PNC Financial Services Group Inc (PNC) 2002 Q3 法說會逐字稿

Good morning.

My name is Jonathan (ph) and I will be your conference facilitator today.

At this time I would like to welcome everyone to the PNC Financial Services Group earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question and answer period.

If you would like to ask a question during this time, simply press star, then the number 1 on your telephone keypad.

If you would like to withdraw your question, press star, then the number 2 on your telephone keypad.

As a reminder, this call is being recorded.

I will now turn the call over to the Director of Investor Relations, Mr. Bill Callahan (ph).

Sir, please go ahead.

Bill Callahan (ph): Good morning, and welcome to today's conference call for the PNC Financial Services Group.

This is Bill Callahan (ph), Director of Investor Relations.

Participating in this call will be PNC's Chairman and Chief Executive Officer, Jim Rohr, and Bill Demchak, the company's Vice Chairman and Chief Financial Officer.

The following comments contain forward-looking statements.

As a result, actual results could differ due to a variety of factors including those described in these statements, in today's release, and supplementary financial information and in our Form 2001 10-K and other SEC reports.

These statements speak only as of October 17th, 2002 and PNC takes no obligation to update them.

Now let me turn the call over to Jim Rohr.

Thank you very much, Bill.

I want to welcome everyone and thank you for joining us.

We truly appreciate your interest in PNC.

This has clearly been a unique quarter for PNC.

Only about 90 days ago we announced our second quarter earnings, and we announced the agreements with our regulators.

Since then we spent a lot of time with our directors and regulators focusing on what we need to do to meet the requirements of those agreements.

And I believe we made significant strides in meeting those requirements.

We've also made a number of significant changes to our senior management team.

I'll discuss that in a moment.

When you take these internal changes and add the challenges such as the stagnant economy and the volatile markets we're relatively pleased with our earnings of $285 million or $1 per diluted share.

This represents a 15 percent increase over the third quarter of last year, and we generated strong returns, including a 17.5% return on common shareholders equity.

I want to be clear that our earnings did not meet our expectations.

But again, given the environment and relatively I'm relatively pleased.

In addition to the earnings, we made significant progress on a number of initiatives designed to reduce risk, improve returns, strengthen our regulatory relationships, and to grow our franchise.

Some of the key accomplishments during the quarter included an 18 percent reduction in nonperforming assets, a 54 percent reduction in loans held for sale during the quarter, and a 7 percent increase in demand deposits over the third quarter of last year.

But these results, I think it's fair to say that our employees have remained intensely focused on the customer.

I believe our business mix has also served us well, generating solid returns in a very difficult market environment.

Of course the Dow reaching a 4-year low did impact our market-sensitive business; this is one reason we did not meet our EPS target.

Bill Demchak will discuss all the reasons in more detail, but I'll review others briefly now.

One (ph), we experienced a larger than expected reduction in net interest income is primarily due to the success we had in reducing higher risk, lower return assets.

A significant portion of our 5 percent reduction in overall loans was our held (ph) for sale portfolio, which we reduced from 2.6 billion at the beginning of the year to $500 million at the end of the quarter for 81 percent.

We believe that this will benefit us greatly in the long run.

One example is that we have reduced loans to the communications sector to $115 million this year, and that has helped us avoid some of the issues faced by others in our industry.

While reducing balance sheet leverage, we have not been repurchasing shares.

As a result, our shareholders equity to total asset ratio has increased from 8.3 percent at the beginning of the year to 9.9 percent at the end of the quarter.

In addition to the financial items, we've made progress on some very significant near-term priorities.

Let me now turn to the management team.

I believe we've significantly strengthened our executive team.

Bill Demchak, who will be speaking to you in a moment, is our new Vice Chairman and Chief Financial Officer.

Bill Whiteside (ph), an individual who has had a number of financial experiences in a number of other firms, has joined us as vice chairman.

Ted Wickstad (ph) joined us in the quarter as our new head of regulatory affairs.

And Deborah Wegswirt (ph) joined us from Citibank to head up compliance.

I'm very excited about breadth and depth of this team.

Each of these people has expressed a deep desire to help PNC reach the next level and I think that will show as we become even more integrated over the next few months.

This is a team that has been reaffirmed by our board of directors following a review of management by an independent consulting group.

As you know, this confidential review was part of a formal agreement we signed with the regulators in July.

Let me briefly discuss the regulatory relationships, if you will.

Of course the question everyone has asked is when will we meet the requirements of the regulatory agreements.

Satisfying the provisions of our agreements has been a major priority, and I believe we've made substantial progress in addressing the various requirements under our agreements.

While it would be inappropriate for us to comment on a specific timetable for the regulators to sign off on our progress, I can state that we have a much improved level of communication with them and we're making good progress in addressing all of the substantive concerns that were the subject of our written agreements.

I remain confident that PNC will be a stronger and better managed company as a result of these efforts that we've been going through in the past several months.

Our board has been very active and supportive throughout this process and they are committed to seeing PNC established as an industry leader in the areas of governance, corporate conduct, risk management, and positive regulatory relations.

Now, speaking of risk management, many of the elements in our regulatory agreements centered upon risk management.

Our goal is to become a best of class risk management organization, and we continue to make progress.

In January we hired McKenzie (ph) to review our risk management structure.

Since then we've centralized and enhanced our risk management function and named Tom Whitford (ph) to the newly created role of chief risk officer in April.

Many of our risk management issues were related to credit risk.

We have been aggressive in transforming our credit culture.

In the fourth quarter of last year we named Mike Hannon (ph) the new credit chief policy officer and we implemented a number of initiatives designed to put the problems of the past behind us.

We are adhering to a more focused relationship-oriented strategy on our wholesale businesses and our plan is to not extend credit that does not meet our risk return criteria.

Executing on these strategies has been a key factor in enabling us to reduce our non-performing assets by almost 20 percent this quarter.

This has resulted in us carrying a smaller but stronger balance sheet.

In fact, our asset base is down $7 billion on average since 1998.

Even though it's smaller, I believe the steps we've taken to strengthen the balance sheet will benefit us in this environment and into the future.

Now I'd like to just take a few moments to talk about our long-term strategy.

I'm pleased we continue to make progress on the key value driving (ph) strategies we began implementing almost two years ago.

We're building a business mix that we believe has a higher probability of growing less volatile earnings.

We have dramatically reduced our reliance on highly volatile lending businesses.

Lending now contributes just 22 percent to overall business revenue.

That's down from the upper 30s several years ago.

We've also focused on our more value demand deposit based which we've grown by almost 8 percent compounded for the last four years.

The result of our success in reducing loans and increasing deposits, we are now more core funded.

Today we've improved our loan deposit ratio from a highly leveraged 120% in 1998 to 80% today.

We've learned that we're more successful when we focus our efforts on more profitable relationships across our product mix.

There are three key imperatives we believe help us achieve long term success in this area -- customer satisfaction, selling our products and services, and risk management.

I've discussed the progress we're making in risk management, so let me focus on sales and customer satisfaction.

This year almost all of our businesses are ahead of plan on sales.

I mentioned the success that we've had in selling demand accounts, but our small business banking team has increased total relationships by 17 percent year to date.

Both PFPC and PFC advisors are ahead of plan in sales, but their bottom line results so far have been dampened by the market downturn.

BlackRock has delivered strong earnings growth over the last year and added a number of new customers, and we're excited about its continued prospects.

As you know, one of BlackRock's core strengths is its management team.

We just announced a performance-based retention and incentive program designed to keep Larry and his team in place well into the future.

As you know, we have only lost one of the original partners to retirement since we acquired BlackRock and we certainly intend for this to keep all of the people in place for a long time to come.

All of us at PNC are also focused on customer satisfaction.

Our ratings are at a five-year high in our retail business, treasury management business, BlackRock, and our call center, as well as some other key segments of the company.

And we're working together to enhance those numbers.

In order to achieve these sales of customer satisfaction numbers, we're also leveraging a strong technology platform, one that was ranked as the second best in the entire financial services industry by Information Week magazine only a few weeks ago.

Let me finally spend one second on capital.

We believe that we are very well positioned from a capital standpoint that will give us a great deal of flexibility in the future.

We've built this strong capital position this year -- so strong, incidentally, that it's had a slight adverse impact on our return on equity.

We're among the upper quartile in our peer group in almost every measure of regulatory capital.

We're looking forward to starting next year in a very strong position.

Well, it's a difficult environment.

I wanted to reiterate that, when you consider the amount of risk we've taken out of the company in the past two years, combined with the strength of our business mix and our strong capital position, I like how the firm is positioned to meet the challenges that we face in the near future.

Now I'm very pleased to introduce Bill Demchak to discuss our third quarter results in more detail - Bill.

Thanks, Jim, and good morning to everybody on the call.

Before I start my specific comments, I want to reaffirm PNC's commitment to improving the company's transparency.

You'll notice in this quarter's release we continued this process by expanding our business and MPA disclosures.

We can do better, and we will do better in the future, and you can expect future enhancements in the upcoming quarters.

This morning I want to spend my time on three topics.

First I'll briefly review the third quarter earnings and isolate those one-off items that impacted the quarter.

Secondly, I'll highlight the progress that we've made on the asset quality front, and third and finally, I'll touch on our outlook for the remainder of the year, with some very preliminary thoughts about 2003 as well.

As Jim indicated, the quarter's results were impacted by continued slowing economy and difficult financial markets.

Net income for the quarter was $285 million and earnings per diluted share were $1.

Returns were strong for the quarter, a 17.4 percent return on equity on a growing equity base, and 1.72 percent return on assets.

Nonetheless the third quarter included a few one-off revenue and expense items that collectively added three cents to four cents to our results.

And I want to take you through them item by item.

On the positive side, we had net securities gains of 68 million.

Now, while our normal portfolio management activity typically would generate gains in this kind of environment, 68 million is higher than what we would think is normal levels.

Most of these additional gains resulted from the sale of a billion 2 of investments with embedded long option positions, and we sought to optimize the performance of these instruments at this point in time through the sale of securities prior to the expiration of the embedded options.

Institutional loans held for sale gains, net of valuation adjustments, added 17 million, and we had a $19 million reduction of fourth quarter 2001 PFPC (ph) reserves, primarily for facilities consolidation that was no longer necessary based on the current plans.

Those were the positive items.

On the negative side, we had a net charge-off of 43 million that was taken in regard to a single credit backed by vocational student loans that resulted from a second quarter draw with market street funding (ph) on a liquidity facility provided by PNC.

We had equity management losses of $22 million, and we had legal, consulting, and accounting fees of 11 million, primarily related to the measures we're taking to address regulatory concerns, and it will strengthen our risk management framework going forward.

Now, as I mentioned at the start, the impact of these combined items was approximately 3 cents to 4 cents per share benefit, assuming some normalized level of securities gains.

Now let's turn our attention to the major elements of the income statement.

Net interest income was 532 million, or a decrease of 6 percent when compared to last year and 5 percent on a linked (ph) quarter basis.

This change was driven primarily by a reduction in earning assets attributable to the downsizing of our higher-risk, lower-return lending assets, and it was partially offset by a higher level of fed funds sold at nominal spreads.

I think it's self-evident that if we wanted to we could increase our net interest income by simply adding riskier assets, either through the investment portfolio or in the loan book.

But I want to reaffirm that we will not chase after value-destroying assets in this market.

At this point in the cycle we've consciously decided to remain very liquid.

During the quarter, fed funds sold average more than 3.3 billion and increased 30 percent on a linked quarter basis.

Going forward we expect that interest income to be relatively flat through the fourth quarter when compared to the third quarter.

Shifting over to non-interest income, third quarter non-interest income was 758 million, an increase of 30 million when compared to the third quarter of last year, but a decrease of 97 million on a linked quarter basis.

Our market-sensitive businesses represented $75 million of that amount.

On a linked quarter basis, asset management decreased by 30 million, fund serving declined by 22 million, brokerage fell by 14 million, and equity management losses increased quarter to quarter by 9 million.

Approximately 70 percent of the linked quarter declines in these market-sensitive revenues are directly related to market factors.

We can track them back to the level of the market.

On the positive side, we continue to make progress in acquiring and retaining profitable customers in all of these businesses.

BlackRock's new business in the third quarter continued to be strong in several channels, including 1.2 billion of net new fixed income business, 2.8 billion from international clients, predominantly in equity assets, and 830 million in net new closed end funds.

And private banking new client acquisition remained on what was an aggressive plan for this environment, reflecting the investments we've made in distribution.

Now I want to stop and spend a little more time on PFPC specifically.

The revenues here decreased on a linked quarter basis by $22 million due to several factors.

Firstly, in the last quarter there was a 1 time benefit of 13 million from renegotiating a customer contract.

The remaining 9 million was largely due to the market impact on the transfer agency business.

Our customers experienced net outflows of funds and a greater loss of accounts as investor are treed for mutual funds.

On a linked quarter basis fund accounting revenues were flat and this is actually a very strong performance when you take into account that equity serviced that, of course, have a higher margin than fixed income assets, declined dramatically in the quarter.

So strong client retention in growth offset declines in the equity -- equities under management versus fixed income.

In order to be successful in this business we must continue to add new customers and deepen our penetration of existing customers combined with reducing our costs.

In the past few months we strengthened our sales management process and we are already seeing positive results on the client side.

On the expense side we've been evaluating system consolidation and expense control strategies.

We believe that by implementing these strategies we can reduce operating expenses at PFPC by roughly $50 million, the majority of which we can expect to capture next year.

Overall, all of these businesses are positioned to benefit from an improving market.

But success in the short run is going to be defined by client retention and acquisition and a strong focus on efficiency and costs.

Finally, tying this back to non-interest income for the whole firm, while we're anticipating that the financial markets will remain challenged in the fourth quarter, we would expect to have fourth quarter non-interest income of similar levels to the third quarter.

The provision for credit losses this quarter was 73 million compared to 110 million in the same period last year.

Net charge-offs for the quarter were also 73 million, and I'll spend some more time on the asset quality trends in a moment.

Expenses for the quarter were 777 million, down from 791 million in the prior year quarter.

However, the decrease in expenses was primarily attributable to the elimination of goodwill amortization expense.

When excluding this impact, expenses increased by 15 million, primarily driven by higher legal occupancy and employee benefit expense.

Also in today's release we announced that we will expense stock-based options using the fair value method beginning with grants made in 2003.

Assuming recurring grants of similar size and value to those made during 2002, the 2003 impact is currently estimated to be approximately 5 cents per share, and when fully implemented, the current expected impact is a reduction of approximately 3 percent to diluted earnings per share.

We currently anticipate expenses to remain relatively flat in the fourth quarter.

The investments related to enhancing our risk management and compliance infrastructure and additional legal and consulting costs are expected to be offset with improved efficiencies in our wholesale banking business and PFPC.

Let's shift to the balance sheet.

Balance sheet activity continues to reflect our efforts to reposition the lending business and focus on transaction deposits and customer growth.

You've heard a lot from Jim already and I'll talk about asset quality issues in a second, but with respect to our loan side, but I'd like to turn our attention to the deposit side.

During the quarter deposits averaged approximately 44 billion.

That was a decrease of roughly $665 million on a linked quarter basis.

Now, our deposit strategy is focused on growing core checking relationships.

Beside the benefit of being a very low cost funding source we believe they provide us with the opportunity to offer other fee-based products.

On a year over year basis, we've grown demand deposits in the regional community bank by 7 percent.

The decline in total deposits on a linked quarter basis was largely the result of allowing higher cost retail and wholesale CDs to run off.

Consistent with our stated objective of strengthening our capital position in this environment, regulatory capital ratios improved during the quarter driven by internal capital generation, continued reduction in lower turn assets, and no share repurchase activity.

We expect our levels will improve and by year-end our regulatory capital ratios should be among the highest in our peer group.

This will position PNC with a great deal of capital management flexibility.

We're committed to deploying capital in a manner that enhances shareholder value over the long run.

One option here would be the resumption of share repurchases.

However, this is dependent on several factors which are outlined in the 10-Q such as the progress of and disposing of loans sold for sale along with regulatory and rating agency capital considerations.

Let's turn to asset quality.

Headline item, the non-performing assets for the quarter of 409 million are down 18 percent from the prior quarter end.

As I mentioned earlier, one of the incremental disclosures that we made this quarter was a breakdown of NPAs (ph) by business.

The largest NPA (ph) in PNC is a secured credit of $65 million.

The next three credits dropped to 18 million, 17 million, and 11 million respectively and then go lower from there.

We'd clearly like to see the NPA (ph) line be zero, but to the extent that we're going to have NPAs (ph), I take a lot of comfort from the fact that we have them in small and diverse size.

During the quarter we have net charge-offs of 73 million, and as I mentioned before, we had -- as I mentioned before, we charged off 43 million related to a single non-performing credit backed by student loans.

PNC is a beneficiary under an insurance policy for this loan, and coverage under the policy is in litigation with the insurance carrier.

We are vigorously pursuing our claim and we believe we are entitled to payment under the policy.

Nonetheless, given the uncertainties and timing related to this credit, we decided to write it down.

Excluding this credit, net charge-offs were 32 basis points to average loans, which is in line with our expectations.

We currently expect NPAs (ph) will remain relatively stable in the fourth quarter.

Currently we have 727 million when combining the allowance for loan losses and the allowance for unfunded commitments.

Clearly we view this allowance as adequate.

This quarter there were continued improvements in NPL (ph) coverage and total loan coverage and the unallocated total reserves stand out .32 percent of total loans.

In the loans held for sale book, we made significant progress this year.

Liquidating institutional loans.

Institutional loans held for sale declined 2.1 billion or 81 percent since the year-end.

Remaining outstandings at the end of the third quarter were approximately 500 million.

It's important to remember that these assets are carried at the lower of cost or market.

Presently the carrying value of these assets held on our book is on average or in the low 60s, or 60 cents on the dollar, which is well below industry recovery rates for similar loans based on historical averages.

We will continue to focus on this effort and pursue options to liquidate the remaining loans held for sale and other credits designated for exit.

Turn to the outlook.

With respect to the overall outlook we believe that the economy and the capital markets are going to continue to be weak.

Given our continuing concerns regarding the economy and our current assumptions for business performance, we expect the fourth quarter results to be comparable on a core basis with the third.

In this environment, I think it's premature to offer specific 2003 guidance.

However, we do expect to enter 2003 with a smaller but stronger balance sheet, a strong capital position that gives us flexibility, and an improved credit risk profile.

As I mentioned previously, we believe we are positioned to benefit from an improving market.

Nonetheless, as I mentioned when I discussed PFPC, we are aggressively pursuing expense control strategies across the firm, and if the core economy does not improve, we will be more aggressive on that front.

In addition to the economy, interest rates, financial market conditions, and the possibility of international hostilities, our ability to meet these expectations will depend on many factors, including disposition of loans held for sale without significant valuation losses, stability of asset quality, revenue growth, and development of value-added customer relationships, successfully leveraging technology and managing the revenue expense relationship, and finally regulatory actions.

Traditional risks and other factors that may affect future results, see our press release and the risk factors, risk management, and forward-looking statement portions of our SEC filings.

With that, I guess we'll open it up for questions.

Operator, would you please give our callers the instructions for asking questions?

Yes, sir.

At this time, I would like to remind everyone, in order to ask a question, please press star then the number 1 on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

And your first question comes from Judah Crawshaw (ph) with Merrill Lynch.

Judah Crawshaw (ph): Hi, Bill (ph), how are you?

A couple things.

I think in my mind the central question is, what's going to make the retail community bank grow here?

It seems to me if you back out security gains over the past year you're still sort of in a downward bias on earnings.

I guess my basic question is, how long do you think it's going to take before that business stabilizes and starts to grow without security gains?

And specifically I'm curious whether you can address the drop in mortgage loans in that unit, the relatively flat transaction deposits for the last three quarters, and overall sort of your sense of when you might reverse the downward trend for overall loans?

I think, Judah, we've increased transaction accounts fairly successfully over the course in the last three years.

As I mentioned, it's 8 percent -- 8 percent compounded.

This year it's been 7 percent in the transaction account area.

We really haven't changed.

The numbers that are well (ph) reported are the CD and the money market rates -- money market accounts where, you know, when you consider the liquidity of our balance sheet with a significant amount of debt funds sold, chasing those type of accounts really don't add much value to the shareholders.

The transaction accounts, too, we're up 7 percent this year in the transaction accounts.

Bill, do you ...

Judah Crawshaw (ph): Can I just (ph) ask you -- on many other banks (inaudible) combined DDAs (ph) and money market accounts and call that sort of the pool of low-cost transaction deposits.

I'm surprised when you throw in MMDAs (ph) that the growth rate has been much more stagnant.

MMDA numbers is the account that we have not been pursuing and we have a few people in our marketplaces that are remarkably aggressive in terms of their interest rates that they've been quoting on those, and it really doesn't make a lot of sense.

It doesn't add shareholder value.

Remember, Judah (ph), we're rolling on average 3.3 billion in funds, and the notion of growing MMDA accounts sort of an equal rate to where we're rolling funds doesn't make sense now.

It gets back to your broader question, I guess, which was both with respect to mortgages and loans in general, when are we going to see a reversal of trend and a decline on interest earning assets, which is completely fair question in this economy, in this market.

On the mortgage side we've obviously been hit a lot by the prepayments.

We've managed the interest rate risk of that, but we've had prepayments the same way everyone else has.

On the generic loan side, you know, we started from the position of basically, you know, being too concentrated in credit on the loan side, and therefore downsizing.

Once we get controls in process and get the loan portfolio in the position we like across the whole bank, we'll get back into using our balance sheet to enhance customer relationships where we're getting the right risk return for what we're adding.

But right now we're still in the process of downsizing the troubled assets, you know, and cleaning up the processes so we can do it the right way when we turn it around.

Judah Crawshaw (ph): Given your economic outlook and rate forecast, does that imply -- do you assume some kind of inflection point next year, or is it longer than that?

And is there some kind of investment spending wave that has to go into this to regenerate revenue growth?

Can you repeat the last part of the question?

Judah Crawshaw (ph): Do you need to step up investment spending, you know, to really drive better revenue performance?

I don't think, on the investment side, we really don't need to do any real spending, especially in the community bank.

We've Web-enabled all our branches last year, spent $60 million.

Our call center today -- as a matter of fact, just last month our customer sat (ph) number hit 90 percent, (inaudible) rate a pool (ph) of 1.7 (ph).

So the spending we've done in the recent (ph) community bank is pretty much behind us.

The real issue for us, I think the strategy has been to add customers and transaction customers.

Our ATM fees were -- for the third quarter versus the prior third quarter were up 3 million bucks simply because people use their transaction account to utilize their ATM machine.

I think we're really finding more ability to cross-sell people in that environment where the transaction account is involved.

Changing the money market account to the extent rates start to move up, we believe that if we're in the relationship bank, we can always get the interest sensitive money.

That's proven to be the case in the past.

Judah Crawshaw (ph): Okay.

If I could switch gears, my other question is on PFPC, two-part question.

Why did you cancel the plan consolidation, and what are you seeing in terms -- are you seeing any evidence that the runoff and repricing pressures are beginning to stabilize or abate?

The one item, Judah (ph), on the building, we had expected to exit a building, and that's why we -- one of the things that we had assumed for the consolidation at year-end last year was to exit one building.

We're now actually going to move people into that building.

We find it more economic to do that.

Plus we have a couple of new customers in that product that actually will allow us to use that building more effectively.

So that's really the reason we turned that around and the decision was made in the middle of the quarter to do that.

We also have, as you know, a new CEO at the - at PFPC.

Tim Shack (ph) has taken over that responsibility as of mid-April, and he's the person that really consolidated all of our banking platforms to a common platform with the single data center and now he's doing the same thing at PFPC where we have multiple platforms for transfer agency and retirement services.

It's different -- it's really a different, new, and a more focused view on expense that Bill mentioned.

Judah Crawshaw (ph): So it's not a signal that you're going to back away from restructuring the business -- it's very much a one-off item?

Absolutely.

And actually, Tim (ph) was the person that really took over our treasury management business a number of years ago, and our customer satisfaction there is at an all-time high.

And our sales frankly are at an all time high for new customers in treasury management.

He's restructured the sales force over there as well.

We're seeing it with new customers coming on.

As you know, we (inaudible) the Wells Fargo relationship in the quarter and a number of others.

And really, it's not to say that there isn't pressure on pricing because there continues to be pressure on pricing, but the customer opportunities are there as well.

Next question, please.

Your next question comes from John McDonald (ph) with UBS Warburg.

Hi, John (ph).

John McDonald (ph): Good morning.

I was wondering if you could update us on the ongoing legal dispute that you have with Washington Mutual on the sale of the mortgage business.

If you could give us a review of what you've booked potentially as a receivable and if you have any reserve against that?

Let me comment on the litigation.

During the quarter the judge in Los Angeles remanded the litigation over one or two of the items that Washington Mutual had asked to litigate in court, remanded it back to the (inaudible) arbiter, as was originally stated in the contract, which is something we've been trying to do since we closed the transaction a year and a half ago is to get to the arbiter.

What Washington Mutual has done is they said they would like to litigate a few of the items with the judge in a Los Angeles court and have the rest of the items go to the arbiter as required in the contract.

The judge in Los Angeles said he believed they all should go to the arbiter and actually demanded there be some action that takes place prior to the end of this year.

So we're pleased with that outcome so far, and that's how those complex items are usually resolved, and that's why it's written into the contract in the first place.

On the receivable side of that, just the balance sheet item, we have 143 million as a receivable, and we do hold a reserve against it that's a substantial portion of the receivable.

John McDonald (ph): Okay.

That receivable is based on your expectation of what you could recover in the lawsuit?

We're comfortable with our financial position with regards to the outcome of the Washington Mutual arbitration.

John McDonald (ph): Okay.

If I could just follow-up, Bill, could you comment on your ability to do buybacks next year?

You comment on the excess capital, and there's a bunch of factors in play there, but do you expect to be in a position to request from the regulators permission to exercise buybacks next year?

Bill Demchak (ph): We would hope to be in a position to do that, yes.

John McDonald (ph): Okay.

Thanks.

Next question, please.

Your next question comes from Jim Auga (ph) with Millennium.

Hi, Jim (ph).

Jim Auga (ph): Hi, guys.

I'm having a little difficulty understanding what core earnings are for this quarter in terms of coming up with a forecast for 2003.

Bill said earlier, I think, if I understood him or heard him correctly, said there was only 3 cents to 4 cents in sort of net nonrecurring items.

I calculate a much higher number.

I'm wondering why you're backing out the market street credit loss and trying to figure out what a normal level of security gains are.

So if you could give us what you deem to be a core number, I'd really appreciate it.

Well, you won't get me down to an exact number, but I'll address your line items.

Market street, the reason why we sort of isolate that off as a one-off I guess is twofold.

One is a -- it was a credit extension that is not a typical and going forward hopefully will not be a typical type of credit extension we will do.

It's outsized and it wasn't core client.

Secondly and more importantly, we do have the insurance policy against it, and we think it was a fairly conservative approach to write it down to the level that we did.

In terms of normalized securities gains in this market environment, we would like to think that we could produce 10 million to 20 million a quarter in securities gains.

Jim Auga (ph): And then I have a question on PFPC.

I didn't follow Judah's (ph) questioning exactly, but you made $19 million in earnings but you also stated you added a $19 million reserve release or restructuring charge reversal.

So in effect that's a break even business right now?

One is pretax and one is post-tax, so -- but you're right if you back that out explicitly this quarter, you'd be in single digits on earnings.

So I went through the line items with you earlier on PFPC's earnings.

The big shortfall there is the transfer agency business, you know, largely driven off of outflows and mutual funds, unless client activity at the Mutual fund level.

Having said that, we have been strong on the client front, you know, 1,000 points in the Dow over the last week don't hurt as well in term of looking forward, but we hope that -- we've seen the low levels that that can fall to and it's well positioned for growth in the future on the revenue side, and we're going to be aggressive about costs as well.

Jim, I can tell you that, with the acquisition of ISG and the market win that was behind us, we were relatively slow to consolidate the platforms that we acquired.

In hindsight, we should have been more aggressive in doing that, and I think that, as Bill outlined, the cost save opportunities we have in front of us I think are very significant.

We've got a plan to capture them.

Actually, I have to be honest about it, that's something that some of our competitors don't have, is that cost saving (inaudible).

Jim Auga (ph): Right.

Okay.

Even though you're not really willing or desire to give a core number, I want to go back to this for two reasons.

When we last met at the Merrill Lynch conference a few weeks ago or whatever, 8 weeks ago, I asked you specifically about the impact of the written agreement and the regulatory exams on expenses.

And I believe, if I wrote my notes correctly, you guys said there would be virtually no impact.

Now you're saying there's 11 million in legal and accounting and professional fees for that just for this quarter.

Let me clarify.

The impact (inaudible) that we made, I believe it was Greg - is that it doesn't really have any impact on our businesses.

Our businesses are competing very well and performing for the customer.

Jim Auga (ph): Right, I understand that.

We do have expenses - and obviously we've just completed the consultants review for -- you know, for the federal reserve, and that obviously (inaudible) expenses, as well as other legal expenses that are associated with it.

Jim Auga (ph): Right.

You know, I didn't ask about the impact on the business.

I actually asked about expenses directly.

I'm sorry if I misunderstood you.

Jim Auga (ph): Okay.

Then back to the core number.

At that same conference and in your press releases that were widely disseminated to investors, you basically endorsed a certain number for 2002.

How do you get there if your core earnings are, you know, shorter than the dollar this quarter?

Because consensus is still a $1.05 for next quarter.

How do you make your earnings forecast that you've recently endorsed, basically, after putting up these numbers today?

We have two significant things that happened since the Merrill conference in the other quarter.

One, clearly, the market sensitive items that we have that Bill pointed to with regards to -- with regards to PNC advisors and (inaudible) which were impacted by the S&P (ph).

We had an impact in our venture capital book as a result of the quarter end numbers.

And quite frankly I think we took a very conservative -- took a conservative view on the $43 million charge off for the insured credit.

So I think those are the items really that made the difference in the quarter vis-a-vis perhaps the perception that we had at Merrill Lynch.

Jim Auga (ph): Right.

So based on what we know right now, Jim, about the markets, what is the new guidance for 2002?

Jim Rohr (?): Short of scripting it, we printed $1 a share this quarter, and we highlighted -- or I highlighted for you the notion that in my mind I thought 3 cents or 4 cents from that is nonrecurring and is the function of these one-off items.

Jim Auga (ph): So that's a good run rate for Q4, then, Bill?

Jim Rohr (?): And with respect to Q4, the fourth quarter right now feels to us a lot like the third quarter in terms of core earnings.

To put a specific number on it at this point in time, given what's going on in the economy and the exogenous variables and the world as a whole, I think is short-sighted.

But the fourth quarter feels like the third quarter to us with what we know right now today.

Jim Auga (ph): Okay.

Thanks, guys.

Next question, please.

Your next question comes from David Hilder (ph) with Bear Stearns.

David Hilder (ph): Thanks.

Good morning, gentlemen.

I guess two questions on PFPC.

The first is, as I understand it, you still have multiple platforms in some of the PFPC businesses.

Can we look forward to an additional restructuring or facilities consolidation charge in the future?

No.

We believe that we have already reserved that at the end of last year.

David Hilder (ph): Even though you've now reversed 19 million of it?

The 19 million was really just dedicated to a building.

There were other reserves taken at year-end last year that related to the consolidation.

David Hilder (ph): Okay.

And then again on PFPC, if you just -- and I'm probably thinking of this too simplistically, but if you just look at the fund servicing revenues and subtract operating expense to get to kind of a pretax operating run rate number, the PFPC business this quarter made $28 million.

That's down almost 50 percent from where it was a year ago.

Does this give you any reason to consider writing down the intangible asset as a result of the acquisition?

We've looked at that and studied it hard, and I think we're comfortable with the intangibles where it is today.

This (ph) is actually still a fair bit of room on it.

Take your math for granted for a second.

Within those numbers, remember, you know, put in there that the possibility of the $50 million cost takeout and don't make any assumptions about what the market might do, and you see profitability levels return to or in fact exceed what we've seen in the past.

Good question, very good question.

Very good question.

It's not too simplistic either.

David Hilder (ph): Again, just so I understand you, Bill, 50 million of cost takeout in the future, your run rate?

We've identified 50 million of savings.

Aggressively we would hope to get as much as 40 of that out of 2003.

We're going to plow some of it back into technology investments that would probably be capitalized, but again, there are big opportunities to take direct costs out of that business.

David Hilder (ph): Okay.

And with no further restructuring charges?

That's right.

We don't anticipate any at this time.

David Hilder (ph): Thanks very much, gentlemen.

Thank you.

Next question, please.

Yes, sir.

Your next question comes from Brock Vandervlite (ph) with Lehman Brothers.

Good morning, Brock (ph).

Brock Vandervlite (ph): Thanks very much.

If you could just give us some color, clarification on what's left in terms of the portfolio, (inaudible) portfolio downsizing that you see going forward?

In the held for sale book we are down to a carrying value of 500 million plus or minus.

You know, and again, as I mentioned, the average carrying value on that is now below 65 cents on the dollar or something.

So it's not huge.

It's aggressively marked down relative to its original par amount, and we are pursuing the strategy to sell that off through the course of the end of the year.

Brock Vandervlite (ph): Okay.

So on balance, (inaudible) it should be stabilizing after that?

I'm sorry, could you repeat that?

Yes, we would think the loan balances would be stabilizing after that, yes.

Brock Vandervlite (ph): Okay.

Separately, on the reserve, at least in the reserve to loan ratio continues to climb.

What do you see over the horizon in terms of charge-offs versus just greater caution, given the economic environment at this point?

You know, with respect to charge-offs, as I mentioned in my comments, we'd expect going forward to get back towards more normalized levels.

I think we had the number in there as 35 cents typically versus this quarter.

With respect to the size of the provision increasing, we're pleased with that at this point in time.

It is a difficult market.

It is uncertain in the future.

And having additional coverage to loans is prudent.

Brock Vandervlite (ph): Okay.

Could you clarify the options expense for next year?

Yeah.

We put that specifically in the release, but basically if we -- in -- sorry.

The simple answer is 5 cents, they're all telling me.

Or 3 percent dilution.

If we did the same program in 2003 as we did in 2002, it's 5 cents earnings per share.

If you roll it forward through time, we would expect it 3 percent dilutive.

Next question, please.

Yes, sir.

Your next question comes from Dennis LaPlante (ph) with Fox Pitt Kelton.

Good morning.

Dennis LaPlante (ph): Good morning.

Thanks for taking my call.

A couple things.

Asset liability position, are you basically asset sensitive now, or could you give a little color on that in terms of the impact going forward?

And also, I'd like to get an update on your venture capital positions now in terms of asset carry values and how much of that's been written down and maybe differentiating between what actually the substance of the assets you have, funds versus direct investments?

And third thing, put liability from the NBOC, how much of that impact was in the quarter?

You said it was less than Q2, but how much indeed was it?

Good questions.

Asset liability question was the first question.

We aren't particularly sensitive to movements in interest rates in either direction.

As they go to zero, we're probably not very happy, but we won't be happy about a lot of other things either, but we'll have a lot of security gains.

We're positioned at the large end of declining net interest margin in the lower rate environment, but not in the very large way with respect to ALM (ph).

If you look at - Dennis (ph), and I know you're familiar with this, we're still in a position of looking back over a period of the last three to four years, (inaudible) dramatic changes, dramatic changes in interest rates.

We've not had dramatic changes in our net interest income lines.

So we're conservatively positioned there.

With respect -- you also had a question on our equity management assets.

One question you had was what percentage is in direct investments versus partnership investments.

And we're around 55% to 60% percent - 55% to 60% direct investments, 45 to -- or sorry, 40 to 45 in partnership investments.

The market value of these assets, the cost of these assets right now is roughly 650 million, market value, about 566.

I think you had one more question on the ...

It's important, we mark those to market, which is low cost in many cases.

Other people mark them to market with a limitation of cost.

They want to go below cost (inaudible).

Dennis LaPlante (ph): I just want to clarify, the 650 was what now?

I'm sorry?

It's the cost across both direct investments and partnership investments.

Dennis LaPlante (ph): Okay.

And the 566?

Was the market value.

Dennis LaPlante (ph): So if I'm understanding you right, you still have potential -- some potential impairment now?

Am I reading those comments correctly?

Mark to market -- we have a market value in disclosed item (ph) of 566.

So it's at ...

Dennis LaPlante (ph): They're carried on the balance sheet at that amount?

Yes.

Dennis LaPlante (ph): Great.

That's what I wanted to know.

Okay.

And the liability?

Sorry, put (ph) liability?

Dennis LaPlante (ph): Yes.

Liability, it's less than 70 million to date.

The earnings impact this quarter I guess was 4 million.

Next question, please.

Your next question comes from Mark Lynch (ph) with Willington (ph) Management.

Mark Lynch (ph): Good morning, Mark (ph).

Mark Lynch (ph): Good morning.

I may have missed this since I got pulled out for a minute, but did you give some idea about the margin going forward or where it was in September?

And the second part of it is the reason for the 3 billion in fed funds sold, can't you find something better to do with them?

Lots of ideas.

Those are two very ...

The margin going forward we would expect to be flat.

Fed funds sold at 3.3 billion; that's not optimal, but at the same time we have been focusing on getting the risk profile that we have today under control and well understood before we sort of move forward in investing in newer incremental risk.

But clearly the 3.3 long term is sub-optimal in running our balance sheet, and we wouldn't expect that going forward.

Mark Lynch (ph): Okay.

Thank you.

Next question.

Your next question is from Jed Gore (ph) with Sunova Capital (ph).

Jed Gore (ph): Hi, good morning, gentlemen.

Just a question on PFPC.

I'm just trying to get to a core earnings run rate for this quarter, and Jim walked through this a little bit, but is it right to assume if I have a 40 percent tax rate, you earned about 7 million in this?

It's close enough, yes.

Jed Gore (ph): Okay.

And you said that next year you anticipate you'll be able to take 50 million cost savings out of the business?

We've identified 50 million -- we think we can get 40 of it next year.

Jed Gore (ph): Okay.

I'm just trying to get a sense, given that you paid $1 billion to buy this business, what you're doing with it strategically beyond waiting for the environment to improve and cutting costs.

I just see you losing accounts and pricing getting weakened?

Our accounts are actually up a million accounts year over year.

So we're actually adding customers in this business.

Jed Gore (ph): Year over year?

Year over year.

And we've announced a big customer that signed.

Wells Fargo is not on yet, for example, because it takes time after you win business from the customer to actually come up (inaudible).

So the customer business is going up, we're actually adding customers.

Clearly, I think we have a couple of opportunities here to add shareholder value.

One is to take the cost out, and secondly, to make any assumption about market growth in the future, the leverage off of the cost savings as well as the market.

So I believe that this company can return to the profitability that it historically had.

One of the questions is, does it have the growth rate that it had in the past?

I don't think the markets will have that kind of growth rate, but that doesn't mean in -- this business doesn't provide a very attractive return to shareholders over time.

We've got some work to do on the cost side, though, in order to get to where it really used to be.

Jed Gore (ph): Right.

Okay.

And you mentioned the other non-interest income line item was down 36 million sequentially due to lower trading revenues.

What were your equity trading losses in the quarter?

Equity valuation losses were 22 million.

Jed Gore (ph): Okay.

But that's separate from this line item?

Yes.

Jed Gore (ph): Okay.

What trading losses are you talking about in the other non-interest income line item?

Why don't we take the next question, and I will come back with the answer to that one as I actually dig out ...

Jed Gore (ph): Okay.

Thank you.

Next question, please.

Your next question is from Claire Pacapio (ph) with Janney Montgomery Scott.

Good morning, Claire.

Claire Pacapio (ph): Hi.

My question is on market street funding.

Two things.

This is the second credit, I believe.

I'm wondering if there are other potential problems coming.

And second, how confident are you of the insurance and what would the timing of that recovery be?

Third, do you plan to unwind market street and if so will the earnings impact the reduction of about 11 million when you do so, what would the timing be?

And then fourth, just -- I want to get clear on your provision in that charge-off outlook for the fourth quarter.

Were you suggesting that you could actually go to a $35 million number in the fourth quarter, or is that more a couple quarters out?

Let's see if I can remember the sequence of the questions.

One is we don't anticipate any additional issues coming out of market street at this time.

Secondly, with regards to the litigation around the insurance, other banks have sued the carrier and we're in the process of considering our position there.

We've obviously put in our claim.

The reason that we took the conservative approach here is that we do believe that will take time, and it's uncertain as to what might transpire there in terms of litigation.

We're very comfortable with the insurance policy in terms of the liability on the insurance company's part.

We have a number of opinions to back that up.

Nonetheless, that means there will be a time value and perhaps a negotiation at some point in time and that's why we felt that it was prudent to reduce it in the third quarter.

Thirdly, I think Bill commented that he really did feel that more normalized provision which would be in the range that you're talking about might be more probable for the fourth quarter.

35 million to 40 million.

And then ...

You had a question, I guess, on just unwinding market street.

Claire Pacapio (ph): Right, bringing it back on the balance sheet and ultimately reducing it very significantly.

Well, I think first off, whether or not it comes back on the balance sheet is a function of accounting changes.

That's a different issue.

But the generic business, the bankruptcy remote secured lending is, if run correctly, a high return on credit capital business.

So we would like to do that well and potentially to grow it, not to unwind it.

You know, the existing portfolio has been very well scrubbed, and there's been a lot of work done on making sure that we align that product capability with our core client franchise, and that's what we'll do going forward.

But an unwind notion, separate from what would otherwise be going on in the industry as a whole as a function of just consolidation of conduits, isn't contemplated at this point.

Going forward we're using a test (ph) that says we aren't going to put any loans into market street that we would not be comfortable having them on our balance sheet at a different rate.

So -- from a credit point of view.

I think that's clearly our (ph) strategy going forward.

Claire Pacapio (ph): What portion of market street is not customer-based at the moment and would you reduce (ph)?

I don't have that.

Very small portion now.

Claire, this is Bill.

A lot of the work that's been done has taken those relationships off, you know, and terminated them in the fourth and first quarter.

Claire Pacapio (ph): Thanks.

Next question.

You're welcome.

Thank you, Claire (ph).

Yes, your next question comes from Mike Mayo (ph) with Prudential Securities.

Good morning, Mike (ph).

Mike Mayo (ph): Good morning.

I had one conceptual question.

To the extent that you're taking risk out of the franchise, what impact does that have on your long-term growth rate?

What had your long-term growth rate been, and where do you perceive it to be now?

Actually I think the key to taking the risk out has been the volatility side, and I think you've identified that in the industry, really, I guess as well as anyone.

You know, the commercial lending business is really a highly volatile business with insufficient returns to justify it (ph).

So really in taking (ph) - and if you look back in our history when we have things like PNC Advisors, which has grown nicely with the exception of the downturn in the market this year, but people like BlackRock and our regional community bank and our treasury management business, things that have grown very nicely over time in the double digits in a more normal economy, if you will, the volatility has always come through the commercial outlook portfolio.

And that's the reason we marked (ph) (inaudible) the strategy four years ago to produce that, and we've taken it from a high 30 percent - high 30s as a percent of revenue down to around 20 percent.

And it's really focused on middle market customers and investment grade companies and in smaller dollars that we have taken before.

So I think the growth rate going forward should be one that's reflective of businesses where we've been successful, and with a reduction of the volatility I think it will be much more shareholder friendly.

Mike Mayo (ph): Secondly, as far as guidance next year, consensus is 450, and I guess currently you're saying your run rate is closer to 390 or so, or less.

What ballpark range would you give for next year?

We really aren't -- it's premature to give a 2003 forecast really.

I would love to have a better view on the economy.

I'd like to have a better view on what the Dow or actually (ph) the S&P, which is more important to us, might do.

I'd like to have a better view on what we might do with share repurchase.

There are a number of factors.

We've got some work to do on the regulatory affair side, so there's a number of factors that we have to really button up over the course of the remainder of this quarter before we're really in a position to say much.

I think there is obviously an economic risk on the downside, and all the risk that Bill mentioned, but there's some upside as well coming from the current run rate.

We'll be looking at those hard over the next, I guess, 60 to 75 days.

Mike Mayo (ph): Last question, simply procedural.

The procedure relating to the review of the directors and senior management by the regulators and the independent consulting firm, is the final review by the consulting firms done, and have the regulators signed off on the directors and senior management yet?

And if not, when do you expect that to happen?

The consulting review has been done.

It has been submitted to the Federal Reserve (ph).

And the management team has been reaffirmed by the board of directors.

Mike Mayo (ph): You're still waiting on the regulators to give their final okay?

I don't know that the regulators -- I can't speak for the regulators.

I don't think the regulators -- it's not in the written agreement that the regulators would or would not give their okay.

The regulators always had and do have the ability to change management whenever they would like.

That's not something that comes along with a written agreement.

That is their option at all times.

So all we can say is they are in receipt and have been in receipt of the agreement, and the board has been in receipt of the -- I mean, they are in receipt of the report, as is the board, and the board has reaffirmed the current management team with myself as the chairman and CEO.

Mike Mayo (ph): And are any changes to the directorate expected or possible over the next several months?

I believe we will be -- we added Steve Seke (ph) - I don't know if you noticed Steve (ph), but he'll be a terrific director.

Retired from the Federal Reserve, was in charge of risk management of JP Morgan and had retired from Morgan prior to the Chase transaction.

He's been added to the board and I think you can expect to see others added to the board in the relatively near future.

Mike Mayo (ph): When it comes to senior management, pretty much what you have is what we'll be seeing going forward?

I believe we'll have another addition for you in the relatively near future, and then that will be -- that will complete the team.

We'll always be adding people or changing people, but that will complete the executive team.

Mike Mayo (ph): All right.

Thank you.

We should go back to -- I guess Jay (ph) had a question on other income.

Just to break that down, the change on a linked quarter basis was down 36 million.

And actually a big chunk of that -- I'll go through the line items, but there was a $14 million gain in the second quarter that came from a building sale.

(inaudible)

Yes.

Also, incrementally, a $6 million change on the put liability and a $6 million change or gain that we had in the second quarter based on student loan sales.

The remaining $10 million is a combination of foreign exchange and various miscellaneous trading line items and capital markets and some small equity valuation numbers, but just a small piece of it.

Next question, please.

Your next question comes from Bob Ecks (ph) with Moore Capital Management (ph).

Good morning, Bob.

Bob Ecks (ph): Good morning.

My questions were asked and answered.

Thank you, Bob.

Next question, please.

Your next question is from John Cline (ph) with Sandler O'Neil (ph).

Good morning, John (ph).

John Cline (ph): Good morning.

Just a question, getting back to PFPC, the cost saves that you're looking to garner, 40 million over next year.

What's the timing of that, when do you think you can get the lion's share of the cost out?

Will it be in equal installments throughout the year?

Completely fair question.

I don't have a specific answer for you.

We're already starting to see some of that.

We expect to see some in the fourth quarter of this year.

But the action plan that they have against the total of 50 million is still being developed, and they're going step-by-step, but I don't know how it's going to trend in through the course of the year.

John Cline (ph): Okay.

And just a follow-up question.

Where do you -- I guess how high would you like to see your capital ratios get?

You know, where do you feel comfortable maintaining your capital?

And just with regard to the dividend policy, any changes there?

With respect to capital, first off, one of the things that we will be reporting and talking about going forward is economic capital, in addition to the regulatory capital items.

And we've made a commitment to manage the firm as a function of economic capital subject to strong regulatory capital targets.

So I think once you see that we start reporting our economic capital and start talking about that, we will maintain economic capital in order to maintain a strong A or weak AA type rating target.

And if we're driven by that, the regulatory ratios will fall for themselves, subject to, again, the well-capitalized standards that we'd otherwise wish to maintain anyway.

John Cline (ph): Okay.

Thanks.

I believe that is it for the questions this morning.

Thank you again for joining us.

Clearly we're operating in a difficult financial markets.

And as a result, our earnings, although I believe they were solid with a good 17.5% return, were not what we aspired to deliver, but we're pleased about the significant progress we've made in a number of initiatives.

We've reduced balance sheet risk, reduced our non-perform being assets, enhanced credit quality.

We're working to strengthen our regulatory relationships even more.

And a number of our businesses have delivered strong sales and taken other measures to grow our franchise when the markets improve.

I believe this progress, combined our strong capital position, positions us well to meet the challenges for the rest of this year and the next.

So thank you very much for joining us and I look forward to talking to you individually in the near future.

Thanks, Jim and Bill.

This concludes today's call.

Thanks for your interest in PNC.

Thank you for participating in today's PNC Financial Services Group earnings conference call.

You may now disconnect.