Heartland Financial USA Inc (HTLF) 2012 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the Heartland Financial USA first quarter conference call. During today's presentation, all participants will be in a listen-only mode. Following the presentation, the conference will be open for questions.

(Operator Instructions).

At this time, I'd like to turn the conference over to Scott Eckstein with Financial Relations Board. Please go ahead, sir.

Thank you, and good afternoon, everyone. Thank you for joining us on Heartland Financial USA's conference call to discuss first quarter 2012 results. This afternoon, we distributed copy of the press release, and hopefully you've had a chance to review the results. If there is anyone online who did not receive a copy, you may access it at Heartland Financial USA's website at www.htlf.com.

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. The management will provide a brief summary of the quarter, and then we will open up the call 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 bearing the Company's hopes, beliefs, expectations and predictions of future are forward-looking statements, and actual results could differ materially from those projected. Additional information on these factors are 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. At this time, I would like to turn the call over to Lynn Fuller. Please go ahead.

Thank you, Scott, and good afternoon. We certainly appreciate everyone joining us this afternoon as we review Heartland's excellent performance for the first quarter of 2012. For the next few minutes, I'll touch on the highlights for the quarter. I will then turn the call over to John Schmidt, our Chief Operating Officer and CFO, who will provide additional color on Heartland's quarterly results. Then Ken Erickson, our EVP and Chief Credit Officer will offer insights on credit-related topics.

Well, we're certainly off to a great start this year, reporting the best quarter in our 30-year history. In today's earnings release, we reported record net income of $12.8 million, more than triple last year's first quarter earnings of $4.2 million. Annualized return on common equity for the quarter was 17.27%. The Company's exceptional performance is a result of a combination of factors, including a remarkable net interest margin of 4.23%. On a per share basis, Heartland earned $0.71 per diluted common share, compared to $0.18 per diluted common share for the first quarter of 2011, and $0.31 per diluted common share in the fourth quarter of last year.

Our pre-tax pre-provision earnings also set a quarterly record at $21.4 million, compared to $15.4 million for the first three months of 2011. Net interest margin jumped by 15 basis points over the linked quarter from 4.08% to 4.23%, matching the best margin we've seen in recent years, and equal to that of the second quarter in 2011. Our strong margin is the result of continued loan growth, and improvement in funding costs. We have now maintained our margin above 4%, for eleven consecutive quarters.

For those of you who follow Heartland, you know that the reduction of nonperforming assets has been our number one priority. And I'm extremely pleased to report more good news on that front, as our credit quality continues to improve. Over the last 12 months, we have reduced our NPAs by over 1%, from 3.14% to 2.07%. And for the quarter, we reduced NPAs by over $12 million. With this reduction, nonperforming loans, now that's exclusive of those covered under the loss sharing agreements, now represent only 1.97% of total loans. And our allowance as a percent of nonperforming loans has increased to 79%.

Now turning to the balance sheet. Total assets remained unchanged, at $4.3 billion. During the quarter, portfolio loans increase bid $51 million, which met our expectations for new loan growth. Year-over-year, loan growth is slightly in excess of 7%. As I've shared with you in the past, our plan has been to move dollars out of securities and into quality loans, with securities now representing 28% of total assets, down from a high point of 32% in last year's third quarter.

In pursuit of our second highest priority, quality loan growth, we are devoting significant resources in the development and management of our commercial and retail sales forces. Our efforts are fueled in part, by participation in the US Treasury Small Business Lending Fund. With a goal of approximately $92 million in qualifying net new loan growth, our progress has been very good to this point, with growth approaching $20 million in qualifying loans. Assuming we maintain this pace, we would expect to benefit from a reduced dividend rate on the preferred shares, while playing an essential role in the economic recovery of our markets through the support of small businesses and new job growth.

Now, shifting to deposits. Heartland margin continues to benefit from favorable changes in deposit mix. Year-to-date, deposits increased by nearly $66 million, with demand deposits growing by nearly $34 million. Compared to this point last year, demand deposits are up 21%, and timed deposits are down 11%. At March 31, demand deposits represented 24% of all deposits. Timed deposits also represent 24%, while savings and money market deposits account for 52% of total deposits.

Well, in terms of capital, our tangible capital ratio increased to just under 6% at 5.93%. Our regulatory capital ratios of risk-based capital and Tier 1 capital continue well above required levels, and again, I would emphasize our very shareholder-friendly equity structure. John Schmidt will provide more detail on our balance sheet and income statement in his comments.

Now, I would like to update everyone on the growth of our residential real estate operations. The continuing wave of residential refinancing activity in the first quarter, combined with the expansion of our mortgage unit resulted in a significant increase of $7 million in gain on sale of loans over Q1 2011. The timely expansion of our Heartland Financial USA Mortgage and National Residential unit is producing exceptional noninterest income. Further expansion is envisioned, as we build our teams of loan originators and support staff, both within and beyond the Heartland footprint.

In the first quarter of 2012, we originated over $290 million in mortgages and expect this number to grow, as we methodically add new loan production teams throughout 2012. While refinance activity currently represents approximately 60% of our originations, we plan to shift our mix from refinance to purchase originations, as interest rates rise and refinancing activity falls off. Appropriately, I want to recognize the extraordinary efforts of the Heartland mortgage team, as Jeff Walton and team continue to build out our loan origination engine.

Now moving to M&A. In addition to solid organic growth, expansion of our banking franchise through mergers and acquisitions continues to be a high priority. Opportunities are plentiful in all of our markets except New Mexico, and I would expect at least one, if not two acquisitions, may be announced in 2012. In terms of how and where we invest our capital, we have prioritized only the most profitable growth opportunities within our current footprint. That being said, I would consider accretive transactions that open new and attractive geographical markets in both the midwest and the west.

Well, our consumer finance subsidiary, Citizens Finance Company, continued at an impressive pace in the first quarter, with net earnings of $907,000. At the same time, Citizens delinquency rate has declined to 3%, it's lowest ever. Citizens currently operates from ten locations in the Midwest, with an eleventh office planned for opening soon in Elgin, Illinois, and plans for a twelfth office later this year.

In concluding my comments today, I'm pleased to report that at it's April Board meeting, the Heartland Financial USA Board of Directors elected to maintain our dividend at $0.10 per common share payable on June 8, 2012. I will now turn the call over to John Schmidt, for more detail on our quarterly results. And John will then introduce Ken Erickson, who will provide commentary on the credit side. John?

Thanks, Lynn, and good afternoon. In my remarks today, I'll look to add additional depth to the press release, relative to the first quarter results. Additionally, I'll provide estimates and some key operating metrics for the second quarter, and remainder of the year. To reiterate Lynn's comments, we are very pleased with quarter results, as we showed improvement in almost every key operating component.

Let me start with the balance sheet. In previous calls, we discussed our strategy of moving out of investments into loans. Obviously, this quarter we effectuated the strategy very well. During the quarter, investments decreased by $105 million, with the dollars moving equally into loans held for sale and held to maturity. The decrease in the portfolio provided an opportunity to sell off some lower yielding securities. As a reference point, the portfolio's duration currently sits at 4.16 years.

Relative to the loan side as Lynn mentioned, we were very pleased with the growth in both loan categories. Loans held for sale grew $50 million during the quarter, and we would expect the average balance to continue near the current $100 million for the rest of the year. The held to maturity loan growth of $51 million exceeded my forecast, but certainly moves my estimate to the $200 million level Lynn emphasized last quarter.

Regarding deposits, I won't add any additional color to Lynn's, other than to say that the continuing improvement in mix certainly contributed to our reduced cost of funds and in turn the expanded margin, which I'll discuss later in my comments. Other borrowings reflected a $4.5 million increase during the quarter. Activity during the quarter included the payoff of a $5 million trust preferred security with a coupon of 10.6%. Consistent with the payoff, we ed our private placement of senior notes by $10 million. At the same time, we stretched our maturities with the $6 million, with the final $6 million tranche coming due in 2019. The entire $37.5 million of this debt bears a coupon of 5%.

Moving on to the income statement. As I mentioned last quarter, our margin has been difficult to forecast. Obviously, this quarter was no exception. While we had suggested the margin would trend closer to 4%, as Lynn noted we experienced a 4.23% margin for the quarter. This outperformance over my 4% estimate, contributed approximately $2 million during the quarter.

I would attribute this outperformance to the following. One, improved investment portfolio performance. Consistent with the sales I mentioned earlier, the yield on the investment portfolio improved quarter-over-quarter. Loans held for sale which primarily reflects the mortgage pipeline nearly doubled from the previous quarter. Given the current rate environment, the additional $50 million in outstandings added an approximately 375 basis points of margin.

The combination $12.5 million of increased loan outstandings over my estimate of $37.5 million, and reduced non-performing assets of $12 million also added to this outperformance. Finally, we are able to reduce our funding costs faster than anticipated with a 9 basis point reduction quarter-over-quarter.

Going forward, we see potential for decreased returns in the investment portfolio. As I mentioned earlier, we see the average balance of loans held for sale continuing near the $100 million level for the remainder of the year. I also mentioned that we would expect loans to grow by a total of $200 million for 2012. We would anticipate much of this growth to be funded out of the investment portfolio, which will certainly help to mitigate the negative impact of the investment portfolio cash flow. At the same time, we are experiencing pricing pressure on existing credit, which will likely increase throughout the remainder of the year.

Finally, relative to our cost of funds, while we feel that we are approaching an effective floor on our non-maturity deposits, we currently have $275 million of CDs maturing in the next nine months, with an average rate of 1.45%. Included in this total, are $130 million of CDs maturing in the next three months, at an average rate of 1.46%. In each case, we would expect a 50 to 60 basis point reduction in our costs. While we are cognizant that our CD portfolio needs to remain a reasonable part of our funding structure, most of our attention remains focused on growing demand and savings deposits.

With that said, I would anticipate that our margin would decrease from the current level. However, I am confident that we can hold the margin above 4% for the quarter, and quite possibly for the remainder of the year. Finally, our modeling would suggest that our balance sheet is very well-structured for an increase in rates scenario, with a 2% margin decrease in year one, and no impact in year two, assuming a 200 basis point rate shock.

Relative to non-interest income. Non-interest income totaled $23 million for the first quarter. Excluding the security gains, non-interest income increased $4.6 million quarter-over-quarter. As with last quarter, gains in sale loans was the largest contributor to the improvement, representing a $3 million increase. Relative to the gains in sale loans, certainly refinancing activity was the largest driver for this quarter's activity representing 60% of the total. Going forward, we would expect second quarter activity to effectively mirror Q1 results.

Other production in the quarter, 70% was done on a servicing retained basis. We would expect at least a similar percentage in the second quarter, with our mortgage servicing rights amortization trending down from the $1.7 million recorded during the quarter. In addition to the $3.9 million of security gains recorded this quarter, we also recorded a $980,000 other than temporary impairment writedown on 3 securities in our bond portfolio. The charge related to a decline in the credit quality, credit quality of these securities.

However, we do not anticipate any further declines on these securities, or any other securities within the portfolio due to credit quality, but will continue to review this quarterly. Based on our analysis, we believe it is prudent to continue to hold these securities, as the economic value exceeds the market value.

Finally in this area, other noninterest income reflected a $2.4 million increase quarter-over-quarter. Most significant in this was a $2 million gain on the sale of two low income, senior housing projects, we developed over 15 years ago.

Focusing on noninterest expense, while the total noninterest expense was flat quarter-over-quarter, we continue to see increases in compensation costs, primarily associated with the mortgage activity and expansion. Contained in this total is $3.2 million of commissions associated with mortgage production. This figure includes $900,000 of sign-on bonuses associated with new mortgage loan originators coming into the organization. This compares to $2.3 million in Q4 2011, with $676,000 representing sign-on costs.

Also included in this quarter's total is $759,000 of additional stock-related compensation expense, in comparison with the $349,000 recognized in the previous quarter. We would anticipate this expense to approximate $430,000 per quarter throughout the rest of 2012. The expense is higher in the grant quarter, due to the required acceleration of expense for those meeting age and service requirements.

Net loss and repossessed assets decreased $1.4 million as compared to the fourth quarter of 2011, but still impacted noninterest expense by $2.9 million. As we previously discussed, we are very diligent about assessing our impaired assets each quarter. Contained in other expenses is an accrual of $300,000 associated with potential mortgage buyback risk. We continue to thoroughly assess this risk each quarter. Also included in the other expenses is a $302,000 charge, associated with the early payoff of the previously mentioned trust preferred security. Given the current level of earnings, we feel the effective tax rate will be in the 30% to 32% range.

In closing, I provide the following, relative to anticipated performance metrics for the remainder of 2012. One, we will see reduced investment portfolios returns. Two, we'll see loan growth in 2012, in the neighborhood of the $200 million range. Three, provision costs continuing to moderate relative to 2011.

Four, deposit growth somewhat slower than 2011, but focus on the demand and non-maturity deposit areas. Five, the margin continuing above 4%. Six, gains of sale loans continued at the same level as the Q1 total. And seven, the overhead to remain in the same relative range.

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

Thank you, John, and good afternoon.

It is my pleasure to report continued reductions in nonperforming assets, and improvements in the credit quality at Heartland. I'll -- we will begin by discussing the change in nonperforming loans in the first quarter. As already mentioned, Heartland experienced a $7.7 million reduction in nonperforming loans in the first quarter, including those loans under loss share agreement. New credits added to nonperforming, totaled $3.4 million. We reduced our nonperforming loans by $11.2 million, of which $8.8 million went to other real estate owned through foreclosures, or deed in lieu of transactions. Please refer to the table within the press release that reconciles the changes in nonperforming assets for the quarter.

As stated in our earnings release, $26.6 million of the $49.9 million of nonperforming loans excluding those covered by loss share agreements, resides in 13 credits where individual exposures are greater than $1 million. The release details the markets that originated these credits. In comparison, we had 25 credits greater than $1 million, representing $53 million in nonperforming loans at March 31, 2011. The industries for these credits are also detailed within the release.

The largest concentration within these nonperforming is in lot and land development, which represents 31.5% of the $26.6 million. $2.4 million of our nonperforming loans are covered by government guarantees through World Development, FDA, or FSA. And on March 31, we had a total of $31.2 million in TDRs, of which $21.4 million were accruing performing loans.

Next I'll comment on charge-offs and provision expense. In the first quarter, Heartland reported net recoveries in the amount of $200,000, and recorded a provision expense of $2.4 million. The allowance, as a percent of loans increased from 1.48% to 1.55%. This slight increase is the result of an additional $1 million in reserves associated with impaired loans, and an increase in some of our qualitative factors associated with the recent increase in loan volume.

The reduction in the allowance as compared to March 31, 2011 is due to the reduction of loans considered impaired, and the specific reserves associated with those accounts. The coverage ratio, which measures the allowance in non-performing loans, increased from 64% to 79%. We anticipate the coverage ratio will continue to increase, as nonperforming loans continue to be reduced.

Delinquencies in the 30 to 89 day range increased slightly in the first quarter. But $6.6 million, or nearly half of the 0.55% delinquency, is related to two borrowers whose renewal did not occur before the account went 30 days past due. So, delay in renewals was not related to credit quality issues.

Regarding expected resolution of the nonperforming loans, I can state that our collection efforts in the second quarter of this year are expected to result in a further reduction of $10.3 million of the nonperforming loans recorded as of March 31. Of this amount, $5.3 million is expected to move to other real estate, and $5 million is to be paid down or restored to accrual status. Relative to other real estate, including those assets covered under loss share agreements, as shown in the table inserted in the press release, other real estate decreased by $5.5 million in the first quarter.

Total owned or residential real estate, including all properties intended to be used as one-to-four family residences is $5.7 million, while owned commercial or agricultural real estate is $33.2 million. Included in the $33.2 million, is $18.7 million of various lots, land and land development. During the first quarter, $8.7 million was moved into other real estate. Sales resulted in $12.1 million, while OREO writedowns were recorded in the amount of $2.1 million. Since the end of the first quarter, $6.3 million of other real estate owned has already been sold or contracted for sale, with most of those sales expected to close in the second quarter. This includes $2.9 million, or 15.5% of the lot and land inventory.

Regarding portfolio diversification, we remain well-diversified with $1.8 million, or 71% of our loans are either fully or partially secured by real estate. Of the $885 million in loans categorized as non-farm non-residential, 59% or $518 million is owner-occupied. A review of the $368 million commercial real estate non-owner-occupied portfolio at March 31, shows that $7.8 million or 2.1% of that portfolio is classified as nonperforming. These loans carry an impairment reserve of $46,000. Our exposure to non-owner-occupied properties increased by $21 million in the past quarter.

We have a total of $109 million in construction, land, and land development loans. $12.2 million or 11.2% of this portfolio segment is on nonaccrual. This is a reduction from $15.6 million at December 31. Consistent with our allowance and impairment methodologies, the majority of the expected losses on these loans has already been recorded by a charge to the allowance, which results in only $240,000 in specific reserves associated with these accounts at March 31. Our exposure and construction land and land development loans was reduced by $7 million from December 31.

My final comments will be directed at the retail portfolio. Our retail portfolios continues to perform quite well. Foreclosures on 7 residential properties for $366,000 were completed in the first quarter, 27 foreclosures on $2.5 million of loans are currently in process. Historically, several of these get resolved prior to final action.

Citizens Finance, our consumer finance company, performed well in the first quarter. Net loans outstandings are $62 million, an increase of $2.6 million since the end of the year. Annualized net charge-offs year-to-date are 2.21%, and delinquencies were 3.01% at March 31, down from 3.79% at December 31.

In conclusion, I continue to be optimistic regarding the positive trends we are seeing in the portfolio. Our nonperforming loans continue to decline, since their peak at December 31, 2010. As mentioned earlier, we expect a further reduction in nonperforming loans in the second quarter, as we gain control over assets, and move them to other real estate. Our 30 to 89 delay delinquency does not indicate any significant problem loans with payment difficulties. The sale of $12 million in other real estate owned gives me confidence that buyers are re-entering the market. To help facilitate the sale of, and exposure to our other real estate, we have created an OREO website. It is linked to each of our bank's websites, or can be directly accessed at www.htlfproperties.com.

Loans held for sale continue to grow, as our mortgage production platform continues to expand. held to maturity have also seen consistent growth over the past three quarters, with growth of $181 million since June 30. The growth was primarily driven by the growth in commercial and commercial real estate, which comprised over 73% of the increase. Pipelines remain strong, which should result in further growth in the second quarter.

I do not expect that the recoveries will exceed charge-offs on a go-forward basis, and I do not expect that we will be void of any new nonperforming loans. But without a fall back in the economy, 2012 should show significant asset quality improvements over the prior year.

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

Thank you, Ken. Now we will open the phone lines for your questions.

Thank you, sir. (Operator Instructions).Our first question is from the line of Jon Arfstrom with RBC Capital Markets. Please go ahead. Please go ahead.

Hi, good afternoon.

Hi, Jon.

Hi Jon.

A question for you on loan growth. Is there any theme or any story there? I know last quarter, when you said you would be disappointed, with the low end of the guidance. But I guess you got your wish. But is there any, any story or any big reasons for that growth?

Well, I, I guess my thing, like Ken talked about, my opinion is that, when we saw fourth quarter growth of $100 million, and I saw our pipelines continue to build, producing somewhere north of $50 million in growth. I just felt with the pipelines developing, that we were going to see a little better loan growth than what we were anticipating. I know John's been careful not to be too aggressive on giving you guidance on loan growth. I guess I tend to be, I tend to be a little more optimistic. I don't know if you have anything to add it that, Ken?

No. I think we've commented on in earlier calls that we have made an effort to, to free up our real rainmaker's out there, make sure that they are focused on, on growth and calling on the customers, better target marketing and better time on their parts. So a lot of good efforts on all of their parts.

Yes. My comment was, we're, we're spending a lot of time and effort in, in improving our sales process, on both the commercial and the retail platforms. And, I'd echo what Ken said. I think we're becoming much for efficient at the front end of prospecting credits, that fit our front end guidance. We're a lot more disciplined on giving front end guidance for the types of credits that we want to pursue. Again, we're freeing up our very best salespeople, to get them on the street. And everybody knows that if we don't convert securities into quality loans, that we're going to suffer a reduced margin. So it's a very high priority. It's number two on our priority list. And I think everybody is pulling the same direction.

And John, you commented on this in your prepared comments. But can all of you, just give us some thoughts on pricing, how competitive is it? And is this something we should be overly concerned about?

I think, Ken, probably sees it more, even more than we do. But I think that we see a ramp in it. It's not rampant at this point, but we do see it ramping up, as far as the pressure. It's coming probably in the -- in some of our larger markets, some of those more approximate say to, Chicago. But I think that some of the deals we are hearing, are LIBOR plus 200 in that range. And again, that's not pervasive, but it's -- we continue to hear more of it, coming down the pike.

We, for a long time, sold not on price, but on value. And that's something we continue to reinforce, that if we can't demonstrate to our clients that we can make a quantifiable, meaningful improvement in what they currently have, that we don't deserve to have the business. So we're not going to give the product away. We can, we can get reasonable returns still in the investment portfolio, albeit much less than we have historically. And it just doesn't make any sense to us, to be to giving loans away, taking both interest rate risk along with credit risk. And there is just some business, we won't do. If it's going to be priced that tight, and somebody is just focused only on rate, then maybe it needs to go somewhere else.

And I would echo that, on some of the very largest transactions we have seen, they have been priced down as John had mentioned. But the majority of what we see, on solid credits, which are the size of our bread and butter, is usually LIBOR plus 300 or 350. And we're a relationship bank where, where we're seeing the entire transaction, relationship come in versus the transactions, so.

And the only thing I'd add to that is, an awful lost our clients are still priced off prime. And we're still able to get prime plus on, on a fair number of our credits.

And a fair amount of floors, that the floors do get pushed down a little bit, on an annual renewal. But we still have floors on a number of our credits.

Which I just add to that piece, Jon, which explains why we had on -- upper rate environment, in the first year, we have a slight depreciation in our margin, as we model it 200 basis points up. But once we burn through those floors, we, we really don't see much exposure of our margin, if any.

Well, that's helpful. Thank you.

Thank you. Our next question comes from the line of Stephen Geyen with Stifel Nicholas. Please go ahead.

Hi Steven.

Hi, good morning or good afternoon, sorry. Just curious, you mentioned the favorable pricing on mortgage loans sold. And what was the gross margin? And then maybe you can give us your thoughts on how much is related to market factors versus systems that you have in place?

The overall gross, we're looking at -- it's certainly, probably in the near, when you look at, without MSR, with MSR, Steven, maybe the question.

I'm sorry?

Are you looking, just -- the?

The gross, the gross number.

The gross number on originations?

Yes.

It would be probably in excess of 250 right now.

Okay.

(Multiple Speakers). -- with MSR.

Right. And do you think, is, I guess I'm trying to get a sense of -- there seems to be some very favorable pricing out there right now in the mortgage market. How much do you think of that -- that you are getting, that spread that you're getting? Do you think it's related?

Just related to volume coming through, you mean, and some of the issues, just a heavy refinancing activity are certainly enhancing our margin in the current marketplace. Is that a quarter? It probably is, somewhere in that neighborhood. If that's, in fact, your question I think.

Yes.

There's a lot of volume going through the pipeline, which we have seen some ability to enhance our pricing as a result.

I would add, though, our goal longer term -- and if you look back in time at our legacy banks, we were not picking up as much margin, as just part of the sales process that -- we weren't doing as good a job of getting the margin we get today. Our goal is still to work up towards 300 basis points on a gross.

Yes.

That's our goal, we're not there.

Yes.

But that's our goal.

Okay.

Dependent on the type of production. And but -- (Multiple Speakers).

Yes, type of production.

And I guess, probably be to more accurate, we're probably right around 275 right now.

Okay. All right. That's helpful. The security assets were down. Looking further out I guess, what kind of ratio are you comfortable with, drawing that down to?

Hopefully, as an organization, we've pegged about 20%, Stephen, of --

Okay.

-- of our overall asset base and investments.

And bank by bank, some banks may go as low as 15%. We don't like them to get below 15%, securities to total assets.

All right.

And maybe in response to that. Certainly, that's one benchmark, but we do spend a long time looking at the overall liquidity profile of the banks, and then the Company as a whole. We continue to put some additional metrics in place. And also some stress testing and liquidity by bank, such that investments portfolio 20% that we've spoken to, is just one additional benchmark of how we monitor liquidity on a bank by bank basis.

Yes. And, Lynn, you mentioned acquisitions. What gives you confidence that some of those banks that you are talking with are going to pull the trigger sometime in the near future?

Well, our pipeline of, of M&A prospect is, is as deep as I've ever seen it. And the thing that gives me confidence, that in markets that we're already in, where we'll have anywhere from two to three prospects that we're talking with at the same time if. If one doesn't take our pricing, which will be accretive to our earnings, we can quickly go to the next. And that's the position you want to be in, whether you're lending money or whether you are looking for partners. You want to have a deep enough pipeline, so you don't have to take a deal that doesn't makes sense.

And maybe from their point of view, what do you think is going to drive their decision? And I suppose it's different from bank to bank, but maybe kind of a general overall theme?

It is different from bank to bank, but one of the things that we see is that some of the smaller banks are just getting tired. It's been a long haul through this recession. Some of the banks have aged management, and don't have a great succession plan in place. Some of the bank's shareholder base is at a point, where they need to get some liquidity. And what we preach is that why, don't pick up a bank stock that's trading as cheaply as ours relative to, to our earnings capability, and ride the stock up, versus taking somebody's currency that's already trading at a heavy multiple to current market and ride it down. So we're finding interest in deals, that are anywhere from hard cash to all stock, or a mix of both. And then of course, you've got branch acquisitions, where banks that are troubled are trying to dispose of branched that fit into our footprint.

Okay. Thanks for your time.

Thank you. Our next question comes from the line of Chris McGratty with KBW. Please go ahead.

Hi, good afternoon.

Hi, Chris.

Lynn, just a question on, on acquisitions again. What type of size are you thinking, in terms of doing multiples at the same time? What are the sizes of assets, you kind of ballpark?

The largest ones that are in our current pipeline right now, would be about $400 million.

Okay.

That's the largest. And they work their way down to, in some cases if it's just a branch acquisition, it might be even a bit less than $100 million, if it's just a few branches.

Okay. And then can you just remind me kind of where you're comfortable running? Obviously, the earnings proved significant this quarter. Where are you comfortable running -- tangible common?

We'd like to be at 6% level. We told new the past it's been -- our range is 5% to 6%. We like to keep it up toward the 6%, and over time work it, may be up between 6% and 7%.

Okay.

But at present, as long as we can remain around that 6% range.

Okay.

I'm comfortable with that.

So certainly that, as Chris said, that, that impacts the overall consideration we look at. If it's a larger deal, as Lynn refers to, we're going to look to structure in such a way that the equity portion is a relatively significant portion, such that we don't see too much impact on that overall 6% goal. It's not to say, we won't come off that a little bit relative to an acquisition, but always building toward that 6% goal. Always in mind too, that we're going to have an accretive, or soon to be accretive transaction as we go through it.

I have just one question on the credit. With the growth this quarter, you built, you built the reserve ratio. But the outline for the outlook for credit looks, sounds pretty good. How should I think about, just reserve levels as a percent, and relative to kind of charge-offs? Will you draw it down a bit going forward?

Not until we see some significant changes in credit quality. I think you heard me say that we increased some qualitative factors as it went with new loan growth, Just looking at the new loan volume coming on we increased a couple of basis points in that end of the cycle. We do have still, I think it's 3.5% to 4% of our total loans are impaired with, with a specific reserve. That continues to come down on a quarterly basis. But I'd mentioned that the majority of the reduction year-over-year of the allowance, came with about 30 basis points coming out of the allowance, that was formally impaired loans that are now gone.

So as we see credit quality improve, there will be a slight reduction in the allowance percentage as we go long-term. Will that happen in 2012? It's hard to say. We haven't gotten a whole lot of year-end financials in yet, to look in the changes of credit quality of companies year-over-year. Charge-offs, I expect them to be significantly less than they have been in the previous few years. But I don't expect them to be non-existent like they were in this first quarter.

That's fair.

(Multiple Speakers). And just to add that, we take such a granular approach to the overall allowance and the building of the allowance, so we -- as Ken pointed out, points out, we need to see the overall financials come in. And then we certainly weigh the [past FI] component on that. The impairment is assessed very diligently each quarter, and then the overall qualitative factors built into it as well so. I mean, I don't see any, certainly wouldn't do it arbitrarily, and it's going to be deliver ultimately by performance in the quality of credit as it should. And then ultimately, the driver of that is the improvement of overall economy.

All right. Last one, John, the $2 million low income gain, there is nothing to suggest that would reoccur, right? Is there is anything left?

Nothing on the horizon right now.

Okay. Thanks a lot.

Thank you. Our next question comes from the line of John Rowan with Sidoti & Company. Please go ahead.

Good afternoon.

Hi, John.

Just one really quick question. Lynn, you referenced that your regulatory ratios remain well in excess of, what you need to have obviously -- I'm just wondering with this swap down securities into assets, whether or not that made any meaningful difference in the ratios as of the end of last quarter?

It, we were so far above the required levels, that I'm sure it came down a bit. But again, we were in some cases, double the required levels, as I've shared with you in the past. So there may be some reduction, but I mean, again, our margins there, unbelievable.

Okay. All right. Thank you.

Thank you. Our next question is from the line of Jeff Davis with Guggenheim Securities. Please go ahead.

Good afternoon. Good quarter.

Thanks, Jeff.

Thanks, Jeff.

A couple questions. One, following up on the last question then, is risk weighted assets, what were they this quarter? If you don't have that, that's okay. I can --

Jeff, we definitely have that. And that risk-weighted assets are driven by roll up of the of the call reports. And we're just about ready to put a final touch on those, but they aren't quite there yet.

Okay. That's fine. I'll get it when it comes out. The bonds, the two or three bonds that were impaired for $900,000, what were they and, anything else like that in the portfolio? And then, just -- go ahead.

These are -- I'm sorry, Jeff, I didn't mean to interrupt you.

Well, I mean just a follow-on question was, do you still have the, I believe the seven Z tranche positions at the parent level?

Yes. So if you look at the, the three bonds that were impaired, they were all private label CMOs, which were purchase three years ago plus. The overall whole return on those securities, even considering this write-down would be still double digit. And as I've attempted to indicate in my comments, we're still looking to hold these securities despite the write-down. We still think there's value in those securities so. I mean, we've been monitoring them for a while. And just, and the more we assess it, felt it was the appropriate time to take it.

And John, John, excuse me for interrupting. You may have said it during your comments, and I just, I just missed it. How much are the three securities par?

In aggregate?

Yes.

I want to say it's, Jeff, going to be an estimate, I think about $7 million would be fairly close, if not, a little bit less than that.

That's fine. And then how big is the private label book?

Still about $100 million trending down, sorry.

Yes. Okay.

Again, we, this has been a one off, those three securities. We feel very confident in that overall portfolio. They're all very well-seasoned at this point obviously, very well structured. And just, we just saw erosion of some the [support] tranches which required us to move. And this was a fairly significant move this quarter, is why we saw it. We've actually seen some enhancement in some, in the performance in some of the other private label performances, relative to the burn through of the support tranches. The -- your other question was to the, the Z tranches, and those still, we have not sold any more of those.

And still the seven at the parent?

There are.

Yes. Okay. And then maybe, Lynn, I don't know if it's for you or Ken, well, or for you, John. Is just a comment, press is full of reports on farmland may be overheating, in terms of what people are paying for it, and presumably what someone is lending against it. You might pencil in the Federal Government first. And I believe the Kansas fed, it put out maybe similar comments. If you can comment on what you see in the Ag sector, and how you're approaching lending there?

In our forward guidance process, that we meet quarterly and go over economic indicators, and look for bubbles being created, we have identified over the last probably 18 months, that there's been a bubble forming in land values and commodity prices. And we do see the government coming in, and lending much more heavily on farmland acquisitions, than we were willing to lend. We will run into anywhere from $6 -- in our area $6,000 to $8,000 per acre on productive land. And we pretty much tap out at $3,000 an acre. We are just not going to follow that pricing up. So I think I said it before, that if we would have had the same discipline on commercial real estate and development property out west, as we've had on Ag credits throughout the last 25 years that we have been lending into that sector, we wouldn't have had the losses that we incurred over the last three to fours years.

I'll echo that. We, we've, we've said for a long, long time in that Ag market, that we will loan, what we consider to be the productive value of that property, not what the current market value may be. Because you still have to be able to turn a dime, and make the payment. So I had a meeting just earlier, of this last week, with a few people including the head of our Ag department, trying to make sure that we still understood what we view to be productive value. And Lynn mentioned roughly $3,000. And, and that's about our upper limit on good productive property.

The larger farm credits that we finance that are properly capitalized, understand that too much leverage in that business is not a good thing for sustainability. And we shock our credits for lower commodity prices, whether it be milk, corn, beans, et cetera. And we try to make sure that we're not lending into those clients, anymore than what they can stand, at shocking commodity prices down to pretty low levels. And the good guys get that. The guys that want to over level, over lever, they have got to go somewhere else.

Has much property changed hands in effect, is a lot of new leverage coming into the system, because a lot of land has changed hands? Or is it, is it few transactions, but prices are up, and therefore a broad generalization is being made that everyone's levered?

I think, well, I know from reading some data in the states of Iowa, Illinois and Wisconsin, that something like 80% of the farm sales are sales to neighboring farmers. And in many cases, these are Ag operations, that have grown through generations, and have become sizable. And so their basis and their current land holdings is quite low. And that's where most of the sales are occurring. Now there are some people that are speculating as always. But those are not people that we're lending money to generally.

Okay. Well, and last question shifting gears. Can you, can you -- Arizona's numbers are getting better? What is -- how's the Phoenix market feel, and et cetera?

I just read an article on that today on that, housing is picking up down there. You are starting to see new development. Their foreclosures are much reduced from last year, and housing prices have stabilized, and are starting to come up a little bit. So still very good affordability index on housing in the Phoenix area. But that has seen about as good a turnaround as anything.

Thank you very much.

Thank you. Our next question comes from the line of Daniel Cardenas with Raymond James. Please go ahead.

Good afternoon.

Hi Dan.

Hi Dan.

Most of my questions have been answered. Just have a couple. In terms of your loan growth outlook for 2012, can you maybe give us a little bit of flavor as to, in terms of geography, where you expect to see that growth coming from in your footprint? And then, what role if any, do participations play in it?

Are you talking about participations from non-Heartland banks, or participations between our sister banks?

Let's start with non-Heartland banks.

Very, very little. We just don't see a lot of participation from non-Heartland banks. We do significant participations across the sister banks. But I'd say, the production of loans is pretty broad-based. We are seeing good production out of the Midwest, with the exception it slowed down a little bit in the Rockford area, but they had some reasonable production in the latter part of 2011. Minnesota is showing some good improvement in production. We are seeing pretty good production in Arizona. Denver is still a bit slow, and New Mexico is a bit slow. I would say that between -- well, John or maybe Ken, I think the slowest markets that I see, would be Denver and New Mexico at this point. New Mexico historically has been a good producer. But they came into the recession late, and they are a little slower coming out of it.

And relative to their participation, I think one of the biggest growth, at least certainly in percentages is showing it's going to state bank. But a lot of that would actually represent participations between Heartland banks.

And I am looking at our current pipeline of just loans to be funded, that have been committed to by us and by the customer. And this includes the participations these banks would pick up. So it's not completely driven by the market that is originating it. But where we sit at the end of the quarter, 35% of it is coming from DD&T. These are just loans ready to be booked now. 30% of it is Wisconsin, 10% of it is Arizona, and then Albuquerque market is little over 10%. So those are the strongest markets right now that we have now.

And, great -- thank you. And then just kind of shifting gears, and going to back to the -- to your M&A strategy. Can you talk a little bit about seller expectations, are they beginning to kind of, come more in line with your thinking?

Well, the ones we are talking to are, to a great extent. And I am not suggesting we will be successful on all of the prospects we have in the pipeline. That's, as I've said before, I am glad that we got two or three deep in each of the markets, because if we can't come to an agreement on what is an accretive transaction to Heartland, we will have to pass and go to the next deal. But I think, what I recognize is that people are becoming more realistic.

Okay. And that's -- the accretion you are talking about, that's year one, or quarter one? What's your timing on --?

Well, we would like it to be accretive in the first year, but if not in the first year, it absolutely needs to be accretive in the second year.

All right --

And obviously, the other component we look at, is at least -- one of the other components we look at is the internal rate of return. And right now, most of the transactions we are modeling, are certainly in excess of 15%.

Great. Thanks so much.

Thank you. And our next question is a follow up question from the line of Jon Arfstrom with RBC Capital Markets. Please go ahead.

Hi. Sorry to belabour the call here, but I did want to touch on one thing. How much more production have you added to the mortgage company in the last quarter? And how much more do you plan to add, in terms of producers or however you choose to measure it?

(Multiple Speakers). I wonder if it would be easier to just to say what we're projecting, as far as production for the year. We had $290 million in production first quarter. And we're looking at a $1.5 billion or thereabouts for the year.

And assuming that would continue to ramp up, I have a suggestion, Jon, that we would be -- essentially quadruple what we have done in Q1, and there would be some potential ramp up. So if we get that done, potentially go to $1.5 billion. So how many producers have we added? I would estimate, probably about 40 or so, a reasonable estimate.

And then, of that $1.5 billion, how much do you think is refinance versus purchase volume?

60% has been refi, but as the refi boom burns off, we are hiring people that are more focused on purchase transactions. And so we clearly want to move our mix, away from refi to purchase to take out some of the swings in the cycles.

Right. Yes, okay. And then, just maybe bigger picture. I was looking at some of your older numbers on mortgage. And when we didn't have big refi booms, you were maybe a $0.5 million to $1.5 million in revenues a quarter. But obviously, if you just look at the purchase volume this quarter and say -- maybe just take off refinance, you are probably at $3 million to $4 million. And it sounds like that base is going to grow. And I guess, bigger picture, what do you expect from the mortgage company? How big do you expect it to get, in terms of percentage of revenues? Just kind of give us an idea of what is possible here?

Well, again, we're still probably early on in this, Jon, in some respects. But I think the numbers we have generally spoken too, would be say, $1.3 billion to $1.5 billion this year. Potentially, another $0.5 billion the following year, and potentially another $0.5 billion the following year, if we hit all our numbers. I mean, that is what we generally try to focus on, as we grow this part of our business. We feel we are in an unique point, relative to a lot of mortgage loan originators finding our model and our Company to be an attractive alternative right now.

So that ramp up, which is still in some respects, the paint is still wet on that. We would still say that there is potential to go on that direction. As a reference point -- I can't give you the overall movement, but right now we have a -- call it about 100 mortgage loan originators, and then we have somewhere in the neighborhood of 30 additional, that would be either, sales managers or producing sales managers. So certainly, over 120 producers right now within the Company, mortgage loan originators.

There are two lines of business that we have recognized that we don't want them to become so large that they are out of proportion to the size of our core business banking. And the two lines of business would be mortgage origination, residential real estate origination. And the other is Citizens Finance. And so, both of those are providing good earnings. Citizens provides a great return on equity for us, and mortgage is providing a great source of fee income. And we don't want those to get out of proportion to the banking side. So we are watching that carefully. But that being said, I still say mortgage has some ramp up to go, before we would be concerned about that.

Yes, it definitely seems like there is room to grow. Well, thanks --

(Multiple Speakers). We believe there is. And again, most -- this has been to this point, our legacy markets. And we see that as beginning to expand, as our primary expansion point. And so the other thing, we think about, Jon, is not only the mortgage side, but then the ability to cross-sell that production to the retail side of the organization, to then includes wealth management and brokerage. And certainly, now all those pieces aren't in place, but we are working diligently to that in place as well. So it's not just a single transaction, but rather a systemic shift in the overall earnings capacity of the organization.

Right. Thank you.

Thank you. And gentlemen, I am showing no further questions at this time. I will turn the conference back over to you for any closing comments.

Thanks, Scott. In closing, I am very pleased with the positive financial performance we have been able to share with you today. Our margin remains very strong at 4.23%. Our investment and expansion of our mortgage banking unit is producing excellent non-interest income. And we have appear to have overcome the nonperforming asset issues that have impacted earnings for the better part of the last four years. As stated in the past, I feel very confident about the earnings power of our Company, as this quarter's results have demonstrated. Needless to say, we are excited about the posting of record earnings for the first quarter, and optimistic about the rest of 2012. I would like to thank everybody for joining us today. And I hope you all will able to join us for our annual stockholder meeting, which is on May 16. And if not then, certainly at our next quarterly conference call, which is scheduled in July. So have a good evening, everybody.

Thank you, sir. Ladies and gentlemen, that does conclude the Heartland Financial USA first quarter conference call. Thank you very much for your participation, and you may now disconnect.