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Operator
Welcome to the Old National Bancorp third quarter 2006 earnings conference call. This call is being recorded and has been made accessible to the public in accordance with the SEC's Regulation FD. The call, along with the corresponding presentation slides, will be archived for 12 months on the shareholder relations page at www.OldNational.com. A replay of the call will also be available beginning at 1 PM Central today through November 14. To access the replay, please dial 800-642-1687, conference ID code 880-3341. Those participating today will be analysts and members of the financial community. At this time all participants are in a listen-only mode. (OPERATOR INSTRUCTIONS). At this time the call will be turned over to Lynell Walton, Vice President of Investor Relations, for opening remarks.
Lynell Walton - VP of Investor Relations
Thank you, Gerald. And again, welcome to Old National Bancorp's third-quarter earnings conference call. With me today are Old National Bancorp's President and Chief Executive Officer, Bob Jones, our Chief Financial Officer, Chris Wolking, Chief Credit Officer Daryl Moore, and our Treasurer, Jim Ryan. Also with us is St. Joseph Capital Corporation's Chairman, President and Chief Executive Officer, John Rosenthal.
Before we begin, I would like to refer you to slide three and point out that the presentation today does contain forward-looking statements that are subject to certain risks and uncertainties that could cause the Company's actual future results to materially differ from those discussed. These risks and uncertainties include, but are not limited to those which are contained in this slide and in the Company's filings with the SEC.
Slide four contains our non-GAAP financial measures information. Various numbers in this presentation have been adjusted for certain items to provide more comparable data between periods, and as an aid to you in establishing more realistic trends going forward. Included in the appendix to this presentation are the reconciliations for such non-GAAP data. We feel these adjusted numbers provide more meaningful comparison and a better picture of financial trends, as most of these are calculated as if hedge accounting had been allowed in 2005, and as consistent with 2006 presentation.
Slide five is our agenda for the call. First, Chris Wolking will detail our third-quarter earnings results, including commercial loan and DDA changes within our various banking regions, and the deposit-generating performance of our newer financial centers; next, Jim Ryan will be discussing components of our net interest margin and provide detail on various initiatives we are undertaking to improve the performance of our margin; Daryl Moore will then lead the analysis of continued improvement in our overall credit quality metrics, including our third-quarter loan sales; Bob Jones and John Rosenthal will then discuss the activity within the last week related to our recently announced acquisition of St. Joseph Capital Corporation; and finally, Bob will discuss the areas of focus we will be concentrating on as we conclude 2006 and enter into 2007.
Before Chris begins, I would like to direct your attention to slide six, where the four bullet points really paint a picture of Old National's performance for the third quarter.
First is the improvement in our overall risk profile, resulting from improved underwriting standards and the efforts of our special asset area, which led to the nonaccrual levels in the third quarter not seen in four years.
Second is the challenges we face in our efforts to grow the balance sheet of the Company. While we are making progress in the generation of demand deposits, loan growth continues to be difficult, although somewhat resulting from our strategic decision to remain cautious in the commercial real estate sector.
Next is our emphasis on expense control as we continually review processes and look for efficiencies to be gained throughout the organization to maintain an appropriate expense base given our current level of revenue generation.
And finally is our focus on improving our net interest margin. From the sales of investment portfolio assets to the sale leaseback of several facilities, to the heavy focus in the Company on DDA generation, Old National is committed to initiatives resulting in the long-term improvement of our margin.
With that I'll turn the call over to our CFO, Chris Wolking.
Chris Wolking - EVP and CFO
Thanks Lynell, and thank you all for joining us this morning. We'll begin on slide eight with earnings highlights from the quarter.
Net income for the third quarter was $0.32 per share, up $0.02 per share from last quarter. The increase in earnings per share from second quarter was driven largely by our decision not to make a provision for loan losses in the third quarter. The fact that we did not require a provision for loan losses this quarter is the payoff, if you will, for all of the hard work and the resources we devoted to credit risk management and our unrelenting focus on sound underwriting. Daryl Moore will provide more credit quality statistics, but the fact that nonaccrual loans were down 13.2% compared to the second quarter, and at 44.9 million are at their lowest level since second quarter 2002, is certainly worthy of special note.
Return on equity of 13.4% and return on assets of 1.04% are the highest quarterly returns we have generated this year.
The net interest margin declined 3 basis points during the quarter to 3.15%, compared to 3.18% for the second quarter of 2006. The decrease in the margin was due primarily to an increase in our core deposit costs. We increased our money market account rates at a slightly accelerated pace compared to previous quarters, due to competitive pressure in our markets.
Also, our core deposit mix shifted toward higher-cost certificates of deposit during the quarter. Our CDs under $100,000 are above $2.3 billion for the first time since 2004.
Non-interest expenses, on slide nine, were down approximately $800,000, although included in the quarter was the reversal of some expense previously accrued for executive restricted stock incentives. It is important to note that we incurred personnel expense for the new branches that are opening in the fourth quarter. Because revenue growth continues to be a challenge for us in 2006, we are sharply focused on the expenses associated with our distribution network, and are continuing to evaluate all of our branches against growth and profitability benchmarks.
Offsetting the margin contraction from higher core deposit costs was the improvement in margin resulting from our decision to reduce the investment portfolio and borrowed funding. On slide 10, you will see that we reduced the investment portfolio $227.9 million, and our borrowed funding $280.6 million compared to June 30, 2006. The reduction in the portfolio is consistent with our objective to reduce the size of the investment portfolio to 25 to 30% of total assets. At September 30th, our investment portfolio made up 29.8% of total assets. Reducing the investment portfolio is important to our efforts to shift our earning asset mix to higher-yielding, quality loans.
You will also note the decrease in premises and equipment of 70.2 million and the corresponding increase in other assets in our balance sheet at September 30th. This is due to our decision to enter into a sale leaseback of several of the properties we currently own in Evansville, Indiana. The sale leaseback is expected to close late in the fourth quarter 2006. Improving our mix of earning assets and reducing our non-earning assets, obviously, should continue to lift our net interest margin in the future. Reducing the investment portfolio in the third quarter and executing the sale leaseback in the fourth quarter will free up capital, as well as improve our net interest margin.
Additionally, as you will note on slide 10, we slowed our stock repurchase during the quarter. During the third quarter we repurchased approximately 127,000 shares, down from approximately 869,000 shares during the second quarter. This cap will be used to support the cash acquisition that we announced last week of St. Joseph Capital Corporation. The acquisition will close in the first quarter of 2007. Jim Ryan will give you more information on our capital outlook, the sale leaseback transaction, and our net interest margin in his presentation in a moment.
On slide 11, note that commercial loans and leases, plus commercial real estate loans, declined by $98 million compared to June 30, 2006. As Daryl will discuss, this quarter included the sale of approximately $28 million of commercial real estate and commercial assets. On average for the third quarter, however, commercial loans and leases were 28.1 million higher than second quarter 2006, while commercial real estate loans were $34 million lower on average when compared to the second quarter. I think it's important to note that commercial real estate loans have declined $206.1 million since September 30, 2005.
Slide 12 shows the changes in commercial and commercial real estate loan balances from second quarter end of period in all of our regions.
On slide 13, note that core deposits declined 124.4 million compared to balances at June 30th. On average, core deposits declined 53.6 million from second quarter 2006. As I noted earlier, we accelerated our deposit rate increases slightly in the quarter in response to competitive pressure, but we certainly remain committed to deposit pricing discipline in all of our markets. I think it's extremely important to note that non-interest-bearing checking accounts increased $11.7 million compared to June 30, 2006, so we remain focused on this deposit category.
Net checking accounts opened increased by 3017 accounts during the quarter, compared to -- 3071 accounts during the quarter, compared to 1017 accounts last quarter. I believe that's 3171 accounts in the quarter. Thank you.
Slide 14 shows the increase in non-interest-bearing checking balances compared to June 30, 2006 by region.
Deposit growth in Indianapolis accelerated in the quarter, with our continued investment in branch expansion, business cash management and marketing. Our strong market share in Western Kentucky also generated an increase in non-interest-bearing deposits.
Our first retail branch in the Louisville market opened in late second quarter, and we are preparing to open our second branch in Louisville in January 2007. We believe that non-interest-bearing deposit growth certainly will accelerate in Louisville.
Slide 15 lists the increases in total core deposits over September 30th for our new branches in -- September 30, 2005 for our new branches in Indianapolis and Louisville. Deposit growth in the Indianapolis branches increased during the third quarter, and our first retail branch in Louisville is performing above original expectations.
Slide 16, finally, lists the expected openings in 2006 and 2007 for currently-planned branches, and we'll certainly continue to provide you with deposit information in all of our new locations. I also think it's important to note that we have new branches planned in Lafayette, Indiana, another market with good growth characteristics.
In summary, while revenue growth has been a challenge for us in 2006, we believe we're making the right long-term decisions for our shareholders by expanding our distribution in Louisville, Indianapolis and Lafayette with new branches, and acquiring a high-quality banking company in Northern Indiana, St. Joseph Capital Corporation. All of these markets have better growth characteristics than most of our current franchise. Additionally, we continue to work to improve our net interest margin, reduce or redeploy our expenses, and reduce our credit risk.
With that I will turn it over to Jim Ryan for detail on the margin and capital level.
Jim Ryan - Treasurer
Thank you, Chris. Slide 18 shows our tangible equity to tangible assets ratio climbing to 6.53% at the end of the third quarter, from 5.87%. We are now within our target operating range of 6 to 7%. If you exclude OCI, the ratio rose to 6.79% from 6.42%. The improvement, excluding the positive impact from the changes in OCI, came primarily as a result of the sale of investment securities, a smaller loan portfolio, and growth in common equity as a result of the smaller share repurchases during the quarter. As Chris mentioned earlier, we only purchased 127,000 shares during the third quarter versus 869,000 shares during the second quarter.
We are clearly positioning our balance sheet for the all-cash acquisition of St. Joe Capital Corporation during the first quarter of 2007. Our intention is to fund the acquisition with internal capital. As a result, we expect the tangible equity ratio to be below our target operating range after closing. However, we anticipate being back within our targeted range within the next 12 to 15 months following the close of the acquisition.
Next, slide 19 shows additional steps we're taking to improve the net interest margin. In our ongoing efforts to improve the margin, we have signed a letter of intent to sell and leaseback our three main office buildings in Downtown Evansville. Reducing these non-earning assets allows us to pay down long-term funding as it comes due.
As a result of the transaction, the margin in earnings should improve. There is a slight negative impact to the efficiency ratio. Further margin improvement may come as a result of additional branch properties being included in future sale leaseback transactions.
Slide 20 shows net interest income was 57.1 million and the margin was 3.15% for the third quarter, which was down slightly from the second quarter. The Fed Fund target rate averaged 35 basis points more in the third quarter from the second quarter, which translated into higher funding costs. Higher funding costs were not fully offset by changes in asset yields, as we will see on the next slide.
Slide 21 shows that asset yields increased only 13 basis points, while interest rate changes on liabilities cost us 21 basis points. Mix and volume were positively impacted by the smaller investment portfolio and the lower amount of wholesale funding. On the next slide I will show you the trend of interest-bearing deposit costs.
Slide 22 shows a 25 basis point increase in the interest-bearing deposit cost during the quarter, as a result of the effect of increases in short-term interest rates on indexed accounts, intentional increases on the rate paid for money market accounts, and the shift in the mix of deposits towards higher-yielding liquid accounts and certificates of deposit.
Additionally, you can see that the rate of increase for Old National since the first quarter of 2005 has been slower than the average of our peers, although they started at an absolute lower level. We were able to accomplish this narrowing of the gap between us and the peers by a continued disciplined process for deposit pricing, despite significant competition in our footprint.
Next, Daryl will update you on the significant improvement in the credit quality metrics.
Daryl Moore - EVP and Chief Credit Officer
Thank you, Jim. As the first slide indicates, we executed loan sales in the quarter, disposing of approximately 28.8 million in commercial real estate or commercial real estate-related loans. Write-down on these sales, including all costs associated with the sales, were roughly $2.8 million. We actually closed two different sales in the quarter -- one being a portfolio of distressed hotel loans (technical difficulty) approximately $6.3 million, with the other sale consisting of multi-family residential property-related loans in a specific industry segment that had begun to show some signs of weakening over the last 18 to 24 months.
The sale execution went as expected, with overall pricing falling into the ranges that we had anticipated. We believe that the sales served to lower our credit risk in the commercial real estate segment of our portfolio, which we continue to watch very closely.
As you can see on slide 25, nonaccrual loans at the quarter's end were $[44.9] million, down [2.8] million from the end of the second quarter. Non-accruals covered in the 50 to $60 million range for the previous seven quarters, which I might add is roughly half the level of where we were during our most challenging period of credit quality. We did break through the $45 million barrier in the current quarter, and at September 30th posted the lowest level of nonaccruals in the Company since (indiscernible) mid 2002.
We continue to try to work down our nonaccrual exposure, and at the end of the quarter we had only two nonaccrual accounts in the portfolio that had exposure in excess of $5 million, and only an additional seven loans with exposure in excess of $1 million.
Our 20 largest nonaccrual relationships now total roughly $28.8 million. At the beginning of the year that number was 35.4 million, so we've reduced our largest 20 nonaccrual relationship exposure by $6 million, or roughly 18% from the first nine months this year. The largest single nonaccrual exposure currently in the portfolio is $6.7 million.
To give you some color on the work we continue to do in this nonaccrual area, of the commercial nonaccrual loans on the books at January 1, 2005 -- so, roughly 20 months ago -- 92% of the dollar exposure associated with those loans that had been resolved was off the books by September 30, 2006. In turn, of the commercial nonaccrual loans on the books at January 1, 2006 -- or nine months ago -- 53% of the outstandings associated with those loans had been resolved and off the books by September 30, 2006.
As slide 26 shows, classified loans fell during the quarter, showing a decrease of approximately $10 million in the period. As a percent of total loans outstanding, classified loans are now at their lowest level in the Company in the last 5.5 years.
As you can see from slide 27, we saw a significant increase in criticized loans in the quarter, with loans in that category increasing $54.3 million. As you know, loans classified as -- or categorized as criticized are those exhibiting potential weakness that, if left uncorrected, could result in deterioration of the payment prospects for the loan or in the bank's credit (technical difficulty) at some future date. While some of the increase in the quarter could arguably be categorized as temporary setbacks, which very well may be corrected over the next several quarters, we believe our credit analysis and rating process may be identifying the first signs of weakening credit that may hit the banking industry as a whole. Whether we're right or wrong will only be proven as the future plays out, but we are taking an aggressive approach to these newly criticized credits, with the majority of them having already been assigned to our special assets area for work.
Turning to slide 28, net charge-offs for the quarter were $4.7 million, up slightly from last quarter's $4 million in net write-downs. To put things into proper perspective, however, I think it's important to remember that we had $2.8 million in charge-offs associated with loan sales in the quarter. The annualized loss rate for the year now stands at 39 basis points, 18 basis point slower than the annualized rate for the same period in 2005.
As a side note, as Chris indicated earlier, we did not make a provision for loan losses in the quarter, despite the $4.7 million (technical difficulty) charge-offs. When evaluating the combination of the net charge-offs for the quarter, the loan sales and their effect on reducing outstandings across several asset quality rating categories, the increase in criticized loans, and the changes to migration loss rates in the quarter, our analysis led us to determine that a provision at any level in the quarter was not appropriate. As we do every quarter we will reevaluate the level of our allowance for loan losses in the fourth quarter and take whatever actions we feel are appropriate given the information at that time.
As you've heard every quarter for sometime now, we are very focused on continuing to improve our credit quality numbers. We continue to work hard at identifying loans that are showing deterioration early on in the cycle so that they can either be rehabilitated in the short-term or moved out of the Bank. This is particularly important, as I've said before, in these times where both elevated borrowing and energy costs continue to challenge our borrowers, and where we are seeing increasing signs that credit quality may be weakening.
We also continue to watch commercial real estate very closely. While we continue to originate loans in this category, we have tightened up our underwriting over the past 12 to 18 months, and have been fairly aggressive encouraging borrowers with marginal projects to seek other lending sources. I would point to the loan sale executed in the quarter as evidence as to our position on reducing commercial real estate exposure. This stance towards commercial real estate, however, does not come without a cost related to loan growth. Again, only time will tell if we're being prudent in our cautiousness.
With that update, I'll turn it back to Bob for his closing comments.
Bob Jones - President and CEO
Thank you, Daryl. It is very nice to be with all of you this morning. I again want to apologize for missing the majority of last quarter's call.
I want to begin with slide 30. I thought it would be valuable for us to spend a few more minutes on our recently announced deal with St. Josephs Capital. Last week St. Josephs did announce their third-quarter results, and I thought I would share them with you.
Third-quarter earnings for St. Joe were $707,000, which represented a 21.5% increase from the second quarter of 2006. These earnings were down 12% from the prior year's third-quarter results, and they continue to suffer through a margin contraction that hurts their earnings. Loan growth was solid, though, up 2.5% over the prior quarter and up 8.2% from a year ago; both of those numbers are before any allocation for allowance. In total, deposits for St. Joseph's are up 14% from the prior year. As Lynell said, we do have John Rosenthal on the call with us, and he'll be available to answer any specific questions you might have on their earnings.
I also thought it would be very important for you all -- this is our first week. We do have our project teams fully engaged on the integration. And I thought I would share kind of where we thought we were and how that was going. I thought I'd begin with an e-mail that I received from Kendra Vanzo -- Kendra is our full-time project leader leading our team of 16 integrated project teams -- and just her perspective on week one with St. Joe. And this is a quote.
We had such a good week that I couldn't wait to share it with you. Everyone we encountered approached us with warmth and friendliness, and overall all of the St. Joseph's associates seem very pleased with our recently announced deal.
To give you some more color on both the associate and client reaction to the deal, let me turn it over to John Rosenthal. John?
John Rosenthal - President and CEO
Thank you, Bob. Good morning, everyone. I apologize; I have a bit of a chest cold. I'm happy to add a little more color. All of my new colleagues did such a wonderful job of giving precise numerical evidence of the quarter just completed, but my part today is to share certain anecdotes with everyone.
We had a plan in place, even before we formally announced the combination of our two companies, to deal very specifically with two of our most important constituents during the first week. Those two constituents are, clearly, our employees, or associates, and our clients.
There were three specific undertakings that we dealt with regarding our employees.
First of all, on Tuesday morning, immediately following our big announcement day, we began with a series of one-on-one meetings with each and every associate of our firm. I think that emphasized the humanness of this process. We talked very transparently with all of our colleagues about what this transaction could mean for them. Clearly, there are many people in our firm that are going to be needed to continue to grow in the northern part of Indiana, which is our charge from Bob and his colleagues at Old National. But there are some expense savings that will be generated through this transaction, and certain positions will be eliminated. So we talked to all of the people on a one-on-one basis.
The next thing that happened is that, as Bob mentioned, Kendra Vanzo was up, along with some of her colleagues from the Human Resource area, and we did small group presentations, where the mission, vision and values of Old National were related to our associates and compared to the mission, vision and values of St. Joseph Capital. And it really reinforced how identical the two cultures are, and gave all of my colleagues and associates here at the bank a great deal of comfort that we were marrying a great partner.
The final activity that occurred with regard to our employees during the week is that we had a major sales meeting with everyone in the bank who touches sales in any way, shape or form. The primary purpose of that meeting was to share anecdotal evidence that they gathered throughout their weeks-long effort to call our different clients. And I'm very happy and enthusiastic to report that the worst reaction we got would be characterized as neutral, but the vast majority of the reactions we got were very excited.
First and foremost they were happy that their current calling officers would remain in place and continue to serve them on a personal level. The loyalty-based relationships that we have formed are both institutional and personal, and the loyalty of our clients towards the individuals that have been serving them is very, very high. So, as long as a particular calling officer was going to continue to be the point person, the clients have indicated the strong willingness to stay with us.
The reaction on the other end of the scale was extremely positive by virtue of the increased lending limits that Old National brings to St. Joe Capital, in combination with the two bank's balance sheets together, as well as the tremendous new products that are being offered through our association with Old National. So I would say that the employee meetings went extremely well.
On Wednesday morning, we all began personally with an outreach in earnest to our clients. I have personally spoken with 74 of our clients in the week that ensued, and I've been able to get to 21 of the 25 largest clients of the bank. The only reason I haven't gotten to the other four is because they are out of town either on business or vacation. And once again, I want to emphasize that the reaction has been overwhelmingly positive, especially due to the fact that, as I said, the management team and the calling team is going to be left in place, and that Amy Kuhar Mauro has been selected as the Chief Credit Officer, reporting directly to Daryl Moore, for the northern district of Indiana.
So while it's been a whirlwind of activity, it's been an incredibly positive week. The integration teams, as Bob indicated, have been formed. Their work is beginning. Their missions are clear. The tasks before them are many. None of us are naive to suggest that change is not going to happen; certainly change is going to happen. But right now I would characterize the enthusiasm and excitement of our team as at a very high level, and we're really looking forward to continuing in this partnership with Old National in the months and years to come.
Bob Jones - President and CEO
Thank you, John, and thank you for your leadership.
Let me ask you to turn to page -- slide 31, going to give a perspective to follow on Lynell and Chris, Jim and Daryl's comments, and kind of my perspective as to where we are.
I think the third quarter is indicative of where Old National is against its three strategic imperatives. I hope you get a sense throughout the presentations of the great progress we've made on improving the risk profile of the Company and the greater discipline that we're bringing to the Company, all of which are aimed at creating a long-term growth strategy. And I think we have made great progress against those.
But while we are continuing to work on all three strategic imperatives, we know we must continue to work towards improving our growth prospects. In the quarter we invested in the Lafayette, Indiana market, which is a better growth market, two new branches in the high-growth markets of Indianapolis, and clearly what we believe is a great acquisition of St. Joseph Capital in the growing Northern Indiana region.
But while we're doing that, as Chris mentioned, we will continue to look at slower growth markets to determine how we can improve returns, as well as the growth prospects within those markets. And I anticipate we'll be giving you more details on a forthcoming basis. But this is a continual process that we have put in place to improve the market dynamics of Old National, all aimed at giving us a greater growth profile for the Company.
But while we're doing that, we know that we must provide a proper return to our shareholders. And to do that, we will continue to focus on our flight to quality. You heard throughout the presentations, and I just want to be very adamant -- we will be -- continue to be very diligent in credit quality and pricing, we will continue to be very diligent in executing our long-term strategy, and we will not sacrifice any of our plans for the sake of growth at any cost. I think that's very, very important. We are very prudent. We're a very prudent lender. We continue to have opportunities to improve our risk profile, and we will do that, because we believe that's the sound basis for a long-term growth strategy.
But we will also continue to manage and reduce expense. Clearly, until the growth engine begins to happen, we know that we have to provide that proper return to shareholders. And we'll do that through reducing costs. And as Jim has mentioned, we will continue to focus on improving our net interest margin by looking at our investment portfolio and continuing with our focus on non-interest DDA, which is beginning to pay benefits for us.
It is for all those reasons we outlined that we remain comfortable with the consensus for the fourth quarter. It's a little early in our planning process for us to give any guidance for 2007, but anticipate doing that on our January call. At this stage, all of us, including John, are available for questions. Thank you so much for your time.
Operator
Scott Siefers.
Scott Siefers - Analyst
Just had a couple of quick questions, the first couple on credit. I was looking for just a little bit more color on the increase in special mention credits, if they're kind of broad-based throughout industry, geography, etcetera, or just anything you can give there. And then just sort of a technical question. Of the loans that you guys sold this quarter, the roughly 28 million or so, how much if any of that was on nonaccrual already?
Daryl Moore - EVP and Chief Credit Officer
The special mention loans -- the color there, it's really interesting. We went back through to see whether we could identify any trends in terms of industries or types of loans, and it really was kind of across the board. It ranged from manufacturers to commercial real estate office buildings. So there wasn't any common thread.
A lot of that, in terms of geography, I would say probably the majority of that came out of our northern areas, the Indianapolis, Terre Haute areas. And that maybe has a little more to do with we're probably slightly behind the Evansville area in just cleaning up some of the legacy stuff. So, it is across the board and not in any certain type of loan. In terms of the loans sold, nonaccruals of those loans sold comprised about $6.6 million.
Scott Siefers - Analyst
So that was mostly the -- I guess, mostly the distressed hotel loans?
Daryl Moore - EVP and Chief Credit Officer
Yes, it was. It was virtually all in the distressed hotel loans.
Operator
Troy Ward.
Troy Ward - Analyst
Daryl, just to follow up on Scott's question -- first of all, you did an asset sale at the end of '04, in mid '05, and now again here in mid '06. And then with the increase in the criticized bucket or special situation, what do you think the likelihood is that you'll continue to do asset sales into the future?
Bob Jones - President and CEO
Actually, let me give some color and I'll turn it to Daryl. As we said, we will continue to look at asset sales when the markets are ripe for them, as well as when we identify opportunities in the portfolio that we can provide a better return to our shareholders. So, I guess the global answer is it's going to be an ongoing effort for us. Daryl can add some color to that, if you'd like.
Daryl Moore - EVP and Chief Credit Officer
Really, Bob, you said it. It's not kind of a one-off special thing; it is a piece of what we're going to do going forward to make sure that our asset quality stays good.
Troy Ward - Analyst
Daryl, one of the comments you made that caught me a little off guard was you said that what you thought you saw in the credit quality was potentially a first glimpse into maybe what could be an industry deterioration. I guess, what led to that comment?
Daryl Moore - EVP and Chief Credit Officer
As we looked at the loans that were being downgraded to special mention, as I said, there wasn't any common thread in terms of things that we had missed in underwriting, or kind of industries that we had gotten on board with that industries as a whole had deteriorated. So, we looked at that and said this is kind of broad-based.
We then went back, and we monitor on a quarterly basis our ratio of upgrades in our portfolio to downgrades. And what we have seen is, over the past 12 months, that that is beginning to slip a little bit, that we're seeing more downgrades in the portfolio than upgrades. That ratio has gone into what we call the red zone. And so those two things put together leads us to believe that we may be seeing the first signs. We don't know. Obviously, this could be a one or two-quarter event, and it could flip back around. But it gives us enough pause for concern that we're taking a pretty aggressive approach to these criticized loans.
Troy Ward - Analyst
I guess my question would be if you look at your credit quality versus peers, Midwest has been tough, and some of your markets, obviously, have been tough. But your credit quality, clearly, has lagged. What makes you think that this is not an Old National slip in credit versus industry, as I've heard no other credit officer make that type of statement?
Daryl Moore - EVP and Chief Credit Officer
There's nothing I can tell you. I don't see other bank's portfolios. All I can tell you is we don't think this is an underwriting issue here. We don't think it's an Old National issue. As I said in my comments, two quarters from now we may find that I was wrong and things will turn around. It's just what our pretty robust process, in terms of analyzing risk and getting out ahead of risk, has indicated for us.
Bob Jones - President and CEO
I could just add a little color. This past weekend I was in Washington at an OCC midcap CEO conference, and I will tell you the that OCC shares Daryl's concerns and some of what they're seeing in at least the midcap banks.
Troy Ward - Analyst
I appreciate that. And Daryl, I appreciate I the honesty, because I know that potentially that -- that's a very bold statement and I appreciate the honesty there. On the sale leaseback transaction -- I guess probably to Chris -- you mentioned that it would negatively impact the efficiency ratio. I'm assuming that's coming through occupancy expense?
Bob Jones - President and CEO
Correct. You move it from capitalized expense to an occupancy expense, and it's not significant. It's one where, through our other cost reduction opportunities, we think we can more than cover.
Troy Ward - Analyst
I'm sorry; has that closed yet, or is it in the process? Where is that at?
Chris Wolking - EVP and CFO
It has not. We expect it to close late in the fourth quarter.
Troy Ward - Analyst
So, it really won't impact until '07 model.
Bob Jones - President and CEO
That's correct. And in January we'll be able to give you a little more color on exact impact and other areas that we think we can mitigate that with.
Troy Ward - Analyst
Chris, you talked about the investment portfolio, kind of a goal of 25 to 30% (indiscernible) assets. Is that correct, total assets?
Chris Wolking - EVP and CFO
That continues to be our target.
Troy Ward - Analyst
And you're at 29 this quarter?
Chris Wolking - EVP and CFO
29 this quarter, even after some fairly significant transactions. And part of that, obviously, is due to kind of a continued shrinkage of the total asset base. We feel like we're certainly headed in the right direction.
Troy Ward - Analyst
So, obviously you're at the top-end of your goal. But given the current yield curve environment and the -- what is your appetite for reinvestment, or will you continue to move towards the lower half of that range?
Chris Wolking - EVP and CFO
I think our appetite is limited, certainly. And you pointed out the yield curve; it just doesn't seem to make a lot of sense, particularly if we've got a high level -- continue to have a relatively high level of borrowed funding on the books. So, kind of -- I'd say that it continues to be something that we watch very closely, and we'll continue to push that number kind of in that 25 to 30% direction.
Troy Ward - Analyst
How much is cash flowing off of that portfolio in the fourth quarter approximately, and what is the approximate yield?
Chris Wolking - EVP and CFO
That's difficult to say. I don't have those statistics now. And obviously, as we've sold a lot of these assets, it's changed our historical cash flow. But traditionally, we've had good cash flow from the investment portfolio in that range of 20 to $30 million a month. I cannot give you a yield indication on those cash flows.
Troy Ward - Analyst
That's fine. But you expect that it's still in the 25 to $30 million a month for rolloff?
Chris Wolking - EVP and CFO
Jim is nodding his head, so I think we'd still see it. Our portfolio, as we've talked about in previous calls, is pretty short. It runs in that 3.25 kind of duration. So cash flows [are] pretty good.
Troy Ward - Analyst
Thank you. One last question for John on the St. Joe's transaction. I guess as I sit here, and obviously -- I guess the biggest question is why an all-cash deal? I understand the premium was very nice, but you obviously incur a huge tax event for the shareholders. And if you're, obviously, staying on, you have some faith in the Old National franchise. And I think if you look at the current valuation, it's hard to say it's rich. Why an all-cash deal here?
John Rosenthal - President and CEO
That's a good question. There are several reasons for that. First of all, I think there's a general acknowledgment among our board that the capital gains tax rate is at a historically-low level. That's one thing.
The second thing is I think you just have to know some of the history of some of the players involved in our company. And the unmitigated truth of the matter is that some of the folks that have been on our board have been involved in previous bank sales, not necessarily in this market or with our company; obviously, we only sell our own company one time. But their experience in having sold banks for stock didn't pan out nearly the way they thought they were going to pan out. So, I think it is experiential in nature that our board had a bad batch of experiences. And it wasn't just one transaction; it was really several transactions. And it's not very fair or appropriate of me to highlight some of those transactions where people had been involved in sales of banks to other bank holding companies, whereby they took the acquiring bank holding company's currency. Let's just say that given our track record and history, we've seen where that doesn't necessarily work out. Cash is, obviously, very easy to value. And I do have confidence in the new company. I do want to emphasize that. I am personally very excited about this. But again, as I said, it was the collective wisdom of our board to go with the currency that was most easily valued, and that certainly is cash.
Bob Jones - President and CEO
John, you may want to reiterate what you said on the first call about the skin in the game that you and Alex and Amy are doing as part of the deal.
John Rosenthal - President and CEO
I'm happy to do that. First of all, I have a fairly significant batch of unvested stock options that I will be rolling into equivalent in the money value option shares of Old National Bancorp. That's over 20,000 option shares. But based on an estimate of a two-to-one exchange ratio, it will become over 40,000 shares.
And on top of that, I plan to make purchases in open-market transactions at or near the closing of an additional 10,000 shares. So, that's my skin in the game. And my other two senior colleagues are going to have a proportion amount of their net worth invested in the game, kind of similar to my proportion of net worth that will be invested in Old National. So, that's where that stands.
So we are big believers, and we've got a vested interest to make sure this works. This was something that we asked for the opportunity to do, not that Old National required it. But I think it was a mutually-beneficial outcome, and I think everybody is satisfied with that.
Operator
[Charlie Ernst].
Charlie Ernst - Analyst
You all talked about the capital earlier, and is the correct interpretation there that you will be out of the market on the buyback for a while?
Bob Jones - President and CEO
Certainly our appetite is much more limited when we are operating outside that range. So, we feel committed to the 6 to 7% range, and I think the third quarter is indicative of pre-positioning our balance sheet for St. Joe.
Charlie Ernst - Analyst
And then, can you talk about the decision on the reserve, to lower the reserve, despite the fact that your feeling on credit is that it could be turning, and also that your criticized assets were up so much?
Daryl Moore - EVP and Chief Credit Officer
Our formula, without getting into the specifics, is pretty disciplined. So, as we put all of our loans and the changes in categories and the things that we sold during the quarter into this formula, it does give us a range in which to operate on the allowance. We actually, in spite of the fact that we didn't have a provision for the quarter, actually made the decision to move up in that range in recognition of the higher criticized loans, and just the general uncertainty about where credit is going in the future. So, although you didn't see that provision, we did recognize that and moved up in that range.
Charlie Ernst - Analyst
Is there any one factor in your kind of formulaic approach that would have caused the reserve to come down?
Daryl Moore - EVP and Chief Credit Officer
Probably the major factor would have been the migration loss rates. And as you see the very heavy losses move farther and farther back through the history of the Company, as we evaluate those on a quarterly basis and look to see what are the representative rates -- as those get farther out from the current threshold, they have less of an impact on the actual loss rates in each of those categories. So that was a factor this quarter.
Bob Jones - President and CEO
I think what I would add is that our provisioning is driven by a model that is reviewed by a committee that makes a recommendation that is signed off by multiple people. So, this isn't an event that management participates in; it's really driven by the model and the committee with their recommendation. So, I feel very comfortable that the decision the model put forth is the correct decision.
Charlie Ernst - Analyst
Lastly, can you talk about the reversal, I'm assuming, of bonus accruals, what the dollar amount was in the quarter?
Chris Wolking - EVP and CFO
I don't have the specific amount at my fingertips, but we had a number of items that moved around in the quarter. And I think if you're driving at kind of what the run rate of expenses should be, I think it's safe to say that number from second quarter kind of is still a good run rate. I've got the numbers here. The incentive accrual for the '05 grant was about 1.5 million. But again, I would say that the accruals changes going forward, and I think that good numbers are pretty easy to (indiscernible)
Bob Jones - President and CEO
Just to clarify, that's not an incentive accrual; those are restricted stock granted to executives. It doesn't affect the bonus pool for the year in the short term, so this is really a long-term incentive. And as Chris said, it's -- the run rate you'd get from the second quarter and the third quarter are probably fairly accurate, because we do also have other expenses we've added on in the third quarter for investment in the new markets.
Charlie Ernst - Analyst
But I guess I'm -- the investment in new markets, I would assume, is sort of an ongoing thing. And this is --
Bob Jones - President and CEO
We opened a lot of branches this quarter.
Charlie Ernst - Analyst
Right. (multiple speakers) you opened them. They're staying open, obviously, in the future; right?
Bob Jones - President and CEO
That's correct.
Charlie Ernst - Analyst
So why wouldn't that be an ongoing expense that will stay there, and this is kind of (multiple speakers)
Bob Jones - President and CEO
You're actually right.
Chris Wolking - EVP and CFO
And I would say, and I think Bob pointed out, that we have to continue to rationalize the expenses associated with the remainder of our distribution network. And clearly, as revenue growth has been a challenge, you'll see us look very, very hard at costs associated with the remainder of the franchise. So, we certainly have opportunities.
Charlie Ernst - Analyst
I apologize; one last question. Can you just add any color on your expectations for your loan outlook in terms of growth?
Bob Jones - President and CEO
Really at this stage I don't know that we're going to see significant change in the fourth quarter, and I would really prefer to wait until '07, until we get a little further through the budgeting and the forecasting process. But it's safe to say we don't look for robust growth. And quite frankly, a lot of that is our continued focus on tightening on the credit side.
Operator
Fred Cummings.
Fred Cummings - Analyst
A couple questions. Chris or Jim, can you talk about the expected margin improvement coming from the sale leaseback? What type of impact should that have?
Bob Jones - President and CEO
The transaction hasn't closed, but it's fair to say that changing that mix of assets, taking those nonearning assets off the balance sheet and paying down the corresponding amount of funding will have a positive impact.
Chris Wolking - EVP and CFO
I would say probably somewhere in that range of 3 to 5 basis points. It's pretty easy to do that arithmetic just by looking at those average costs out there. But it's clearly a nice accretive transaction to our margin for us.
Fred Cummings - Analyst
Secondly, for Daryl, you mentioned that the 28.8 million of loans -- so, 6.6 is on nonaccrual. (indiscernible) the remainder, the 22.2 million, was that on -- was that in special mention?
Daryl Moore - EVP and Chief Credit Officer
No. Actually, about 8 -- a little more than $8 million of that were in past categories, about 6.3 in special mention, and 7 million, [7.7] roughly, in the classified category. This was really more of a play of industry segment diversification. We just wanted to get out of this industry segment. So, that's the past loans being sold.
Fred Cummings - Analyst
Can you give us a breakdown of your charge-offs between commercial and consumer? Gross charge-offs were 4.6 million. Do you have a breakout of --?
Daryl Moore - EVP and Chief Credit Officer
I have a net breakout.
Fred Cummings - Analyst
That would be fine as well, Daryl.
Daryl Moore - EVP and Chief Credit Officer
Of the $4.7 million, roughly 3.1 was in the commercial area, and 1.6, roughly, in the retail area.
Fred Cummings - Analyst
Just one last question. You guys have made a lot of changes to your underwriting over the last few years, and you've -- you're changing the concentration risk. Where do you, Daryl, view as a normalized charge-off ratio? Many of your peers are playing in a range of 20, 25 basis points, maybe even 30 basis points the longer term. What should we expect of Old National after having tightened its underwriting and having eliminated certain maybe higher-risk categories?
Daryl Moore - EVP and Chief Credit Officer
That's a good question. Today our target is in that 40 to 50 basis point range. You would expect, obviously, as our risk profile continues to come down, that there will be some shift downward in that.
Bob Jones - President and CEO
Freddy, if you can wait, we should have that number for you if not at next week's analyst meeting, we'll have that in January. That's a number that we'll be looking at and doing some forecasting on. So, I don't want to dodge it, but I think I want to be able to give everybody a fair and accurate assessment of that. So, if you can bear with us (multiple speakers)
Fred Cummings - Analyst
Certainly. One last question, Bob. Are you retaining all of your commercial lending staff? I just want to get a sense for what's happening in that regard. Are you losing people you don't want to lose, or how is that working out?
Bob Jones - President and CEO
No; we haven't lost anybody of any significance that we -- and actually, our retention rates are fine. It's a capacity issue for us right now.
Operator
Kenneth James.
Kenneth James - Analyst
I had a question on kind of the loans this quarter, kind of the 100 million decline exclusive of the loan sale. Just curious, was there any loans in there that kind of fall into the category of higher-risk but performing relationships that you previously said you wouldn't mind seeing leaving the Bank? Or was this all just a function of kind of customer paydowns combined with maybe some weak demand?
Daryl Moore - EVP and Chief Credit Officer
That's a very good question. There were some loans in there that we did ask the customers to exit, and they did. I can't -- however, I don't have those, and I'm sorry -- the breakdown of that $100 million, what that would be. Can't even tell you what a guess would be, but we continue to move those types of loans out of the Bank.
Bob Jones - President and CEO
We'll get back to everybody with that number. But I think, Kenneth, you hit the nail on the head. We continue to work out of credits that we believe have potential to be risk -- riskier to the Company, and we'll get that breakdown for you.
Kenneth James - Analyst
Kind of second part of that question -- if you scroll back a year and look at the second and third quarter, you had a couple nice quarters of 6 to 7% annualized loan growth. That's obviously been a lot different this year. Is it all -- what do you think it's more attributable to, your own internal outlook on credit, pricing and stuff in the market, or just maybe more of an economic deterioration in your market in terms of demand?
Bob Jones - President and CEO
I actually probably believe it's more the economic environment, and the fact that we are not aggressively going after commercial real estate and commercial development loans. So, I don't -- we were using the same underwriting standards a year ago that we're using today. So I would believe it's more environmental. And if there's anything internal, it's our continued concern for the commercial real estate area.
Operator
Ben Crabtree.
Ben Crabtree - Analyst
A question on [Alco]. Could you update us as to whether or not at the end of the quarter you're still liability-sensitive, and then project, maybe to the end of the year after the transaction closes, what your Alco position would be at that point?
Chris Wolking - EVP and CFO
Clearly, with the transactions in the portfolio that we had in the quarter, we've reduced our liability sensitivity. As we have talked about in previous calls, we generally are a liability-sensitive organization. But obviously, we've been able to maintain our margin. So this, clearly, reduced our liability sensitivity somewhat. I think you can expect that the transaction, the sale leaseback transaction, will continue to reduce that liability sensitivity. Jim, anything to add?
Bob Jones - President and CEO
I think it's fair to categorize it as getting closer to flat on our liability sensitivity, although as noted by the margin decrease that St. Joe Capital realizes, that will add some additional liability sensitivity to our books, barring any other changes in their total portfolio.
Ben Crabtree - Analyst
Thanks. And then, I'm assuming the 2.8 million write-down on the loan sales were credit-related. But were there any pricing-related metrics involved there?
Daryl Moore - EVP and Chief Credit Officer
Ben, I'm not sure I understand what [your question is].
Ben Crabtree - Analyst
(multiple speakers) significantly underpriced you might have to take a haircut to sell them.
Bob Jones - President and CEO
No. That's all credit.
Ben Crabtree - Analyst
Pardon my being too simplistic, but doesn't that mean you were significantly under-reserved if you have to take a haircut to sell them?
Daryl Moore - EVP and Chief Credit Officer
Some of these loans actually carried with them -- well, all of these loans actually carried with them some level of reserve. Those loans that were impaired had that impairment in our analysis, in our reserve calculation. So, as we sold those loans and took the losses, those losses were, obviously, charged to the allowance. But the need associated with those loans also came out of the allowance. So that is a little bit of the explanation about how you sell those loans and take a $2.8 million loss and don't have to replenish the allowance, because the impairment associated with those loans also came out with those loans. So, I'm not sure that I explained myself well. Does that make sense to you, Ben?
Ben Crabtree - Analyst
In part, but I don't want to bog the call down with having you explain it to me in detail. And then there was, I thought, a comment that kind of went by fairly quickly that I thought was interesting, or I would like to pursue a little bit further. I thought that there was a comment, I guess, in Daryl's presentation that you were seeing some stress, some weakness in multi-family loans, which certainly caused me to perk up my ear. And I'm wondering if I heard it right. And if that's true, if that's in some localities, or if it's kind of a generic statement.
Daryl Moore - EVP and Chief Credit Officer
Actually the bulk of the loan sale was in the multifamily area, and it was a segment that specifically related to some low-income housing multifamily. And that's a segment that we were beginning to have some concern about. So that's why we sold a good share of that specific portfolio. So that was the reference to multifamily.
Ben Crabtree - Analyst
So that comment wouldn't necessarily apply broad-brush to multifamily loans across your [whole market]?
Daryl Moore - EVP and Chief Credit Officer
Right.
Operator
Troy Ward.
Troy Ward - Analyst
Just to follow-up quickly on something Ben brought up that I guess I would like more color on as well. In the sale of the loans, when you think about -- obviously, you had some reserves held against those nonperforming loans. If you look back to '04, you took an additional loss of 3.5 million in '05 loan sale, you took additional loss of 5-plus million, and here you took an additional loss above already reserved levels. I guess, where should we find comfort in the fact that if credit is deteriorating, why would you not be providing to the current portfolio, based on you continue to take additional charge-offs beyond your reserve level?
Daryl Moore - EVP and Chief Credit Officer
I think it's important to distinguish what a charge-off represents in a loan sale. If we have a group of loans that's in our portfolio today, and we have a reserve against those loans, and we haven't charged those loans down yet -- we have impairment in the reserve or we have pools against those reserve -- if in fact we sell loans at a discount, that discounted portion gets charged back to the allowance. And that charge-off piece isn't necessarily an under-reserved piece. The reserve for those loans is already in the allowance. And so for instance, if you take a $1 million loss on a sale, that $1 million may be fully covered by the impairment or the pool loss rates in the allowance. It's still a charge to the allowance. What you have to do is sort out at the end of the day was that charge in excess of what you had provided for those loans? And I don't believe it's just as simple to say that charge-off represents that difference.
Troy Ward - Analyst
I understand what you're saying. If we look back -- I'm just trying to think more in line of where are you gaining comfort on the reserve level? Obviously you're very comfortable at current levels because you didn't have a provision this quarter. If we look back to '04 reserves as a percentage of loans after the sale -- before the sale was 190; dropped down to 173; again -- 10, 15 BIP drop after the 2005 loan sale. And then this quarter, obviously, only a 5 basis point drop. How do you get -- what are you managing to -- I know you're not managing to it -- but where is your comfort level with your reserve levels going forward?
Daryl Moore - EVP and Chief Credit Officer
Again, Troy, the actual loan analysis or allowance analysis we do in the formula drives what the appropriate range is. We, obviously, look at a number of things. Where we are in that range. We look at coverage to nonaccruals. And though I would acknowledge to you that our allowance to total loans has come down over that time period, I think you've actually seen some improvement in coverage of nonaccruals. So we're pretty comfortable where we are today.
I think one of the limiting factors in looking at allowance going forward, we probably will want to keep our allowance relatively higher -- and I want to make sure that you understand the term relatively higher -- as our coverage of nonaccrual loans continues to be below our peers. If we can get that coverage to our peer level, then I think we would all look at and be a little more comfortable with a lower level of reserve. But there's a lot of moving factors in that analysis on a quarterly basis, and I couldn't tell you -- we do not have a target; it's just where we are with our portfolio and risk at each quarter as we do that evaluation.
Operator
Gentlemen, there are no further questions. Do you have any closing comments?
Bob Jones - President and CEO
Just thank you to everybody. If there's any follow-up questions, please contact Lynell. We have a couple of follow-up items to get back to all of you, and we will do that. Thank you so much for your time.
Operator
This concludes Old National's call. Once again, a replay, along with the presentation slides, will be available for 12 months on the shareholder relations page of Old National's Website, at www.OldNational.com. A replay of the call will also be available by dialing 800-642-1687 and entering conference ID code 880-3341. This replay will be available through November 14. If anyone has additional questions, please contact Lynell Walton at 812-464-1366. Thank you for your participation in today's conference call.