Prosperity Bancshares Inc (PB) 2009 Q3 法說會逐字稿

Good day, everyone, and welcome to today's program. At this time all participants are in a listen-only mode. Later you will have the opportunity to ask questions during the question-and-answer session. Please note this call may be recorded. I will be standing by if you should need any assistance.

And it is now my pleasure to turn the call over to Mr. Dan Rollins. Please go ahead, sir.

Good morning, ladies and gentlemen. Welcome to Prosperity Bancshares' third-quarter 2009 earnings conference call. This call is being broadcast live over the Internet at prosperitybanktx.com and will be available for replay at the same location for the next few weeks. I'm Dan Rollins, President and Chief Operating Officer of Prosperity Bancshares. Here with me today is David Zalman, Chairman and Chief Executive Officer; H.E. 'Tim' Timanus, Jr., Vice Chairman; and David Hollaway, our Chief Financial Officer.

David Zalman will lead off with a review of the highlights of our recent quarter. He will be followed by David Hollaway, who will spend a few minutes reviewing some of the recent financial statistics. Tim Timanus will discuss our lending activities, including asset quality. Finally, we'll open the call for questions.

During the call interested parties may participate live by following the instructions that will be provided by our call moderator Shannon, or you may e-mail questions to investor.relations@prosperitybanktx.com.

I assume you have all received a copy of the earnings announcement we released earlier this morning. If not, please call Tracy Schmidt at 281-269-7221, and she will fax a copy to you.

Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for the purposes of federal securities laws and as such may involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of Prosperity Bancshares to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in Prosperity Bancshares' filings with the Securities and Exchange Commission, including Forms 10-Q and 10-K, and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements.

Let me turn our call over to David.

Thank you, Dan. I would like to welcome everyone to our third-quarter 2009 conference call. I am delighted to report another quarter of solid performance by our team.

Among our successes this quarter are the operating earnings increased to $29.3 million or $0.63 per diluted share, and that's compared to $24.6 million or $0.53 per diluted share for the same period in 2008. This represents an increase in earnings per share of 18.9%.

For comparison purposes I have excluded the loss on the Fannie Mae and Freddie Mac preferred stock that we recorded during the third quarter of last year. GAAP earnings for the third quarter of 2008 were $0.33 per diluted share. The $0.63 was an increase of 18.9% over the $0.53 in the same quarter last year.

Our third-quarter net interest margin was 4.08% compared with 4.15% for the same period of 2008, and 4.04% for the second quarter of 2009. Our non-performing assets increased 3 basis points to 29 basis points of average earning assets, up from 26 basis points in the same period last year, and from 26 basis points at the June 30, 2009.

Our tier 1 risk-based capital ratio is 11.85% at quarter end. Our total risk-based capital ratio is 13.01% at quarter end, and our tier 1 leverage capital ratio is 6.09% for the quarter ending September 30, 2009. That's compared to 5.81% for the quarter ending June 30, 2009, a 28 basis point increase in one quarter, or a 19.3% increase on an annualized basis.

Our efficiency ratio improved to 44.6% from last quarter's 49%. Our loan loss reserve increased to 1.39% from 1.05% for the same period last year. Our allowance for loan loss has increased 39% over the past year to $47.3 million compared to $33.9 million for the same period last year.

Our earnings momentum continues to be very strong. This is especially true when you take into consideration the additional $16.5 million in provision expense over last year for nine months and an additional $10.2 million in FDIC insurance expense over last year for nine months. These two items alone have increased our nine-month total expenses by $26.7 million above last year's level.

A little bit about loans -- excluding the loans that were acquired in the FDIC Franklin Bank transaction, loans remained relatively flat for the quarter, decreasing less than 1% on a linked-quarter basis. Additionally, it should be noted that our construction loans decreased 32.1% on an annualized basis or $49.3 million from June 30, 2009. Excluding the reduction in construction loans, we actually experienced an increase in loans for the quarter. We continue to see opportunities for loans that we did not have a year ago.

We continued to record deposit inflows. Again excluding the deposits assumed in the FDIC Franklin transaction, linked-quarter deposits increased 4.1% on an annualized basis.

A little bit about the Texas economic outlook is that we believe Texas is one of the best places to be living and working in, in today's economic environment. Unemployment in the state is 2 percentage points below the national average. It has one of the lowest rates of housing repossessions. There is no state income tax. There is no tax on capital gains in Texas. Also, the Lone Star State has more Fortune 500 headquarters than any other state. California has 51, New York has 56 and Texas has 64. AT&T, Dell, Texas Instruments, Continental Airlines, Exxon Mobil, JCPenney, American Airlines, Conoco Phillips, Southwest Airlines and Halliburton are all located in Texas. Texas created 70% of all the new jobs in the United States in 2008, and our state government is operating with a budget surplus.

Texas is the fastest-growing state in America with 150,000 new residents arriving each year. Three out of the top 10 largest cities in the United States are in Texas -- Houston, Dallas and San Antonio. Texas, and Houston, in particular, has no broad, racially mixed population of Hispanics, whites, Asians and blacks with virtually no racial problems. Texans welcome new people and are eager to see them succeed.

We obviously feel we are in the right place at the right time. Our business model has not changed. We continue to be plain vanilla. We take in deposits, make loans and watch our expenses. We continue to be disciplined in the type of assets and liabilities we put on the balance sheet as well as the acquisitions we make.

In closing, I would like to say thank you for your support and confidence. I'm very confident in our model and our continued success. We have a great group of bankers and we will continue to grow and prosper. We are proud of our past and we intend to stay the course. We plan to continue our focus on organic growth, and we plan to continue to pursue accretive acquisitions. Although we want to grow, we will not take our eye off the ball when it comes to asset quality and building shareholder value. We intend to continue building our loans, focusing on our customers, rewarding our people that produce results and building shareholder value and honor our service commitment by greeting the customer with a smile, calling the customer by name and find a way to say yes.

Thanks again for your support of our Company. Let me turn over our discussion to David Hollaway, our Chief Financial Officer, to discuss some specific financial results we achieved. David?

Net interest income for the quarter ended September 30, 2009 increased 33.9% to $77.4 million compared to $57.8 million for the same period last year. The increase was primarily due to a 35.7% increase in earning assets.

Non-interest income increased $2.1 million or 16.2% to $15.2 million for the three months ended September 30, 2009, compared to $13.1 million for the same period in 2008. The increase was primarily due to an increase in service charges on deposit accounts related to the Franklin transaction. Non-interest expense decreased $5 million or 10.9% to $41.2 million for the three months ended September 30, 2009, compared to $46.2 million for the same period in 2008. However, last year's numbers included the $14 million impairment write-down on the Fannie Mae and Freddie Mac preferred stock. So, excluding the impairment, non-interest expense increased $9 million or 27.9% and was mainly attributable to the increase in staff and general expenses related to the Franklin transaction.

Deposits at 9/30/09 were $7.1 billion, an increase of $2 billion or 39.4% compared to $5.1 billion at 9/30/2008, and if the deposits from the Franklin transaction are excluded, deposits increased $480 million or 9.4%.

The bond portfolio metrics at 9/30/09 reflect a weighted average life of three years and an effective duration of 2.9 years, and the projected annual cash flow is approximately $1.2 billion.

And with that, let me turn over the presentation to Tim Timanus for some detail on loans and asset quality. Tim?

Thank you, Dave. Non-performing assets at quarter ended September 30, '09 totaled $21,920,000 or 0.64% of loans and other real estate as compared to $19,587,000 or 0.57% at June 30, '09. This represents a 12% increase.

The September 30, '09 non-performing asset total consisted of $8,816,000 in loans, $366,000 in repossessed assets and $12,738,000 in other real estate. Approximately $3,767,000 or 17% of the September 30, '09 non-performing assets are at this time under contract for sale. But obviously, there can be no assurance that any of these contracts will necessarily close.

Net charge-offs for the three months ended September 30, '09 were $2,549,000, down 28% from $3,526,000 for the three months ended June 30, '09. $7,250,000 was added to the allowance for credit losses during the quarter ended September 30, '09, compared to $6,900,000 for the quarter ended June 30, '09.

The average monthly new loan production for the quarter ended September 30, '09 was $77 million compared to $76 million for the second quarter ended June 30, '09. Loans outstanding at September 30, '09 were $3,406,000,000 compared to $3,451,000,000 at June 30, '09. The September 30, '09 loan total is made up of 40% fixed-rate loans, 26% floating-rate loans and 34% variable rate loans.

I will now turn it over to Dan Rollins.

Thank you, Tim. While I'm sure everybody would like to hear us drone on for hours more, I think we are ready to turn it over to questions. Shannon, can you assist us with that?

(Operator instructions) Ken Zerbe, Morgan Stanley.

Dan, maybe you can comment a little bit about what you guys are seeing in terms of additional FDIC-assistant opportunities within the Texas market. And I guess, as a follow-on to that is, if you were to get another deal done, how would you feel about substantially lowering your loan-to-deposit ratio from here, given it's already the lowest in the industry? And, would that be a hurdle for another deal?

I think David and I will probably both take a stab at that, Ken. I think opportunities in Texas for FDIC -- we believe there's going to be opportunities out there. The FDIC is doing their part, and we think they are doing a fine job of trying to keep everything together on their side of the aisle. When those opportunities present themselves, we want to be prepared to look at them.

Remember, Ken, we value core deposits above all else. So the core deposits is where the value is in a commercial banking franchise such as ours. It's not on the asset side of the aisle. As we can all see today, assets aren't selling at par; assets are a discount and a problem for banks. So core funding is where the key strength and the key value in banks are.

However, Ken, as you know, most banks today that the FDIC is marketing, outside of a very few that we've seen, are being sold as whole banks. So you are getting assets with the deposits. And the Franklin transaction -- let's go back and walk through that. You remember Franklin had $3.7 billion in deposits at the time we took them over, and we said at that time that we were going to immediately run off the brokered funds. We had no need for those brokered funds, we didn't want those brokered funds, and what we valued the most out of the Franklin transaction was the core low-cost, sticky funding.

And if you look at our performance in the past year, I think you can see that the Franklin transaction has been very beneficial to us, and the fact that, even though we only have $300 million or $400 million in loans in those locations that we acquired and we've made a little bit since then, we are still sitting on $1.6 [million] or $1.7 [million] -- I don't need to tell you the exact number -- in deposits that are out of the Franklin transaction, yet our earnings have been propelled greatly from that. We've got $1.533 billion in deposits left out of that, and I think that was where we thought we would be all along.

So we have allowed the high-cost, non-core funding from the Franklin franchise to run, and we've maintained the low-cost, customer-based relationships that are in those locations. And then we can invest that money into low-risk securities and make money on it. And then, our goal would be to continue to grow the balance sheet on the asset side. That's the challenge in front of us is to grow loans to improve our margin and be more profitable.

But our process today -- it wasn't but just a few years ago, in 2003, we were at a 37% loan-to-deposit ratio.

David, do you want to tag onto that?

Yes. Ken, first of all, I would say we do have a very low loan-to-deposit ratio. And, again, it's not our goal to stay at this ratio, but whenever you get $2 billion of deposits piled onto you without virtually any loans, it's just -- it's not something that you can just do automatically and it's not something we would want to do automatically.

So, as Dan said, we've been in this situation before. In the '80s we bought a lot of failed banks, and all we really got were deposits. And our loan-to-deposit ratio was probably in the 30% -- 30%-something range. It took us about four or five years to get up to the 65% or 70% loan-to-deposit range and I have no fear that we will do that again. But at the same time, you've got two factors going against you right now, probably, where most banks are getting rid of -- I don't know if they are getting rid of; they are just paying down construction loans. If you look at our construction loans this quarter, we lost or we paid down $49 million. So we did grow, if you take that out of the equation. But whenever you have a slower economy, you're not going to have a 20% growth factor each year.

But I can assure you that, within a reasonable period of time -- and again, that's not a year or two years -- we will be back to the 65% to 70%.

Moving on to the opportunities, I think you asked a question about what kind of opportunity that we are seeing out there with FDIC. I guess most people are aware, we spent a lot of time and bid very vigorously on the Guaranty deal, spent -- we didn't get it. So it took a lot of our time and efforts during the quarter working on the deal.

There's still a lot of deals out there. The difference is, there's probably not as many big deals out there like the Guaranty transaction was. I think what you're going to be seeing or what we are seeing is a lot smaller deals. But again, the FDIC is giving you some options now. We're taking some of the small deals where they may have two or three at one time in a certain regional location and letting you pool those together and make a bid on that.

So we will probably look at making some bids on some of these FDIC transactions. They probably, for the most part, won't be like Franklin and probably will all have -- for the most part, right now, will all have loss share agreements with them. Having said that, I think Sheila Bair spoke recently and said that we are going to have maybe 400 banks next year. Who knows? But there's going to be, definitely, a lot of opportunity for us. And so we are not going to just jump at the first thing. We are looking at them; but, again, if we do it we are going to really try to make good money off of them. I don't know if that's answering your question or not. I hope I did.

It absolutely does. The other thing I was just wondering about -- have you seen any change in business demand for loans? Obviously, commercial loans are down again this quarter. But (multiple speakers).

There is virtually no organic loan opportunities going on right now. I think most of the loans that we are seeing we are taking from other players that are not focused on external items; they are focused on internal items. We are seeing very little market expansion type business going on out there.

But we are seeing, Dan, opportunities that we didn't see two years ago where, because we just weren't competitive when the market, what I'd say, went a little crazy. You know, people weren't requiring personal guarantees, not requiring the money down, giving terms and conditions that extend into never-never land. And you could go to what we call the shadow banking market and get all these done. They would package them and selling them.

That's not out there anymore. So we really are getting some very good opportunities to see these kind of loans. And these loans are usually bigger than some of the loans that we are used to seeing, too. So that can help as we grow.

I think our loan pipeline is actually looking pretty good again. David said it in his comments, Ken, but if you look at the loan portfolio at quarter end, commercial and construction loans shrank almost $50 million for the quarter. That's by far the biggest shrinkage in that piece of the business we've had now in the last four or five quarters. We've been averaging $20 million or $25 million a quarter in shrinkage, and we shrank $50 million this quarter in construction loans. Outside of that -- and total loans shrank $50 million. So outside of that construction loan shrinkage, we were doing pretty well.

Andy Stapp, B. Riley & Company.

Hey, nice quarter. What was driving the strong reserve build? Was it related to potential problems coming down the road, or were you just being cautious in the current environment?

Remember, our loan portfolio is very granular and very small. And so, when you build in your metrics into your loan loss reserve modeling that we all do today, the metrics that are out there are looking at the economic factors. And Texas -- the unemployment, all of the economic factors are still getting worse, they are not getting better. So I think, when you look at our portfolio, I would say, I think, that the tale for us would be unemployment. Our borrowers are dependent upon consumer disposable spending. And if that continues to contract, that could lead to future problems.

But our modeling is all looking at economic factors, and the economic factors continue to deteriorate.

Yes, but more so Andy -- this is David Zalman. Primarily, it wouldn't be -- I don't know that anybody would think that we were doing our job right or that we would be prudent not building a reserve in these [kind of] economic times. Even though Texas is probably better than any other state out there, it would -- if we just -- we kind of -- we're putting almost double -- whatever we're charging off, we are putting about the same amount in building reserve. And I think we will see that, probably through the end of the year. Maybe next year that will change, but I think it would be prudent and our model would suggest that, just because of the economics that Dan is referring to, that we do build.

And I think it's the only prudent thing to do in these kind of times. It wouldn't look good if we showed a $30 million income, I think, for the end of the quarter and put less than provision than what we charged off, especially in these kind of times.

Okay. Your CRE non-performers are up quite a bit. Can you talk a little bit about what was driving this as well as how much heartburn commercial real estate gives you?

I think that the same answers that we've been giving for the last couple of quarters -- when you look at CRE, and I'm (inaudible) our book, fumbling pages here. But when you look at CRE, we had a couple of bigger items that were there last quarter. Those items are still there this quarter, and then a couple of smaller items have kicked on there with it.

So I think -- overall, I think we continue to look at the big-picture item on where we are. And we would look at the big picture for looking forward. I think we are still -- David, you might want to comment -- but I think we're still looking at 25 to 75 basis points in total non-performings.

I'm sure somebody will ask that question. But I think two things that I would comment on with regard to the loans and the charge-offs -- from what we can see, I think that things do look better. But again, I'm going to be, say, cautiously optimistic. But having said that, I think that we've told most of the market that our non-performing assets would run in a vicinity between 25 and 75 basis points. I think that still holds true for the next quarter, and I would still say that charge-offs, where they were probably less this quarter than last quarter -- again, it's still hard to look past two quarters. So I'd still say that for the next quarter you'll probably still see charge-offs where we have been, really.

Specifically, last quarter, CRE -- we had three credits in the CRE category over $1 million. And as we've said many times before, where a credit or a problem of that size comes on, it's not as quick to be resolved as smaller credits. When you look at the total number of credits, we had 108 credits on the non-performing list last quarter. We have 108 credits on there this quarter. Those are not the same 108 credits; about 60 of them were there at the end of last quarter, and three, the three larger CRE pieces that were there last quarter, are still there. And now there's another $1 million-plus item that's kicked into that category in this quarter.

Thankfully, in the numbers that Tim gave -- and I don't remember exactly what you said, Tim. But the numbers that Tim gave of what's in the process of being resolved now -- two of those larger CRE pieces are in that category of under contract and ready to resolve out.

Yes, in round figures, it was $3.8 million.

You would also have to say, though, in the earlier stages when all of this started, maybe in September of last year, too, a lot of the non-performing were like residential home loans. And our experience with loans are, those move in and out pretty quick. You go through foreclosure, you foreclose on them and you can sell them a month later. The problem with a lot of these commercial deals -- a lot of the people feel that -- or companies that you have, they feel like they have an equity stake in it. And most of the time, when you try to foreclose, they don't let you foreclose or they declare bankruptcy. And that just takes you 180 days down the road before you can really get anything done and get the court to give it to you.

Thankfully, the foreclosure laws in Texas are not onerous on us, so we are able to move pretty quickly. And I think that our process has not changed at all. We talk about what's in here, the 108 items that are in here at quarter -- remember, this is a snapshot in time. I would venture to say, and we don't track this in numbers, but I would venture to say that during the quarter we probably had 30 or 40 other items that kicked into the non-performing category and was resolved during the quarter so it never made it onto the final quarter-end report.

So we are pretty aggressive and pretty fast on what we are trying to do to work through that.

Okay, great. Could you discuss what you see as far as opportunities for further net interest margin expansion?

In a big-picture discussion of net interest margin, I don't know that if you are looking over the next three to six months, I would say that the opportunity is that that margin should be pretty stable going forward in the very short term. And, again, obviously there's opportunities on the deposit side in the repricing of our deposits. But then the counterweight to that is, if we don't put the loans on the books and [net] grow the loans, it's probably going back into the security portfolio and the yield that you get today because we need to stay shorter, not go long and take extension risk. We'll lose yield on that side.

So when you build all that in, I think, over the short term, the three to six months, that margin should be pretty stable.

I would add, from a deposit repricing standpoint, Andy, remember, we bought the Franklin franchise last November and we maintained all of their existing retail deposit rates in place on their CDs. We had the right under the FDIC rules to reprice some things. We ran off the brokered deposits, but we maintained existing contract rates on all of their CDs.

Well, we are coming up on a one-year time period, and the large majority of that business was less than one year in term. So we've basically been through a one-year repricing time on that Franklin side. So the ability to continue to reprice deposits downward on the Franklin side is dwindling. There's still some opportunity there, but it's not near what it's been for the last couple of quarters.

Okay, that's helpful. Do you have 30-to-89-day delinquencies at quarter end?

Yes. Let's see. That's a good news story for you. If you look back over the last -- starting in December, December '08, 30-to-89-day numbers were $39.8 million. In March that number increased to $42.5 million. In June it improved to $34.2 million, and in September 30-to-89-day past-due numbers was $23 million.

Joe Stieven, Stieven Capital.

First of all, great quarter. My question was just sort of addressed on the CD funding, but let me ask you two macro questions. Number one, what do you see competition doing on the deposit side now with guarantees gone and things like this? So let's talk about CD funding just from a macro perspective.

And, number two; David, this is really addressed to you. With the fact that you guys have become such a well-respected company, there's a proposal out for essentially full mark-to-market accounting on the loan portfolios, which is a disastrous proposal. What type of thoughts do you guys have? I know the ABA has come out very strongly against it. I just sort of would like to hear your thoughts on it and what you think is going to happen with it.

First of all, I'll address the competition for the CDs. Today it's much, much better in CD pricing that it has been. A year or two years ago, I don't know why our customers stayed with us, quite frankly, some of them. You could go to Washington Mutual or Guaranty or --

GMAC or Franklin or --

-- GMAC or Franklin, almost every bank we bought or went under -- [Downey] -- and you could get 200 basis points more than you could. So that's helped tremendously. I would say even right now, today, we are probably paying a little bit more than we have to for our CDs and some of our deposits. Again, it's just primarily, probably again -- not a whole lot. But a lot of our customers stuck with us when we weren't paying the most. Now we are probably paying a little bit more than we really have to, and this kind of a reward to the customers.

Now, having said that, when we bought the Franklin Bank, we got about $2 billion in deposits and we felt that we would have probably $700 million to $800 million loss on that. We are doing better than that; I think we're probably about $1.5 billion, $1.6 billion.

Dave, do you have that number?

$1.533 billion.

$1.533 billion. So we actually kept more of that money than I thought. And having said that, they have a real rate-sensitive client base. So what that tells me is that we are probably somewhere in the middle, that we kept more than we thought we were.

The number two question was on the mark to market. And I will just say that it would be a disaster. I would have to tell you, if there was a mark to market, I don't know that -- gosh, I don't know how you could do it because, when you make a loan, today -- let's just use today for an example. If you had to go sell your loans today and there's nobody to buy them, even if you're -- you might get $0.50 to $0.75, but nobody's going to pay you for the full risk. In the good boom times, there will be a big premium because there's no fear in the market.

So I don't think it's something that they can do. It would be disastrous. If they thought the last thing that happened in mark to market, back in March when all the other stuff happened -- they did this, it would be a complete disaster. I don't even think the regulators will allow it. In listening to Sheila Bair, she even comments on most of her -- when they ask her about it, that would be a complete disaster for banks to mark to market because there is not really a readily available market for it at any given time; it's just not a tradable market. So I don't know how you can mark something to market when you don't have a readily marketable way of selling the loans.

Thank you, and great quarter, again.

Terry McEvoy, Oppenheimer & Co.

I think it was on the last call you mentioned the potential for some of the larger US banks that were headquartered outside of your state to possibly look to divest their Texas operations. And I didn't hear that mentioned earlier in your call. Do you still see something like that potentially happening?

Well, yes. I think we've seen one of those transactions. The guys out of St. Louis have divested their 15 or 16 offices. Certainly, there has been talk of Citibank wanting to do something in Texas. There were other players that were in the game. A quarter ago, Colonial was marketing their offices in the state of Texas. There are several other players that are out there that are still talking. So I think that's still one of the opportunities that are out there, is people are trying to find things that they have that can help either shrink their balance sheet to preserve capital or generate some capital for them. We continue to look at all opportunities.

And then, as I look at the yield on loans, it was down about 18 basis points this quarter, a little bit more than last quarter. Is that a function of the roll-off of construction loans? And it looks like you added some one-to-four family mortgages. Is there anything beyond that this last quarter?

No, I don't think there's anything special in there. Rates are down. I think that, as we continue to -- speaking of one of those products that you just brought up, we have put on some one-to-four-family. The jumbo home loan market, as you know, is very disrupted on the secondary market, and many of our higher net worth customers, we are happy to put those onto our balance sheet here for them. And so that's where some of that has come from.

This isn't factual, Terry, but I guess probably the answer -- you answered the question. I think a lot of those construction loans probably had a higher rate on them than regular standard commercial. When you drop $50 million a quarter, that's probably the reason for the decline right there.

Are you sure it actually went down 18,Terry? We are not seeing that number.

I thought it went from 479 to 461, but I'll doublecheck from the press release.

That's the bond portfolio.

Okay, I'll doublecheck. But directionally, it was still down. I may be off on the number.

Yes, that was the bond portfolio number. The loans is in the 6's (multiple speakers). It only dropped 4 basis points on the loan side -- 638 to 634.

Okay, great. And just my last question -- the CRE growth this last quarter -- could you just talk about where that growth is coming from, the types of deals you are doing and maybe in what part of the state?

We're doing transactions all over the state. I don't know that we are seeing any growth more or less in any of the markets. Proportionately, I think we are probably similar. Houston represents 40% or 50% of our market, and so we are seeing 40% or 50% of our opportunities there. The types of credits that we are doing are no different than what we have been doing. It's the smaller owner-operated, owner-occupied -- it could be a doctor's office, it could be a dentist's office, could be a veterinary clinic, it could be a multitude of whatever is in there. It's all just smaller credits or customers that we take care of.

We are getting, though, opportunities at some bigger loans. We haven't funded many of them, but we have two larger loans from larger banks that we should be funding this quarter, right now. And again, it's just an opportunity where the times have changed and we've got an opportunity to do them.

In one case, it's probably something, this company had a loan and it's in a residential development. You would think, well, nobody would want to make a loan on a residential development right now. But this is probably one of the best areas of Houston. And where we might have a $20 million or $30 million loan, we probably have over $100 million in collateral in a really good area where homes are still selling and doing very good.

So we are not running away from any one category, either, if the borrowers are strong and there's really a market for it at the same time.

Bain Slack, KBW.

On the bid for Guaranty, I wonder if you could just entertain, I guess, a theoretical scenario that Prosperity had gotten that deal. How would that have played out with regard to the two markets?

I think our intention all along, Bain, would be to focus on Texas. I think our plan would have been to, as quickly as possible, partner up with somebody and divest the California piece, just like we did with the Franklin piece, run off the high-cost, non-core funding, consolidate the offices in Texas that were closer to our offices and move down the road from there. The Texas piece represented about $7 billion or $7.5 billion in deposits when they were marketing it, and our belief was that a big part of that is hot, non-core expensive deposits that we don't have a need for. So we would have expected to have seen that shrink over the next couple of years, just as the Franklin Bank did.

Right. And I guess I had read somewhere that it sounded like you all had four or five investors set up to split capital and, if necessary. I guess I'm just curious; is there any color you can give on these investors? Are they current shareholders outside, and are you all still working with them for other deals? Or, because the other deals might be smaller, maybe you don't need them?

We've commented to the market that we're really not -- I think some people have asked us, why don't we raise capital? And, again, we've kind of made a commitment to existing shareholders that we really were not going to raise capital unless we really needed capital for a particular deal. And even in our bid with Guaranty, I don't know that we necessarily needed the capital the way that we bid the transaction. On the other hand, we thought it would look good politically if we did raise some capital.

And I think we really started on a Thursday afternoon. This was kind of a come-over-the-wall type of situation that was to some of our existing shareholders and some non-existing shareholders. And, basically, in a day and a half we were trying for about, I think -- was it $200 million, Dan? And we got comment months for over $375 million.

So it was a good response. But again, it was contingent upon us getting the deal, and we didn't get the deal. And I think everybody understood that. And it would have been raised at the market price; it wasn't a discount to it.

It was purely contingent capital, 100% dependent upon successfully being the winning bidder on the Guaranty transaction.

Okay, I appreciate that. I guess this is the last question, you've talked a little bit about the CRE and your book, which, again, looks very granular out there. But we've heard some, or at least in the Fed reports, about potential CRE problems in Texas, in general. And I think, David, you noted that at the higher level loan size that there might be some issues. Any anecdotes or anything there that you guys are seeing that could cause concern as it trickles down, or is it just so much at the larger end that it doesn't concern you guys?

Well, I think there's always concern. David's going to jump in here. Let me give you some specific numbers. This quarter we've been putting out some average numbers for you guys. Average commercial real estate credit on our books is $406,000 this quarter; it's actually down a little bit from last quarter. So the average construction loan is down from $300,000-something down to $238,000 for the average construction loan for us. And that's the two biggest pieces. The average loan on the whole portfolio is $101,500.

So very low average loan size; even on the commercial real estate size, a $406,000 loan -- that would be considered very, very small for most of the folks in our peer group today. But, having said that, I think all of us continue to watch the economy. We continue to see -- Tim and I live close to each other; we continue to see the strip centers that have been built now going on two years that are less than 50% full. I think we continue to have some concern that there is some big items out there that are going to have to have a day of reckoning.

I think some of the commercial deals that we have, Bain, are larger than the $400,000 that Dan was talking about (multiple speakers). But most of those loans did come from one or two of the banks that we actually purchased that really focused on commercial real estate. That's primarily what they did. And it does take longer to get the deal done because usually it's fighting bankruptcy, and it just takes a while to get out of those things.

But quite frankly, I really thought that the commercial real estate loans, it would be worse than they are right now today. I really thought that we would see more pressure, and I'm trying to ask myself the question, why aren't we seeing more pressure from the commercial real estate, especially with so much rhetoric and stuff coming from the Fed and everybody else.

And I think it's because, unlike in the '80s, when you had a bunch of banks failing, us especially would buy the deposits of the banks and we would give all the loans back to the FDIC. And in today's market, the way it works is, you have a loss share agreement and you're almost in an agreement with the FDIC for five years, and they are not having to throw all those loans back into the market, which is collapsing the market. And I think that's what's really helping the economy and the overall market in commercial real estate.

If they continue doing that and they can continue finding buyers who are willing to participate in the loss share agreement, I think you will see -- I don't think it's going to be as bad as they all think it is.

John Rodis, Howe Barnes.

Just one question on, I guess, operating expenses on the salary line item. Expenses were up about $1 million, linked-quarter. Can you just talk about that real quick?

Yes. After these past few quarters we've been, in effect, cutting expense reduction mode from Franklin. But, as you can tell from our numbers, by the end of the second quarter I think we were where we needed to be. And now we've flipped around in how we look at things. And that expense that you see is just our general overall operating expenses and things that we are doing internally. Having such a good year, we are doing some things on the salary line in preparation to reward our people as we go forward.

So another way to ask that question is, you see our efficiency ratio at something less than 45. So I find it hard to believe we'd go down much lower at this point. At this point, we've got to run our business and reward our people and reward our customers. So the expense level, if anything, could trend up a little bit. Again, this depends on top-line revenues. But I think that's a more normalized overall general expense run rate than what you've seen in the past quarters, now that we've gotten it down to this level.

Okay, so have there been any new hires or anything in there, or it's just generally (inaudible)?

There's a couple of new hires in the group. But I think, if you look at total headcount, total headcount is down 30, give or take. So total headcount is down. But absolutely, we've been able to hire some folks. I think that's one of the bright spots we would want to talk about. We've hired a couple people in the Central Texas market, we've hired a couple of people in the North Texas/Dallas/Fort Worth market. We've hired a couple people here in the Houston market. They've come from a multitude of different players that are, again, not customer focused today the way these lenders would like to be, and they've decided to come over and join our team. So that certainly helps.

And certainly, when you hire folks it takes a while for them to be able to generate enough business to pay for themselves. But I think a big part of this is just the normal processes that we go through.

Fair enough, guys, nice quarter.

Christopher Marinac, FIG Partners.

Would risk-weighted assets have changed much this quarter? Would they have gone up commensurate with the balance sheet?

I don't think so. Are you seeing something that we're not seeing?

Actually, I was going to make the point that, when you look at tangible capital relative to risk-weighted, you've built a lot of capital just in the last couple of quarters. And I'm curious; as that continues to accumulate in the future quarters, is there any point where the excess is enough that you feel deemed to do something with it?

I think that's a true point. If you're looking at tangible capital to risk-weighted assets, risk-weighted assets are close to the same proportion as they were last time. Certainly, we want to build loans. And building loans takes money out of a 20% risk-weighted bond portfolio into a 100% risk-weighted loan. But that's a longer-moving, slower-moving process. We are not going to go grow loans $300 million or $400 million in a quarter. We are not going to go buy shared national credits. Remember, we don't have any shared national credits on our balance sheet.

So I think you are exactly right. If you are looking at tangible capital on a risk-weighted asset basis, I think we probably are pretty strong.

A separate question -- this had to do back with your point on the small CRE loans. Are you seeing anything on the cash flow at the property level where the cash flow is changing?

I'm glad you brought that up. Bain asked that question; you are asking kind of the same question. Remember, we stress test all of our CRE on a regular, ongoing basis. We cash flow, stress test it, we valuation stress test it. We rate stress test it, and those are the things that we are looking at that allow us to continue to look at and allows, I think, David to continue to be comfortable that we're in the 25 to 75 basis point non-performing range, and we don't see big issues coming up in front of us.

Dan, I don't have the numbers in front of me, so correct me if I'm wrong. But when we stress test, we stress test our loan to value right now on most of our commercial real estate, overall, the whole portfolio. Again -- this may not be accurate, but I think it's probably around the 50% range. I'd have to get with Chris Bagley on our loan to value. Do you remember, Tim?

Yes; it might be a little higher than that, but --

50% or 60%.

On a relative basis, it's low. I think --

And that's after they stress it, what, going up -- or that's so much (multiple speakers) --

You are looking at what is the total outstanding to the total appraised value at the beginning. And, because we require so much equity in the deal, you are right; our loan to value is very low in the portfolio to start with.

Even after stressing them in a rate increase, in an income-down scenario.

That's correct.

I think the bottom line is there's certainly no guarantee as to how our portfolio is going to perform in the future, but it's clear to me that one of the reasons we don't have the same level of problem that you see out in the general marketplace is the discipline of our underwriting, to begin with. We've got down payments. We looked at cash flow closely when we made these loans, and we simply haven't had as many go bad.

That may change tomorrow -- no guarantees, obviously.

Chris, we are obviously not immune to the ills that are out there. But I think, by and large, remember, over half of the CRE book is owner-occupied. So we feel very good about our credit quality.

(Operator instructions) Jim Margard, Rainier.

First of all, congratulations on your cost and lending discipline. Keep it up. Could you comment just a little bit on the competitive landscape on the deposit side and the liability side that you had referred to, suggesting that CD rates are kind of sticky on the up side? Is the competitive landscape, in general, also -- is capacity kind of leaking out, or is it building? Are the larger banks becoming a little more aggressive, less aggressive, more accommodative or not?

And also peers in the smaller bank [ends], are you seeing many banks, contrary to your situation, that are under significant stress?

You asked several pieces of that. We compete with all of the different players. Because of the customer base that we've attracted and that we like, I would tell you that we're competing with a lot of community banks out there in the market every day, in addition to the bigger guys. The bigger guys continue to pay. They have got their marketing specials, and we see this special or that special. But there's strings attached; it's not so far off the chart. Again, what David was saying was earlier, a year ago when we bought Franklin -- again, let me remind everybody, it was November 7 a year ago we closed on the Franklin transaction on November 7, which was a Friday. And on Saturday, they were running full-page ads for 4.25% CD's, which was a full 1 or 1.5 more than we were paying in any market we were in.

That spread has narrowed greatly for rate competition across the board, whether it's the big guys that need the funding or there's smaller community banks that are fully loaned up that are stressed on the funding side that need the funding. Some of that has gone away, but part of the other issue there is, back then, wholesale funding was a lot more expensive. Today, we are hearing many of the banks that are stressed basically singing the praises of the wholesale funding window by lowering the Fed funds rate to darn near zero. You've got banks that were in a funding stress that are able to fund for less than they can go fund it on the retail deposit side.

So again, that comes back to us and our customer-focused and relationship-based deposit funding. We have never really gone after what we would call an individual's investable funds to put in some high-rate CD. We'd like to have their operating money, their checking account, their rainy day savings account, just the everyday folks that -- money that people keep on hand.

I would add that, for the most part, this is probably the most rational times for banking that I've been in, in a long time. And I guess it's because a lot of the guys that were paying the higher rates have been knocked out. But for the most part, almost everybody is behaving pretty good. Once in a while, as Dan says, you get some of their smaller community banks that may have other issues with their loan-to-deposit ratios, where they need something and they're really paying something off of the beaten path or maybe some credit union.

But for the most part, almost everybody is really --

On good behavior.

-- there good behavior, and everybody has become very disciplined. It's been a very good (multiple speakers) good market. And I think it's going to stay like that for a while; I really do. And again, a lot of times, where customers would move just because of rates, we are seeing customers come to us because of stability. A lot of customers, unbelievable to me, are coming to us because we didn't take TARP money. I hear it over and over again, on the loan side and on the deposit side. They just -- I got an e-mail from one of the lenders the other day that just said that basically that -- he sent the e-mail from the person who was making the loan said, I'm not a customer of yours but we know you didn't take TARP money. We looked at the stability of the bank, and we are going to do business with you and move our accounts just because of that. And that's happening over and over again.

So, again, the assumptions for net interest margins near term is probably kind of steady, conceivably maybe widening a little bit, mainly because cost of deposits continues to edge down a little bit. But the pricing of loans maybe not just down a little bit, too. Is that a fair assumption?

I think the asset return, the rates we're getting on all assets, continues to nudge down, and I think deposit pricing can continue to nudge down a little bit. Deposit pricing, on average -- I don't remember exactly. David, isn't it 125 or 126, our weighted average cost of deposits only, not other borrowed money --

Yes.

-- it's in the mid-120's. So you know, in reality, there's not a whole lot of room there. So yes, I think we want to be able to maintain the margin where we are. We'd like to see expansion, but I think it's more likely that we are going to be able to hold.

Again, thanks. Great job in your disciplines.

Matt Olney, Stephens, Inc.

I think you've answered most of my questions, but looking just at the construction book, you mentioned the decline in balance during that third quarter. But it looks like the sequential charge-offs in that book declined for the third consecutive quarter and NPA's in the construction book were pretty flat from last quarter. So a question is, do you think within the construction book, you've probably seen the worst this cycle will give you?

I'm taking a breath before I say (multiple speakers) --

Let us all say our prayers here.

You know, we had the same conversations before we even came into this meeting, with our chief credit officer and our chief lending officer. We'd like to jump on and say we are through with it and it's going the other way. But again, when we all looked at ourselves in the eye, we said, you know, it's hard to look past two quarters. And for the most part, we are going to say we are going to stick with where we are at. But maybe I'll, say cautiously optimistic.

Okay, fair enough. Last question -- David, you mentioned in the prepared remarks that we could see more reserve build going forward again in 4Q. And if we assume a similar reserve build next quarter, I think eventually we get to a reserve of loan ratio around 1.5%. So, beyond 2009, is there a certain reserve-to-loan level where you'd say, enough is enough; I feel good about my reserve coverage, regardless of how the national economy is doing?

Well, first of all, I'd have to answer the proper way and say that we'd have to look at our methodology.

3.5%, 4%, David? What number are you looking at? I'm kidding.

No; you're exactly right. I think, again, it's hard to look past two quarters. But I would say, there is going to become a point in time, and probably next year, where, if banks stay where they are at, that we probably won't be provisioning as much as we are doing right now.

John Pancari, Fox-Pitt Kelton.

Can you talk a little bit about what you did with the bond portfolio this quarter? Obviously, it looks like some reinvestment of excess liquidity sitting on the balance sheet, but also your borrowings were up. So can you just talk a little bit about that?

Again, we stuck with just our normal stuff. Again, the yields are down. We hit a home run when we did the Franklin deal because we invested almost all of the $2 billion at that time, and we knocked the cover off the ball on that. I think our gain in our bond portfolio right now is, what, Dave, about $140 million or something like that?

I want everybody to remember that because when interest rates go up 300 basis points in about six months and we have a loss on that portfolio, that they remember that we did have a $140 million gain, at the same time. But again, most of that is in held-to-maturity. The stuff that we bought again is basically the same kind of stuff, probably a little over a three-year average life, a little under three-year duration, for the most part. That's what we are sticking with.

I think, going forward right now, we may even shorten the duration more. You may see [us] just buying even some shorter duration stuff, just because we think that rates are going to eventually have to go up if this thing turns around. But that's why, probably, we are always cautious when, if you just look at the deposits repricing and you compare that to reinvesting, it almost looks like your margin is going up a lot. It's really not, because what we are reinvesting in and staying shorter offsets a lot of that.

Plus, in the next 12 months, you've got over $1 billion --

$1.2 billion.

-- that you will probably have to reinvest, and you're just looking for opportunity during that time period.

And I don't even know that we'll stick with the three-year average life or three-year duration. We may try to bring it down shorter than that, too.

In the current environment.

In the current environment, and that causes -- you don't get as much on yield on that, either.

Just separately, on the capital side, I know you've mentioned in a couple of meetings the capital generation, the TCE generation you've seen has been in the 20 to 30-basis-point range on a quarterly basis.

That's definitely still there. And I think, if you just kind of continue to project out going forward, you can see we roll out well over 6 before the end of next year, pushing 7.

So you still feel good about that?

Absolutely. The earnings momentum -- that's purely a function of earnings momentum. And I think the earnings have been -- our earnings momentum and the quality of what we believe is just poor -- as David said on his remarks, this is plain vanilla. This is -- we take deposits and we make loans, we are conservative in our underwriting. We are conservative in our deposit pricing. And so that allows us to be profitable even with a 50% loan-to-deposit ratio and the excess provisioning and the excess FDIC costs. But we feel very good about the quality of the earnings that we are producing.

The increase in the deposit service charges in the quarter -- does that look like it's sustainable, or is it -- something impact that, that it could come off?

I think, as we look at it today, projecting it forward, I would use that as a stable number going forward. I know there are some changes out there through the regulatory --

Depending on the political winds --

Yes, the political winds have some changes, and we are looking at that. But when you throw it all in, I think using that number as a stable run going forward, I think, is pretty good.

Jennifer Demba, SunTrust Robinson Humphrey.

Long call today. Question for you on potential FDIC transactions -- David, is there any thought to considering transactions outside Texas?

I've got to be careful when I say that. The last time I told the world that, our stock went down 10%. I would say right now, we don't have an interest. Somebody asked earlier in the phone call what our plans were if we got the Guaranty deal. And when we were bidding on that, we almost had somebody on the side to take the California stuff. I don't think we want to be in California, I don't think we want to be in New York.

But to get maybe a bigger deal, we may have to look at a state that's adjoining to us, maybe a New Mexico or Oklahoma or Colorado, in this area, down to Louisiana, Arkansas, Florida. We probably will look at something like that, if it's a reasonable deal and we can make money on it.

It's got to be big enough to be worth our while. It's got to be enough size to generate income to make it worth our while.

That's right. And a lot of people say, well, God, if you jumped over to Oklahoma or New Mexico, that's going to be another state. But we are eight miles from the Oklahoma border right now.

We are four miles from the Louisiana border.

We are four miles from Louisiana. So Texas is such a big state, going an extra 10 or 15 miles is not that big of a deal, really.

I still like the company plane. If Southwest Airlines can get me there, that's okay.

Thank you very much. Nice quarter.

(Operator instructions) Andy Stapp, B. Riley & Co.

I'm sorry, I thought I got out of the queue, but all my questions have been answered.

It does appear that there are no further questions at this time.

Thank you, ladies and gentlemen. We certainly appreciate everybody participating. Sorry we've run so long today. We appreciate the support of our Company and we look forward to seeing and visiting with all of you all, down the line. Thank you all very much.

And this does conclude today's teleconference. Thank you again for your participation. You may now disconnect, and please have a wonderful day.