Heartland Financial USA Inc (HTLF) 2009 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Heartland Financial USA third quarter conference call.

During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today, Monday, October 26 of 2009.

At this time, I'd like to turn the conference over to Leslie Loyet, Financial Relations Board. Please go ahead, ma'am.

Thank you, and good afternoon, everyone. Thank you for joining us for the Heartland Financial USA's conference call to discuss third quarter 2009 results.

This afternoon, we distributed a copy of the release and, hopefully, you've all had a chance to review the results. If there is anyone online who did not receive a copy, you may access it at Heartland's website at www.HTLF.com or you can call Han Hoi 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'd 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.

Additional information on these factors is included from time to time in the Company's 10-K and 10-Q filings, which can be obtained on the Company's website or the SEC's website.

With that said, I'd now like to turn the call over to Lynn Fuller. Please go ahead.

Thank you, Leslie, and good afternoon. We certainly appreciate everyone joining us this afternoon, as we review Heartland's performance for the third quarter of 2009. For the next few minutes, I'll 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 insights on the status of our nonperforming assets and credit quality.

For the third quarter of 2009, I'm pleased to report another profitable quarter, albeit short of our expectations. Net income for the quarter was $2.2 million or $0.13 per diluted common share, compared to $3 million or $0.18 per diluted share in the third quarter of 2008, with the primary difference being our preferred dividend on TARP.

Core earnings continue to be very solid, aided by an exceptional net interest margin of 4.06%. Additionally, we continue to benefit from mortgage banking revenues, securities gains, and the gain on our FDIC-assisted acquisition of Elizabeth State Bank.

These benefits are somewhat offset by FDIC assessments, which have grown nearly five-fold over last year -- $3.7 million of write-downs and expenses related to OREO and provision expense of $11.9 million for the quarter. With nonperforming assets rising from $102 million to $117 million during the quarter, reduction of nonperforming assets clearly continues as our number one priority. And as with others in our industry, we remain dependent on the direction of the economy.

Solid core earnings and a solid net interest margin at 4.06% have allowed us to cover the costs associated with our nonperforming assets and still produce positive numbers on the bottom line. In a few minutes, Ken Erickson will provide more detail on credit administration topics.

We continued to operate in an adverse economic environment. The favorable trends we see in our balance sheet composition and income statement provide reasons for optimism.

Total assets, for example, have increased by $434 million year-over-year, with $249 million year-to-date for 2009. We continue to focus on improving the composition and quality of our balance sheet through exiting low quality credits, reducing our loan to deposit ratio, and in general, becoming much more liquid. I think it's pretty amazing that we've been able to accomplish this, while at the same time increasing our net interest margin. As a result, the earnings power of this Company has never been greater.

Loans are up $40 million over the third quarter of 2008, primarily as a result of the Elizabeth State Bank acquisition. Representative of the continued softness in loan demand, current outstandings still slightly trail year-end 2008. At this point, we don't see measurable loan growth for the remainder of 2009, though we continue to target deposit-rich operating companies where we can develop a full banking relationship.

In contrast, investments are up $346 million or 45% over the third quarter of 2008, and up $202 million year-to-date, adding greater liquidity to our balance sheet. Fueling the increase in our securities portfolio is continued strong deposit growth. In fact, deposits have increased 15% over the last 12 months, with all of this growth occurring in non-interest-bearing demand, savings, and money market deposits.

We've seen substantial reduction in brokered funds and some CD run-off; at the same time, we've reduced overall short-term borrowings and believe there's still room for even more improvement in our funding costs. I'm extremely pleased with our continued success in executing on our second highest strategic initiative, which is to emphasize non-maturity core deposit growth versus high cost certificates of deposits.

Going forward, we will be very focused on executing strategies, such as relationship pricing, to secure these deposits and the corresponding customer relationships.

So that brings us to net interest margin, which we would describe as remarkable this year. Growing by 14 basis points during the quarter, margin is now at 4.06% and continues to be a bright spot in Heartland's performance. Net interest margin is a key indicator of Heartland's long-term performance and a vital component of our value proposition.

Going back 10 years, margin has been at or above 3.79% and now, at 4.06%, has risen near our historical highs despite the worst economic conditions we've seen in nearly 30 years.

Next, non-interest income was a major contributor to our third quarter results, increasing 51% over last year's third quarter. We experienced an even greater increase for our nine-month totals with exceptional increases in mortgage-related revenue, security gains, and a gain on acquisitions.

After three profitable quarters, our capital ratios continue to improve. The tangible capital ratio moved up to 5.35% and remains within our benchmark range of 5% to 6%. Although our balance sheet has grown, nearly all of this year's growth has come from a $202 million increase in our securities portfolio, which provides greater liquidity and a lot less overall risk on our balance sheet.

With our allowance for loan losses at 1.78% of total loans, we believe we're properly reserved at this point. However, we continue to closely monitor the loan portfolios of our most economically challenged markets, which would be Phoenix, Arizona; Denver, Colorado; and Bozeman, Montana.

With respect to M&A, we just completed the data processing conversion for Elizabeth State Bank, which was acquired through Galena State Bank in an FDIC-assisted transaction. The purchase added approximately $50 million in assets and resulted in a $1 million gain. We continue to work with the FDIC on similar opportunities; and like the Elizabeth purchase, we're seeking fill-in acquisitions where we can grow market share, achieve efficiencies, and provide greater convenience to our current clients.

We were also pleased to discover a story on cnnmoney.com this month that listed the top 10 small metro areas in which to start a new business. Included on this list are two Heartland markets, with Billings, Montana in the top spot and Dubuque, Iowa at number eight. Both markets share strengths in employment, service industries, and educational opportunities.

In concluding my comments today, I'm pleased to report that at its October Board meeting, the Heartland Board of Directors elected to maintain our dividend at $0.10 per common share payable on December 11, 2009.

I'll now turn the call over to John Schmidt for more detail on our quarterly results. John will then introduce Ken Erickson, who will provide commentary on credit quality and real estate exposure. John?

Thanks, Lynn, and good afternoon. In my comments this afternoon, I'll provide additional detail on Heartland's performance in the past quarter, 9/30/09 versus 6/30/09.

Again, starting with the balance sheet, the first thing I'd bring to your attention is a $45 million increase in investment balances, as funding continued to outpace loan growth. Nearly 53% of the investment portfolio is invested in mortgage-backed securities. Private-label securities comprised $132 million of the $578 million total mortgage-backed securities.

While these investments require additional evaluation prior to purchase, as well as more intense monitoring, we remain comfortable with our current ownership position. Additionally, as spreads have come in on most mortgage-backed product, we have been able to sell much of our older purchases and move into better structured mortgage-backed securities.

Similar to last quarter, investments comprised over 28% of the assets on our balance sheet. For the quarter, loans and leases held to maturity decreased by $7.2 million. This is exclusive of $36 million of loans acquired as a result of the Elizabeth State Bank acquisition, which are covered under a loss share agreement with the FDIC. As Lynn indicated, we anticipate that loan outstandings will remain flat or reflect a slight decrease by year-end.

Net charge-offs for the third quarter totaled $6.9 million as compared to $10.1 million in the second quarter of 2009. With the $11.9 million provision taken in the third quarter, the allowance as a percentage of total loans increased to 1.78%. The increased level of allowance is largely related to specific credits in our Western markets of Phoenix and Bozeman, as well as the overall level of nonperforming loans.

One change that you will note in the release is the most -- in the release is the loan-related data and asset quality ratios reflect the most recent five quarters of historical information; whereas the previous releases reflected annual data.

Deposit growth was significant again in the third quarter, as we saw core deposits -- meaning, excluding brokered CDs -- increase by $69 million from a quarter-over-quarter perspective. This increase excludes the $49 million of deposits acquired in the Elizabeth State Bank acquisition. We are pleased with the continued shift in deposit mix, as demand and savings balances increased by $113 million during the quarter, while certificates of deposits decreased by $44 million.

As I mentioned last quarter, we remain focused 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. As of 9/30, certificates now comprise just 38% of our total deposits.

As Lynn mentioned, tangible common equity ended the quarter at 5.35%, up from the 5.24% recorded at 6/30/09. The third quarter tangible common equity ratio benefited from the $10 million in unrealized gain on securities. Again, I believe this level of tangible common equity should be viewed within the context of investments, which comprise over 28% of our balance sheet. By comparison, the June 30, 2009 bank holding company performance report for banks with assets between $3 billion and $10 billion reported just 18% of their assets in securities.

Moving on to the income statement. Net income totaled $3.5 million for the third quarter, while net income available to common stockholders totaled $2.2 million or $0.13 per share. Relative to the margin, we expect to see investment yields decline as pre-payment speeds decrease on our mortgage-backed security portfolio.

At the same time, we feel that we'll be able to further control the interest costs on the money market and savings account balances. Thus, for the remainder of the year, with a focus on balance sheet management, we're comfortable that the margin will continue in the current range.

Third quarter non-interest income of $11.9 million reflected a $2.8 million decrease from the second quarter peak of $14.7 million. The majority of the decrease was related to reductions in loan servicing income and gains on sales of loans of $2.9 million. Residential mortgage loan sales during the third quarter were approximately 37% of the second quarter peak volume of $258 million.

While certainly dependent upon the direction of interest rates, we believe the current run rate to be sustainable. We will continue to see ongoing non-interest income benefit from the residential mortgage loan servicing portfolio, which stood at $1.08 billion as of 9/30/09. While security gains decreased by $915,000 from the second quarter, we are still pleased with the $1.3 million result.

During the third quarter, we continued to sell lower rated securities in favor of higher coupon offerings. In doing this, we feel that we have positioned ourselves for an increasing rate environment. I'd like to remind you that this quarter, like last, we were able to monetize these gains while maintaining current yields with a similar duration.

Finally, included in noninterest income is a $998,000 gain associated with the FDIC-assisted acquisition of the Elizabeth State Bank.

Moving on to total non-interest expense -- total non-interest expense was comparable to the second quarter at $30.3 million. The reduction in FDIC assessment costs of $1.4 million was largely offset by the $1.1 million increase in costs associated with repossessed assets. This line item reflects write-downs and other carrying expenses on foreclosed property.

As was the case in the second quarter, the majority of the costs incurred were on lot loans and one land development in Arizona. In addition, the third quarter professional fees included approximately $370,000 of one-time costs related to the Elizabeth transaction.

We would expect our tax rate to be in the 30% range for the remainder of 2009. We also think it's important to note that regulatory examinations were recently completed at all of our member banks, with an examination date of 6/30/2009.

In closing, while the size of this quarter's provision is larger than we would like, the majority of the Company's other metrics are very positive, and speak very effectively to the true earnings capacity of the Company, particularly as the economy improves.

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

Thank you, John, and good afternoon. All of my comments this afternoon will be exclusive of those assets covered under the loss share agreement.

I'll begin by discussing the change in nonperforming loans in the third quarter. As already mentioned, our nonperforming loans increased in the third quarter by $12.8 million. [10] credits representing $11.3 million were removed from nonperforming status during the third quarter. $7.1 million of this was transferred to other real estate; $20,000 was charged off; while the remainder was resolved through payment, restoration to accrual status, or sale of the collateral.

17 new credits exceeding $300,000 on an individual basis were added to non-performing loans this quarter for a total of $28.7 million. $7.9 million of these were originated by our New Mexico bank. The Arizona and Montana markets added $6.5 million and $6.2 million of nonperforming loans, respectively.

The largest of the additions to nonperforming loans is a credit for $6.5 million. This credit first became nonperforming in the third quarter of 2008. In the second quarter of 2009, we believe we have reached resolution on this credit and it was restored to performing status. In the third quarter, it has again become nonperforming. It is now expected that this property will be in other real estate prior to the end of the year.

The industries of the largest of these 17 new credits are real estate credit provider, $6.5 million; land development, $5.7 million; gas station and convenience stores, $2.7 million.

I'll now turn the discussion to total nonperforming loans. Of the $84 million in nonperforming loans, $55 million resides in 19 credits where individual exposures are greater than $1 million. The majority of these loans were originated by Arizona Bank & Trust, $14.7 million; Rocky Mountain Bank, $11.7 million; Summit Bank & Trust, $9.1 million; and Wisconsin Community Bank, $7.3 million. These four banks originated $42.8 million of the $55 million.

The industry breakdown for these 19 loans is lot and land development, $16.7 million; real estate credit provider, $6.5 million; construction and development, $6 million; transportation, $5.8 million; lessors of real estate, $4.9 million; and seven other industries make up the remaining $15.1 million.

Next, I'll comment on charge-offs and provision expense.

Since many of our loans are participated across our member banks, I analyze our losses as if they had been recognized by the bank originating the loan. $5.2 million of our losses in the first nine months of 2009 were from loans originated by Arizona Bank & Trust; $4.2 million by Rocky Mountain Bank; and $3.9 million by Summit Bank & Trust.

The majority of the losses for the third quarter of 2009 were incurred in two loan categories -- first, construction, land development and other land loans, $3.9 million, which represents 5.7% of their annualized loan outstanding; and non-farm, non-residential real estate, non-owner occupied, $974,000, representing 1.2% of their respective loan outstandings. No other single category accounted for more than $400,000 of losses in this quarter.

In the third quarter of 2009, Heartland recorded provision expense of $11.9 million. This expense covers a net loss of $6.9 million and increased the allowance by $5 million. The allowance as a percent of loans was increased from 1.57% at June 30 to 1.78% as of September 30.

With the increase in nonperforming loans, as well as the continued weakness of the general economy, our allowance for loan and lease losses was increased to the 1.78%. While I anticipate that some of the new nonperforming loans will be returned to performing status in the near future, until the issues that resulted in the relationship becoming nonperforming are fully resolved, some additional loss exposure will exist.

A significant review of our portfolio has occurred over the past several months. Stress testing was conducted on several industry segments to include hospitality, retail, office, and the manufacturing segment supporting the auto industry. We will use this data to strengthen our position in those credits showing heightened levels of credit risk as a result of the applied stress.

We have also taken a hard look at all of our remaining acquisition and development customers. Most of our remaining customers in this segment in performing loan categories appear to have sufficient resources to survive this economic downturn.

We have also taken an in-depth look at our non-owner occupied commercial real estate. Losses year-to-date in this segment are 0.46%. The detailed review does not reveal any significant concentration risk, either by industry type or market, nor any significant credit risk exposure due to deteriorating credit quality of individual credit. Migration analysis of our commercial real estate, hospitality, and retail portfolios show only a modest deterioration over the past two years, while the office portfolio shows modest improvement.

Continued analysis of our portfolios will be necessary to make sure we are maintaining an appropriate level of allowance for loan and lease losses. While weaker credit and the current level of nonperforming loans will continue to impact near-term credit trends, it appears that by the end of the fourth quarter or early in 2010, we will begin to see decreases in the levels of nonperforming loans as we begin to see recovery from this adverse credit cycle.

Regarding expected resolution of nonperforming loans, I can state that collection efforts in the fourth quarter of 2009 are expected to result in a reduction of $24 million of the nonperforming loans recorded at September 30. Of this amount, $18.9 million is expected to be moved to other real estate.

Relative to other real estate, it increased by $3.3 million to $32.6 million in the third quarter. Total owned residential real estate is $4.1 million, while owned commercial real estate is $28.5 million. One residential subdivision property comprises $11.9 million, or 37% of total other real estate.

Carrying values were reduced by $3.2 million in the third quarter upon receipt of new appraisals or upon the sale of the properties. Liquidation strategies have been put in place for all the assets held in other real estate. We continue to carry and market these properties in an orderly liquidation. It remains our opinion that the current market for quick liquidation requires a discount in value that exceeds the projected carrying cost of these properties.

$9 million was added to other real estate in the third quarter, representing 20 separate properties. $2 million was sold, which was comprised of 13 properties.

Regarding portfolio diversification -- we do remain well diversified in our loan portfolios, $1.8 billion, or 76% of our loans are either fully or partially secured by real estate. Of the $851 million of loans categorized as non-farm, non-residential, 61% or $519 million is owner-occupied.

My final comments will be directed at our retail portfolio. Our retail portfolio continued to perform quite well. Losses in the first nine months for residential real estate loans were only 0.41% of outstanding. Foreclosures have only been required on $2 million of our portfolio loans year-to-date, with another $2.8 million currently in process of foreclosure. Delinquency at September 30 on our $199 million held in portfolio was 4.18%, with only 2.36% over 90 days.

Consumer loans have resulted in $1.5 million in net charge-offs for the first nine months of the year, or 1.1% of net outstandings. Delinquency at September 30 was 2.8%, with 24% of this represented by one large [C-lot] loan.

Citizens Finance, our consumer finance company, continues to perform quite well. Net loan outstandings are now at $47 million; year-to-date, we have experienced 3.91% in net charge-offs, which is only slightly higher than expected. Delinquency at September 30 was 5.35% with only 29% of the past due accounts over 90 days.

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

Thanks, Ken, and now, Leslie, I think we can open up for questions.

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

A few questions here. I think we all know what's happening in the Phoenix market, but can you touch a little bit about Bozeman and Denver? Kind of give us an update as to how those markets are behaving?

I can touch on it just from a more global standpoint. Ken can add to my comments, John. With regard to the Montana market, most all of our issues are in the Bozeman, Big Sky area. And what we've seen is, in resort type areas, that we're very aesthetically attractive, especially to the California market. There's an awful big influx of dollars into those markets running the cost of property up.

And most of the problems we've seen there are as a result of those values coming back off substantially. We had one credit or two possibly in Billings, but as I mentioned in my comments, the Billings market is really in very good shape. It's very well diversified, low unemployment, and thought of as a premium spot for new businesses to locate into.

So we just didn't see the big run-up in values on real estate there. As a result, we haven't seen huge devaluations.

The rural markets in Montana really are not that heavily impacted, as we would say throughout the Midwest; the rural markets seem to be doing better. They just haven't seen the big run-up in values.

As it relates to Denver, Denver was hit pretty hard in real estate. We had a couple of real estate deals there that went south on us. We had some properties in Cherry Hills, Cherry Creek area, which is a very high-end residential area. And unfortunately, those values have dropped off because there's just no sales.

The sales that occur on those very high-end homes are done only at bargain basement prices. So if you've got to sell a home in those areas, you're probably going to take a hit.

I think commercial real estate in the Denver market has been hit a little bit as well. But I think Denver will probably come out of that slump a bit sooner. Just as late as last month, everybody felt that they could start to see some light in the Denver market and thought that it was starting to come back around a bit. What will happen in commercial real estate is still a big question mark in my mind, in any of the metro markets -- Midwest, or West.

Ken, do you have something to add to that?

Just a little bit. I think that summarizes quite well in Bozeman and the Montana area, it seemed to come more from the acquisition and development, with as much influx of people coming into those areas. There was a lot of activity, which slowed to nearly a dead stop when the economy started to slow. So there was an abundance of lots, an abundance of some spec real estate properties that we held, as well as other banks in that market.

And as Lynn mentioned, the area in Colorado just seemed to be a reduction in value as its loans slowdown in the real estate sector. And one of our newer banks that has not yet had the opportunity to build full more operating company relationships, they're probably a little more susceptible to the real estate market than we are in some of our mature banks.

Just -- Ken, as long as I have you, just one question on OREO balances, I guess. When I looked through the numbers, that's the one number that I think we'd all like to see come down. And you talked a little bit about the potential of another $19 million going into OREO. And just -- what is it going to take, do you think, to start to move properties out of that category more aggressively?

I understand your lack of willingness to take fire sale prices, but how long do you think it's going to take and what do you think it's going to take to be able to move some of these properties out?

I wish I had an easy answer for that. The easy answer I suppose is how quick does the economy start to show some recovery and people are willing to spend again?

We are seeing activity. Unfortunately, it is just -- we are seeing more go into there than we see coming out right now. I did mention we had several sales this past quarter. I know that there's another one that's being entertained now in that subdivision that I had mentioned. There's a group of [eight loss] that I believe the offer has been accepted on those. So, we are seeing activity in there.

With -- I believe -- and I'll let Lynn and John respond to this as well -- I don't feel that from a liquidity or from a capital level that we still feel the pressure, the need to dump some of these properties is what we are seeing to be significant reduced values as much to $0.25 on the $1.00, if you wish to turn them into cash today.

I think that's the number that still gets our attention, Jon. If you look at $0.25 on the $1.00, as we work them through and as Ken indicated in his comments, we were able to resolve 13 properties in Q3; not huge dollars, $2 million, but hopefully, we'll see some slowing in what's going on in the top, and we'll see some acceleration on what's coming on at the bottom.

And again, it's not that we're unwilling to take losses in them, but I just don't think they're realistic valuations on some of these, particularly the larger developments at this juncture.

The only thing I would add to that is that to date, we have been consistently getting new appraisals and writing them down to current appraisals, which are coming in as ridiculously low as probably they were ridiculously high on the high end of the market. And we've also seen some properties in Montana move, which is a positive. And on those, I think we should show a couple of gains, Ken, on some of that Montana property is moving.

So there's a little bit of movement. It's looking better all the time. How long it's going to take ultimately is anybody's guess.

Okay. That's helpful on the appraisals. Is that something you can maybe give us an idea of how frequently you do it on -- is it on all the properties?

We have been doing it annually on the anniversary, or if for whatever reason, we believe that we've got a value that is much below what we've got them on the books for. So it's no less than annually, and more frequently if we believe there's a need to do so.

So it's a rolling process?

Yes.

Okay, thanks.

John Rowan, Sidoti and Company.

John, can you elaborate a little bit more on the securities that you're buying?

To this point we have, as I indicated, we've been buying private-label CMOS to some extent, John. And that -- we've been buying those for probably about the last year and a half. More recently, we've been buying -- we really have seen that market to some extent dry out, so we're probably moving back into agencies -- agency-backed CMOS.

But as I -- I gave you some color on the private labels we did buy and it was -- total right now is about $132 million in that portfolio. We have been buying what we would term to be re-REMICs, some restructured CMOs. And again, in all of those, we continue to evaluate all those and feel comfortable under a stressed environment that they can perform very well.

Okay. And as far as the Elizabeth State Bank acquisition, are you accreting any discount from that into the income statement? Or is there just the one-time gain booked? Can you just give me more information on that?

I think by and large what you see, right, it recognizes the majority of that gain coming through.

Okay, so there's not a discount accrual over five, six years?

There will be -- yes, we'll probably see some minor amounts, John, but I think what's been recognized at this point, there's some CDI, et cetera; but the majority of the accretion has been recognized at this juncture, at 9/30.

Okay. And how sustainable do you think that the compensation line is at this reduced rate? You didn't have any reverse outs here, did you?

I mean, there's a lot of ebbs and flows at this point. There was probably some bonus adjustment that did flow through there. But there's things going back and forth in that line item, John. I would say that maybe the previous quarter is a little more representative than this quarter. But that's a $300,000 swing quarter-over-quarter. So if you look back to last quarter, I think that's probably at least realistic for 2009.

Okay. And just one more question. How much margin drag do you guys have right now with -- from the [MPA] balances?

Well, if you think about $120 million, $117 million, I mean, that's anybody's guess. It's probably $4 million to $5 million is a rough estimate -- I guess that's the way I've thought about it.

Okay, thanks.

Adam Klauber, Fox-Pitt Kelton.

Seeing that you continue to build up strong core deposits and effectively cash through securities, are one or two markets looking more attractive for acquisitions, whether FDIC or not?

I think our general philosophy and statement has been we're looking in our existing markets, which I think we all know. I think right now we continue to look at all the potential FDIC acquisitions that come through the pipeline, if you will. And I'm not sure that there's one market over another.

I think we'd like to augment some of our banks, maybe our smaller banks, if you will, Adam, to get them up to a more operational size. Maybe that's one way to slice it. Another way maybe we could address it, Adam -- this is Lynn Fuller -- we're looking at the core deposit mix of acquisition targets, whether it be FDIC-assisted or those that are just tired and they're looking for a partner.

If we find banks that have a very strong deposit franchise and they have branch locations that fit nicely into our footprint, where we can get pretty significant cost takeouts, and they provide us some quality management, generally, that would not be in an FDIC-assisted transaction.

But those are the keys to where we would find an acquisition to be attractive -- core deposit mix, being attractive; low cost of funding; good mix; quality people; good fit with the branch footprint. We find some of those out West; we find some in the Midwest, quite frankly.

And we've got a number of them we're talking about right now. The early looks that we've had at FDIC-assisted transactions did not tend to fit that definition. Elizabeth was an outlier. It showed us a very nice deposit franchise. Many of the other markets where we looked at FDIC-assisted transactions, they were full of hot deposits, broker deposits, borrowed money, FHLB, and were really, really heavy in real estate on the asset side.

So I would say that we would be willing to accept an acquisition, whether it be FDIC-assisted or otherwise, in almost any of our markets. We're probably not going to look outside of our current market.

Okay, thank you for that answer. Moving on to -- looking at the nonperformers moving up in New Mexico -- and thank you for a lot of the detail there -- is your sense that this is a handful of credits? Or, by the nature of that jump, do you think we'll see further deterioration in the New Mexico bank?

This is Ken. The big jump there was when you see the numbers, you see a $5 million in over 90 days is still accruing. We have a relationship that has extended the renewal. It's our expectation that that's going to be renewed, while secured in the process of collection here. We think there's some extended negotiations and renewal terms on that, but we all still hold fast that that's going to be renewed here very shortly and pull $5 million back out of that. So that makes up the majority of it.

Okay. That gives me a good answer. And then on the movement into OREO, over the last -- with this quarter and next quarter, again, there's going to be some movement. Are the write-down as the properties move into OREO in the last two quarters, is it more significant than you saw maybe towards the end of last year and earlier this year?

Yes, I think without a doubt. (multiple speakers)

Yes.

Yes. And I think the point that Lynn made earlier is probably one of the most salient point in all of this; whereas the appraisals were maybe unrealistic two years ago on the high side. Since there's no comparables out there in the current environment on the low side, it really has been forcing down evaluations and almost across the board.

That's where we're at, though, but it certainly is we are recognizing margin losses in Q3 versus Q2 and certainly versus the fourth quarter of 2008.

Okay. Well, thank you very much.

(Operator Instructions). Brad Milsaps, Sandler O'Neill.

Most of my questions have been answered but just wanted to follow-up on some of the investment purchases. John, just kind of wanted to reconcile some of your comments. Some of the securities you're buying to prepare yourself for rising rates, you've maintained that you've actually increased the yield on the securities portfolios pretty significantly. Just kind of curious what your (multiple speakers) --

(multiple speakers) Oh, go ahead, Brad. Finish your question. I'll (multiple speakers).

Yes. Just curious what you guys are thinking about in terms of how you're viewing rates for the next 12, 24 months and what kind of extension risk you might have there?

I think the one thing to note, and I did allude to it, that some of the return we're seeing is a function of pre-payments fees and we have some discount on securities that we've seen some accelerated speeds on these mortgage-backs. Suddenly we're realizing some pretty significant returns on them as, again, the speeds have accelerated, both due to the paydowns, driven in part by foreclosures.

And again, that -- we do see that ultimately impacting the margin; that can't go on forever. We've been replacing -- and that would be by and large in private label, CMOS, that we're seeing those high returns.

The replacements, though, would be going more into agency-backed, mortgage-backed, versus the private label. We just don't see the spreads that we'd like to see in the private labels at this juncture. So we are moving back more into agencies at this juncture.

Again, that's going to hopefully -- I think that will impact margin. We won't see the higher returns, but by the same token, what I was alluding to in my comments, offsetting that, we do think we have some additional room on the savings and money market side to offset that reduced return on the investment portfolio.

Right, yes, I was just curious -- a lot of banks we're seeing just really go very short Fed funds, whatever it might be. And just thought that you guys might maybe have a different view on banks.

We're pegging our duration at about two to three years, depending on the bank. That's kind of where we're landing. We think it's appropriate to buy -- what I've been alluding to in my comments is we're buying some higher coupons with the thought that the speed will slow down and we'll ultimately get some better returns on that portfolio.

That can go -- cut both ways. What we're saying now, again, some of the higher coupons are getting faster paydowns as people refi, or as I said, there's also some foreclosures coming through.

Right. And then final question, the (multiple speakers) --

Let me -- just one last point there, Brad. Too, you know, we talk about acquisitions and I think some of the offset to that is what we'd like to do with acquisitions to avoid expanding our balance sheet any further, we'd see the paydowns in the investment portfolio potentially being replaced by an acquisition of a bank, I would say. So there's some balances to that, as well.

Brad, to kind of follow-up on John's comment, we've got a lot of cash flow coming off of our investment portfolio. And if we should see the economy pick up, and some of the savings and DDA balances of our commercial depositors go back in to support their business functions, we could see a pullback and shrinkage in our balance sheet, which we would like to replace with an acquisition.

And that's kind of why we're pursuing both FDIC and non-FDIC-assisted transactions in our current markets, thinking that there will be some shrinkage of this investment portfolio and some of the deposit side, which we can replace with a good earnings spread type of dollars from an acquisition.

The other thing you asked about interest rates, what we think is going to happen -- I guess it's anybody's guess. But we think there's a greater probability 12 to 18 months from now, for rates to be up versus down. So that's why we position the portfolio with the two to three-year duration with securities that will do better in a bit of an increasing interest rate environment versus a falling rate environment.

Right. And John, finally, what do you have in terms of CDs, repricing, say, over the next couple of quarters? It looks like costs are still hovering maybe just under 3%. Looks like you've still got a decent opportunity there and (multiple speakers) --

Yes, I think we show on the release that we have 40% of the CD balances repricing within the next six months at an average rate of 2.23%. So I think we'll be able to pick up some there, Brad; I don't think it's huge, but we should be able to pick up some there.

I think there's more savings quite honestly, Brad, on the savings deposits. Those have been held up in some cases pretty well. And I think if rates remain flat here for the next six to nine months, I think we may have an opportunity there, maybe even greater than what we would see on the CD side.

But there's still somewhere between $80 million to $100 million in CDs coming through every month, and I'm seeing 80 to 100 basis points reduction in costs. We see a little bit of reduction in renewals as a result of that, but that's fine with us right now..

Yes, so in all of that, you look at it. You look at the investment side -- arguably, it's going to be hard to replace some of those returns, but as I mentioned, I think we have offset on the reliability side that should leave our margin in the same relative range.

Right. Okay, great. Thank you.

(Operator Instructions). Chris McGratty, KBW.

Just a quick couple questions on credit. What was the balance of those TDRs in the quarter? I think they were about $12.5 million in the second quarter?

What balances, Chris --?

Troubled debt, restructuring, restructured credit. I think the reg report said it was, like, $12.5 million last quarter.

I don't have those right in front of me. Do you?

Okay. Maybe moving along (multiple speakers) --

It was probably minimal. I don't think we had much in restructured credit at 6/30.

Okay. What's the total SNC exposure you guys have for -- have you disclosed that historically?

The total --? (multiple speakers)

Shared national credits.

Shared national credits?

I don't think we have any -- (multiple speakers) I'm sorry, (inaudible) correct me --

We do have just one credit. We participated it out. Dubuque Bank and Trust has originated that. We'd have about $25 million participated between the Heartland member banks and slightly more than that participated out, mostly to Iowa banks.

Okay. I guess, John, on your comments on the fee income outlook, I think you -- correct me if I'm wrong, you said your guidance this quarter was a decent run rate. Did I hear that correctly?

Yes.

Now does that include -- I guess, what are your assumptions in terms of gains? Like, I think you had some gains this quarter in securities and the one-timer with the deal. Is your guidance excluding that or including that?

The gains on the sale of the loans?

No, the (multiple speakers) --

The security gains?

Yes.

I think, yes, I would say there's a potential for them to actually go down, but I think we're going to monitor that. And I think in all of that, we're looking for opportunities. And when we find an opportunity to potentially, as I said, take the gain, if we move out a little bit further -- and not a lot; again, we're trying to keep the duration of it two to three years -- we'll do that.

But I think it really is dependent on where the market goes and how we see the overall position of the portfolio. So we're aren't doing it just s to pick up the gains. I think it really comes back to structuring the portfolio. So I'm not really going to forecast on that, but I would suggest that it will be this range or potentially lower.

Okay. So I think your guidance before said you got, like, $10 million of unrealized securities gains in [OCI]?

Yes. And you know -- well, as we look at that, the discussion we've had with our portfolio managers is if there's, again, an opportunity to look at some of those gains and better position the portfolio, we'll certainly do that. But at this point, we don't have -- we're not forecasting a material increase in gains and potentially a decrease.

Okay. Thanks, guys.

Jeff Davis, FTN Equity Capital Markets.

Ken, if I heard you right, non-performers are expected to find a peak late this year or early next year. Is the reserve building thus far pretty much run its course and from here it's provision matches net charge-offs?

If you'd like to think so, Jeff. You hate to be too predictive on where things go, because we, like everybody else -- our portfolios will follow the economy. I do -- it appears we've had a run up here in this quarter with what I can put my finger on and see that will be reduced in this coming quarter.

I certainly don't see problematic credit standing in line to take their place. We seem to be getting to the bottom of a lot of the problems, but I would kowtow all that with saying it depends on how long this economy drags out the way it is. Because businesses that are having trouble cash flowing now is the longer we go, the more of those that will find it problematic to keep paying their debt.

Okay. And so, not to put words in your mouth, but it sounds like your monthly credit review would be that credit downgrades have sort of run their courses; you're not seeing fours turn into sixes and sixes turn into sevens so frequently?

Not as quickly. Not as quickly as we are bringing resolution to other ones that are there.

Okay, thank you.

Brian Martin, FIG Partners.

Just a quick question part on Jeff's. The 30 to 89-day past due, how do those look at this point?

Just one second, Brian. We are looking at -- those are approximately 30% to 35% of what the off accruals are.

Okay. And how does that stand relative to last quarter?

They are up, but remember -- they are up by about $9 million quarter-over-quarter -- $7 million quarter-over-quarter.

Okay. That's all I had. Thanks, guys.

Thank you. And at this time, we have no additional questions. I'd like to turn it back to Mr. Fuller for any closing remarks.

Thank you. I'll bring it to a close. In conclusion, I think we're seeing solid core operating earnings, which is the strength. We've got a strong net interest margin in combination with increased non-interest income, which is providing earnings sufficient to cover our provision expense, our increased FDIC assessments, and pay both our common and preferred dividends, while at the same time, adding to capital.

Deposit growth, as I mentioned, is exceptional and it's in the categories that we've targeted. We've reduced short-term borrowings and brokered funds, and we continue to improve the composition of our balance sheet with high-quality securities.

In short, I feel very comfortable with our earnings power, and continue to see excellent opportunities ahead in M&A activity in our current markets.

I'd like to thank everybody for joining us today and hope you can all join us again at our next quarterly conference call, which is scheduled for January 25, 2010 -- another year.

So, thanks, everybody, and have a good evening. Good night.

Thank you, sir. Ladies and gentlemen, if you'd like to listen to a replay of today's conference, please dial 1-800-406-7325 or 303-590-3030, using the access code of 4172485 followed by the pound key.

This does include the Heartland Financial USA third quarter conference call. Thank you very much for your participation. You may now disconnect.