Heartland Financial USA Inc (HTLF) 2012 Q2 法說會逐字稿

Welcome to the Hartford (sic) Financial USA second-quarter 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)

I would now like to turn the conference over to Scott Eckstein. Go ahead.

Thank you and good afternoon, everyone. Thank you for joining us on Heartland Financial USA's conference call to discuss second-quarter 2012 results. This afternoon we distributed a 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.HTLFcom.

With us today from management are Lynn Fuller, Chairman, 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 the call up to your questions.

Before we begin the presentation I would like to remind everyone that some of the information that management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines I must point out that any statements made during this presentation bearing the Company's hopes, beliefs, expectations, and predictions, 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, everyone. We appreciate everyone joining us this afternoon as we review Heartland's excellent performance for the second quarter of 2012.

For the next few minutes I will 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. And then Ken Erickson, our EVP and Chief Credit Officer, will offer insight on credit-related issues.

Well, I am extremely pleased to begin my comments by reporting another quarter of record earnings. You may remember from last quarter's call that Q1 had been the best quarter in our 31-year history. So once again we have set a new record for quarterly earnings of $14 million and a new record for earnings per share of $0.77.

Well, that's a 37% increase over last year's second-quarter earnings of $10.2 million. Year to date, net income stands at $26.8 million or $1.48 per common share, which is nearly double the $14.4 million or $0.71 per common share earned in the first half of 2011. Heartland's annualized return on average common equity for the quarter was superb at 18.28%; and year to date, that is 17.78%.

The Company's exceptional performance in 2012 is a result of five significant factors. First, Heartland's exceptional performance continues to be bolstered by a solid net interest margin, which exceeds 4%. Annualized at 4.05% for the quarter, we continue to benefit from solid loan growth. We have now maintained our margin above 4% for 12 consecutive quarters.

The second factor in Heartland's exceptional performance is solid loan growth of $97 million in the second quarter. Our emphasis on outbound calling, combined with improving economies in our Midwest markets, is generating opportunities with new and existing borrowers.

It is also worth noting that we are making good progress with respect to the U.S. Treasury's Small Business Lending Fund. To date, we have achieved a net increase in qualifying small-business loans of nearly $86 million, against a goal of approximately $92 million. We are now benefiting from the reduced dividend rate on the preferred shares, while playing an essential role in the economic recovery of our markets through the support of small business and new job growth.

Third, we are experiencing strong mortgage loan origination demand. Our mortgage banking business is driven by continued refinance activity along with a concerted effort to attract more purchase business. We believe our long-term success in residential real estate financing depends on our continued shift towards purchase originations, which will drive revenue when the refi boom finally comes to an end.

For June, we have achieved an origination mix of 46% purchase to 54% refi. In the second quarter, mortgage banking revenue -- the combination of gain on sale of loans and loan servicing income -- increased by $5.5 million or 53% over our strong first quarter.

Well, fourth, steady improvement in credit quality. I am 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 nonperforming assets by nearly $26 million or 23%. This quarter alone we reduced nonperforming assets by $7 million.

Additionally over the last 12 months the percentage of nonperforming loans and leases to total loans and leases have been reduced from 2.9% down to 1.7% or $23 million. With this reduction, our allowance as a percent of nonperforming loans has increased to 92%.

We feel very good about our reserve position. And with the continued sale of other real estate very close to our marks, we don't anticipate additional material losses on the sale of same.

Fifth and last, for the second quarter nine of our 10 subsidiaries were profitable, with eight of 10 profitable year-to-date. It's extremely gratifying to see the favorable impact on Heartland's earnings when our de novo banks are standing on their own.

Our pretax pre-provision earnings also set quarterly records at $24 million compared to $18.9 million for the second quarter of 2011. And year-to-date, pretax pre-provision earnings are $45.4 million compared to $34.4 million for 2011.

Now turning to the balance sheet, total assets increased by $115 million in the second quarter, taking total assets to $4.4 billion. As I mentioned, loan growth is the driver here, with $97 million in growth during the second quarter and over $277 million in year-over-year loan growth. That is 12% in loan growth year-over-year.

As I have shared in the past, our plan has been to move dollars out of securities and into quality loans. Securities now represent 30% of total assets, down from their high point of 32% in last year's third quarter.

Well, in terms of deposits, we continue to see growth in noninterest demand, low-cost savings, and money markets. And as a result, the favorable shift in deposit mix continues. Year to date, deposits have increased by $125 million, with demand deposits growing by $62 million.

Compared to this time last year, demand deposits are up 23% and time deposits are down 8%. At June 30, demand deposits, savings, and money markets represent 76% of total deposits.

Moving on to capital, our tangible capital ratio increased to just under 6% at 5.98%. 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 provide a brief update on our growth initiatives, starting with our residential real estate operations. We are very pleased that the timely expansion of our Heartland Mortgage and National Residential unit is providing growing noninterest income. In the first six months of 2012, we have originated $668 million in mortgages and expect this number to grow as we methodically add new loan production teams.

As I mentioned earlier, our goal is to focus on the purchase market, which we believe is a more stable revenue model for the future. Currently, Heartland Mortgage is operating in all nine Heartland subsidiary banks, with our National Residential Mortgage unit serving San Diego in three locations, soon to be four; along with Reno, Nevada; Minot, North Dakota; Boise, Idaho; and Buffalo, Wyoming. Other sites on the drawing board include Des Moines, Iowa, where we will open soon.

Now moving on to M&A, in addition to solid organic growth, expansion of our banking franchise through mergers and acquisitions continues to be a high priority. During the second quarter, we announced a three-branch acquisition from Liberty Bank FSB. The three branches, representing $54 million in deposits and $10 million in loans, will merge into our flagship bank, Dubuque Bank and Trust, on July 13, less than 90 days after the announcement.

We continue to see many opportunities throughout our footprint and would expect to announce one, if not two, more acquisitions yet this year. We continue to seriously evaluate the most profitable growth opportunities within our current footprint. That being said, however, we would consider accretive transactions that open new and attractive geographical markets in the Midwest and the West.

Our expansion plan for 2012 also includes the opening of two new banking offices in the third quarter. In early August, Rocky Mountain Bank will open its new main banking office in downtown Billings, Montana, the 10th location in Montana. And in early September, Arizona Bank & Trust will open its seventh location, which will serve the Scottsdale market.

Our consumer finance subsidiary, Citizens Finance Company, continued at an impressive pace in the second quarter with net earnings of $719,000. Year to date, Citizens' ROE is a lofty 26%, with net income of $1.6 million compared to $1.2 million for the first half of 2011. Leveraging this successful business model, Citizens just opened its 11th office in Elgin, Illinois, with plans for a 12th office later this year.

Well, in concluding my comments today I am pleased to report that at its July Board meeting the Heartland Board of Directors elected to maintain our dividend at $0.10 per common share, payable on September 7, 2012. I will now turn the call over to John Schmidt for more detail on our quarterly results; and then John will introduce Ken Erickson, who will provide commentary on the credit side. John?

Thanks, Lynn, and good afternoon. In my remarks today, I will again look to add depth to the press release relative to second-quarter results. Additionally, I will provide estimates on some key operating metrics for the remainder of the year.

To reiterate Lynn's comments, we are very pleased with this quarter results and feel very positive about the remainder of 2012. Let's look at the balance sheet.

During the quarter, investments increased by $109 million as we were able to deploy more overnight money into investments. As a reference point, the duration of the portfolio currently sits at 3.88 years versus 4.22 years at the end of the first quarter.

Relative to the loan side, loans held-for-sale decreased by $30 million during the quarter as we were able to more efficiently process and deliver production to the secondary market. For the majority of the third quarter, we would anticipate the average balance to continue near the current $70 million.

We are currently working to create a mortgage-backed securities prior to delivering this production to the secondary market. This will likely expand our hold period, potentially pushing the average balance back to the first-quarter levels.

The held-to-maturity loan growth of $97 million for the quarter and $255 million in the last three quarters is really a positive reflection on one of the core competencies of Heartland. Certainly, Lynn's estimate at $200 million of loan growth in 2012 is well within reach.

Let's move on to the income statement. This quarter we saw a 17 basis point reduction in the net interest margin, moving from 4.23% to 4.05%. This change is generally related to the investment portfolio performance and, specifically, the aforementioned growth in the investment portfolio combined with the sale of a portion of the securities that had been increasingly more susceptible to prepayment risk.

Ahead of the last quarter's outperformance, we were forecasting a trend toward a 4% margin, and this quarter results were more consistent with our expectations. At the same time, even with this reduction in the net interest margin percentage, total margin dollars decreased by $1 million quarter-over-quarter, and this quarter's net interest margin dollars still exceeds every quarter of 2011.

As we have discussed in the past, our focus has been to fund loan growth from the investment portfolio, keeping the balance sheet relatively stable. However, we continue to see opportunities to expand and improve our already granular deposit base.

As a result, the investment of these new low-cost deposits, combined with the runoff of the existing investment portfolio, will have the obvious effect of reducing the return on that portfolio. At the same time we are experiencing pricing pressure on existing credit which will likely continue throughout the remainder of the year.

Relative to our cost of funds, we continue to look for opportunities to reduce our funding costs. In that regard we see some incremental pricing opportunities in our non-maturity deposits.

Our CD book, on the other hand, continues to reflect some large opportunities, with $181 million of CDs maturing in the next six months at an average rate of 1.19%. We generally model a 40 to 50 basis point reduction in our CD pricing. Much as I mentioned last quarter, we are cognizant that our CD portfolio needs to remain a reasonable part of our funding structure, which is best evidenced by the expansion of balances this quarter.

In summary, we see the potential for further margin reduction, including slipping below the 4% level in the third and fourth quarter. Saying that, we see the margin holding very flat in terms of total dollars.

Additionally, loan growth would serve to boost the margin as expressed as a percentage of average earning assets and gross dollars. Finally, while we aren't forecasting an increase in rates, our modeling would suggest that our balance sheet is very well structured for such an event.

Relative to noninterest income, noninterest income totaled $28 million for the second quarter. Excluding security gains, noninterest income increased $3.9 million quarter-over-quarter.

Consistent with the last two quarters, gains on sale of loans was the largest contributor to this improvement, representing a $4.2 million increase. Relative to the gains on sale of loans, refinancing activity was the largest driver for this quarter's activity, representing 58% of the total.

We feel it's important to point out that in the current quarter $3 million of the gain on sale reflects mark-to-market gains directly linked to the expanding mortgage pipeline. Importantly, we see the pipeline continuing to expand, consistent with what we experienced in the second quarter.

Relative to the servicing portfolio, 66% of our production in the quarter was done on a servicing retained basis. Much as we had predicted, amortization of mortgage servicing rights decreased by $1.7 million in the first quarter to $1.1 million in the second, which is a level we would expect to see on a go-forward basis. As a result, we feel the current level of mortgage servicing income would continue through the rest of the year.

Also of note during the quarter was the $5 million of bond gains. The majority of these gains are directly attributable to the movement out of the investments I mentioned earlier. Other noninterest income reflects a $2.4 million increase, as the first quarter reflected a $2 million gain on the sale of two low-income senior housing projects.

Focus on noninterest expense. Total noninterest expense increased $1.3 million quarter-over-quarter. The largest component to this expense continues to be salaries and employee benefits, which increased by $1.4 million.

Contained in this total is $4 million of commissions associated with mortgage production. This figure includes $800,000 of sign-on bonuses associated with new mortgage loan originators coming into the organization. This compares to $3.2 million in Q1, with $700,000 representing sign-on costs.

Finally, during the second quarter we increased our bonus accrual, consistent with current financial results. Net loss on repossessed assets decreased by $1.6 million as compared to the first quarter of 2012. Much as we previously discussed, sales of the other real estate are not only occurring but, as Lynn suggested, occurring near our marks.

Other expenses again reflects an accrual associated with potential mortgage buyback risk, in this case $363,000, bringing the total accrual to $1.1 million. We continue to thoroughly assess this risk each quarter.

Given the current level of earnings we feel the effective tax rate will be in the 32% to 33% range.

Lynn mentioned our success in developing SBLF qualifying loans. To put a little finer point on that, qualifying loan growth in the first quarter of 2012 will reduce our quarterly SBLF payment for the third quarter by $73,000. The loan growth now recorded in the second quarter will reduce our fourth-quarter dividend payment by approximately $526,000 for a total quarterly reduction of approximately $599,000.

In closing, I'd provide the following relative to anticipated performance metrics for the remainder of 2012. We feel we will see reduced investment portfolio returns. Our provision costs will continue to moderate. Deposit growth somewhat slower than 2011, focused in the demand and NOW maturity deposits areas.

We now see the margins slipping under 4%, with total margin dollars remaining flat; gains on sale of loans continuing at roughly the same level as the Q2 total; overhead to remain in the same relative range. SBLF loan growth reduces the annual dividend payment by $2.4 million starting in the fourth quarter.

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

Thank you, John, and good afternoon. It is my pleasure to report continued improvement in the credit quality within Heartland's loan portfolio. As shown in the earnings release, we continued the reduction in both nonperforming loans and other real estate owned, with nonperforming loans reduced to 1.71% of total loans and nonperforming assets reduced to 1.87% of total assets.

Our personnel in charge of other real estate continued to actively market our properties. We completed the sale of $5.9 million of properties in the second quarter, 15% of the assets owned at the beginning of the quarter. As of June 30, we had $4.4 million contracted for sale to be delivered in the third and fourth quarter.

In addition, seven properties with an aggregate book value of $7.6 million are entered into an online auction. The bid deadline on these properties is August 10, so we will soon know if we were successful in moving any of these properties.

At June 30, we owned 21 residential properties with an aggregate book value of $4.6 million. We owned a total of 109 commercial properties with an aggregate book of $33.4 million. Of the commercial properties, 43 are individual residential lots with a value of $2.3 million, and 33 are land or lot developments with a value of $16 million.

Over $3 million of recoveries on previously charged-off loans have been received in 2012. This puts our banks in a net recovery position year-to-date. And when including Citizens Finance, our consumer finance company, our net loan losses were $923,000 in the second quarter, $723,000 year-to-date.

Our allowance for loan and lease losses as a percent of loans and leases increased from 1.55% to 1.58%. This was primarily driven by an increase in the allowance associated with loans deemed impaired. While the allowance has been reduced by 28 basis points over the last nine months, from 1.86% to 1.58%, the portion of the allowance maintained for impaired loans has gone down 29 basis points during that same period.

As mentioned by Lynn, our loan growth was $97 million in the second quarter. Loans year-over-year are up $278 million.

The increase has stayed in line with our current portfolio mix, with commercial accounting for 70% of the increase. Within the commercial loan portfolio, the mix is changing, as evidenced by the reduction within construction by $28 million and increases shown in manufacturing by $44 million, wholesale by $52 million, and healthcare by $24 million.

In the second quarter, Heartland became a minority investor in BluePath Finance. BluePath Finance been organized by two energy-conscious individuals to provide a turnkey solution that lowers end-user energy usage and operational expenses. Through this investment, Heartland expects to generate up to $100 million in new loans over the next five years. We are excited in this new opportunity geared towards energy conservation.

In June we executed a contract with SunGard for the acquisition of software developed by Custom Credit Systems, which will be implemented in phases. The first phase will be completed in January 2013 and will streamline the application process for small business credit, allowing us to better serve this customer base. We believe this customer segment is underserved in many of our markets and through improved service will allow us to penetrate the small-business market.

The drought has certainly been a leading story in the past months. It is too early to estimate the impact it could have on our $279 million agricultural portfolio.

While well diversified within this portfolio, a drought-damaged crop will impact most agricultural segments. Grain operations will see reduced income from lower yields; livestock producers will see increased cost for feed; and dairy operations will not only see increased costs for feed but also may suffer reduced income to the heat stress on the dairy herd.

Most of our grain producers carry crop insurance that will protect them from catastrophic loss but will not be sufficient to protect their expected profit. Most of our larger livestock operations also forward-contract feed cost to protect from rising costs. Recent rains in the Midwest have been beneficial, but not sufficient to ward off the damage that has already occurred to the crop.

The third quarter is off to a good start, showing continued improvement in credit quality issues, with the collection of $2.4 million in nonaccrual loans; over $2 million in charge-off recoveries; the elimination of $1.3 million in impairments; and the sale of $1.5 million of other real estate. With that, I will turn the call back to you, Lynn, and remain available for questions.

Thank you, Ken. We will now open the phone lines for your questions.

(Operator Instructions) Jon Arfstrom, RBC Capital Markets.

Thanks. Good afternoon, guys. Nice job. I guess Ken or Lynn, a question for you in terms of the loan growth. You had obviously a good quarter, maybe even a little better than last quarter. You talk a little bit about how it is better economies and also calling effort.

Can you talk a little bit about the mood of the borrower and whether or not you think that this is due to organic growth and expansion by your borrowers, or it is more a function of an increased calling effort on your part?

First, I will start out, Jon. I think it's a little of all of the above that you just mentioned. We have improved our commercial banker group down in the Southwest, so that has helped.

And we have got a better focus on the target markets that we are trying to pursue. Those tend to be in the area of professional services, healthcare, C&I-type loans. And so that has been a big help.

I would say across the Midwest we are getting help from an improving economy. We are seeing some loan demand from existing customers who are expanding, as well as new business that we are bringing across from competitors. So I think it's been a bit of all of what you've mentioned.

Just a better calling effort, a better economy in the Midwest. We are starting to see Arizona come back. Denver is starting to pick up a little bit.

The only market that is still really a bit slow would be New Mexico, but they came into the recession late and so it is still pretty quiet in New Mexico. We have a good team of commercial bankers there, but there is not a whole lot going on in the Albuquerque/Santa Fe area right now.

And I would just piggyback off of that; I would echo all of those comments. We have got quite a few loans in the pipeline; that is well mixed throughout the different banks, but well over half of it is Midwest-based.

When we've got a mature bank like Dubuque Bank and Trust, a large portion of that growth is going to come from opportunities from the existing borrowers. But we've had a lot of success in our smaller banks such as Minnesota, that has brought a lot of new business to the table over the last six to nine months with just the calling efforts and introduction of their staff to new customers of the bank.

Okay, okay. Then I guess, just following up on your ag comments, I appreciate the comments on the direct impact; but how should we think about maybe some of the indirect impact particularly in the Midwest? And how do you go about monitoring some of your existing exposures for that second derivative effect?

We are having all of our banks drill down into their portfolios, have conversations with their customers to see what are they doing, how are they going to react to this. Naturally, rain is spotty. We looked at one new opportunity this morning at a loan committee, and the crops in that area were normal; they have received proper rain in that part of the Midwest.

So it will be very spotty. I know the forecasted number of acres and bushel per acre were much greater than last year. The last I saw, we had a presentation by an individual within the last week that showed total grain production may be very close to last year, albeit we are still waiting for the final production numbers to come in.

In our portfolios, I would say the majority of what we see will roll into 2013, to see the true impact versus any severe credit risk within our portfolios this year. As I said, they protected themselves through crop insurance and forward contracting on feeds to protect from increased costs. But what we won't see is how many of the inventory of cattle are going to market early because of reduced grain; and that is going to have an increase on, one, our costs at the grocery store, but it's also going to impact that farmer who doesn't have the amount of livestock to sell in the upcoming year.

So, it is going to be a lot harder to predict throughout the balance of this year. As we start to see forecasts of what they expect to be doing in 2013, will become a lot clearer of how they adjust their agricultural production.

I would just add to that, Jon, that I have always felt that we have some of the very best ag businesses that are out there. We focus heavily on the larger operations that are extremely well capitalized. They have been profitable throughout time. They have professional management that hedges their inputs and their outputs, and we believe these are the operations that will best weather the storm.

Beyond that, we are a heavy user of FSA guarantees, so a lot of the credits are guaranteed 90%. So I think we will get through it reasonably well. There will be some pain, obviously.

Ethanol, we have a couple ethanol operations but they are extremely well capitalized, very profitable, and they look at this as an opportunity, because the more heavily leveraged operations will probably shut down and there may be opportunities for them to buy out these operations.

Okay, okay. Then, John, just a quick question for you. Of the year-over-year FTE increase, is the vast majority of that mortgage driven? Or is there any other FTE increases going on with the Company?

The vast majority is all related to -- the vast majority is related to mortgage expansion, Jon. I mean certainly there is some forward support at the Heartland level. But it's not -- call it two-thirds or three-quarters of the expansion in personnel is related to mortgage.

Okay. Do you feel like you guys are -- I know you've got a couple of offices. But you feel like that is nearly complete, the hiring in mortgage?

On the mortgage expansion?

Yes.

I think we will continue to see, much as Lynn indicated in his comments there, I think there's opportunities out there to pick up teams. It's a measured growth approach, but we're certainly going to continue to look to expand that.

We are going to leverage the back shop we have in place, which we think is one of the better back shops out there. So I think you will continue to see some additional offices along the way, in a measured approach, again.

Okay. Thanks, guys.

Brad Milsaps, Sandler O'Neill Asset Management.

Hey, good evening, guys. Nice quarter. Just a couple follow-up questions, Ken or John. Ken, I appreciate the additional color on the asset quality numbers in the quarter, but did notice that the professional fees jumped up quite a bit from the first quarter. And I apologize if I missed this in John's comments, but just curious if you've got even more things teed up, maybe to exit the bank, given that increase in professional fees, that maybe just didn't get out the door at June 30. Just any additional color there would be great.

Yes, there was a couple that didn't make it by the end of the second quarter. I commented we've had some success in the month of July. We've got several more.

I am quite, quite certain that the third quarter will show a more rapid reduction in NPLs than what the second quarter did. I don't see a lot that should be moving into nonperforming, so it is easier to look at those that are there and see what moves out.

We've got a pretty good expectation we will see further reduction there. John, you might want to comment more on the professional.

Yes, I think again much of that is legal, just things moving into the pipeline. As for legal, that $436,000 represents quarter-over-quarter increase in legal costs.

Okay. Ken, do you happen to have what the new NPL formation number was in the quarter? The new nonperforming loans?

The new ones that went nonperforming?

Okay, I'm sorry, (inaudible)

Yes. For those over $300,000 we only had six, for a grand total of just under $2.4 million on nonaccrual. So a relatively small amount.

Okay. And John, do you project getting the SBLF down to 1% hopefully by the first of the year? Is that the timing of it based on you guys are now?

Well, yes, if we -- the dividend payment may be delayed by a quarter, but the pace we're at right now we feel pretty comfortable we will be down to 1%.

Okay. Then final question. Did you guys sell any of the bonds? I know you had some [REMIC] bonds had some pretty big gains. Were any of those part of the sales that you made during the quarter, or do you still have that remaining out there?

You mean the Z tranche?

Yes, the Z tranches, that's right.

No, there were no Z tranche securities in those gains. Those remain out there.

Okay, and what is the size of that, approximately?

Call it $4 million.

Okay, great. Thanks, guys.

John Rowan, Sidoti & Company.

Good afternoon, guys. John, just on the mortgage banking again, can you just go over the guide? I didn't quite get the number written down.

And also if I am not mistaken, you did say that there was a $3 million mark-to-market for the quarter. Is that right?

There is. So, just to reiterate, of the $12.8 million there is $3 million marked to market. If the expansion of the pipeline did not continue as it did in the second quarter, that $3 million would potentially go away, depending on some other nuances of the rate fluctuations, etc.

What I also said though is that we expect that pipeline to continue to expand. As a result that $3 million mark-to-market increase would reoccur in the third quarter, much as it did in the second quarter. So everything else being equal we would expect to see $12 million to $13 million of gains on sale of loan.

Okay. Does the mark-to-market ever go away? Or how does that go back down to a $10 million run rate?

If we didn't expand our pipeline that potentially would go back down to $10 million run rate.

Okay. The provision comment about the provision continuing to moderate, I mean -- does that assume that there is an allowance release? At this point you are almost 100% covered on your NPLs; you are over 1.5% allowance ratio.

Is that just a function of lower chargeoffs? Or is that a function of both chargeoffs and allowance reserve?

As I mentioned, the reduction in the allowance over the last three quarters has all come from impaired loan reduction. We had a 29 basis point reduction of the allowance based upon just a reduction of that segment of the allowance that is backing the FAS 114 or the impaired loan.

Of our total 1.58% allowance, 28 basis points of that is the portion held for those impaired loans. So if we had no impaired loans today, we could see a release back to 130 would be our base allowance for FAS 5 and our qualitative factors.

Okay. Fair enough. Thank you.

Stephen Geyen, Stifel Nicolaus.

Hey, good afternoon, guys. John, you mentioned a little bit about the pipeline, around 200 is a good number for the year. Just curious about the average size of the credits that you are adding today.

I'll look to Ken answer that.

It really hasn't changed much. Our average commercial loan when I look at all nine banks is a little over a $500,000 relationship.

They have ranges by bank size. Certainly our Wisconsin group would be well over $1 million in average size. In some of our smaller bank markets, where their opportunity comes with smaller customers, would be less than that. The average credit that we put on wouldn't vary much from that.

Okay. On the mortgage banking, I am just curious how you guys have added quite a few people over the last several quarters. How quickly does it take for them to get running full speed, to ramp up to where they are operating at full speed?

I think we typically think of about 90 days to really get them ramped up. Some of them are able to ramp up a bit more quickly; but you can figure 90 days.

Okay.

And just to put another point on that, Stephen, what we are seeing again -- much as I've probably talked about throughout the call -- is that these people are really focused on purchase that are coming in the door. So they really have that as one of their key skill sets.

So when we look to see -- when the refi boom comes off, we do think that they have the capacity to put on some significant purchase business versus just relying on the refi business.

Sure.

From a backroom operation standpoint, we have been able to close on our purchase transactions within 30 days from the lock, when we lock the rate. As far as the refis, we push those out to 60 days. So we have effectively been able to move the production through the pipeline at much greater rate than what we see from the very largest banks in the country.

Okay.

Stephen, I would go back to that -- you asked a question about average credit size. I guess to add a little more clarity to that, about almost 40% of our total commercial portfolio is made up of small credit relationships of under $250,000; and those probably average a little over $100,000. So we have got a lot of smaller customers in there.

Our bread-and-butter customer is probably relationship that is in the $3 million to $5 million total relationship size. We certainly have a handful that are $10 million plus; and I mentioned we've got a lot of smaller customers. But probably the bread and butter for each of our banks is that $3 million to $5 million borrowing need.

Okay. You gave good color on the refinance versus the first mortgage. Just curious; if you guys look at the first mortgage, how much of that is investor versus how much of it is primary residence?

Oh, it's almost entirely in primary residence. We really don't do hardly any investor business.

Okay. And, John, last question for you. Just looking out to 2013, the margin. Any thoughts on what it might look like, where the pressure might come from?

I think the pressure is still going to probably come from the investment side, certainly. Again, the swing on it becomes the loan growth. We do think we have a significant capacity as far as our ability to generate commercial loans; and with 30% of our balance sheet still sitting in investments, there is our upside.

Modeling out, I was trying to suggest in Q3 and Q4 we do see the margin relatively flat in terms of dollars. And again, with some loan growth to offset the deposit runoff I think we have an opportunity to maintain the margin dollars in that relative range, and maybe some upside depending on the amount of loan growth we could see.

And we will see more pressure on loan pricing too, I think, for the higher-quality credits, the larger, very, very high-quality credits (technical difficulty) type.

Okay, thank you.

Daniel Cardenas , Raymond James.

Evening, guys. Just a quick question. I think, Lynn, you mentioned that the economies were getting a little bit better in your footprint, which is good to hear. Is that affecting M&A activity at all? Is that kind of keeping people -- putting them back on the sidelines and maybe disengaging them from conversations?

Well, in the size range that we look at, I would say no. If you are looking at banks between $100 million and call it $500 million to $800 million, I just think the pressure is still very, very heavy on that segment of the banking industry. A combination of compliance costs, cost of obtaining talent, the cost of technology in all the different channels of delivery of products, mobile, Internet, so forth and so on. They are just -- I think a lot of the banks are getting worn out.

You have succession planning issues. There are an awful lot of us that are in our upper 50s to lower 60s. So I think a lot of these banks and their ownership are trying to look for a way out. So we are seeing more M&A activity than I have ever seen in my entire life.

Good, good. Then in terms of states outside of the footprint that you are considering, can you talk about which states you are looking at?

Well, we don't really have any in particular right at this moment, because our focus has clearly been on in-market and in-state acquisitions to try to build scale. We really don't have anything that is on the front burner outside of our current footprint.

But we would look in adjoining states, fill-in type of states in the West or the Midwest. But that clearly is a second priority. The first priority is to build scale in our current markets.

Okay, great. Thank you.

Thank you. Gentlemen, I show no further questions in queue at this time. Please continue with closing remarks.

Very good. In closing then, I am very pleased with Heartland's record financial performance for the first six months of 2012 with continued a solid margin above 4%; very strong loan growth; continued reduction in nonperforming loans; excellent noninterest income growth from our mortgage banking unit. And with nine of our 10 subsidiaries profitable, we are delighted with our progress and excited about the future.

I would hope to have everyone join us at our next quarterly conference call, which will be in late October. So, thanks again for joining us and have a great evening.

Ladies and gentlemen, that concludes our call this afternoon. We thank you very much for your participation and you may now disconnect.