First Merchants Corp (FRMEP) 2012 Q2 法說會逐字稿

Good afternoon, and welcome to the First Merchants Corporation second quarter 2012 earnings conference call. All participants will be in listen only mode. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions. (Operator Instructions). Please note, this event is being recorded. I would now like to turn the conference over to Mr. Michael Rechin, Chief Executive Officer. Please go ahead, sir.

Thank you, Denise, and welcome to our earnings conference call and webcast for the second quarter ending June 30, 2012. Joining me today are Mark Hardwick, our Chief Financial officer, and John Martin, our Chief Credit Officer. First Merchants released our earnings in a press release at 10.30 a.m. this morning, Eastern Standard Time -- I'm sorry, Eastern Daylight Savings Time, and our presentation speaks to the material from that release.

The directions that point to the webcast are also contained at the back end of the release and my comments begin on page 4, a slide titled second quarter 2012 highlights. Well, First Merchants Corporation has reported second quarter 2012 earnings per share of $0.28, compared with $0.18 during the same period of 2011. Net income available to common shareholders totaled $8.1 million for the quarter, a 79% increase over the $3.6 million earned in the second quarter of 2011.

As a team, you know, we are very encouraged by the composition of the earnings in the period. And the slide shows a few aspects of the growth in our core business. Specifically, quarterly revenue up 10% year over year. Net interest income up 6% year over year, fueled by loan growth at a modest level; the preservation of our long coupon, coupled with an attractive deposit mix and smart deposit pricing.

Mark Hardwick will and amplify comments on the balance sheet and margin, but even when factoring out the Shelby County impact, our net interest margin eclipsed 4% for the quarter. At the bottom of the slide, I'd like to reference a few points. Over the weekend of July 6th through the 8th, we successfully completed a full database conversion of Shelby County Bank. Our systems and product offerings were up and running for our customers' benefit 18 hours after close of business on Friday night, July 6, a really terrific partnership between our back office operations and technology team, with our marketing and customer facing bankers in Shelby County.

Stepping back from the integration itself for just a moment, our Shelby County transaction closed in February of this year and is running quite smoothly. We are benefiting from market managers who joined us from Shelby County Bank to lead our effort in that growing county. We are currently refreshing our main office physical property and look to finalize plans for a new banking center here shortly in that county.

From a commercial perspective, we've begun to expand our coverage to adjacent counties on Indy's southeast side, where we currently have no physical presence. It's going well there. John Martin will offer his credit thoughts later in the call, but I like our risk position and the flexibility it provides us. We are employing prudent underwriting that, in combination with our aggressive market coverage, will facilitate our goal of loan growth.

Our current results -- second-quarter results we are addressing -- include ample provisioning in light of our charge-offs, preserves a strong loan loss reserve. In our view, the reserve is very adequate for our current portfolio and the environment we see moving forward. The last thought of this page is a reference to our committed workforce. I think our release describes our team as steadfast and competitive, and I know their pride in seeing our results more tangibly reflect the momentum we see in our marketplaces. At this point, I'll turn over the program to Mark to cover our results more completely.

Thank you, Mike. We are very pleased with virtually every income statement category, which I'll cover in a moment. But as you know, in most community banks it all starts with the quality of the balance sheet. And we're most pleased with three items on the asset side of our balance sheet. First is the quality of our investment portfolio, which continues to perform exceedingly well. On line 1 of slide 6.

And second, is our demonstrated ability to grow our portfolio loans again for the third consecutive quarter, on line 3. And third, we're pleased with the quality of our allowance on line 4, which totals 2.5% of loans and 111% non-accruals. The composition of our loan portfolio on slide 7 is diversified, granular and allows for pricing power. The loan portfolio produced a 5.22% yield on loans for the quarter and 5.19% year to date.

On slide 8, our $944 million bond portfolio continues to perform well, producing higher-than-average yields with moderately-longer duration than our peer group. Our 3.79% yield compares favorably to peer averages of about -- of approximately 3.02%, and our duration is just 10 months longer, totaling 4.2 years.

The net unrealized gain in our available-for-sale portfolio totals $32.4 million and the total net gain, including held-to-maturity securities, is $40.7 million. Our yield should hold up really well as we move through the remainder of 2012 and into 2013, as we have just $81.0 million that will mature through the remainder of the year with yield of 3.36%. And $136 million maturing in 2013 with a current yield of 3.07%.

Now turn to slide 9. I'm also pleased with the strength of the right side of our balance sheet. Non-maturity deposits on line 1 are up again and represent 71% of total deposits. Broker deposits and federal home loan bank advances are only being used as an inexpensive way for us to lengthen our liabilities for ALCO reasons, where appropriate. Our tangible common equity continues to grow nicely and totals $10.37. We believe, and remain expectant, that our quality balance sheet and bottom line results will soon command a tangible book multiple higher than 1.25.

The mix of our deposits on slide 10 continue to improve and our total deposit expense is now just 63 basis points, down from 98 basis points as of the first half of 2011. Our regulatory capital ratios on slide 11 are well above the OCC and Federal Reserve's definition of well-capitalized, and all Basel III-proposed minimums. We are pleased that tier 1 common, on line 4, now totals 9.54% and tangible common equity on line 5 now totals 7.27%.

As we reevaluate our current mix of capital, we do not believe that it is necessary to maintain total risk-based capital levels as high as 16.75%. It's our desire to begin paying down our SBLF capital as a way to -- as we move into 2013, given the quality of our common equity and the high coupon that SBLF carries.

The Corporation's net interest margin on slide 12, as Mike mentioned, totaled 4.11% for the quarter, but more importantly, our net interest income improved $2.2 million over the same quarter last year. Shelby County Bank contributed $1.8 million to net interest income during the quarter, including the $729 million of discount accretion mentioned by Mike previously.

Total non-interest income on slide 13 continues to improve and remains very additive to our operating income. We are pleased with core non-interest income improvements of 15% year to date. Non-interest expense, on slide 14, totaled $34.2 million for the quarter, down from the prior year's second quarter by $200,000, and down six months over six months by $72,000.

Our pre-tax, pre-provision run rate on slide 15 is now $18 million per quarter and net income available to common shareholders totals $8.1 million. Our release mentions a winner's confidence and it's for good reason. In 2007, First Merchants net income totaled $31.6 million, which currently stands as our record net income. Based on our current run rates, our teams are expecting to establish a new high in 2012.

Our employees and management teams are very pleased with our core EPS and our trend lines, on line 16. And we hope that, as shareholders, you are pleased as well. Now, John Martin will discuss our satisfying asset quality trend.

All right. Thanks, Mark, and good afternoon, everyone. I'll be covering the asset quality changes and migration, as well as allowance coverage provisioning, and highlight areas of low growth and then provide a couple of high-level thoughts in the portfolio. I am pleased with the progress we made in the overall asset quality in the second quarter.

Please turn your attention to slide 18, where I'll detail some of those improvements. Starting on line 1, we saw meaningful improvement in the level of nonaccrual loans. For the linked quarter, nonaccrual loans declined to $63.1 million, down from $74.5 million. The decline continued a downward trend from $69.6 million at the end of 2011 and $87.6 million from June of 2011.

This quarter's improvement was led by lower new non-accrual loans which contributed to the meaningful progress in lowering nonperformers. Total nonperforming loans were 2.39% of average loans, down from 2.95% of average loans from the linked quarter. Other real estate owned, on line 2, declined to $14.2 million from $15.6 million. OREO continues to trend in the right direction. As I mentioned last quarter, we continue to see strengthening demand for the property we hold.

OREO and other related credit expenses continued to improve with current quarter expenses of $2.1 million, in line with the $2.2 million for the first quarter. On line 3, total renegotiated loans declined to $3.9 million from $6.7 million, with the seasoning performing A notes.

Our strategy has been, and continues to be, one of aggressively using A/B note restructures while avoiding whole loan interest-only restructures that generally served for long and ultimate problem resolution. Then on line 4, 90-plus days-past-due experienced a modest increase for the quarter, but remain under control.

Not shown, but worth mentioning, is the quarterly improvement in overall delinquency. 30 to 89 days past due declined to 0.75% of total loans from 0.81% in the linked quarter, and declined from 1.38% of total loans at year end. This trend is following the improvements in the overall portfolio and has helped us to make progress in the overall asset quality.

But turning now to lines 5 through 7 to discuss the allowance, provisioning and charge-offs, which are highlighted in the charts on slide 19. With the previously mentioned decline in non-accrual loans, the allowance to non-accrual loans increased, as I think Mike and Mark mentioned, to 111%. Net charge offs for the quarter were $4.8 million for an annualized 0.68% of average loans, offset almost entirely by a $4.5 million provision expense.

We had four recoveries greater than $250,000 this quarter, three of those four recoveries totaled $1.3 million and were all related to prior year's charge-offs of land development loans. Despite the improvement in asset quality, allowance remained at approximately 2.5% of total loans, as changes in the environmental component offset much of the declines in the historical component of the allowance.

As shown on line 5, specific reserves were $6.1 million, with a historical allocation of $28.4 million and environmental component of $35.6 million. The level of allowance coverage positions us well to work through nonperforming loan issues, as well as to address the potential impact of global and/or regional economic concerns.

And finally, rounding out asset quality on lines 8 and 9, we continue to see improvement in both classified and criticized assets, decreasing respectively for the linked quarter to $205 million and $291 million from $225 million and $340 million, respectively. This represents improvement in both on an absolute and a percentage basis and is down over $100 million, as compared to the end of 2010.

Please turn to slide 20. Beginning in the green box, in Q1 2011, I've once again highlighted the improvement in asset quality over the last year and a half. NPAs to 90-days delinquent have decreased roughly 32% and show exhibit significant improvement. Moving to the far right column, Q2 2012 on line 2, new nonaccrual loans is the story for the quarter, which fell to $6.6 million, and were down compared to the linked quarter of $16.4 million.

This is the lowest level of new nonaccrual since the fourth quarter of 2007. To provide additional color, there were five customers greater than $250,000, comprising the total new nonaccrual loans, with the largest being $2.3 million. On lines 3 and 4, we reduced $9.2 million in non-accruals and reduced OREO by $1.1 million.

Moving to line 5, gross charge-offs were $7.6 million, compared to $6.3 million in the linked quarter, and was offset by quarterly recoveries of a total of $2.8 million. Moving down to migration to lines 7 through 10, we saw a $1.4 million net reduction in ORE, which represents both lower ORE sold, but also lower ORE write-downs.

And the jumping down to line 13, total nonperforming assets in 90-plus-days delinquent loans, declined a total of $15.1 million, driven by lower new nonaccruals and continue the improvement in overall asset quality. Now please turn to slide 21. I wanted to take a moment this quarter to highlight the quarterly growth in the core portfolio and highlight some of the areas that we are seeing growth.

We've seen growth in C&I and increases in seasonal agricultural production loans, and have selectively grown investment real estate. Likewise, we continue our originate-and-sell model for 1- to 4-family loans, which is leading the residential real estate portfolio lower. Net-net, the core portfolio is beginning to show some growth and we've seen signs of strengthening in loan demand.

Please turn to slide 22 now. In summary, we've seen improving loan demand, led by C&I. Asset quality continues to improve and we continue to be effective with the use of A note/B note restructures. And a brief word on the agricultural portfolio. With the drought in the Midwest, we are expecting that farmers will likely see significantly reduced yields, offset somewhat by higher grain prices and crop insurance.

This dynamic will be studied on a case-by-case basis in our portfolio as we head into the fall. The loan production portfolio, just as a note, is roughly $106 million, and it's performed well over the last several years, which should help to mitigate some of the impact of the drought.

And finally, ORE and credit related expenses are lower. The $2.1 million in expense has some potential for additional improvement as asset quality continues to improve. That concludes my remarks. Thanks, everyone, for your attention, and I'll turn the call back over to Mike Rechin.

Thanks, John. On page 24, I'll pick up my remarks, without repeating on the recap page, all of what you heard as components of a strong earnings picture. I do not believe I spoke to the increase in dividend from $0.03 per share, up from $0.01 per share. It was announced in our May shareholder meeting concurrent with our Board meeting. And I just think it speaks to the fact that in light of our capital levels and our earnings, the Board of Directors moved to increase that dividend level, knowing that there's a component of our ownership base that looks for dividend yields.

And so should our trends continue, in terms of ample capital and earnings, I'm sure it will be revisited meeting to meeting, and I think it was well received. All the points in the middle of the page, relative to growth, have been touched on by either of my colleagues. Other than the last point, which speaks to a strong commercial and mortgage pipeline. In actuality, all of our business lines -- mortgage, commercial, retail, and business banking -- have larger pipelines as of June 30 than they had in the prior quarter. Retails, consumer lending continues to be slow so the pipeline growth is modest.

Our HELOC activity grew a little bit, which -- I'm sorry, down a little bit from our overall installment consumer lending group, which we were pleased -- first time in several quarters. Our business banking group is closely linked to retail, falling on that $10 million in revenue and below segment, typically in concentric circles around our retail franchise.

It's been our greatest investment in people resources, as we've added six people from the first of the year and looked at a couple of more as the lift in that business begins to show itself, and the velocity of it, both in deposit gathering and credit extension, are meeting our expectations. So we're pleased there. So the two items that are listed specifically on the page, commercial and mortgage, are doing exceedingly well.

Our mortgage pipeline at the end of June was over $100 million, up from $70 million in the prior quarter, and more than twice what it was at this point last year. And similar descriptors for our commercial portfolio pipeline, which is in excess of $210 million, up from just less than $170 million at April 1, or the end of March, and up almost $100 million from where we were at the end of June of last year.

So in that definition, as First Merchants thinks about it, we think there is a substantial flow-through of that pipeline, given the credit looks and approvals that are in place, that we ought to harvest a fair amount of that onto our balance sheet. Knowing that until it closes it hasn't actually happened, but our tracking of that definition of pipeline is -- which is only about seven or eight quarters old at this point -- is proving itself out to be a reliable indicator that we should have some directional growth on the commercial side of the bank. And that's what I would offer today, looking out toward the third and fourth quarter of this year.

At a level perhaps equal to, or should be in excess of what we saw in the second quarter. The bottom of that page -- and I'm still on page 24 -- a couple of investing comments. As it relates to the investing in customers, it can be taken in a couple of different slants. But what I had in mind in drafting this slide was, our online banking upgrade, which has been done in phases, has one phase yet to go. But the first couple, in terms of giving customers more choice to do their banking with us, has been well received. I don't think we had a mobile banking target that we openly shared, knowing its newness to us, and it hasn't been an overwhelmingly popular choice amongst our customers, but it's gaining traction month to month.

Our retail product launches, which took place both in the fourth quarter of last year, the first quarter of this year, in terms of substituting out better choices in a pre-tracking world, while preserving and grandfathering those relationships, has worked out well in drafting product structures that give customers the ability to have free checking, and bringing together various customer behaviors, utilizing other delivery, direct deposit, debit cards and such. We are pleased with that.

As it relates to investing in employees, we've added internal development resources to drive sales and leadership programs. Relative to sales, we're trying to take advantage of that business banking segment by going down the channel into the retail bank and have a full-time retail sales trainer. That's intended to trigger needs that either themselves or the business bankers can then seize upon. And relative to leadership, we're three years into a program that has identified a growing width of involved bankers that is well in excess of 150 now, to participate in an iterative leadership training that is intended to drive our skill level.

The bullet point on there says hiring, training, development equals engagement. We've employed the same outside third-party firm to measure our engagement. We're pleased with the results. I think they're consistent with the improvement in our financial results, but in terms of the participation of our roughly 1200 teammates, the candor with which they share their ideas on how we can be a more effective company -- really pleasing to me.

It points out the changes that we have made come from all parts of the Company, reflecting the One Company, One Culture direction that we've aspired from the time we combined our charters three or four years ago.

I'm going to flip page 25 and then we'll get on to questions. I already referenced the first couple of points -- converting that pipeline critical to offset what the interest rate environment does, both to the loan portfolio, in terms of raw coupon and the investment portfolio, as Mark highlighted. The middle of the page -- trying to be efficient, as all of those bullet points speak to.

We've got a couple of concurrent initiatives. We've announced in a few of our communities we'll be combining retail delivery, holding strong in all of these communities. Richmond, Frankfort, Indiana and Connersville. In Connersville, for example, we're going to right-size our investment for two banking centers that are very close by, have a shared customer mix. In closing one of those, combining it into a remaining location and then putting a sizable six-figure investment in that to accommodate would-be combined traffic that we view as a win-win for our customers.

The second bullet point around consumer collections and finance systems pretty much -- 2012 deployments of technology investments, that have reduced our direct people costs and produce quicker answers for our customers. So we're pleased with that. And when I think of efficiency, while it is an expense reduction term, by definition, clearly, I also think about execution speed, our ability to act, turn, add, in general, just compete. And so we feel like we have some continued upside there.

The last bullet point just talks about evaluating non-organic growth opportunities. And the Shelby County opportunity, I think was a reminder of our proven experience in loan due diligence, risk assessment, data integration, and ultimately, customer on-boarding. With those competencies in mind, we do look to participate in the likely consolidation of our industry.

I think paramount in our evaluation would be cultural fit, franchise fit, earnings-per-share accretion, and kind of coincident with that, tangible book value earn back. But we've evaluated what we think is the Midwestern landscape and markets contiguous to us and we'll continue to, as opportunities present themselves, but feel very comfortable with the plateful of work and just driving the organic growth in the Company forward, and the earnings that that can produce for us.

So at this point, Denise, you can open the lines for questions and we're happy to take any from the listeners today.

Thank you, Mr. Rechin. We will now begin the question and answer question. (Operator Instructions). Scott Siefers, Sandler O'Neill.

Good afternoon, guys. Let's see, Mark, so I think it was you who discussed exiting SBLF. It sounded like your aspiration would be sometime next year. I wonder if you can give us a sense at a top level for any costs you would expect to incur with that. I guess what I'm getting at is, do you feel like the exit costs are significantly less onerous than they would have been under TARP, i.e. having to raise capital, et cetera?

Yes, with the level of our classified assets coming down at the bank, it allows for an easier upstream of capital from the bank to the holding company. This year we were on a routine of upstreaming $2.5 million per quarter and we'll continue that through the third quarter and the fourth quarter, which will be 10 for the year. But this quarter, before the end of June, we upstreamed another $20 million from the bank to the holding company, just to strengthen the overall cash position of the parent to create flexibility.

And next year we would anticipate having a similar type of flexibility, where we could move earnings or excess capital from the bank to the parent. Our thought process isn't to repay TARP in full anytime soon. We're just -- I'm sorry, to repay SBLF anytime soon. We have $90 million outstanding and our thought is to start chipping away at it, with the use of the capital and the earnings that we're generating.

Okay. That's perfect. Thank you. And then, Mark as well, just on the margin, I'd say both the headline number and then the core, when you back out the discount accretion, both came in a little stronger than at least I was anticipating. I wonder if you can talk a little bit about your expectations, whether it's for the margin in aggregate, or if it's possible for you to dis-aggregate your expectations between where the core margin was this quarter; where you would expect that to go. And then any sense you have for anticipated discount accretion as you look into the back half of the year.

Yes, I saw your note from today suggesting a 4.03% margin and that's exactly on track. That is the number that we had. The discount accretion, I'll start with it. We had a $17 million discount applied to their loans. It was essentially a 17% mark. And we are anticipating that that comes in over some timeframe, at maybe $125,000, $150,000 a month.

There are clearly events that can accelerate that, a pay down of a note with a large mark. So I can't give an absolute predictor as to what is going to be. We know what it should be on a go forward basis, absent anything extraordinary.

On the core balance sheet, we just continue to lower deposit costs and I do think that we are -- with a number of large borrowings that paid down at the end of the first quarter, there were pricings that have been happening in our CV portfolio. 60 basis points starts to feel like we found the bottom. And so I do think that, as the bomb portfolio reprices, we'll see some modest compression in our core margin on a go forward basis.

And then, really, I guess the more significant item is the loan portfolio and what kind of pressure we see with renewals of notes or competitive pressures. But so far, if you look at our trends quarter by quarter, we've been able to manage the reduction in loans, we think, very well. And, so, keeping the core margin, at least in the 3.95% or better range for some period of time throughout the next year, we feel good about.

Okay. Perfect. That's good color. I appreciate it. And then final question. Mike, you talked about your interest in future M&A. Just wondering if you can talk about how the environment seems. We just haven't seen a lot of activity generally this year. Just curious. Any thoughts you might have on people's willingness to sell, or are they trying to tough it out. What's the general conversation been like?

I think tough it out up until this point, Scott, is the way I would characterize it. It's a good choice of words. We've got less than a dozen franchises that we know pretty well that would seemingly operate really well in our system, where we spend time either competing with folks or very close by. So we were trying to keep and A-list of best targets and then have anything else, where tough it out isn't the strategy on the part of a management team or a Board that might come up on shorter notice just to put ourselves in a position to evaluate it really, really quickly.

We've had two of those that just didn't make sense to us, based on how well we thought we would execute at expectations of price, that were beyond what we thought was smart. So we're going to be disciplined about it because I think if we can harvest some of the upside we continue to see in our own business, that the timing will prove, whatever it proves to be, for those that still feel like going it independently make sense for the balance of this year at least.

Okay. That's perfect. I appreciate that. Thanks a lot.

Thanks, Scott.

Steven Geyen, Stifel Nicolaus.

Hey, good afternoon. Just a couple of questions. One, related to the tax rate. Just curious about the cash flows from the security portfolio. The reinvestments, if you expect any significant changes there and where that's redeployed, and the impact on the tax rate.

That's a good question. Over the last six months we've primarily just have been actively buying in the mortgage-backed space. A couple of our most recent reinvestments have been in the muni space. So I think that mix of 25% tax exempt, 75% taxable, will, at least based on the current yield curves, will probably continue. So I don't see a real dramatic change in our allocation in the bond portfolio.

Okay. And curious about the runoff of Shelby loans. Was that any greater than maybe the repricing of what you're seeing in the rest of the portfolio?

Yes. So the portfolio came in and we're working through just your normal levels. The loans were priced and there's nothing abnormal about how they were priced in that book. They were all performing loans when they came in, so it wasn't as though there was a necessary premium on any of the loans beyond what the market would bear. So we're not seeing a repricing in that book any more than what was the existing First Merchants book.

It's Mike, Steve. And we've been really pleased with both the grading of those loans and the subsequent collection of financial statements from that borrower set. But also the ability for the bankers that joined our Company through Shelby County, to acclimate them to both our turnaround time, reviews periods. So we kind of view it as core portfolio at this point.

Sure. I appreciate the color. And last question, I had to jump off the call for just a moment, but just curious about the -- if there was any accelerated accretion on the acquired portfolio? Were there any pre-pays or anything that impacted the margin?

Not accelerated. It was about -- in our press release we say $729,000, but there really wasn't anything that created an acceleration event during the quarter.

Okay. Great. Thank you.

Daniel Cardenas, Raymond James.

Good afternoon, guys. Maybe you could just give me a little bit of color as to what the loan footings in Indianapolis were at the end of the quarter, and then maybe some comments as to how competitive factors in that market are shaping up.

Yes, I'll look amongst the material I have here, Dan, for a specific Indianapolis number. I know it's not right in front of me. The pipeline part of it, which is clearly not in the portfolio, is responsible for just under 50% of that $210 million type number I shared earlier. And that's up almost 50% from the prior quarter.

The marketplace is very competitive there. Not only has the full cadre of regional banks that have always been there, but as you know, there's a couple of community banks that have directed some efforts toward there. Our sweet spot there is kind of $50 million in revenue and below. It kind of loosely correlates to a $12 million kind of credit appetite and below. And as such, if you called that middle market for the lower middle market, depending on your vocabulary, it's less competitive than the market that sits right on top of that.

And so we're trying to compete with speed. There has been some erosion in the rate at which you win the business there, but we think that the risk/return trade-off associated with that has been fine to this point. And so we think of it as sane pricing, if you will, for an all-in customer relationship that would include not only the coupon on the loan itself, but deposits, treasury management, and cross sell into either insurance or trusts.

I do have a report here that might help out. Our combined, what we call central region, is just about $1.1 billion of this. It's $850 million -- just shy of $850 million in Indianapolis itself, and with like calling officers have $250 million in the Anderson market, which is how I came up to that number.

All right. And how does that compare to last quarter? Is it about par or is it a little bit higher?

They would have both grown. It is a little bit higher. Not a meaningful amount. Certainly less than $100 million. Things are good there; they're not great. Yet.

All right. That sounds fair. And then on -- just jumping over to the ag portfolio, briefly. Thanks for the color on that, but a quick question. How much -- I guess if you can quantify -- what percentage of your growers have crop insurance?

We don't -- let me back up. We don't monitor or we don't have, rather, the statistics on that percentage. I would say is that kind of a national average -- I saw an article that 85% of all growers have crop insurance. And I think it would probably hold true within our portfolio as we're going through our underwriting. That is something clearly that we're looking for. There's going to be an interesting dynamic, as I kind of highlighted there, between crop yields and the price for corn and beans, as well as how much of that 85% makes up for it.

And really, I think, over the last several years, farmers have de-leveraged as a result of the better times, if you will. And there is room within the land that they do own for the farmers that we bank that should allow us the flexibility to move past it. But it's something that, clearly, we've got our eye on.

Okay. That's fair. And then just quickly on the M&A front. If you could talk about how the disconnect between buyer and seller expectations is progressing, if at all.

I would say slowly, meaning that they're coming together towards each other slowly. My guess is that those discussions take place in private in lots and lots of boardrooms. But as I referenced to Scott's question a moment ago, on two specific exercises of ours, that gap kind of prevents you from moving forward at some point. So I don't know the rate at which that closes the gap, but we're just trying to be diligent in our communication around banks that I think would be great adds to us.

Okay. And then in terms of an earn-back period on any tangible book value dilution, what's your thought? How far would you be willing to go out?

I think three to five years kind of is the bandwidth that we talk about with our Board that make sense. We've had a fortunate runoff based on our performance in our stock price and clearly the stock price affects the currency that we use for acquisitions, which should make things more comfortable going forward. I don't know that it would change my answer to the last question you just had, given that the book value moves with our earnings. But I think that's the timeframe we're looking for -- three to five years at the outside.

Okay. Thank you.

(Operator Instructions) John Barber, KBW.

Good afternoon, guys. Mark, it looks like you had almost $35 million of FHLB advances this quarter that matured. Just wondering if you could comment on the impact that had on the margin this quarter. And also your maturity schedule for FHLB borrowings in the second half of the year and into 2013.

I don't have the schedule with me. I know that we're finally getting into maturities of Federal Home Loan Bank advance borrowings that are at much lower rates. I think the end of the first quarter is where we really saw the big decline or pay down of the more like 5% type advances that we had from a number of years ago.

So our yield -- I've got it right here -- our yield in the Federal Home Loan Bank advance expenses is down to 1.98% now -- or I should say our cost of funds for $97 million for the month was down to 1.98%. And a year ago, that same number was 4.97%. So we've seen the biggest pickup as we move forward from the cost of the borrowings. I'm not sure of the impact it had on the total yields -- on the total margin. A year ago, when we were at 4.97%, the expense of our FHLB borrowings was $315,000, and now it's down to $160,000. Just the monthly expense.

Thanks, Mark. That's helpful. And then on credit, John, you mentioned the four sizable recoveries this quarter. What types of credits were those?

Yes, those were actually legacy land development loans that had been charged off in prior years. They were for the sale of real estate that the borrowers still had in their name, that we had charged down on non-accrual. Said three of those four were that, and the other was a C&I name.

Thanks. And for your risk profile, the 2.5% reserve to loan ratio looks pretty high and it's definitely above peers. What are your expectations for that in terms of coming down? How quickly should we think of that reducing?

Yes, you know, we look at that 2.5% and look at the environment and that was kind of the color I provided within my allowance commentary. I think my expectations would be -- well, first, obviously the allowance model drives that percentage at 2.5%. The environmental components of it with -- there is a lot of uncertainty out there at both the national and regional level, in terms of the drought and what the farmers are going to do into the fall. So I can't give you a real clear answer other than, obviously, credit quality will drive what that allowance is and the levels. And today it's driving about that 2.5% level.

And we'd like to think that if the economy stays where it is, that we see charge-offs that exceed provision by some dollar amount, and that we move to, over time, closer to 2%. But I can't really envision a time where we have it decline much more than that based on the cycle that we just went through.

Okay. Thanks. And then last one on M&A. Just curious, how large could you grow the institutionals with your current infrastructure?

Well, when I hear that question, John, I think of our back office and the folks that run that for us day to day feel like $6 billion to $7 billion could be managed, throughput-wise, with a really limited incremental investment. And so, for purposes of today, I'd say 6-ish really comfortably. We're modeled for that. We think of the vendors that kind of drive our back office in tandem with our direct management and feel comfortable that when I answered a question earlier in the call about quantify the number of institutions that we follow closely, in almost every case, the inclusion of that company into ours would fit that answer I just gave you in a $6 billion to $7 billion range.

Thanks, Mike. Thanks for taking my questions.

Brian Martin, FIG Partners.

Hey, guys.

Good afternoon, Brian.

Say, Mike, could you just talk about what the new capital rules with Basel, just kind of how you think about long-term capital management here and just as it relates to the preferred, and where your expectations are. I think Mark mentioned the expectations that keep risk based at a certain level. I mean, what are you guys targeting and how are you thinking about that?

Mark modeled that for us in a couple different aspects that relate, not only to upcoming regulatory hurdles, but our own desires to deal with our balance sheet, vis-a-vis the SBLF or our sub debt, and so he's got his hand up like he wants to speak so I'm going to let him.

Well, we wanted -- as a Board, we wanted to get our tangible capital over 7%, and we've accomplished that. We wanted our tier 1 common to be over 9%, and we're 9.54%. The Basel III proposals, I think the only item there that really stands out that could modify, at some level, the strategy going forward is just the added capital requirement for investment real estate. So our CRE.

It's an area where we're well below the regulatory thresholds. We're about half of the regulatory thresholds. So it's an area where we think, if we're smart with our underwriting, where we have some capacity to add to our balance sheet. And more evaluating the impact of that with the new regulatory capital ratios. But we want to stay over 7% tangible. We want to be over 9% tier one common.

And 16.75% we think is high on the total, and if we were to be in the low 14s, I think we would have a really safe and sound balance sheet on a go forward basis. Which means we have, over time, we'll have to work through some of the hybrid equity to allow our total capital and our tangible capital to come a little closer together.

Okay. And working through that, Mark, is that more like a 2013 event at this point, it sounds like? Or at least start thinking about it? Nothing in the back half of the year?

You know, if there's something in the back half of the year, it will be small. If that doesn't happen, we're looking early 2013 to make some kind of a meaningful reduction, to at least get the process started.

Okay. All right. And, Mike. Just you talked about -- not to beat a dead horse at the M&A, but I mean most of the opportunities that are out there right now, are they still -- the couple deals you looked at that maybe don't make a lot of sense, are most of the acquisitions -- opportunities still related to credit at this point? You know, the people that are stepping forward to try to sell their banks, is it credit related or are there other reasons at this point that they're thinking about selling or is it still all credit?

I think it's mostly credit, coupled with the weight of the interest rate environment as to what it does for your going-forward margin possibilities.

Okay. And as far as markets, I guess you guys would look at. Is your sense it's more going to be getting bigger in existing markets? Are you looking to go to new markets? Or if there's an opportunity, kind of where are you guys focused? Is it just in the markets you're already in or would you look at something new? Or is that more important to you?

Well, having an additional growth market for our Company would be really attractive if it was affordable. But given the same interest rate environment that I alluded to earlier on the last portion of your question, I think expense takeout, knowing where the interest rate environment is likely to be for the next 24 months, would clearly make a market that we are already in more attractive, I think, in terms of what we could do to it to deliver great service with a less heavy expense load.

Okay. That's fair enough. And then just the last two. Mark, with regard to the expenses, do you think that there's still opportunity? It sounds as though there is still opportunity to X the OREO expense. That there is still opportunity to move the expenses a bit lower. Does that seem fair or is there -- I guess you are finding less opportunity now then you thought earlier.

Well, I think X the -- we'll have some reduction in our core deposit amortization, which I think you've modeled in the past, Brian, and I think we'll see continued reduction in our OREO. The other categories -- the salary and benefits and occupancy expense, I think it's going to be really marginal. We're looking at ways to make sure we are a more efficient organization, like these three consolidations. But they are not big needle movers. They're just incremental and allow us to be smarter about our expense limit.

Okay. Perfect. And then the last thing. John, just with regard to the recoveries you saw this quarter. Given what kind of -- I guess at the back end of the credit cycle, would you expect that there's more opportunities to see recoveries going forward? Or is this kind of a one-time thing? I think we've heard from other banks that there's more opportunity now to see some recoveries, or possibilities for it. Does that seem fair with how you guys are looking at it at this point?

Yes. When we are doing the A-note, B-note restructures, Brian, one of the things to make note of is that we are not forgiving the B-note. We're charging it off, right. There's the difference there. So in that situation, there might be the possibility for recovery there. There are a number of loans that we have taken charges on that, if the borrower is able to return to health, or for that matter, we get refinanced on one of those, we could see recoveries going forward. I'm not sure that it's going to be at that pace, and a $2.8 million is the number, but obviously we're trying everything we can to get the money back that we can.

Right. Okay. Thanks, you guys. Nice quarter.

Thank you, Brian.

And ladies and gentlemen, this will conclude our question and answer session. I would like to turn the conference back over to Mr. Michael Rechin for any closing remarks.

Thank you, Denise. I have just appreciation for the continued interest in our Company and following of our progress. We appreciate the questions and look forward to talking to you again in a couple of months when we cover the third quarter. Thank you.

Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.