Prosperity Bancshares Inc (PB) 2010 Q2 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 and I will be standing by if you should need any assistance. It's now my pleasure to hand the call over to Mr. Dan Rollins. Please go ahead, sir.

Thank you. Good morning, ladies and gentlemen. Welcome to Prosperity Bancshares' second-quarter 2010 earnings conference call. This call is being webcast 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, and here with me today is David Zalman, Chairman and Chief Executive Officer; Tim Timanus, Vice Chairman; and David Hollaway, our Chief Financial Officer.

David Zalman will lead off with a review of the highlights of the recent quarter; he will be followed by David Hollaway who will spend a few minutes reviewing some of our recent financial statistics. Tim Timanus will discuss our lending activities including asset quality; I will discuss our recently completed purchase of the First Bank branches and, finally, we will turn the call over for questions.

During the call interested parties may participate live by following the instructions that will be provided by our call moderator, Megan. Or you may e-mail questions to investor.relations@prosperitybanktx.com. I assume you have or 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 the federal securities laws and as such may involve known and unknown risks, 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. Now let me turn the call over to Dave.

Thank you, Dan, and I would like to welcome and thank everyone for listening to our second-quarter 2010 conference call. I'm very proud of our bank's performance and the support we received from our Board of Directors, our associates and our newest associates who joined us during the second quarter as part of our First Bank branch transaction.

We are appreciative of the hard work and dedication our Board members and associates have exhibited in helping us achieve the success we are reporting. Our financial results may be considered impressive in normal economic times, but in light of the current economic conditions we believe this performance is remarkable.

In the first half of 2010 and we have increased assets and deposits significantly through the acquisition of 18 full-service banking locations from U.S. Bank and First Bank. After consolidations with nearby Prosperity Bank locations we have enhanced our footprint in both the Houston and Dallas areas. As a part of these transactions, we reviewed and individually selected loans totaling approximately $130 million from U.S. Bank and First Bank that resulted in an increase in loans outstanding.

Some of our successes this quarter include -- our first-quarter earnings were up 19.8%; we earned $31.7 million in the first quarter compared to $26.5 million for the same period in the prior year, an increase of $5.2 million; we reported diluted earnings per share of $0.68 for the second quarter of 2010 compared to $0.57 for the same period in the prior year, a 19.3% increase.

We continue to be pleased with our asset quality. Our non-performing assets totaled only 0.27% of average earning assets at June 30, 2010, one of the lowest levels reported in our industry. The allowance for credit losses was $52.7 million, or 1.54% of total loans in ORE at June 30, 2010 compared with $[42.6] million or 1.23% at June 30, 2009, an increase of $10.1 million in our allowance for loan losses. The allowance stands at 2.4 times our non-performing assets.

Our tangible common equity ratio improved to 5.19% at quarter end, that's compared to 4.84% as of June 30, 2009. Even with our assets increasing 7% or $627 million over the past year, our total risk-based capital increase to 13.5% compared to 12.28% last year at the same time.

Our deposits at June 30, 2010 were $7.8 million, an increase of $556 million compared to June 30, 2009. We continue to actively manage our deposit costs which includes the willingness to allow higher cost deposits to leave the bank.

Our loans decreased $26.2 million or eight-tenths of 1% compared to June 30, 2009, although they increased 2.3% for the quarter or $76.6 million on a linked-quarter basis. As we look forward with respect to loan growth opportunities we recently met with our area managers to discuss business trends and loan demand.

We meet regularly with our senior management team who has direct responsibility for the six different geographic areas across Texas. As a result of our July meeting I'm pleased to report that the overall feeling is positive and our team reports a strong loan pipeline.

As I mentioned earlier, we completed our second acquisition of 2010 last quarter and we are very pleased with our progress. We continue to look for opportunities at prices that reflect today's market. More bankers appear to be thinking about selling, but the largest hurdle continues to be finding a price that is fair for both parties. We believe the additional regulatory burdens and higher operating costs imposed by the new financial reform legislation will ultimately lead many smaller banks to review their options and seek a strategic partner.

Looking forward, as we expected, our net charge-offs continue to fall from the 2009 levels. We are modeling net charge-offs for the second half of 2010 to be similar to the first half. Our non-performing loans for the first half have ranged from $15 million on the low side to $25 million on the high side. We expect to continue to operate within this range as long as some extraordinary item or event does not arise.

While we did not experience a noticeably stronger economy in the second quarter, we do see signs of improvement. We remain cautiously optimistic for the second half of the year with a continued focus on the organic loan growth and the attraction of new customers who are looking for customer focused bankers.

Again, I would like to thank our whole team for a job well done. Thanks again for your support of our company. Let me turn over our discussion to David Hollaway, our Chief Financial Officer, to discuss some of the specific financial results we achieved. Dave?

Thank you, David. Net interest income for the three months ended June 30, 2010 was $80.6 million compared with $75.5 million for the same period in 2009, an increase of $5.1 million or 6.7%. The increase was primarily due to a 7.9% increase in average earning assets.

The net interest margin on a tax equivalent basis was 4% for the three months ended June 30, 2010 compared to 4.04% for the same period in 2009 and 4.20% for the three months ended March 31, 2010. The First Bank and U.S. Bank transactions impacted the second-quarter margin by about 10 to 12 basis points.

Non-interest income decreased $1.8 million or 12.1% to $13.3 million for the three months ended June 30, 2010 compared with $15.1 million for the same period in 2009 and increased $318,000 or 2.5% on a linked-quarter basis. The linked-quarter change was impacted by a $1.7 million loss on sale of ORE and an increase in service charges on deposit accounts of $1.1 million. About half of that $1.1 million increase in service charges on deposits was generated by the new locations acquired in the First Bank and U.S. Bank transactions.

Non-interest expense for the three months ended June 30, 2010 was $43.1 million compared with $44.3 million for the same period in 2009, a decrease of $1.2 million or 2.8%. Non-interest expense increased linked-quarter $3.4 million or 8.4% which was primarily due to the expenses associated with the new locations acquired from First Bank and U.S. Bank.

The efficiency ratio was 46.04% for the three months ended June 30, 2010 compared to 48.98% for the same period last year and 43.77% for the first quarter of 2010.

The last comment I would make, the bond portfolio metrics at 6-30-2010 continue to reflect a weighted average life of 3.1 years and effective duration of 2.8, the projected annual cash flow is still approximately $1.2 billion. The percentage in the AFS category continues to be about $500 million and the total unrealized gain on the total portfolio as of 6-30 is about $190 million. And with that let me turn over the presentation to Tim Timanus for some detail on loans and asset quality. Tim?

Thanks, David. Non-performing assets at quarter end June 30, 2010 totaled $21,856,000 or 0.64% of loans and other real estate compared to $19,868,000 or 0.59% at March 31, 2010. This represents an increase of 10%. The June 30, 2010 non-performing asset total was made up of $9,063,000 in loans, $273,000 in repossessed assets, and $12,520,000 in other real estate.

As of today assets totaling $2,701,000 of the June 30, 2010 non-performing asset total are under contract for sale, plus an additional $1,485,000 is under contractual due diligence. But there of course can be no assurance that any of these contracts will close.

Net charge-offs for the three months ended June 30, 2010 were $2,440,000 compared to net charge-offs of $4,381,000 for the three months ended March 31, 2010, this is a 44% decrease. $3,275,000 was added to the allowance for credit losses during the quarter ended June 30, 2010 compared to $4,410,000 for the first quarter of 2010.

The average monthly new loan production for the quarter ended June 30, 2010 was $71 million compared to $59 million for the first quarter ended March 31, 2010. Loans outstanding at June 30, 2010 were $3,425,000,000 compared to $3,348,000,000 at March 31, 2010. The June 30, 2010 loan total is made up of 41% fixed rate loans, 26% floating rate loans and 33% variable rate loans. I'll now turn it over to Dan Rollins.

Thank you, Tim. As David said earlier, we were very pleased to complete the purchase of the 19 former First Bank locations. The addition of these banking centers to our Texas franchise is a natural fit. Our operational integration teams have done a fantastic job of working with our newest associates to assist our newest customers as they were converted into our service model.

All of these locations are now fully functional as Prosperity Bank locations. At this time I think we are prepared to answer your questions. Megan, can you assist us with questions?

(Operator Instructions). Dave Rochester, FBR Capital Markets.

Good morning, guys. Given the big drop in interest rates we've seen recently, can you just talk a little bit about the way you're approaching vesting excess liquidity for the loan portfolio or excess deposits at this point? Are you guys buying MBS? Are you going short, doing a barbell strategy, some kind of combination of that? And can you talk about the rates you're getting on those?

Dave, this is David Zalman, I guess I'll take that question. First of all, fortunately we were pretty lucky because when we did some of our last transactions starting all the way back with the Franklin transaction, even with the U.S. Bank and First Bank we knew we were getting those transactions and we knew we'd have a bunch of deposits coming on board. So we bought pretty far in advance; even today we probably are still in a purchasing position of $100 million to $200 million a day because we bought in advance.

Having said that, we knew some of those deposits would roll off too, so it's helped protect us while these rates have been going down so much. But, having said that, we're still purchasing. We haven't purchased lately because, as you know, in the last few weeks the yields that you're getting really aren't that -- we think we can do better. But having said that, we can wait because we're purchasing.

But what we are purchasing, being more direct to your question, usually we're trying to buy the 10-year fully amortized mortgage-backed security that has an average life of about 3.6 years. That increases if interest rates go up 300 basis points the life will increase about a year to 4.6 years.

And again, our bogey before that when we go in to buy is a minimum of 3% or we try to get close to 3%, it's not there right now, it's probably in the 270 range. So we're not buying right now. But when we do buy that's what we try to look for.

In addition to that, periodically we're in so many different communities within the state of Texas we probably bank over 200 municipalities. So we're focusing on them a lot, a lot of times right now they're borrowing money again, they're not borrowing a lot of money at any given time, but they'll borrow anywhere from $2 million to $7 million at any given time and we'll take the whole issue and it will be a pre-negotiated rate.

Usually it's a tax-free rate and we try to stay within the 10-year time frame again. And we do a little bit better on that. We're probably -- we're probably yielding closer to 5.5% on that on a tax equivalent yield probably.

Dave, remember Dave Hollaway just told everybody that the duration is still 2.8 years on the portfolio, the effective duration.

Great. And you were saying that you were targeting a 3% yield typically or a 3% margin over the funding cost? I didn't quite catch that.

No, I mean if you're buying mortgage-backed securities right now you're probably not going to be much better than a 3% yield.

We'd love a 3% margin.

Yes. I just wanted to make sure I got that. And also can you update us on the M&A picture as you see it now? Are you getting more calls from banks looking to do a deal at this point just given regulatory reform and poor outlooks?

We have -- this -- I guess this second quarter we probably did get more calls than we have gotten in the first quarter and the last quarter of last year. We probably had two to three what I would call calls that are maybe more serious, you get a lot of people kicking tires that are not that serious. Probably you saw two or three different entities.

Again, we're seeing more people that are considering doing something, especially some of the bankers that have a lot of stock. They want to try to do something before year-end -- just for tax purposes, capital gains going from 15% to, depending on the tax bracket, 20%-23%.

But again, we haven't been able to really come close to closing a deal. The pricing is still -- it's got to be fair for both parties and it's getting more realistic, but it's still not there yet.

Okay, that's great color. And one last one. On the pipeline, you mentioned that the loan pipeline was strong and you certainly saw that in the production this quarter versus last quarter. Is the pipeline -- I guess the increase from last quarter to this quarter reflected with the same rate we saw in the production numbers? I mean is it up like 10% or 15%?

Are you talking about into the third quarter?

No, from the first -- the end of first quarter to the end of second quarter. Just where the pipeline stands right now going into the third quarter.

The production numbers that Tim gave, we went from $59 million on average in the first quarter to $71 million in the second quarter. Is that what you're asking?

Well, in terms of the loan pipeline, you talked about that being strong. At the end of the first quarter versus the end of the second quarter.

Oh, where are we? Yes, I think our guys feel like there's probably a little more activity going on out there, there's a little more stuff that's coming through the system today than there was then. So it's up a little.

I would say -- I was really surprised, Dave, because when we did hold our meeting, and you asked that question, again we had some -- again, we have people that run the Dallas market, the Houston market, South Texas market, Central Texas and everywhere. We had a couple that didn't feel as positive.

The overall feeling on most of the lenders that their pipelines were good and that they think we will see a pickup. Now having said that, we saw a lot of pay downs even from the banks that were -- some of the loans that we just purchased. We got or we're expecting like a $20 million pay down on one deal just in this (multiple speakers).

Happened yesterday.

-- yesterday. So, we're seeing a lot of pay downs at the same time, so we're having more loan demand, so hopefully we're going to get a plus on that or a push up.

All right, great. Thanks, guys, appreciate the color.

Thanks Dave.

Ken Zerbe, Morgan Stanley.

Great, thanks. I just kind of want to follow up on the question about acquisitions and when you're talking to the other management teams for some of the targets -- just help us understand their thinking a little bit. Because it seems that if they're a decent bank and the economy is let's very generously say it's slowly improving, that they're better off waiting to be bought until the economy is a little bit better, until they're a little bit stronger.

And it seems that into that logic that the guys who are a little bit weaker might be more interested in having conversations today. I mean, is that generally what you're seeing out there and is that going to affect the timing of any potential acquisitions you make?

Well, there are probably -- there's two groups. I think there's a group that's still doing good and there's a group that --

(inaudible) weaker.

-- weaker (inaudible). But the people we've been dealing with quite frankly are banks that are still pretty healthy and more similar to ours in size. We really have not had as much negotiations with the banks that they're on the weaker side, they're having some problems. I think you're right and so I don't have a really good feel or can give you a whole lot of color from those kinds of banks really what they're thinking.

Part of what David said earlier, Ken, was -- and that window is closing pretty quickly. But if you're a seller today and you're looking at your capital gains taxes, that significantly changes here coming forward. So I think there are some people that are talking about that, but not able to pull the trigger.

Okay.

And I would say too, Ken, if some of the banks, and I think -- you can agree or disagree on this -- but a lot of the banks that are having problems, you can say they can wait, but for the most part usually at a minimum half of their capital is impaired or it's in not performing. And the profitability of those banks making any money over the next three to four years is pretty remote unless there's just an immediate turnaround in the economy.

So, I think those people really have -- from what we can tell, are going to have to weight do they want to be a zombie for the next three to four years or would they rather team up with somebody that can mark those to market, get on and have some growth in their [sub].

Yes, makes sense. The next question I had was just in terms of competition. Obviously Texas has been a much stronger market than the overall US economy. With your sort of let's call them cautiously optimistic statements about the pickup in second-half, are you guys seeing any competition increase?

Because it seems if you're a larger bank with operations in Texas and Texas provides you with the opportunity to grow whereas other places may not, it seems that there should be more of an emphasis on Texas creating higher or greater competition. Is that what you're seeing?

Many of our competitors are very active out there in the market today. And then you've got some -- again, it's kind of a mixed signal. You've got some banks that are in the regulatory penalty box or in the earnings penalty box or the asset quality penalty box and are not able to play. But there are a lot of people that are out there knocking on doors. Many of our peers are out there actively pursuing customers just as we're doing.

I think there are two camps. I think there's a camp that's in the penalty box that really can't land, they're more worried. I think the regulators have told them you don't need to worry about lending or increasing your loans, you need to worry about cleaning up what you do have. And then you have several banks that are really in good shape and those guys are -- they're like us, they're being very aggressive right now going after the other guy's customers.

Okay. All right, thank you very much.

Thanks, Ken.

Jon Arfstrom, RBC Capital Markets.

Thanks. Good morning, guys. A couple of follow-up questions, just on the margin maybe. Maybe Dave Holloway, you talked about 10 basis points in NIM compression from the acquisition. And when you look to the yield rate table it looks like maybe there is some room to take deposit pricing down a little bit. Is it fair to say you can get some of that back?

Yes, I mean, I think that's a fair observation. It kind of -- if you're looking back at our quarters, the last few quarters, it's interesting to me -- we had been running up until the last two quarters in the low fours -- 4%, 4% or 5%, something like that -- and you saw our margin rebound up into the 420s which if you guys recall I kept saying that was a little too hot for us and it would come back down.

And so, yes, the answer to the question is when we're running at this 4% level, that is being impacted by these acquisitions to some degree but it's actually spot on to say that we can manage rates on deposit side a little bit more if we'd need to. And so what all in what that's saying is over the short haul here over the next few quarters that our margins should stabilize a little bit, maybe a few basis points pick up just depending on what happens.

And that's obviously mostly from funding?

Correct.

Yes, okay. And, Dave Zalman, I just wanted to pull up on the securities portfolio management a bit. I'm always interested in hearing your thoughts. What do you do if rates stay here? Are you forced to put money to work or what is your approach in an environment like that where maybe this lasts longer than you think?

Well, I've been wrong for two years. So the only reason I think we're lucky is because we didn't any choice, we had to buy. But for two years I've said rates have got to go up and they continue to go down. Having said that, because of the banks that we bought we had to put the money to work.

Right now there's a theory out there and we have every bond guy in the world talking to them saying, guys, you've got approximately a $200 million gain in your portfolio why don't you take the gain and rates aren't going anywhere and invest it in some 20 year product with an average life of six years. I would tell you that's not what we're going to do.

I think what we're going to do is stick really with the model that we have, we're going to try to stick around a three-year average life. Having said that that would tell you that if these things were around for an extended period of time that the yield on the portfolio would go down.

But again, we're going to try to shoot and stay where we're at and probably we're going to push harder onto the loan side to try to make up the difference to try to -- right now our loan to deposit ratio is extremely low. And if we can match the two and get our loan to deposit portfolio back up to say 65% over the next couple years or so and still have some margin or interest rate decrease on this I think we're still going to be okay, we'll be fine.

We like our business model the way it is, we don't think we need to reinvent it.

Just remember though, Jon, if interest rates do go up 400 basis points and our $200 million gain goes to a $100 million loss, be patient with us.

I've been patient with you guys for a long, long time. Just the last question on the service charge line. I don't know how much work you've done on regulatory reform. But what kind of risk do you think there is to that revenue line?

There are two pieces of that, Jon. You've got the Reg E piece and we are actively in the sales mode there. Our team has been selling that opt in for sometime now. The latest numbers we see is we're at about 70% opt in out of our heavy users into that process. We continue to see that number inch up a little bit week after week. Our teams are actively involved and I think it's important to look back and talk about how we manage the bank.

Remember, we've got 175 profit centers, 175 locations, they all see their own income, they know what their income is, they know what income is at risk for them. They are the ones that are actively pursuing that customer base to opt in. And so with almost a month to go still before the drop dead date of 8-15, I think we're going to be close to getting good response back. I don't know whether we'll be at 85 or 90 or better, there's going to be some that will opt out.

So we do have some money at risk. I think we ran numbers yesterday. If we don't opt anybody else in from here forward the number is on a pretax basis almost $2 million, on an after-tax basis a little over $1 million at risk on an annual basis.

Is that for the opt in?

For the opt in, for the Reg E piece. The second piece of the puzzle is the interchange expense or interchange income and there's a lot of moving parts there. Certainly we get income on the interchange side. To be able to give you any kind of quantifiable number as to what we expect to see from that is way too early in the game at this point I think for us to put a number out there.

One other -- just another little color on the opt-in piece, what will be interesting -- because again, if you big picture this and this whole opt-in Reg E thing is about educating, making sure that customers understand how the product works. And what we found in our customer base and they're absolutely -- they absolutely do understand it and they do want to have it.

So that's why our percentage of people opting in when they're responding to us and the percentage opting in and opting out it's 90 -- it's between 90% and 95% of the responses are opting back in because they do understand the product.

And if you think about it functionally, when August 15 comes around for the people that are heavy users of this product, and specifically they go to use their debit card at the restaurant, it doesn't work, my guess is they start going what in the world is going on, they first get mad at the bank, then they're going to call the bank and say hey, why did you turn this off. And then we'll say because you didn't respond, and then they'll say, okay, I didn't understand.

We'll fix it.

We'll fix it for you. And then so over the longer term our guess is most of these people that use the product today will get back into the product. Because our program was never one of trying to trick the customer, if you will.

Jon, I'm with, Dave. I think the opt-in product, you'll be -- you may have a few months where you're not making as much money off of that, but I think over a six- to 12-month period you'll be where you were or above where you are because people like that product. The interchange fees, that's a whole another story.

And if there is some downside on that, which everybody thinks that there will be, I think that all banks are going to be looking -- where some people have been paying more for service charges than the others have, I think all banks will have to come up with -- assess what their service charges are, basically.

Yes, we've got to review our fee structure across the board to make sure that we are not going backwards. And I think -- again, I think the idea was to be consumer friendly. But I don't think there's very many bankers that believe that the interchange piece is going to help the consumers in any form or fashion.

And other than just the opt-in part of it, you haven't made any other changes on overdraft?

No.

Okay, thank you.

Thank you, Jon.

Bob Patten, Morgan Keegan.

Good morning, guys. How are you doing? Most of my questions have been asked. But I guess just in terms of where David talked about meeting with regional managers and seeing improvement, it was talked generally about, but can you give some specific detail on the improvement?

And then also Comerica and BBT specifically mentioned Texas as their next growth opportunity, like there is not new news. Any thoughts about how they are going to come down there and change any of the landscape?

You know, I guess as I talk about our management committee, David was talking about our management committee. Our management committee is a 17-person group that is the key players that manage the bank across the state. It's our executive management team plus our area managers. And I think every market has some positives, and every market probably has some negatives going on.

So you hear that when you are talking to them, and that is one of the strengths I think that we bring to the table is if you are in Central Texas, we've got Central Texas folks that are living, eating, and drinking the water up there that are paying attention. And they are watching what is going on.

When you talk to them, you hear that they think they have got good pipeline, good loan prospects coming forward. But they also see payoffs coming. So customers that have cash are wanting to reduce debt. David mentioned a minute ago you know the big payoff on one of our larger credits that is completely gone as of this week.

So you've got the headwind of the paydowns and the financially strong customers, and then you've got our guys out trying to find business. I don't know that we have any real specific stories to tell today from one market over the other, except for I think our entire team, 100% of the team, is very focused on building the loan book, getting people out from behind their desk and out into the field, finding a way to get in front of the good customers that we want to attract to our bank. So, you know, I think we feel good about that.

Part of it may be coming too, I think, this may be coming from us because we are really -- I don't want to say pushing our regional managers, but the size that we have gotten, we have a lot of people that work for us and we have a lot of lenders out there in the field.

I'm not -- you could've almost had it and we wouldn't have known about it, where today we're asking all of our regional people to really identify everybody that they have working for them, what's their production, what has their production been, what do they have and keep tabs on it.

And so there's probably a lot more monitoring on our side. And I thank them for working with their people to know where we're at and where they're going has really gotten us going in the right direction. We're really spending a lot more time on that.

Got you. And one different question. I noticed shareholders equity, common equity went up, tangible book went down $0.12. I'm assuming something is going on in OCI?

No, we paid cash for the First Bank acquisition in the quarter.

Okay.

Yes, so you created some goodwill on the First Bank acquisition in the first quarter and we created some goodwill on the U.S. Bank transaction in the first quarter.

Then can you guys -- if I missed it I apologize. But did you give any breakdown from the 20 basis point decline from the first quarter on the margin, what with the drivers of that? Was it all liquidity?

Yes, Dave did. Remember, Bob, the First Bank transaction -- two pieces of the puzzle. One, we closed the U.S. Bank transaction on March 26, so just four days before quarter end on the first quarter. That transaction was deposit rich, asset poor -- earning asset poor I should say. That was roughly $400 million in deposits and $30 million or $35 million in loans. And so the rest of that money had to be invested. That's a negative on margin.

Then on April 1, 30 days into the quarter -- and let me remind everybody, remember from an expense run basis, and I guess from an income basis, the First Bank acquisition was only in that quarter for two months out of three. So looking forward you've got another month to pick up from an expense run and an income run.

But that transaction was a little less than $500 million in deposits and we did pick up almost $100 million in earning asset loans on that one. But both of those were a negative 2 margin because of the low yielding assets that came with that or the investments that we made. I think Dave said that those acquisitions represented 10 to 12 basis points of the margin compression in the quarter.

Bob, I would say that we knew that going in when we bought these transactions.

We talked about it on the first-quarter call.

Yes, and I thought it was more like 10 basis points compression was our expectation I thought and it just (multiple speakers).

And that's what we said -- well, yes, what we said in the first quarter was that we thought our margin would experience some pressure just from the natural liability sensitive balance sheet that was going to cause some pressure on the margin in the quarter. And then on top of that was the acquisition pressure and so that's what you see. You see roughly 8 to 10 basis points of natural margin compression and 10 to 12 basis points of acquisition margin compression.

Got yet, okay. That's helpful, thanks, guys.

Jennifer Demba, SunTrust Robinson.

Good morning, everyone. This is [David Grayson] in for Jenny.

Doesn't sound like Jenny.

Well, it's been a rough earnings season, so my voice could have changed. Most of my questions have been answered. Good color on the margin outlook and the mechanics in there. First question I have left is kind of just I wanted to ask you to repeat the number when you were talking about asset quality, the assets under contract for sale at present?

Tim will pull that up for us.

They're contracts on $2,701,000 and then there is an additional set of contracts that cover $1,485,000 that are under due diligence. So in other words, on the $1,485,000 piece, that's not a hard number yet.

We don't have hard escrow money yet.

That's right.

Okay. All right, thank you. And the properties that you have under contract, did you characterize what types of properties they are? Did you see more homes (multiple speakers)?

It's a mixture of residential and a little bit of commercial.

Yes, it's kind of like the NPA, there's a little bit of everything in there.

Okay, and I guess kind of along that same theme, when we're looking at loan -- I guess the loan pipeline getting a little stronger and monthly loan productions on a gross basis going up. Can you put a finer point perhaps on the composition of new loans you're booking or where the interest is picking up?

I think it's all across the board really.

Yes, it's all types. We've seen some CRE credits, we've seen some commercial credits, we've seen some -- believe it or not a couple of construction or (inaudible) credits. I think that we're actively -- remember, we're not pursuing a type of a customer, we're pursuing -- I mean, we're not pursuing a type of a loan, we're pursuing a type of a customer.

What we're not seeing much of, for obvious reasons, is a lot of new significant residential development. But having said that, there are residential and commercial loans out there that are happening. So, there are not too many new projects be they residential and commercial coming out of the ground, but we're looking at refinancing existing transactions. And there are a few new ones.

And the number of players soliciting those loans has increased, as we said earlier. But there are still a lot of banks that are involved. So we're having a chance to look at some of these and presumably some of them will fall our way.

I can probably guess -- you're right, Tim, I mean -- and Dan both. There are loans of all kinds out there. I'm just thinking about loan committee and there's one loan that may be $10 million or $20 million they're looking at building some dorms at a college. There's another big loan for a church, $10 million or so.

There are loans, and I still see loans once in a while, believe it or not, for a convenient store, a strip center. So I think there's a variety of different loans out there right now. What we are seeing is what Tim said, and you can even see it in our numbers, we're down on residential construction loans even this (inaudible). Correct me if I'm wrong, I'm thinking --

$25 million.

$25 million. So I think that's really why we're a little bit excited is that we see even with the pay downs that we're getting on the residential construction, we still seem to be making some headway.

Let me try that a different way, David, David and Tim -- David Grayson, we'll try a different way to answer your question. David and Tim sitting loan committee. Are we seeing organic economic growth in loans coming in new projects or are we seeing mostly existing projects that are refinancing coming our way?

I'd say the majority and I will characterize that it's just above 50% are existing transactions looking for a new home. But there is some element of new business out there.

Which is more then there was a couple of quarters ago.

It has improved a little bit, that's right.

I think you're seeing, though, what I'm drawing kind of a conclusion on is you're seeing more and more not for profit loans coming through and also municipality type loans and educational loan type deals where obviously --

Comes in spurts.

That's correct. We've always done a lot of church lending and it's been good business for us and that continues to be the case. And it seems that a lot of significant churches are expanding their real estate footprints. So, a lot of that's coming our way.

All right, that was a very expensive colorful answer. Thank you, that was great.

Thanks, David.

Christopher Marinac, FIG Partners.

Thanks, good morning. David and Dan, there's a theory out there that it's very difficult to do M&A due diligence right now. And I'm just curious as you look specifically at Texas and other markets near your footprint, is that as true relative to other parts of the country where there's this concern that M&A is really hard to do given credit issues still outstanding?

The due diligence is hard just because the picture looking forward is cloudy, is that the theory?

Yes, correct.

I don't know that I heard the question.

He's saying that as we're looking at acquisitions -- I think this is what you're saying, Chris, correct me if we're wrong. What you're saying is if we're talking to somebody and we get far enough along to go in and do due diligence, how do we look at that due diligence looking forward from a credit quality perspective when you've got the unknown of the economy in front of you, is that really a problem today?

I think our position would be we've always done a very deep dive in a due diligence and we feel pretty confident that we understand the Texas market. Clearly if we were going to some market we didn't understand maybe that would be different. But I don't know that we feel that.

I mean, I think there are two different types of banks. And I mean, I think there are banks that are running where we're at, 50 to 100 basis points of non-performing assets and they've been pretty conservative and watch what they're doing. When you go into a bank like that you're a little bit more comfortable especially if they've been in business the last 50 years. You can kind of count on the management in looking at it.

And then there's another kind of bank that I think you have to be careful of. There's a bank that has a lot of problems; you may have to overshoot on the deal where if they say they've got a certain amount of non-performing you may have to double that, or at least that's been our industry in the past.

And if we're going after a bank like that we need to really make sure that that bank has enough capital or excess capital where we can mark those loans to market where they're not impacting us and drag us down at the same time. And so those are the challenges that you have in doing the M&A in today's world I think.

You call some of those banks build to sell banks.

Well, there are some -- a lot of the build to sell I don't even know that we're even in a market with the build to sell banks, the ones that have just started up in the last few years. I'm really kind of talking some banks that have really been around for a long time but have come onto some harder times.

And it is harder because you want to dance and you want to love on them, on the other hand you don't want to throw something out there and you have to really consider it, is it something you can do, can you go into there -- can you go into the bank and once you've made a deal and feel comfortable in doing a deal that you're not just spinning their wheels and your wheels saying that you can do it. You have to be comfortable that there's enough equity and capital there to take care of something like that.

It's certainly different than it was when you look back to 2005 and 2006 where you weren't worried about what was coming down the pipeline. You felt a lot better about what you were looking at. In hindsight maybe we shouldn't have been that clear on some of that because we've certainly taken some losses on some loans that we purchased in 2005 and 2006 and 2007 that we -- in today's world we may look at differently.

That's helpful. Thank you very much for the dialogue there.

Thanks, Chris.

[Ariel Shoshay], [Hite Analytics].

Hi, guys, it's [Ari Shokin] with Hite, how you doing? I have two sort of related questions and the first is when you look at your own footprint how do you think about your own desire to do M&A up with the first category of bank that's in a better situation versus continuing to look at more distressed FDIC type deals? And in a sense would you rather get a larger bank that is in better shape where you want the loans versus you know a more distressed bank where it your goal is to really get rid of the loans?

Well, it's obviously -- this is David Zalman, obviously it's easier on management to buy a good bank. And there's probably a lot less risk in buying a good bank. So, that would be my first preference. At the same time a place that you could probably make more of a gain and more money because you're not going to be paying what you're going to be paying for a good bank if you can make a deal.

If you can find a distressed bank and there's enough money there you can probably, if you caught it right, you can probably make a whole lot more money if you do a distressed bank. But in doing a distressed bank, it takes a lot more work, it takes a lot of your team and you may not be able to grow as fast if you're looking at buying a distressed bank. You can do maybe one or two of those but you're not going to grow as fast as if you bought a good bank.

Well, we haven't seen any distressed banks priced the way we would want them priced in a long time.

Well, I think the distressed bank, somebody on the phone earlier said why would a distressed bank even be willing to even look at selling right now? Why wouldn't they just work their way through it (multiple speakers)?

Last time it was an FDIC transaction, we haven't seen a price there either.

Yes, a distressed -- I mean the distressed bank from the FDIC we haven't seen any -- I'm not going to say bargains we haven't seen -- it's just not worth doing. But again, I think there will be more banks. I think there will be some distressed banks that are going to really -- they should do something because, again, I think for two to three or four years they're zombied.

I mean, they're not going to be making any money. The money that they're going to be making is really going to go to clean up their loan portfolio. So, you have to ask the question, do they want to do that or do they want to try to mark these things to market and let's get going. And I think that some of these guys will make the decision to go ahead and let's mark to market, let's find a partner, a strategic partner and let's get going forward. At least that I am hoping that is the case.

So I guess my follow-up, you sort of maybe answered it in saying that there's a lot more risk in doing a distressed transaction. But I also know you said earlier that, and it's true, I mean you stick to your knitting and don't change your strategy over time. You certainly in the time that I've covered you, haven't done that.

But a separate question is, in areas outside of Texas that have been so much harder hit, there are still weekly FDIC deals that would be in your profile of -- your economic profile of what you would be willing to do if that transaction were in your footprint. And I guess given that you have such a large group of people that their job for so many years has been integrating and working out assets and taking care of the nitty-gritty of getting rid of a bank, at some point would you consider doing FDIC assisted transactions that are outside of your footprint?

Absolutely. We're looking at -- we probably get three to four transactions every week from the FDIC. So, we're looking at them, it's just that so many of those transactions are really transactions where they started up their bank five years ago or 10 years ago and you look at the core deposits, there are really not any core deposits (multiple speakers).

There are none.

It's just 70% or 80% CDs. So we're not interested in that. Having said that, there are two or three banks out there that's on our screen that we think the FDIC is going to close and we're going to be aggressive on those banks when they do come up, if they come up.

Multiple speakers.

I'm sorry.

I was going to say, I don't think our story has changed over the last three or four quarters on that front, Ari. And that we've said repeatedly now that we're willing to look outside the borders of Texas, but it's going to have to be a compelling transaction, it's not going to be -- when you look at some of the pricing we've seen on FDIC assisted deals here in the last six months, that's not very compelling to us. But that doesn't mean that there might not be opportunities. So we continue to look, we continue to spend the time and effort to review what's out there.

So just so I understand one nuance though, it's important for you to have those banks have the deposits? Meaning you would want to keep the branches and keep the operations? Or the goal would really be to just wind it down?

Well, I mean your point is well taken. I mean, we thought about it I guess. What you're saying, I think what you're getting at, why not just go buy -- one of these banks has a bunch of loans, the FDIC is guaranteeing the loans and after five years at least you'll have a place to put your money for five years. And it's -- if you can trust the FDIC and everything I guess it's a possibility.

Well, I guess my real question is, would you be willing to have a branches and operations significantly outside of your footprint versus buying it with the intent of selling off the branches and selling off the pieces bit by bit?

My feeling is no. If we can't -- if we really can't get -- we really are traditional plain-vanilla bankers and we want relationships. We're really not trying to go out and buy just something short-term and get something we need. If we can't buy something that has real core relationships, real bank branches and real customers over the long period it's not something we would be interested in.

So I would've answered that question, yes. He asked you two questions. Yes, we would want -- if we're going to move outside the state of Texas we want a big enough presence where there is real branches with real customers with a real deposit base that we can build on long-term.

Right.

Got it. No, that's very -- it's a very different type of transaction and I congratulate you on sticking to your knitting. So, thank you so much for taking the call.

Matt Olney, Stephens, Inc.

Hey, good morning, guys. Hey, going back to that last question on FDIC assisted transactions outside of Texas, could you let us know if you've done any on site due diligence outside of Texas or has it all just been from a distance from your office in Houston?

Yes, I don't know that we can answer that question. I think that we certainly see what the FDIC is offering to us through their regular channels, but to talk about specific what we've done on-site, not on-site, who we've [boosted] with, that's kind of hard to answer.

Okay, and also on going back to the margin -- I guess this is for David. Since we just got two months of the margin impact from First Bank in 2Q, could we see anymore incremental negative impact in 3Q?

No, I think just kind of how we laid it out it will play out. I mean, in fact they were -- the First Bank transaction was on there for two to three months. I don't think we'll change the dynamic materially.

So if I understand what you're saying, it sounds like the margin -- we could get some more relief on the deposit pricing side that could offset some lower yields on the security side, is that kind of what you're saying?

Absolutely right, exactly. The other thing, that is what I am saying. And also, just another thing to point out to support that is over time, if you look at the second quarter 2010 compared to second quarter 2009, if you look at the net-interest margin page, one of the things that's going on is a rebalancing of a mix of money that we have and it's kind of what we said all along or what you hear David Zalman say is over time we'll take that percentage of CDs, which is the higher cost money to total deposits.

Historically we probably run around 30%, 33%, whatever that number is. And if you go back and actually look, a year ago we were at 37%. Today it's about 32%, exactly how we would do it. And what that's telling you is we're bringing our cost of funds down by changing the mix of money.

We've been actively managing the deposit base for a long time. When you look at just the free money, one of the things we could've been bragging on, our non-interest-bearing DDA money was up 3% linked-quarter, that's 12% annualized growth and non-interest-bearing DDA money. We're actively working to improve our deposit mix.

Which will help the margin.

That's right.

Okay, guys, great color. Thank you very much.

Thanks, Matt. Talk to you soon.

Dave Bishop, Stifel Nicolaus.

Hey, good morning, guys. A question for you. Just curious in terms of comments, what you're seeing in terms of the various housing market there in terms of your various markets there. Are you seeing sort of the buyers -- obviously the stimulus had some effect there, but there's been concern once that trickles down there could be some impact there. I guess what are you seeing in terms of available lots, lot takedowns and home sales and such?

I'll answer that, Dave. Again, I may not be as versed as I should be at this -- but from what they're telling me Texas, first of all, never had a lot of the same issues as the rest of the other states. And so we've had a pretty good market. But they're telling me right now in some of the major metropolitan markets that, believe this or not, they're running short on lot loans for builders to build on -- which is really contrary to the rest of the country.

That was Austen (multiple speakers).

Yes, Austen was telling us that the other day.

Dallas I don't think is (multiple speakers).

Dallas (multiple speakers) world. But I think overall the market has been okay in Houston, Austen, Dallas has a more difficult time.

Dallas and Fort Worth.

And Fort Worth, yes, Dallas-Fort Worth. So maybe some mixed results right there.

I think from a sales perspective, my friends (inaudible) in real estate again, David we were never in the starter home, we've never really financed the track builders that I'm aware of. We've had maybe -- we may have stuck our toe into that pond with a customer or two, but that's not --

A few but not many.

-- but that's not been our big cup of tea. We're probably at the next level up. And I think many of that level was not dependent upon the stimulus money that was out there.

Great, thanks for the color, guys.

John Rodis, how Barnes.

Good morning, guys. Dan, real quick, as far as operating expenses go is there any room for improvement I guess in the second half of the year taking into account I guess you only had first two months of First Bank in the second quarter?

Well, you know us, there's always room to improve expense control. We've got Dave Hollaway on our team, we can always work on our expense control. Clearly we've got to add another month in of expense on the acquisition of the First Bank side. And you saw some what we classified as one-time expenses.

We've never taken charges per se before on acquisitions and we really didn't take a charge this time. But under the new accounting rules where we used to take some of those expenses be they accounting expenses or legal expenses in a transaction and that would become part of goodwill, now those items hit the expense line. Those items obviously go away because they're clearly part of the transaction.

As you look out, we will continue to manage the headcount across the Bank the way we always have. And so, yes, there are opportunities for us to continue to improve on that front. The other side of that would be where we've been able to find good people we've actually hired people to join our team. And so I think there's a little bit of room, but I don't know that there's a whole lot of room.

John, I'm going to jump in on that because I have personal feelings about that.

Do you?

Yes I do.

What a surprise.

As Dan mentioned earlier, there is not as much cost savings because what we bought were branches for the most part, at least in the First Bank situation, U.S. Banks were a little different. But our net overhead is running higher than it should run. And again, my experience or our experience over time is we will get back down to the overhead ratios that we're normally accustomed to, it just may take a little bit longer to do but we'll get there.

Which will improve our efficiency ratios.

Yes.

But the efficiency ratio is also driven off of the income (multiple speakers).

And again, it's not going to happen in one quarter usually, it takes -- it could take two, three or four quarters before it gets back to normal.

Okay, fair enough. Just one more question and I guess it's sort of a big picture question or just what are your thoughts as far as the impact from the oil spill? And obviously people talk about the potential negative impacts on Texas, whether it's direct or indirect. I just kind of want to hear your thoughts.

This is Dave again, anybody else can jump in if they want to. But we really haven't seen or I haven't seen the negative impact that everybody is talking about. In fact, a lot of the people that were actually in the fishing industry, some of them even say they wish that this thing may have not stopped because they're making more money working for BP than they were fishing and shrimping.

So I think if there's an impact it's going to be probably on a level or a type of customer that doesn't really impact them -- when they imposed the no drilling or the moratorium on no drilling, I think that's really going to impact some of the larger companies that are just going to move those rigs to other countries. And so in the long run it's probably going to impact some employment there and will impact some. But again, not a lot of direct -- again, I don't think there's been a lot of direct hit on this thing to Texas anyway.

Yes, Texas has been very fortunate in that the natural currents have moved the oil away from us, so the beaches haven't been impacted, the dollars that are flowing through Houston in the remediation and the cleanup has been large.

So my answer would be the immediate impact has been positive; the long-term impact, as David says, if the political winds continue to blow, I think the Greater Houston Partnership, the economic development arm of the Houston area, has put out anywhere from 20,000 to 70,000 potential jobs at risk that could be lost if the drilling moratorium stays in place. And that would certainly be a negative impact on the long run. But so far on the short run there's a lot of money being poured into cleaning this thing up.

I still think you're going to keep -- your drilling (inaudible) like energy service, they're still --

Well, they're going to be operating --

They're going to see profits this year, it's just -- who it's going to impact is the guy -- are the workers that are out there on the water.

That's right.

I think it's important to emphasize that we have never done a significant amount of direct lending to either the offshore energy industry or the fishing industry, either one.

Right.

So what effects we end up feeling will be more on the indirect side than the direct side.

All indirect and probably all employment based in the Houston area. And remember, the Houston economy still is performing fairly well.

Is it fair to say though that as far as direct exposure is it less than 5%?

(Multiple speakers) way less than 5%.

That's what I thought. Okay, thanks, guys.

Thank you.

Bain Slack, KBW.

Hey, good morning. I guess I just have a question and it's not so much as it relates to you, but I guess what I noticed was looking at the one to four family credits including home equity -- I know we're still talking about some small amounts -- but just kind of the number of loans that were added and then I think it went over $1 million linked-quarter and that's -- that was a side after taking a net charge-off in that same category, about $1 million. Is this an indication of anything going on I guess in the broader economy or I guess is there anything going on in there that is significant with these numbers?

(multiple speakers).

He's talking about on the non-performing, David, non-performing in one to four went from 3.9 to 4.9 and went from 36 items to 50 items. There is nothing in there, Bain, but the normal stuff that rolls through, it could be 20 next quarter. There's nothing special, there's no underlying economic issues that we're aware of, it's just the normal run through items that are there.

Yes, I don't see any -- I don't see any change really.

Okay, yes, I just didn't know if it was -- I guess I was more trying to relate it to see if there was any -- if this was any sign at any change maybe in the broader economy. You know, people seem to throw around some theories that they keep waiting still I guess for a double dip in Texas but it doesn't seem to be happening. So, just kind of curious your thoughts with regard to (multiple speakers) your bonuses.

I don't think there's anything systemic in there.

Yes, no, when you look at one to four for us is $750-plus million in outstanding and actually the outstandings in that category went up 20 -- lost my page here -- but went up almost $30 million in the quarter. So outstandings went up $30 million and non-performers went up $1 million. I don't think we see anything that we would want to hang our hat on in there.

I think to the extent that there's up and down, it's normal up and down.

When you look at those numbers there, I saw your note earlier. You talk about the numbers and there's one more item in commercial real estate. That's not a real look at that, the 12 that were there last quarter are not there this quarter. There's probably nine or 10 new items in there and only a few that rolled over from the last quarter. But the turn in that MPA book is fast.

I don't know that really -- I want to make sure -- I don't know if this is an accurate statement. But I don't know that there are really any homes that over a year old (multiple speakers).

Oh, not over a year.

-- in the other real estate category. We generally turn those pretty quickly.

I don't know that there are any over six months on the one to four.

I can give a little more color to that. Our range on the low side from one quarter to the next of NPAs staying on the list is 40% and on the high side typically is 80% and this last quarter it was 43%. So --

So the different way -- Tim is saying 43% of the items that are there at June 30 were also there on March 31.

That's correct.

The other 57% are new.

Are new.

Okay.

So there's good and bad in that.

It is (multiple speakers).

(Multiple speakers).

And there's going to continue to be (multiple speakers). The pipeline in that category is good too.

Good, that helps. I appreciate that color and great quarter, guys. I'll talk to you later.

All right, thanks, Bain.

And it appears that we have no further questions at this time.

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