Heartland Financial USA Inc (HTLF) 2009 Q1 法說會逐字稿

Good evening, ladies and gentlemen. Thank you for standing by and welcome to the Heartland Financial USA first quarter conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions).

This conference is being recorded today, Monday, April 27 of 2009. I would now like to turn the conference over to Leslie Loyet of Financial Relations Board. Please go ahead, ma'am.

Thank you. Good afternoon, everyone, and thank you for joining us for Heartland Financial USA's conference call to discuss first quarter 2009 results.

This afternoon, we distributed a copy of the release and, hopefully, you have all had a chance to view the results. If there is anyone online who did not receive a copy you may access it at Heartland's Web site at www.htlf.com or you can call [Han Hoy] at 312-640-6688 and she will send you a copy immediately.

With us today from management are Lynn Fuller, President and Chief Executive Officer; John Schmidt, Chief Operating Officer and Chief Financial Officer and Ken Erickson, Executive Vice President and Chief Credit Officer. Management will provide a brief summary of the quarter and then we'll open the call up to your questions.

Before we begin the presentation, I would like to remind everyone that some of the information that management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines I must point out that any statements made during this presentation regarding the Company's hopes, beliefs, expectations or predictions of the future are forward-looking statements and actual results could differ materially from those projected.

Additionally and for -- or additional information on these factors is included from time to time in the Company's 10K and 10-Q filings which can't be obtained on the Company's Web site or the SEC's Web site.

At this time, I would like to turn the call over to Lynn Fuller. Please go ahead.

Thank you, Leslie, and good afternoon, everyone. We appreciate everyone joining us this afternoon as we review Heartland's performance for the first quarter of 2009.

For the next few minutes, I will touch on the highlights for the quarter and will then turn the call over to John Schmidt, our Chief Operating Officer and CFO, who will provide further detail on Heartland's quarterly results. Then, Ken Erickson, our EVP and Chief Credit Officer, will offer insight on the status of our nonperforming loans and credit quality.

In today's earnings release, Heartland reported first quarter 2009 net income of $6.1 million, slightly below the $6.3 million reported for the same quarter last year. On a per-share basis, Heartland earned $0.29 per diluted share compared to $0.38 per diluted share in the first quarter of 2008.

Given the current economic environment, we feel pretty good about our first quarter results. This was our best quarter of the last four and as a result, we are cautiously optimistic. Earnings were aided by bond gains and fee income from mortgage activities, both offset to a great extent by provision expense of $6.7 million.

For the quarter, we increased our allowance for loan loss by $1.6 million, reduced nonperforming loans and increased OREO as we gained control of our collateral.

With nonperforming assets up slightly to $98 million, reduction of nonperforming assets continues as our number one priority. In a few minutes, Ken Erickson will provide more detail on credit administration issues.

In terms of total assets, we have experienced exceptional growth. Year-over-year growth was $430 million, and first quarter 2009 growth was $100 million. While we continue to focus on strengthening our balance sheet, I would expect asset growth to moderate for the remainder of 2009.

In terms of deposits, we experienced a surge in deposit growth during the first quarter and, along with slowing loan demand, we find ourselves in a very strong liquidity position. With our securities portfolio now at 27% of assets and our loan to deposit ratio at 83%, we have substantially reduced the risk on our balance sheet.

While the banking industry is experiencing annualized deposit growth near 12%, Heartland's core deposits grew at a rate of 18% over the last 12 months, with the vast majority of that growth in our maturity deposits. During the same period, we were able to reduce our reliance on broker deposits by 50%. Our second highest priority has been the growth of non-maturity deposits which have grown by 29% over the last 12 months.

Fueling this growth is a great menu of deposit products, targeted promotions, and an increased focus on commercial treasury management sales and service. We attribute much of our deposit growth to a loyal customer base that places confidence in our strength.

In terms of loans, year-over-year loan growth was $85 million while loans declined by $48 million for the first quarter this year. Even though loan demand has slowed considerably as the recession has deepened, we continue to target high-quality credits with attractive deposit relationships. If economics conditions stabilize rather than continue to decline, then somewhere in the range of $70 million in annual loan growth should be attainable for 2009.

As a TARP recipient, we are acutely aware of the inherent conflict between the government's focus on loan growth during a period of reduced demand, and our regulators' and stockholders' emphasis on making sound, fairly priced loans. As challenging as this is to balance, we are making progress on several fronts.

In addition to mortgage modification activities, we are working with Fannie Mae on their refi plus program. One of Heartland's subsidiary banks was the first in the nation to sell a refi plus loan to Fannie Mae under President Obama's homeowner affordability and stability plan, which is designed to streamline refinance progress of existing Fannie Mae-funded mortgage loans.

In total, we have modified nearly 200 mortgage loans to help our borrowers stay in their homes and avoid foreclosure during this time of financial stress.

Additionally, we have introduced in several of our markets, a new consumer loan promotion called Buy Local. This product was created to stimulate local economic activity through the support of local businesses and consumers. Qualifying customers, that's those customers with the primary checking account at our banks, can receive a zero interest loan up to $5000 upon purchases from local businesses.

Another bright spot in Heartland's performance is net interest margin. After a dip in last year's fourth quarter, margin returned to 3.94% in the first quarter. We are pleased that our margin has held near that 4% level for some time now. Our success at maintaining and growing margin is a direct result of disciplined pricing on both the deposit and loan site.

While we are committed to spurring economic growth through new lending, we are balancing that obligation with loan pricing, which is commensurate with risk.

Noninterest income was a major contributor to Heartland's first quarter results, increasing 51% over last year's first quarter. This was primarily a result of two initiatives. One, we took the opportunity to book significant security gains by repositioning our securities portfolio for a rising rate scenario while, at the same time, maintaining our portfolio yield, increasing portfolio appreciation, and holding our duration at less than two years.

John Schmidt will expand on this in his comments.

Number two, we have also been actively participating in the latest residential real estate refi book. During the first quarter Heartland banks originated $305 million in new and refinanced mortgage loans to 1600 borrowers.

Our servicing portfolio has increased by 22% over year end 2008, resulting in a large number of new customers for our banks, generating both short- and long-term earnings as well as significant cross sell opportunities.

Another positive outcome from the first quarter is that our capital ratios are all running in the right direction. Our tangible capital ratio moved up to 5.23% and remains within our benchmark range of 5 to 6%. Although our balance sheet has grown, the $102 million increase in our securities portfolio from year end '08 results in less overall risk on our balance sheet.

As I mentioned earlier, we have added $1.6 million to our allowance for loan loss. And I believe we are properly reserved at this point. However, we continue to monitor our most economically challenged markets which are Phoenix, Denver and Bozeman.

Now with respect to M&A, our strategy is to pursue FDIC-assisted transactions in our current markets. More specifically, we will focus on filling acquisitions with attractive branch footprints and deposit mixes where we can grow market share, achieve economies of scale and provide greater convenience to our current clients.

Finally, as more banks announced dividend reductions and eliminations, I am pleased to report that at this month's Board meeting, we elected to maintain our dividend at $0.10 per common share, payable on June 12, 2009.

Well, that concludes my comments. I will now turn the call over to John Schmidt for more detail on our quarterly results and then John will introduce Ken Erickson, who will provide an update on credit issues. John?

Thanks, Lynn, and good afternoon. In my comments this afternoon I will provide additional color on the most substantial changes to Heartland's balance sheet and income statement in the past quarter 3/31/09 versus 12/31/08.

Starting with the balance sheet, the first thing I would bring to your attention is the $36 million increase in cash and cash equivalents. The largest portion of this increase represents dollars held in our Federal Reserve account.

You will also note our investment balances have increased by $102.5 million. This increase in liquid assets is driven in large part by our higher deposit balances and slowing loan demand.

For the quarter, loans and leases held to maturity decreased by $48.6 million. Obviously, given the starting point and the aforementioned slowing loan demand, we would revise our forecast to $70 million of loan growth for the entire year from the $100 million we had previously indicated. The majority of this growth is expected to occur in our Minnesota and Rockford, Illinois markets.

Net charge-offs for the quarter totaled $5 million as compared to the $14.3 million in the fourth quarter of 2008. With a $6.7 million provision taken in the first quarter, we grew our allowance by $1.6 million, ending the quarter with an allowance of 1.58% of outstanding loans with the majority of the increase occurring at Arizona.

Deposit growth was significant in the first quarter as we saw core deposits, meaning excluding brokered CDs, increased by $155.3 million from a quarter-over-quarter perspective. Additional good news was reflected in the mix of deposit growth as demand and savings products accounted for 54% of the total.

In the coming quarters we will focus on optimizing both sides of the balance sheet. Accordingly, we continue in our efforts to book solid credit and replace CD funding with demand and savings deposits.

Short-term borrowings decreased by $92.4 million in the first quarter as we saw normal seasonal fluctuations in retail repurchase agreements, primarily in our New Mexico market.

Finally, additional funding is also reflected in other borrowings as we chose to lock in some longer term FHLB borrowings. Tangible common equity end of the quarter 5.23%, up slightly from the 5.19% recorded at 12/31/08.

Important to note in this analysis is the fact that securities now account for almost 27% of our balance sheet, which suggests not only a higher level of liquidity but a reduced amount of overall risk.

Moving to the income statement, net income totaled $6.1 million for the first quarter while net income available to common stockholders totaled $4.8 million or $0.29 per share. As Lynn mentioned, we feel very good about our ability to sustain our net interest margin, which was 3.94% for the first quarter.

Included in this result was eight basis points of benefit from a balance sheet hedge, one of which matured at the end of the first quarter.

Going forward as I previously mentioned, we are now focused on appropriately pricing credit and driving down CD costs, which should enable us to maintain the margin around 3.85%. Thankfully there was a lot of noise in our noninterest income in the first quarter. With the refi boon running at full [bore], we saw 1.8 -- we saw a $1.8 million increase in loan service and income. Evidence of this is the growth of our mortgage servicing portfolio, going from $713 million at year-end 2008 to over $868 million at the end of this quarter.

The most substantial shift in noninterest income came in the form of security gains which totaled $3 million for the quarter, an increase of $2.5 million from the 12/31/08 quarter. The majority of this increase ensued as we elected to sell lower rate securities in favor of higher coupon offerings. In doing this, we feel that we have positioned ourselves for an increasing rate environment.

Importantly, we were able to monetize these gains while maintaining current yields with a similar duration. This is best evidenced by the fact that only -- that our unrealized gains in the investment portfolio improved by $3.9 million as of 3/31/09. Gains in the sale of loans increased by $1.5 million from the quarter ended 12/31/08, again reflecting the benefits of refi activity.

As a final note in the noninterest income area, bank-owned life insurance reflected income as opposed to the fourth quarter 2008 loss. The separate count portfolio's performance still remains nearly 250 basis points below our expectations on this $54.5 million asset. However, we are hopeful with the recovery of the MBS market, we could continue to see improvement in this area.

Total noninterest expense for the first quarter increased by $4.1 million for the fourth quarter of 2008. The fourth quarter of 2008 included a $2.7 million reduction in expense from the third quarter, related to bonus and profit-sharing reductions. The first quarter of 2009 total was impacted by commissions and overtime associated with the mortgage refi activity.

On a go-forward basis, we would forecast a run rate closer to $16 million. This assumes a a similar amount of refi activity and the realization of our cost control initiatives in this area. Included in outside services is increased FDIC insurance costs of $556,000 as compared to the fourth quarter of 2008.

Assuming a six basis point special assessment, this line item would increase by $1.6 million in the second quarter. Other noninterest expense includes the cost associated with other real estate owned, which increased by $349,000 for the fourth quarter of 2008.

We would expect our tax rate to be in the 32% range for the remainder of 2009 as earnings contain a proportionally smaller amount of tax-exempt income.

In closing, we are pleased with several aspects of the first quarter performance, including deposit growth and continued margin maintenance. At the same time, we remain focused on the reduction of nonperforming loans and rightsizing our balance sheet.

With that, I turn it over to Kenneth Erickson, our Executive Vice President and Chief Credit Officer.

Thank you, John, and good afternoon. I will begin by discussing the change in nonperforming loans in the first quarter. As already mentioned, our nonperforming loans decreased in the first quarter by $10.8 million. This decrease is primarily due to the transfer to other real estate of a $12 million land development loan as we accepted deed in lieu of foreclosure in early February. In addition, eight other credits were removed from nonperforming status during the first quarter.

In total, these nine credits represented $18.7 million of nonperforming loans at December 31. $13.5 million was transferred to other real estate, $1.3 million was charged off while the remainder was resolved through payment or sale of collateral.

14 new credits exceeding $300,000 on an individual basis were added to nonperforming loans this quarter for a total of $12 million. Five of these loans were originated by our Wisconsin bank and represent $6.9 million or 57% of the addition. Only $1.4 million of new credits were added from our markets in Arizona, Colorado and Montana.

The industries of the largest of these 14 new credits are transportation, $2.8 million; office, $2.3 million; agriculture, $1.8 million; single-family homes, $1.1 million; and convenience stores, $840,000. We expect resolution on $4.6 million of these new credits by the end of the second quarter. Only one other credit in this group exceeds $1 million and appears to have sufficient collateral to liquidate the loan if cash flow problems being experienced by the business are not resolved in the near future.

I will now turn the discussion to total nonperforming loans. Of the $67 million in nonperforming loans, $43 million resides in 17 credits where individual exposures are greater than $1 million. The majority of these loans were originated by Arizona Bank and Trust, $10.2 million; Rocky Mountain Bank, $10 million; Wisconsin Community Bank, $8.3 million; Summit Bank and Trust, $7.7 million; and Riverside Community Bank, $3.1 million. These five tanks hold $39.3 million of the $43 million.

The industry breakdown for these loans are high-end residential, $11 million; transportation, $6.6 million; real estate credit provider, $6.5 million; lot and land development, $5 million; construction and development of commercial real estate, $3.8 million; and then eight other industries make up the remaining $10.6 million.

Next, I wish to comment on charge-offs and provision expense. As stated in the past two quarters, Heartland has generally recognized that charge-off on a loan when the loan was resolved, sold or transferred to other real estate. However, in the third quarter of 2008, Heartland began to recognize charge-offs on loans it considers impaired by writing down the loan balance to an estimated net realizable value based upon the anticipated disposition value. That practice continues as we recognize our losses on impaired loans.

Since many of our loans are participated across our member banks, I have also analyzed our losses as if they had been recognized by the bank originating the loan. If so, $3 million of our losses in the first quarter of 2009 would have been shown at Arizona Bank and Trust with no other bank responsible for more than $400,000.

Our 2009 first quarter charge-offs were concentrated in a few larger credits. The largest charge-off was in an Arizona credit, which filed bankruptcy in the first quarter. We charged off $908,000 and will pursue our rights through the bankruptcy courts.

An additional $1.1 million was charged off on two Arizona credits, both representing commercial real estate transactions. One credit was sold at a discount while the other was transferred to ORE in the amount of $1,260,000.

In addition, $535,000 of losses were recognized on various lot loans in the Phoenix market. The majority of the losses for the first quarter of 2009 were incurred in the two loan categories. First, construction land development and other land loan, $2.5 million representing 3.2% of their annualized respective loans outstanding; in commercial and industrial loans, $1.1 million, 1% annualized on their respective loan outstanding.

No other category accounted for more than $500,000 of losses.

In the first quarter of 2009, Heartland recorded provision expense of $6.7 million. This expense covered the net losses of $5 million and increased the allowance for loan and lease losses by $1.6 million, which increased our allowance as a percent of loans from 1.48% at the end of 2008 to 1.58% as of March 31.

With hopes that we may be approaching the depth of this credit cycle, we are not blinded by the fact that uncertainty still exists in the financial arena.

Regarding expected resolution of the nonperforming loans, I can state that collection efforts in the second quarter of 2009 are expected to result in a reduction of $13 million of the nonperforming loans recorded at March 31. Of this amount, $10 million is expected to move to other real estate.

Then in regards to other real estate, it did increase from $11.8 million to $29.3 million in the first quarter. This is primarily the result of taking the deed in lieu on the $12 million land development in Bozeman. Total owned residential real estate increased by $1.4 million to $1.8 million and owned commercial real estate increased by $16 million to $27.6 million. Liquidation strategies have been put in place for all of the assets held in other real estate.

We remain well diversified in our loan portfolio. $1.9 billion or 79% of our loans are either fully or partially secured by real estate. Of the $877 million of loans categorized as nonfarm, nonresidential, 64% or $559 million is owner-occupied.

In conclusion, in the first quarter we completed the installation of a software package acquired from Inmatrix. A key feature of this software was the design of a dual risk rating system measuring probability default and loss given default. It is also designed to allow the user to perform various stress testing scenarios on defined segments of our portfolio.

We expect this software to assist us with enhanced portfolio management and allowance methodology. We will begin to run this new software parallel to our existing allowance methodology throughout the balance of this year.

Our business bankers have completed training on this new software and are receiving very favorable feedback from their customers. We expect this tool to help differentiate our business bankers within their respective markets.

With that, I'll turn the call back to Lynn and remain available for any questions.

Thank you, Ken, thank you, John, for your comments. We will now open the session up for questions.

(Operator Instructions). Jon Arfstrom with RBC Capital Markets.

Good afternoon. Couple of questions. Ken, just a follow-up on some of your comments on REO. That was -- I understand that it was one large credit that really caused the increase, but you talked about liquidation strategies in place. And I'm wondering if you could expand a little bit on that in terms of how aggressive you intend to be, on (inaudible) some of these credits out?

This one $12 million is certainly the largest making up $12 million of the $30 million in ROE. We have signed a short-term listing agreement to attempt to market that in whole at a national auction to come up in the middle of June. So that's one strategy for that larger piece.

The balance, it's all by individual property. Most of that is just getting the property listed and marketed appropriately.

But it's basically -- it's all for sale is what you're saying?

Yes. I mean it is all for sale.

Okay, and then how do you -- when you talk to the brokers and get pricing feedback from the market, how do you feel about the valuation that you have attached to those credits?

First you'll probably comment that when we take a property into other real estate that we take it in at 90% of a current appraised value we get right before that transfer. So we are allowing a 10% marketing cost in that or for some further slide in that value.

We did have four sales out of other real estate this quarter. In aggregate, they didn't amount to a whole lot of dollars, but when you look at all four of them combined, it came out with just a very small gain. So I'm feeling our values that we have placed on there today are appropriate going in.

Now the bigger question is the value that we have assigned to those, will they hold up? I think that is anybody's guess, especially when we get into the Arizona market where we've seem such a decline in values. We do approach ROE, where we will be getting valuations on an annual basis if the property stays in ROE for longer than that so that we can reassess the value and, if need be, take further write-downs on those to keep the values appropriate to market values.

And then, just one follow-up on that as long as I've got you, Ken. Some banks and economic commentators talk about how they are seeing signs of stability or, at least, movement in the Arizona housing market. Do you share that view or are you starting to see that?

Yes, we are. We saw a recent stat in I'd ask Butch or John to help me quote it if necessary here, but I believe that the amount of home inventory was down to about 8.5 months. Construction, as we had seen it, virtually stopped in that market while we were waiting to see the existing inventory of homes absorbed. And with as many thousands of people that still moving into [Phoenix] on an annual basis, they are quickly moving through that housing inventory.

We seem to see, hope to see, I believe we are seeing close to the bottom of the valuations in that market. There does seem to be some stabilization and not as much decline in values on a month-to-month basis.

Couple of other questions if I might. John, in terms of the -- you talked a bit about repositioning the securities portfolio and the fact that you still had an unrealized gain. Are we likely to see some or that in the coming quarters? Maybe you prepare a little bit for higher rates on down the road.

You mean as far as monetizing some of the games in the portfolio, John?

Yes.

Or reposition the portfolio. I think we've done a pretty good job of repositioning the portfolio at this point. So I don't see a lot of that. Maybe it would certainly be more selected than we saw in the first quarter. Very comfortable with where the portfolio is right now.

And then can you talk a little bit about the lot maturities in terms of what kind of an impact that has on the margin. I know you're talking about stability. Just help me understand that.

Yes, really, I think it's funny. Basis points between a swap maturity and some other swaps, we saw about an eight basis point pickup, John. So that's where I get from 394 or 385 or in that range as far as a run rate going forward. So, impact on one maturity was about four basis points and some of the other were picking up -- we were picking up four basis points on the hedge that matured and then the others were contributing about four basis points and we feel that one's -- or those have pretty well been -- have run out at this point. So 385 is a pretty good assessment at the point.

And then, Lynn, I know it's becoming a smaller and smaller piece of the overall bank in time but can you just comment a little bit on the (inaudible) any changes in that?

Yes, Dubuque is still our largest bank, John, and this economy here is holding up surprisingly well. As is, surprisingly, the New Mexico, Albuquerque area is holding up pretty darn well.

We are starting to see some softness leak into this market as well as New Mexico, but we just did not experience the huge increase in real estate valuations that we experienced in some of the other Western markets. Since we didn't get the big up, we're not getting the big down on valuations.

Our unemployment levels still remain very low at 105%, so I feel pretty good about that and we have some economic development activities, one of which is IBM moving into town adding -- I think we talked about that last month -- some 1300 jobs to start with. This economy has held up surprisingly well and I would expect we just won't see the kind of devastation real estate values because we just never got the big ups.

Thanks, that was helpful.

John Rowan with Sidoti & Company.

First question for Ken. Can you repeat what you said about how much of the net chargeoffs came from Arizona.

Yes, as easy as it is for me to repeat anything today. I apologize for my voice. A little bit of a cold has me talking about an octave lower than normal here.

It is not swine flu, though.

Yes. $3 million of our losses in this quarter came from credits that were originated by Arizona. So I think that represents about 60% of the total losses we took at the Company and -- (multiple speakers). Go ahead.

And as -- obviously a few quarters ago, you changed your policy into taking reserves against loans and they went into NPL versus liquidating through OREO. How have your losses been relative to where you would make the loans as you moved out of OREO this quarter? Was it in line, did you have to take additional losses? Can you give us a little bit more detail on that?

Could you repeat that question, John?

Well, I am saying, you obviously -- you moved stuff out of OREO, right? Previously, you used to liquidate through OREO and take losses when it went through. But now -- now that you are -- I guess now that you are moving, let's say, into -- from [NPL] into OREO, those losses that you had marked those loans down to, are you seeing additional losses as you move through those loans?

I answer that two ways there. First, we had four small properties. They didn't aggregate to a lot of dollars that we had in ROE as of the end of the fourth quarter that did sell in the first quarter. And when those sold out, we had small gains and losses on each of those but in aggregate it came out to a $2,000 gain.

So it felt pretty good about the values we had on that. Hate to use that too much as a benchmark because it was a relatively small dollar amount.

Now in your comment of taking the losses as we put it [through] ROE, I want to make sure we got a clear understanding of our changes of the timing of the charge-off. That, beginning in the third quarter of last year, following FAS-114 in the past, when we had an identified loss, we would go ahead and increase our allowance by taking a provision and hold that as a specific reserve against that credit until such time that we closed that loan, brought it to final foreclosure and then trued up whatever our loss was on that before we took it into other real estate.

Beginning in the third quarter last year, as we recognized and impaired loan, instead of creating that specific reserve which would have pushed additional dollars into the allowance account, what we did was charge off that portion immediately. Though as we move through foreclosure, hopefully that one recognition of loss immediately upon impairment is the one and only loss.

But if that takes two or three quarters to move through that, that could be trued up with additional write-downs on that throughout that period.

Okay. Tanks.

And, Ken, as you pointed out we are taking those properties in at 90% of appraised value.

I thought, John, maybe your question was if we're writing these off, the moment we find out that we've got an impairment, is that amount adequate by the time we put it into OREO or are we having to write it down again?

That's what I was asking.

And I think the only evidence we have so far or those for small credits that went through.

And in most cases I made the foreclosure process in some takes an extended period of time. We really haven't seen a second write-down on those loans as we finally get title to that as we are transferring it to ROE.

But we've got a lot of nonperforming loans that are in the process of collections. So we will continue to true those up as we see if our original estimate of impairment needs to be increased.

It will keep the market apprised at quarter end certainly.

John, in your comments you issued a couple of guidance pieces for, I think, noninterest expense. Can you go over those again. I didn't quite get everything.

Yes, the thing I was pointing out [importantly], John, was the run rate on salaries and benefits. I said right now we look to about a $16 million run rate, which would include a similar level of refi activity, i.e., the commissions in overtime that ensue from the refi activity.

Also we are working through some cost initiatives. Our cost takeouts and sellers and employee benefits as well. The other thing I noted in my comments is the fact that anticipating a fixed basis point impact from the special assessment of the FDIC that impact the cost by $1.6 million in Q2 and we will recognize that in Q2 assuming we get guidance from the FDIC on that.

That's just the one-time expense, right?

That is exactly right.

Last question, what's a fair tax rate to use going forward?

32%.

Thank you. (Operator Instructions). Brad Milsaps with Sandler O'Neill Asset Management.

Brad Milsaps. John, just maybe a little more clarification on the loan servicing income this quarter. It looked like this balance if I have my notes correct, you are up about 20% from about $700 million to $870 million, but the actual income was almost kind of almost triple what it has been. Can you kind of give me some additional color they are, how sustainable that is going forward?

I would tell you that the impact overall and increase in lawn service income, that was quite a spike. What we saw was the valuation came in quite high, relative to the new originations versus the previous origination in the portfolio. So it would be more of a -- call it a one-time event in some respects as far as a $1.7 million increase from Q4 '08 to Q1 2009 where we went from $1 million in Q4 08 to --

(technical difficulty)

Chris McGratty. KBW.

Just a question on the securities portfolio. I assume that part of the increase was to shift the mix to an asset-sensitive position. But I was wondering in terms of the offset from the TARP, did that play a factor in increasing the securities portfolio?

Certainly part of the proceeds went into securities from the park proceeds, Chris, as -- and did until we can move it into loans. That's where the holding 10 is if you will at this point. I mean I may be missing the gist of your question.

I guess what I'm getting at is I'm just trying to get a sense of how large is the securities portfolio you are targeting over time? Is this a decent size? Are we going to see further growth?

I would tell you that I think it's probably the optimal size or maximum size. I would like to see it at least for the coming year so in my mind let's keep the overall balance sheet the same relative size and let's shift some of this investment portfolio into loans. And that's if you look back to my comments as far as loan growth -- and Lynn's as well -- where we said we think we can hit $70 million of total loan growth for the year 2009. I think there would be some shift out of the investment portfolio into loans.

Again, I think we've -- Lynn pointed out in his comments, we've seen a lot of deposit growth. We've put a lot of infrastructure in place to achieve that deposit growth. We aren't going to necessarily slow it down, but we are going to optimize it. I mean let's make sure we get the best mix of savings and DDA in the door.

Chris, I would add that we are seeing opportunities for good quality credits with good deposit relationships coming out of some of the larger banks as they continue to downsize and get their capital in line. So there are those kinds of opportunities.

And in a couple of our markets, our primary competitor in the Rockford area is Amcor, and our primary competitor in New Mexico is First State. And both of those -- both of those competitors with their struggles are having to do some things that are benefiting us. So this is a very unique period of time.

The only other thing I would say that could potentially happen is on the M&A side whereas if we had a very attractive in market type of FDIC-assisted acquisition that made sense to us from a deposit franchise and a branch footprint, then we could potentially liquidate some of our securities portfolio to help pay for that.

Okay, and then in terms of capital targets, How are you looking at I guess the TC ratio? I think in the past, John, you said 5 to 6%. You are towards the lower end of that. Just wondering how you are thinking about managing capital?

Yes and I would tell you, Chris, maybe that comes back to your first question as well. But again recall, both my comments and Lynn's comments that our investment portfolio now comprises 27% of our balance sheet. So as far as risk in the overall balance sheet, I think it has diminished relative to maybe some other banks' measures at 523.

If you're 523 and you are 100% loan to deposits are in excess of that, certainly there is a lot more risk in our balance sheet at 523 and 27% of our balance sheet is in investment securities. All that being said, yes. I would like to see it closer to certainly 6%, but if you maybe strip out some of that excess investment portfolio that certainly gets you quite a bit closer to 550.

There's more analysis, I think that needs to be done in that 523 than maybe an initial analysis that goes through.

And one final. I guess what's the overall interest in any of the government programs being floated from converting the TARP? And how are you guys thinking about just overall capital levels from that perspective?

I would say we are still assessing the programs, but at this juncture I think there's some other alternatives for us yet.

Yes, we are not looking for more assistance, Chris. Initially we thought we were going to use the TARP proceeds for acquisition, we were looking at a five-year payback. But now that it doesn't appear as though proceeds are going to be used aggressively in that area, we are looking at a shorter time frame and I think we'll pay it off as soon as it is practical to do that.

Jeff Davis with [Hal Barnes].

Good afternoon. When we look at the subsidiary bank does the loss that we see coming out of Arizona, is that likely to -- and I guess maybe it varies from a quarter to quarter, but a little bit more of a consistent drag in the operations profitability. Is the Arizona loss likely to taper off here in another quarter or two or am I being a little too optimistic?

Again much of that loss is driven by the August provisioning this quarter and the previous quarters. We have taken some steps to address some personnel issues down there. So when I spoke to their reduction of personnel costs of $16 million, some of the modifications of personnel expense down there are, overall, resulted from addressing personnel staffing and overall staffing in that marketplace.

So I would hope that we would see that come back into profitability or, at least, a reduced loss. Certainly by year end.

Ken, do you want to comment on what you see in the [problem] loan area?

I guess we continue to work through the issues that we have there. Their portfolio is only $140 million in size. We certainly have gone through and have dealt with a great number of those. So I would say there's still some problems to be uncovered in that market. I'm sure there are some that will still become problematic. It depends on how long and how deep it takes to get through this credit cycle.

But I would expect that the majority of the losses and the big surprises are behind us. We will still have some losses going forward.

OK and then, just a general question. When -- as you travel around your footprint, is there more of a willingness along the customer base to be risk-taking question, in terms of taking on projects?

You mean as far as our (multiple speakers).

Are things getting better? I mean, just that -- not that we can necessarily see in the numbers, but the risk-taking among your customer base or even if they are not your customer where it's a -- maybe a leading indicator of things to pick up six, nine months from now?

I don't think I would necessarily say that. I don't think people are generally stepping out and trying to take on more risk. I think what I would observe is that people are still working on making sure that they can generate earnings and preserve capital. They are rightsizing their businesses.

Now, there are isolated cases where we see business activity increasing, but it's pretty spotty. I wouldn't say that I would necessarily even in our best markets, I think people are pretty cautious still. I would guess that is going to continue until we start to see widespread stability settle in here in the stock market, and the government programs and the credit markets.

You know I think that's a good follow up. You look at our overall reduction, a reduction of loans on $49 million, it's not that we are not out there looking for loans. We are aggressively looking for good loans.

But I just don't think we're -- one, we are seeing the appetite and, two, probably not seeing the quality of those that do approach (inaudible) we are seeing the quality.

And Ken, you can probably add to that more than any of us, but I think it's first that we just aren't seeing the demand yet. Which is why we saw the portfolio shrank.

Where we have opportunities to provide credit that we haven't provided before, it is generally in good credits that are moving away from some of these big banks and these troubled banks that we've competed with. I don't see -- and that's just a replacement of credit elsewhere and putting the credit here. I don't see a mass movement of people looking to lever back up. I think everybody is still pretty darn cautious.

Yes, I would agree with that. We don't see that yet, where you got an existing business that says this is the time to make the break and let's get out in front. I think they are very very cautious of when they plan to take back. So we are not saying the turn of the beliefs out there that the customers are saying we are at the bottom, let's charge forward.

I think it will be interesting to follow our liquidation of OREO and where we are doing some auctions on some of this stuff. It will be interesting if people recognize the opportunity to step in and buy at very, very depressed prices. And I think once we start to see that firm up, it will be an indication that things are maybe starting to bottom out and we can get moving in the other direction.

But that hasn't quite happened yet?

Well we are a little bit away yet. We are going to find out some of that this next quarter. So we will be able to stay you better what we see at the next quarterly conference call.

(operator instructions). John Rowan with Sidoti & Company.

John, just a couple of more quick questions. The preferred dividend that UK, that was a full quarter right? So that's a good run rate?

That was a full quarter.

Okay, can you remind me what the -- it looks like the -- there was a minority interest expense. Can you remind what that is?

That's for the -- our bank in Colorado -- I'm sorry. Minnesota.

Okay, but the diluted shares outstanding went down. Were the warrants included in the diluted shares out for the quarter?

I believe the -- were the warrants included in the (inaudible)? I think there are 10,000 -- it would have been consistent Q1 versus Q4.

Okay, and just one last question. If your loan sales go down to where there were trending the $300,000 to $500,000 per quarter, what happens then to your competition expense? How much does that go down?

I would tell you probably about $200,000 to $300,000. There's some FAS-91 implications that go through as well that offset some of the costs that increased the cost we saw, John, but probably $200,000 to $300,000.

So there's not much cost offset if the gain on sales loans goes down?

Not -- probably not as much, given the FAS-91 implications. Probably $200,000 to $300,000.

But, John, over and above that, we've had some job elimination for low productive type of staff positions that we just exited.

John, let me make sure on your previous, your warrant question, let me just confirm that I'm responsive to that. You there yet?

Yes, I'm here.

You're asking if there's any diluted nature of the warrants in our Q1 EPS numbers?

Yes.

No. The answer to that question is no.

Okay, do you know what level of earnings you have to get to before they become dilutive?

I believe the strike place is $20.10.

Thank you and there are no further questions at this time. I would like to turn the call back to Mr. Fuller for any closing comments.

Very good. In closing, we've communicated this to our employees that there are always opportunities that arise out of hard times and that the Heartland board and management team at Heartland believe that our community bank model positions us very well to take advantage of these opportunities.

Our member banks remain focused on the communities they serve and are truly an integral part of their Main Street fabric as they energize their local economies through collection of deposits and origination of quality loans. Our saying is the big bank punch with the little bank touch continues to set us apart from competitors, both large and small.

I would like to thank everybody for joining us today and hope that a number of you will be able to join us next month at our annual stockholder meeting. And that is on May 20 here in Dubuque at the Grand River Center 6 PM in the evening.

And our next quarterly conference call is scheduled for July 27. So, again, appreciate everybody joining us and a have great evening.

Thank you. Ladies and gentlemen, this concludes the Heartland Financial USA first quarter conference call. If you would like to listen to a replay of today's conference, please dial 1-303-590-3030 or 1-800-406-7325 and enter access code 405-4774 followed by the pound sign.

AZT would like to thank you for your participation. You may now disconnect.