrual status in the first quarter of this year. This totals $57,000,000 million and represents 43% of the non-performing loan portfolio. These two credits have specific reserves of $33 million, or $22 million for the Pennsylvania credit and $11 million for the Missouri project.

Our consumer, our in-market investment real estate, our CNI and our corporate finance portfolios continue to weather this recession relatively well. Our top priority continues to be credit, both resolving current challenges and building the credit infrastructure. As John mentioned earlier, we're still seeing favorable trends in substantially all areas of our community banking operations. Bob discussed our positive results in net interest income, net interest margin, non-interest income and non-interest expense.

I'd like to expand on our balance sheet profile. We're getting good loan spreads and a better mix of lower-cost transaction and savings deposits. Household growth continues, and our attrition rates remain remarkably low. Regarding loans, as you can see on page four and five, total loans decreased $103 million, or 2% from the year-ago results, with commercial loans declining $76 million, or 3% and consumer loans decreasing $27 million, or only 1%.

Going forward, small business, middle market, consumer including HELOCs, selective commercial real estate and corporate finance will be the opportunities and the keys to driving our growth. We exited the mortgage origination business about three years ago, and this portfolio continues to run off. We experienced runoff of about $100 million in the last 12 month in that portfolio. So, including runoff, consumer loans would have increased approximately $75 million, or 4%. For the second quarter, our average FICO scores remained flat, with the average scores for the first quarter and for the year 2009. Our average score of 746 still indicates that we're not sacrificing our underwriting standards in generating new consumer loans.

As you can see on page four, total deposits increased $252 million, or 6% from June 30, 2009. Lower cost in transactions savings deposits, however, increased $382 million, or 14% during the same time frame. These lower cost and deposits represented 66% of total deposits at June 30, 2010. Just a year earlier, that was only 60% at June 30 of 2009. That's a nice, positive shift in the mix of the deposits. This has really helped our net interest margin in the past year and in the past quarters. As Bob mentioned earlier, this deposit growth has helped the bank in its deleveraging efforts as well.

Going forward, we will continue to take advantage of the opportunity in the Pittsburgh market and in small business, which have fueled our growth in low costing, DDA and savings deposits. We've really done a nice job enhancing our sales and service culture at the bank and will continue community banking focus in delivering locally and responsibly as a community bank. I would now like to turn the call back to the operator and open it up for questions.

Thank you. (Operator Instructions) At this time, we will pause momentarily to assemble our roster. Our first question will come from Tom Alfonzo from Macquarie.

Hello, good morning, guys.

Good morning. How are you?

Not too bad, how are you guys?

Good.

Just on the -- on kind of the way you're thinking about the balance sheet here, with loan growth slowing down, you guys going to let the securities run down too where you are going to see overall shrinkage, or?

We're going to be probably experiencing a little bit of challenge with the loan growth for the remainder of 2010. We think that flat scenario is probably more likely, but we feel that we'll be able to pick up some steam in 2011. The investment portfolios will probably maintain a fairly liquid position. There's only so many borrowings you can pay off.

Okay, okay, fair enough. When you guys are talking about the NSF and the interchange impact in the back half of this year, that's just the NSF, right? Because I thought the interchange stuff didn't start until next year.

That's correct.

Okay, okay. Just fair enough. I think -- I missed this when you were talking, on non-interest expense, there was something related to an OREO for a food processing plant. Can you go back over that? I missed the numbers you put out there.

Yes, hi, Tom, it's Bob Rout. We executed a sales agreement on an OREO that we've had on the books for a while now. It's a food processing plant that a potential buyer is an independent third party. And as a result of the price that we had, that sales had, and the associated closing costs, we took a $2.2 million charge down on that property to get in it line with the sales agreement.

It's the bulk of our other real estate owned balance right now.

Okay, okay. And the bump up in 30 to 89 days past dues in construction that's on slide 12, is that -- it looks like it's probably -- just given what the numbers are, I'm curious if you can give us any color on that.

This is Bob Emmerich. We had two accounts go delinquent as of 6/30, and one is more of a technical default. The other one is -- the credit is a substandard credit, and we have been negotiating with them. But that's -- it's still a work in progress.

Okay, okay, that's all I have. Thanks, guys.

Thank you.

Our next question will come from Andy Stapp from J. Riley & Company. Please go ahead.

Good afternoon.

Hi, Andy.

I may have missed this, but are you able to quantify any estimate on Reg E at this point? The impact?

We've talked in the past about having an impact of about $200,000 a month beginning this month, so this third quarter. That was what we had expected.

Okay, okay. And there's a number of banks that have reported customers just feeling a lot more stress due to the extended nature of the economic weakness. Are you guys seeing much of that?

Bob?

What customers -- this is Bob Emmerich again. What customer segment are you referring to?

Across the board, but primarily commercial.

Our consumer portfolio has held up very well. Delinquency there is performing very nicely. On the commercial side, within the C&I credits that we have had, a lot of those people had a lot of distress in the recession last year and actually, we seen a number of them bounce back in the first and second quarter of this year. I think our concern would be more in commercial real estate. I think people in general have a concern about that segment, and that would be where we would have the most concern going forward.

Okay. And -- I'm sorry, was somebody going to add something?

Yes, this is Mike Price. I would add to that, that we continue to see a trend over the last four or five quarters about --in our commercial rating system, about two downgrades for every one upgrades. So, downgrades are out numbering upgrades about two to one.

Sure.

That continues.

Okay. And I think your effective tax rate in the quarter was 23%. Is this good run rate?

We would think so.

Okay. I have some other questions, but will get on queue -- back in the queue and let some other folks give out some questions.

Thanks, Andy.

Thank you.

Our next question will come from Rick Weiss from Janney Montgomery Scott. Please go ahead.

Hello, guys.

Hi, Rick.

I was wondering if you could talk about your loan portfolio, and still looks like it would take a while to clean up the credit. Where would you expect business to come from over the next 18 months? Are you emphasizing Pennsylvania? What kind of loans are your sweet spots?

Yes. Just end market -- this is Mike, by the way, small business, middle market loans. We've had some traction in the last few years with consumer home equity loans and even some auto loans, particularly on the used auto side. And then selectively, with corporate finance loans end market with kind of it Pittsburgh based names, and then again, selectively with end market real estate.

Okay, that makes sense. What size loans would you figure for the C&I, commercial real estate would you try to shoot for?

Really, $5 million to $15 million.

Okay. And then my other question would have to be more with M&A, and would you expect there to be any opportunities coming up in the near future?

This is John, Rick. It's really hard to say. I think that the regulatory environment is going to have an impact on -- particularly smaller banks, that this wasn't what they signed up for. And I have a feeling that that's going to open up things a little bit more freely. Until you have a slowdown in the regulatory assisted or driven transactions, you probably won't see real M&A very active in the near future. But I'd say in the intermediate future, yes, there's going to be an ability to have some more M&A transactions.

Okay, that's all I have. Thank you

Thank you.

Our next question will come from Damon DelMonte from KBW. Please go ahead.

Hi, good afternoon. This is actually [Timor Braziller] with KBW. Just a couple of questions. First on the Florida condo that was charged off this quarter, with what was the specific reserve on that loan?

The specific reserve was around $34 million, I believe. There was an increase in the reserve during the quarter, probably a couple of million dollars. We had one appraisal received in March, and that resulted in the large provision expense in the first quarter, I think or around $22 million. And we did get a second appraisal in and added a little bit to the reserve prior to the charge off.

Okay, thank you.

We have written that down to be as-is value, so the $34 million charge off is what was in the reserve at the time we took the charge.

Okay. Now with the current level of reserves, are you comfortable with that level, and do you think that that $4 million provision that was taken this quarter, is that going to be something that is going to be sustainable in the coming quarters?

We feel our reserve is adequate. It adheres to our methodology, and so we are comfortable with where the reserve position is. We have -- again, because with the new regulatory guidance, you need to write down to the as-is value. We have taken a lot of charge offs on our real estate loans to get them to the as-is value and those carry no reserve. We have -- seven of our larger non-performing loans have no reserve to them, mostly due to that fact. In term of the $4 million, I think that, we had some things go our way this quarter. We had -- we didn't have much in the way of new non-accrual loans. We had two new non-accrual loans, both near $3 million. And then we had the recoveries, which John had mentioned early on in the call, which totaled about 3.6 -- between a charge off recovery and we were able to sell two properties and have some specific reserves relieved from those assets.

Having said that, you can't count on those recoveries every quarter.

Right, right. Okay, regarding the borrowings paid off this quarter, do you happen to have an average rate on that? And how much more deleveraging should we expect to see?

John Previte?

The average rate would have been somewhere around 35 to 40 basis points. They were all short-term borrowings.

Okay, and is there more room for that in the coming quarters?

We think there is. It would be primarily dependent upon deposit growth and loan activity. As John mentioned earlier, we expected that portfolio to remain somewhere around these levels, so it would come from those areas.

And we also have some long-term debt still on the balance sheet that will be coming due this year. That will give us an opportunity with pay downs of these little higher rates than what this short-term was this quarter.

Okay, great. And then regarding the capital position, specifically with the total risk based capital, there's been a lot of speculation recently 12% is going to be the new 10%. Have you guys felt any kind of pressure from your regulators regarding that ratio?

We have not. But I think that the environment is such that we believe that's where we need to be moving anyhow, so that's why you have seen us manage our need for need for capital downward a little bit, by deleveraging some of those assets.

Okay, great. And one final question. Regarding the TruPS portfolio, has there been any kind of internal discussions of ways to dispose of that whole portfolio?

There has been. At the same point in time, the options that people have been giving us were too big of a deep discount. So until the market recovers for those, we're probably not interested in selling them.

And do you happen to know the original book value of that portfolio?

It's about $104 million for the total pool trust preferred.

Perfect, thank you very much. That's all I have.

Thanks, Tim.

Our next question will come from Mike Shafir from Sterne Agee.

Hello, good afternoon, guys.

Hi, Mike.

I was wondering, you guys did mention the DTA, and as we start to think about that and clearly the positive GAAP net income that you had this quarter, are you guys more comfortable, I guess, in terms of dealing with the regulators and your projections moving forward that that will be less of a potential scenario in terms of the write down?

Oh, sure, any time you're making positive earnings, that helps that whole analysis. So, we haven't written it down at this point, we continue to have earnings and our future earnings look strong that we will be fine. But again, it's one of those areas, it gets looked at very closely every quarter.

Yes, I think Mike, that they prefer real earnings versus projected earnings, and so we get a little bit extra credit for this quarter.

And then also, it looked like your cost of borrowings went up quite a bit this quarter sequentially, and I was wondering what brought that on.

You're going to make us get into a spreadsheet here, Mike, so hold on just one second.

I apologize.

That's all right.

Prior quarter? Yes. We're not seeing it, Mike. What's that again? We aren't seeing it. What did you say?

On the long-term debt?

Something came off, and that would -- it's not something new we put on. It would be just what came off as lower rate.

Yes, that would be it.

Okay. And then as we -- just to follow-up on what a provision and so forth, as we think about that provisioning line, clearly credit costs have been very, very lumpy here. So, could you give us any idea of how to think about it moving forward?

I'll make a statement and see if Bob needs to make any clarifications there. But we've been mentioning there's a few large credits. Mike mentioned a few and he actually listed a couple there. When you exclude those from the rest of the portfolio, realizing the rest of the portfolio is all we have going forward, we're not seeing that significant of an outlier with our provision for loan loss. So I would think that this quarter is, with the exception of having to recover, you can't count on recoveries, is more in line with what it would have been had we excluded those in the past number of quarters, those significant credit. Bob, is there anything you would like to clarify there?

No. It's an issue -- we actually, we have been talking about that we have had a few -- a handful of large problem credits. And that always subjects you to a lot of potential volatility around the provision expense and -- as you work through the problems. And hopefully, I think we're working through these larger ones, that source of volatility hopefully would go away and we'd be left with more of a normal run rate.

Okay, and then as far as you guys previously have discussed the actual number of larger loans at the bank, and I know that you guys are looking to reduce that number. Do you have an update on that?

At year end, we had 63 accounts where the commitment level -- not the outstanding balance, but the commitment level exceeded $15 million. At June 30, we were at 57 accounts, and our forecast is that by the end of the year we would be down to probably around 49 accounts. And we realize that we wanted to work down these large exposures, but we wanted to do it in a very sensible way and not disrupt customer relationships.

Well, thank you very much for that detail. I'm sorry, when was -- what day was the 63 accounts? That was at year end. That was at year end '09, thanks.

Yes.

Alright, thank you very much.

Mike, working them down below $15 million doesn't necessarily mean paying the entire amount off, either.

Fair enough, fair enough.

Okay.

Thank you, guys.

Thanks, Mike.

Our next question will come from Matt Schultheis from Boenning and Scattergood. Please go ahead.

Good afternoon.

Hello, Matt.

Couple of quick questions for you. With regard to the technology solutions that you put in this quarter, how many of those were pretty much demanded by Reg E requirements?

Actually, I don't think any, Matt. These are -- some were put in this quarter. Some were put in over the last year, so they do affect your year-over-year comparisons. But I can't think of any Reg E systems that we put in, our current system can handle what we need.

Okay, and you're an in-house processor, right?

That is correct, so some of what we've done was to provide, for instance, cash management enhancements to be able to help continuing growing in the small business and middle market areas. So they'll be focused on the front line.

Okay. And the cost that you had this quarter related to that, are they going to be ongoing or are these one-time costs? in other words, do you have to amortize these basically over the life of the project?

No, I think they're going to be a combination, Matt.

Okay.

Some are one-time, some are new systems that we put in that will be amortized over three or five years or new software. Certainly the cash management, probably the bulk of that is going to be an amortizable. Now, with the credit ratings for our commercial loans, that's going to be more of a one-time thing. We still have some more cost to come to that. And database management would be more of a one-time versus the amortizable. So, it's a mixed bag.

Okay. When was your lead regulator, when was the last time they were through and did their review?

It was about a year ago. We have a date on that? It was about a year ago.

Last August.

Last August. That would be about a year ago.

Okay, so we can expect them back, then, in August?

I would expect it in the foreseeable future.

Okay. And one last question with regard to your methodology on your reserves. When you have an appraisal that comes in on a property that's below what you're carrying it for and obviously, you've taken an appropriate reserve or provision for that particular property, are you taking that new loss severity into consideration when you either identify new loans or go back through the existing portion of the book that already may be substandard in your opinion?

I'm not quite sure -- this is Bob. I'm not quite sure I understand the question. Can you restate it again?

If you have an appraisal that comes in below the carrying cost of something -- of a loan, or a piece of collateral, if you will, and you take the appropriate provision for that particular loan, obviously. But are you taking new assumption surrounding loss severity and putting those back into your equation for all loans that are of similar nature and calculating appropriate reserves?

Okay. You would -- if you have an impaired loan, you would be looking at either taking a discounted cash flow -- a discount of future cash flows or you would be looking at the appraisals that you would get in and take a specific reserve against that, for that pool of loans, for impaired loans. For all other loans, our methodology is that we measure the collateral shortfall for anything that is -- would be substandard or worse. And then based on a migration study that we have, then you utilize a percentage of that overall collateral shortfall for that classification.

So Matt, to answer that a little simpler, I think, yes for the not impaired loan, but impaired loans, no.

Our methodology is maybe a little different. We do not utilize the two factor approach of PD and LGD. That's probably what you are thinking of, that you would say for this class of credit, if it's real estate secured or secured by receivables or inventory you would have, for that entire class, you would have a certain severity rate that you would apply to that whole portfolio. We don't do that. We look at each loan individually that's either OEM or substandard and measure the collateral shortfall for each loan. And then a migration analysis that we've done, take a percentage of that.

Okay. Thank you very much.

Thanks, Matt.

Our next question comes from the follow-up from Andy Stapp from J. Riley & Company.

I have another modeling question in here. Just in terms of your overall reserve building going forward, what do you foresee there? For example, some banks are forced to build their reserves because their model backward looking components. Do you have anything like that or any color you could add?

Yes, Andy, it's Bob Rout. Yes, we have features in our model that considers their historical loss factors and yes, they will have an impact building reserves as we go forward

Okay.

But I should mention that with this new project that I had discussed earlier about rate risk systems that will take into consideration the probability of defaults, given default we think will transition to a more refined model, probably over the next year or so.

Okay.

We don't expect there to be a significant differ between the --

Two models.

Yes, the two models.

Okay. And what can you provide -- can you provide some color on opportunities for future net interest margin expansion?

I think we can continue to -- this is Mike Price. I think we can continue to grow our non-interest bearing DDA on the backs of business deposit gathering, both in the small business space and on the backs of middle market. So where I think we started probably in `06, ``07 at 11%, we've gotten that number, and I'm looking at John because he'll know the number. About 14%, and I think if you look at our best in class competitors, that number is in the low 20s. So, I think over a period of years, that's a clear opportunity.

I also think that historically, we haven't been a very good consumer lending and small business lending shop. I think there's lots of opportunity within our market to grow there, and I think those still present attractive opportunities. And as we grow households, there's lots of fee income with checking accounts and so forth. And then on the commercial side, I think our cash management foundation that we built in the last two years make us much more attractive to your garden variety $20 million, $30 million, $50 million company and for us to get in there and not just do a loan, but also really get the whole relationship. So, I think there's some really clear business opportunities that we're executing on, primarily in the small business and the middle market and corporate banking segment that give us a nice path for growth for the foreseeable future.

Okay, thank you.

Our next question will come from Mac Hutchins from SunTrust. Please go ahead.

Good afternoon.

Hi, Matt.

Thanks for the presentation, by the way, that you all put together. That's a lot of good information. One comment in there, wanted to see if you could elaborate on was, I think looking to reduce the muni exposure. Can you go through the exposure there and what you plan to do to reduce that?

Yes, hi, Mac, Bob Rout. We just -- a couple of issues. The first being $200 million seems like an awful big chunk that we had that portfolio up to at one time. And some of that portfolio is instruments that we would not buy today, but probably have acquired in acquisitions historically. And the long-term nature of most of these certainly adds to your interest rate risk, and we don't like some of the anecdotal information that we're hearing on the credit issues. So, we think that it's appropriate to, if not significantly reduce that exposure, to even maybe just outright not have it on the books anymore.

So while we're in a market that seems cooperative and receptive to those type of instruments, we are going to take that opportunity to significantly reduce that exposure, and that's keeping in like with our strategy to significantly diminish the balance sheet on a number of different fronts. So this is a great position to take advantage of the economy when it does turn positive.

Is there -- does that book have a certain amount of unrealized losses or gains?

No, right now it's just pretty much book value. In fact, the chunks we sold over the past quarter was probably the lower-level credit quality ones that have either low ratings or had lost insurance, if the insurance was on, that company is no longer around and was actually able to book some small gains on those dispositions. So we're getting rid of the lessor quality stuff first.

Okay, great. And another question -- I don't know if this was Mike's comment bot -- or John's, but I believe somebody mentioned that you're seeing signs of life in the secondary market. They're leaving some payoffs, so I was just curious if you could elaborate on what types of properties that are going to the secondary market.

Yes. The -- we've seen a couple of real estate payoffs, regional shopping centers and just loosening up in that market, fairly significant payoffs on some larger credits. Regional shopping malls, strip centers and that's just been in the last 90 days.

Is it -- is that life companies?

(inaudible) potential targets as well.

I'm sorry?

Might be some potential apartment buildings as well.

Yes, yes.

Is that life companies that are providing the financing?

Yes.

Just one last question on the reserve -- again, I know Bob, you've hit on it a few times. If I take the specific reserve that you had at the end of the last quarter and back out the charge offs and some of the adjustments this quarter, I get around specific reserve of around $47 million, 48 million, which is slightly over half of the total allowance, which would put the allowance slightly below 1% of loans, excluding the specific reserves. That seems kind of low to me, given some of your commentary on two downgrades for every upgrades and still some caution on the economy. How do you handle the general or non-specific part of the reserve, and do you feel that level, below 1% non-specific is adequate?

I think actually, that number is going to be above 1%, specific reserves around $42 million. If you take a step back and strip out eight to 12 loans for this organization, they got it into some very deep earnings pressure. There's a common theme around this, say dozen loans. They were out of market, they speculative construction, the types of businesses that you wouldn't get involved in today. Condo, hotels, water parks, casinos. It's there's just a blurb in the history of the organization in that 2005, 2007 timeframe where most of these loans hit. And I truly don't think they're representative of the rest of the credit quality of the core portfolio. So, yes, we think that number is adequate at that point.

If you go back, Mac, and do a trend on that, you'll see that if you take out the impaired loans from total loans and take out the impaired or the allowance related to those impaired loans, the remaining number, we'll call that our performing reserve, against our performing loans, that's going to be improving quarter-over-quarter.

Has it been holding fairly steady in the first half?

Actually getting higher.

Yes, it's getting higher.

Getting higher, okay. Okay, well, appreciate the color. Thank you.

Thanks.

Our next question will come from Jay Daniel from Eagle Asset Management. Please go ahead.

Hey, there, guys. Glad to see the good news on credit in the quarter. I just have two questions. The first is you were speaking earlier about mergers and acquisitions and FDIC assisted transactions, and I didn't quite catch the gist of what you're saying. I think what you were saying was that you're probably not going to be trying to do any deals until the FDIC stuff winds down. So, I was wondering if you could elaborate on what you said earlier. And then the second question I had, I think it was last quarter, you had mentioned the Marcellus shale as being an economic opportunity up there, and I was wondering if that's still something you folks are looking towards, or is that maybe on pause a bit, given some of the concerns about the water shed I'm hearing from folks in it Pittsburgh? Thanks.

I'll take the first part of that, Jay. The M&A, I think that not a whole lot of real deals are going on right now, other than assisted transactions. There are some that have gone, as you know, just right before they go, I'll say go dead, they get some government push. So not a lot of regular deals are happening right new. And I would expect that to continue for the next six months or so, and maybe it will start migrating back to where you are going to have some real deals. When that happens, we obviously would be interested in participating and expanding our franchise a little bit. Mike, I'll let you talk -- take the Marcellus shale.

A couple of different opportunities come out of the Marcellus shale. One is that we have a bunch of rural landowners up in our rural counties that have a lot more money through leases. And so that's created a wealth management opportunity. And then there's branches, when you look at our footprint, we have 65 branches of our 115 in Pittsburgh MSA, but the other 50 so are really outside of that, probably half again or two-thirds of them are up in the northern part and really in the sweet spot of the Marcellus shale. So, we're just seeing overall updraft from Marcellus shale.

Obviously, the companies that are coming in and drilling, the Rangers and the Halliburtons and people like that, they are not getting lines of credit from First Commonwealth Bank. So, what we're trying to do is position our middle market and our small business on the surface and the supply side, to be part of the -- hopefully the gold rush, but the increase in the economic activity that comes with the Marcellus shale. And that's pretty routine, garden variety stuff from taking away the wastewater to hotels filling up, et cetera, et cetera. So I would say that the opportunity for us is just the rising tide kind of lifts all ships on both the consumer and on the small business side. We are seeing a lot of demand for office space and real estate in the south part of Pittsburgh, in Washington and Green and Fayette county and then in other places in our footprint as well.

Right now I think that, Jay, it may be considered a potential to change the sleepiness of western Pennsylvania, but it's probably too soon to tell.

Okay, thanks a lot. I appreciate it.

Thank you.

Our next question is a follow-up from Mike Shafir from Sterne Agee Please go ahead.

Hello, guys. I just wanted to make sure I understand. As we think of the provision, clearly your charge offs exceeded your provision this quarter. And from what you're describing, in terms of a more normalized provisioning level as we look at this quarter and backing out the money that you had come in from the resolution of some credits, that would, in terms of the reserves staying consistent, that would be a scenario where charge offs could exceed the provisioning line moving forward for quite some time.

I think the charge offs exceeded provision because of the huge provision we took in the first quarter for the one land loan in Florida. And so that made the comparison unusual for this quarter. What am I missing here?

Well, I guess what I'm saying is obviously this quarter specific reserve that you guys charged off and that the charge off exceeded the provision. But if you're comfortable with maintaining a reserve in and around -- the loan losses are at the loan, as you know, around 2%. As we move forward, if there's other specific reserves that have to come out you guys look like -- specific reserves run about 54% of those larger loans and then, like you said, 100% in terms of the loan loss reserve (inaudible) covers the rest of the delinquencies. If you guys aren't building reserves and see charge offs that are going higher as a function of cleaning up problem credits, can we see a scenario where charge offs are going to continue to exceed your provisioning line?

There could be -- again, we have had some large credits -- a handful of large credits and -- both in terms of the provisioning and the charge of,f that creates some volatility around the numbers. But -- and there still could be a couple that we would be taking a write down on of existing provisions.

Mike, hi, it's Bob Rout. One of the things to keep in mind, I'm not sure that a 2% loan loss reserve is necessary for community bank in a non-credit cycle time period.

Sure.

So yes, you may see the reserve coming down, depending on what happens, if we are truly coming out on the other end of the cycle. But right now, we're comfortable where it's at.

Okay. Thanks, guys.

Thank you.

We show no further questions at this time.

Okay, well, thank you, everyone, for joining us and wrapping up the call. I think that the progress we've made towards resolving our credit issues have allowed us to -- the underlying solid performance of our Company can truly be seen in the second quarter. We recognize that there's a lot to be done still and a lot of uncertainty that must be properly managed, and that's exactly where our focus will be. So, thank you and have a great day.

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