PNC Financial Services Group Inc (PNC) 2005 Q2 法說會逐字稿

Good morning and welcome to today's Mercantile Bankshares earnings conference call.

At this time, all parties have been placed on a listen-only mode and the floor will be open for questions and comments following the presentation. (Operator Instructions).

It is now my pleasure to turn the floor over to Dave Borowy, Director of Investor Relations for Mercantile.

Sir, the floor is yours.

Thank you, Gabe.

Good morning everyone and thank you for joining us today.

I'd like to inform you that this call is being recorded and will be available for reply along with our earnings release at our company's investor relations web site, www.Mercantile.com.

With me on the call this morning are Ned Kelly, Chairman, President and CEO of Mercantile Bankshares Corporation;

Terry Troupe, Executive Vice President and Chief Financial Officer;

Ellen Harvey (ph), Senior Vice President and Portfolio Manager and Kaye Simmons, Senior Vice President and Treasurer.

Before I turn the call over to Mr. Kelly, I would like to address some regulatory protocols.

The press release announcing our earnings was distributed via PR Newswire at 7:00 AM Eastern time.

I would like to remind you that during the course of this conference call, we may make forward-looking statements within the meaning of and pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

A forward-looking statement encompasses any estimate, prediction, opinion or statement of belief in the underlying management assumptions.

Forward-looking statements are based on current expectations and assessments of potential developments affecting market conditions, interest rates and other economic conditions and results may ultimately vary from the statements made during this call.

In this call, we will discuss some non-GAAP measures in talking about our company's performance and you can find a reconciliation of those measures to GAAP measures within our news release, which is posted in the investor relations section of our web site.

Without further delay, I present to you Mr. Ned Kelly.

Thank you, David, and good morning.

I thought we had a good quarter.

We had good loan growth, the net interest margin continued to expand, notwithstanding the fact that CBNV added 2.3 million in noninterest expenses that (indiscernible) expense control was good.

Credit quality was very strong; we had net (ph) recoveries for the quarter.

Return on assets, return on equity and the efficiency ratio all improved, both linked-quarter and year-over-year.

Our GAAP earnings were up 20.5% year-over-year and 8.4% linked-quarter; our GAAP diluted EPS of $0.84 was up 18.3% year-over-year and 7.7% linked-quarter.

Our cash operating earnings were up 17.1% year-over-year and 6.3% linked-quarter.

Our diluted cash operating EPS was up to $0.83; that was a 15.3% increase year-over-year and 5.1% linked-quarter.

There was a gain on the sale of a building during the quarter, which rounded up to $0.03 per share.

I think as all of you know, we have completed the merger with Community Bank in Northern Virginia.

It's going well.

Certainly no cost savings to date.

We expect to get them later in the year and into next year.

By our calculation, the transaction currently is about $0.01 dilutive; that is marginal rounded up, but about $0.01.

The merger-related expenses -- there were none this quarter, will come in the third and fourth quarter of this year.

On the net interest income front, it was up 14.1% from last year and 6.5% from the first quarter.

The margin was up to 446 from 429 last year and 444 in the first quarter.

We estimate that the Community Bank of Northern Virginia cost us about 1 basis point of margin expansion.

The principal benefit both year-over-year and linked-quarter as we have discussed in the past is attributable to the effect of non-interest-bearing funds.

In that connection, it's interesting to note that loan spreads have held up very well.

They were at 629 versus 604 in the first quarter and 557 in a second quarter of last year, but the yield on securities is down to 377 from 379 last quarter and 380 last year, which generates an overall yield of earning assets at 576 versus 555 last quarter and 513 last year.

The cost of interest-bearing funds has gone up to 181 from 156 last quarter and 117 last year.

Interestingly, that is equivalent to the increase in the loan spread linked-quarter and is actually 8 basis points less than the increase in the loan spread year-over-year.

As a result, the net interest rate spread declined to 395 from 399 last quarter and 396 last year, but that was more than offset by a 6-basis-point improvement linked-quarter and 18 basis points year-over-year in the effect of non-interest-bearing funds.

On the loan front, average balances were up 13.3% year-over-year and 5.7% linked-quarter.

There was growth in all categories.

C&I was 2.7% linked-quarter and 7.6% year-over-year, but was not as strong as other categories.

End of period loans were up 16.4% year-over-year and 9.1% linked-quarter, and that connection C&I (ph) was up 2.5% linked-quarter and 5.6% year-over-year.

On the deposit front, the average balances were up 8.4% over last year and 5.2% over the first quarter.

Non-interest-bearing were up 11% year-over-year and 3.7% linked-quarter.

The end of period balances were up 11.2% from last year and 7.8% from the first quarter; non-interest-bearing was up 8.2% from last year and 6.3% linked-quarter.

Our cost of interest-bearing deposits is up to 155 from 133 last quarter, 22 basis points.

It's driven by increases in time deposits greater than 100,000 and other time deposits, both on a volume and a rate basis.

That is partly attributable to an intentional funding strategy on our part and partly attributable to the acquisition of CBNV.

The bulk of the time deposits greater than $100,000 and the other time deposits come from CBNV in terms of the increase.

Our cost of interest-bearing funds, as I had mentioned earlier, is up to 181 from 156 the last quarter, again, increases in volume and rate and short-term borrowings and long-term debt.

The percentage of our non-interest-bearing deposits to total deposits is 27.8%; that is versus 28.8 last quarter and 27.2% last year.

On the interest sensitivity front, we continue to be asset-sensitive.

We are marginally less so than last quarter, not much, due to modest changes in the asset and liability mix.

Our analysis suggests that a breakthrough of up (ph) gradually over the next six months by 100 basis points, our net interest income will increase by 13.5 million over the next 12 months; that is roughly 2.2%.

If rates go up 200 on the same basis, our net interest income would be up 29.3 million, or roughly 4.7%.

Given the increase in rates, we're modeling a downward rate scenario.

If rates were to fall 100 basis points, it would hurt our net interest income by 14.5 million, or roughly 2.4%.

I should note that this analysis for the second quarter at least going forward does not include CBNV.

We will include them as we go forward.

Credit quality continues to be very strong.

Nonperforming assets are at 27.7 million; that is down from 31.4 million last quarter and 40.3 million last year.

NPA's as a percentage of loans in OREO (ph) are at 24 basis points; that's versus 30 basis points last quarter and 41 basis points last year.

We actually had net recoveries this quarter of 1 million; that compares to charge-offs of 740,000 last quarter and 560,000 last year.

We took no provision this quarter.

The allowance is at 138 versus 143 last quarter and 162 last year.

Improved credit quality in the acquisition of CBNV.

I would note that our coverage of NPL's (ph) is now at 5.8 times versus 4.8 times the last quarter and roughly 4 times last year.

We are no longer including a discussion of monitored loans in the release.

They are actually down to $500,000; they have become an immaterial amount and we've chosen not to include them.

On the securities portfolio, the average balance is actually up $26 million linked-quarter; it's down $49 million from last year.

Were it not for CBNV, the average balance would have been down as we did acquire some of their securities and on average basis, it caused an increase; otherwise, it would've been a modest decline.

Composition has changed only slightly from the last quarter.

Mortgage-backed are now at 48% versus 47%, treasuries are down to 16% from 18%, agencies are stable at 31%.

As I mentioned earlier, the yield is down to 377 from 379 last quarter and 380 last year.

As you will see in the release, treasuries and agencies are driving that; they are down to 337 from 343 last quarter and 374 last year.

That was partially offset by an increase in yield on mortgage-backed securities (indiscernible) 5 from 402 in the first quarter and 378 last year.

As I'm sure all of you know, the curve was actually much flatter in the second quarter than in the first quarter; up a few years, showed an increase 2 to 30 (ph) actually sell (ph).

I had seen somewhere that the average three-month to five-year treasury spread in the second quarter of '04 was at 263 basis points.

In the second quarter of '05, it was only at 96 basis points, reflecting that flattening.

Our portfolio is even shorter.

The duration is 1.8 versus 2.2 last quarter.

The average life is 2.1 versus 2.4 last quarter.

If rates were to rise 100 basis points, our duration goes to 2.2 and the average life to 2.5.

That compares to 2.4 and 2.6 the last quarter.

There was a loss of 17.4 million at June 30, '05 in the portfolio, versus the loss of 37 million at the end of the first quarter.

On the non-interest income front, we're up 17.5% year-over-year to 60.1 million; that was up 2.8% linked-quarter.

IWM revenues were up 3.7% year-over-year to 23.8 million, but they were down 1.2% linked-quarter from 24.1 million.

Not a great quarter in that respect.

We're suffering to some extent from terminations and negative net sales in prior quarters, which we've discussed previously.

Our pretax income in that segment was roughly 5.3 million, which was down from 7.5 million last quarter and 6.4 million last year.

The margins obviously compressed to 22.3%; 25% cash from 30.7% and 33.5% cash last quarter.

That was driven by a $1.7 million increase in expenses and a marginal decline in revenues.

The expenses in turn were driven by roughly $800,000 in salary increases and staffing additions.

That's $600,000 in additional operation expenses, $100,000 in the state tax and some increased incentives and commissions.

Our assets under administration were up slightly to 48.3 billion from 48 billion.

Stated assets under management at 21.7 billion were flat with last quarter.

What I should note, however, is that there has been a reclassification in the personal line for this quarter, which we did not restate for prior quarters, which involved moving 200 million out of assets under management into assets under administration.

In the absence of that personal assets under management, would've been down 100 million rather than 300 million.

Institutional was actually up 300 million from 13 billion to 13.3 billion.

So on an apples-to-apples basis, assets under management were actually up 200 million.

The net new sales were better than last quarter and there were some signs of improvement in the latter part of the second quarter.

Personal -- on the personal front, we had net annualized revenues of $25,000 on the net sale front versus 140,000 last quarter; that was due to lower sales, but our terminations were also down significantly.

On the institutional side, we had actually positive net annualized revenues of 47,000 versus a $500,000 loss last quarter.

Sales were about the same, but terminations were significantly lower.

That gave us overall net annualized revenues of 72,000 versus a $360,000 loss last quarter.

Net new assets were up 16 million versus a $206 million loss last quarter.

As I said, there's some encouraging signs in the new sales net revenues front in the latter part of the second quarter; we certainly hope to sustain that.

One thing tat I should note is that we will have lower assets under administration next quarter and some loss of revenue from a large custody account that we lost largely on price in a bidding process.

There was some cash management associated with it.

We decided not to stretch the price matter.

As I've discussed I think with many of you before, custody I think for us is best as a niche business.

We're not frankly in competition with the larger providers of those services nationwide.

I remain confident in our prospects.

We have a good team in place in the investment and wealth management business.

In other non- interest income, and here, I'll just focus on the linked-quarter.

Service charges on deposit accounts were up 6.3% over the last quarter, mortgage banking fees were actually up strongly 26.8% with commercial up roughly 14% and residential up 80% from a relatively low level in the first quarter of '05.

Other income was up 16.6%; that was driven by a branch sale which I've mentioned of roughly 3.4 million, and increases in electronic banking fees and charges and fees on loans, partially to offset by fees on decline in insurance revenues.

On a year-over-year basis, those revenues were actually up roughly 9%.

They did decline on a linked-quarter basis due to seasonality.

Those positives offset partially by a 1 million linked-quarter decline in revenue from nonmarketable investments.

We had a 2.1 million increase in private equity investments that was more than offset by a $3.2 million decline in the hedge fund investments on a linked-quarter basis.

I think as you know, we have a one-month lag of the hedge fund, so our hedge fund numbers would've included March through May, and that was a very difficult period.

June was generally better and in fact, May was better;

I think June was better generally for everyone.

On the non-interest expense front we, were up $3.7 million from the last quarter to 103.9 million this quarter, but 2.3 million of that is CBNV, which I think is important to stress.

If you look at page 13 of our release which details the non-interest expenses, even including CBNV there were only three line items that were up materially -- salaries, advertising and furniture and equipment.

Two other lines were up marginally and every other line is down, which I think is actually a very positive story.

If you exclude CBNV, our expenses were 101.6 million; that's up 1.4 million from the first quarter.

That is explained entirely by $1.4 million in normal salary and staffing increases.

But having said that, we also had 1 million in increased incentives based on performance.

We had an increase in furniture and equipment expenses and in charitable giving, which is in the other expense line, which totaled to roughly $1 million, and we had a $1 million increase in advertising.

Those latter items were actually offset by declines in other areas and if you go through those lines, I think you can see those declines.

The 101.6 million for the quarter, which is ex-Community Bank, is 2.4 million above the 99.2 million that I had mentioned as an adjusted matter in the first quarter.

And again, that is explained -- that increase is explained entirely by the increase in the incentive, which as you know, is performance-driven of 1 million and the normal salary increases of 1.4 million.

The other increases had actually, as I said, been offset by declines.

I actually feel good about expense control.

I think as everyone here would attest, it is a constant focus of ours.

On the operating metric front, GAAP efficiency was down to 4854 from 4945.

Our operating efficiency was at 4829 from 4868, the return on intangible equity was up to 19.64 from 18.57, ROA was up to 179 from 175.

Our average tangible equity to average tangible assets was at 967 versus 10; at end of period, it was roughly 9.25.

Looking forward, we're very much focused on the successful integration of CBNV.

That gives us an expanded presence in important markets for us.

We continue to focus intently as I've said on achieving operating leverage, which we did this quarter.

We will continue to focus on generating net new sales on additional revenues in IWM and focus generally on what we do best, which is basic blocking and tackling of commercial banking.

With that, I would be happy to take any questions.

(Operator Instructions) Gerard Cassidy, RBC Capital Markets.

A couple questions for you.

First is, your credit is obviously outstanding for you folks, which has always been a hallmark of Mercantile.

In regards to the loan loss reserve to total loans, is there any targeted ratio or level that you will take that down to from where it is at the current time?

There is no target, Gerard.

As I think you know, we have instituted what amounts to a bottoms-up process with a top-down check, if you will.

That analysis yields a number which we review with our accountants very carefully and it's driven frankly by historical loss ratios, what's going on in the economy, what's going on in the mix of the portfolio.

And ultimately, we live with the number that that generates.

I think your point ultimately is a fair one, which to some extent, the industry itself will have to confront, which is -- at what point or another do you reach a floor?

I don't know the answer to that question.

I do know that at 138, we're down considerably from where we were, but I think you would attest still probably at the high end of our peers in generally.

But we continue to go through the analysis each quarter to see what the analysis yields.

Okay.

And then the second question is, any update on just the outlook for acquisitions?

Obviously you just closed one, and are you on the sidelines for the time being, or can you, if other things come up in northern Virginia or other markets that you find attractive, you guys could seize the opportunity?

Gerard, as you know we're focused very intently on trying to get CBNV right at this stage.

Having said that, we're always alert to opportunities.

And as you know, as well as I do, at the end of the day, banks are sold not bought.

So to some extent, we're going to be forced to be opportunistic.

We as you know look at banks that we believe are in markets that are incrementally better than our current ones in the sense of adding incremental growth where we can get people and where we think there's fit and where it makes sense economically.

When you combine that with the fact that we have to be opportunistic, acquisitions are not an ordinary course of business for us, because obviously they are difficult ultimately to get done.

Having said that, we will continue to be alert, especially in those markets that we've identified.

Virginia in particular I think makes an awful lot of sense for us.

Finally, you've had two new entrants -- or I shouldn't say two.

Of course Commerce is new, but P&C is taken over regs (ph).

Have you guys seen any impact yet to those guys being in your territories down in Northern Virginia or D.C.?

We haven't, Gerard.

It's early days, but we have not yet seen any particular impact.

I noticed today as a matter of interest that Commerce had bought a bank in Florida, which I thought was interesting.

Yes, great, thank you very much.

Faye Elliott-Gurney, Lehman Brothers.

Hi, good morning.

Can you just comment on what you're seeing for loan growth in the next couple of quarters, what you might be seeing in terms of the pipeline?

I think Faye anecdotally, and obviously it's always difficult to be certain or analytical about it given changes that could occur -- but anecdotally, I think our people are feeling pretty good about loan growth.

Having said that, anecdotally, I can also tell you that there seems to be some pressure in price and terms.

And as you know, as you can see from our credit quality and our historical posture, that's not someplace where we are inclined to stretch.

But as a matter of general condition, I think we feel pretty good about it.

And in any particular category there, are you feeling better or worse?

As you know, construction and commercial real estate have been extremely robust.

Residential is a large part of.

In this market, given the demographics and the population growth and the relative absence of housing and land, it creates a very strong market.

I would like obviously to see some more growth in the commercial and industrial portfolio.

But in general as I said, I think our people are feeling pretty good about it.

If you look at history, at least over the last couple of years, clearly, construction and commercial real estate have been the strongest and I'm hoping that there will be some balance on that front with respect to C&I.

Right and for your construction and commercial real estate portfolio, how much of that is in the D.C. vicinity?

I know that The Washington Post has been putting out a number of articles on the strength of the CRE market there being possibly one of the strongest markets they have seen in the past 20 years.

So obviously holding up very well.

Do you have a concentration down there?

No.

I think the fact as we acquired some obviously in connection with Community Bank, they tend to be smaller rather than larger projects.

As you know, we manage pretty carefully our exposures with respect to clients and projects generally, and I think the bulk of our exposure actually could still -- and ultimately the mix of it may change given our increased presence there -- is in Maryland.

And again, just to stress the fact that we do by an large still make big bets.

Right.

Thank you very much, nice quarter.

Thank you.

Collyn Gilbert, Ryan Beck.

Just going through some of the things in your presentation, and you get a lot of information there and you go quickly, so I'm sorry that I missed some of it.

I try to slow down.

I know, it's inevitable, it's fine.

You had mentioned, there was a gain on the building sale?

Yes, the $3.4 million.

Okay, what was that?

It was Fredericktown (ph);

F&M (ph) related.

Okay, and that was this quarter, right?

That's right.

And one of the things you may be confused about -- there was 3.4 million this quarter; there was a million or so last quarter, which created a six-month over six-month difference of 4.5 million versus 900,000.

But the building sale in this quarter was 3.4 million.

After tax, as I mentioned, that rounded up essentially to $0.03 a share.

Alright.

In the advertising, did you run any specific promotions, or was that in conjunction with the CBNV deal closing (multiple speakers) had that up so much?

No, I think it's just seasonal.

As you know, that number, if you look back over it historically, tends to spike from time to time.

It's a little bit volatile, but we just had advertising programs going on in the second quarter.

The CBNV cost, as I mentioned, really won't come through until the third and fourth quarter.

Okay, which leads me to my next question.

Can you run through again what the anticipated merger costs are as well as cost savings tied to the deal?

We've taken about 300,000 so far basically.

We'll probably a something along the lines of 2.5, 2.6 million will come in the third and fourth quarter, which will get you to a rough total of $3 million.

And then on the cost saves front, I would ask Kaye actually comment on that.

We were actually looking to have about a $4 million cost save out of their $60 million in operating expenses, of which probably 1.2 million would be seen this year.

Because our theory was, it would be 25/75 when we announced the deal, so we get 25% this year, 75% next.

Gotcha, okay.

And what was Community Bank's loan mix, like prior to the close, on a percentage basis?

Primarily commercial real estate and construction.

Very little residential and indirect dollars (ph) in consumer.

Do you want the period end, or would you want the -- I assume you want the period end?

Sure.

Loan mix, say $670 million in loans -- 274 million of that was commercial real estate, 142 million was construction, 183 million was consumer, and that's largely the indirect auto (ph) portfolio.

Okay.

And what do you intend to do with the indirect auto portion of that?

Watch it closely.

Okay, good answer.

Okay, in terms of share repurchases, where are you and what did you do during the quarter?

We did nothing during the quarter.

We have roughly 500,000 shares left.

We monitor it continually.

Is the reason you didn't do anything in the quarter was just because of some of the restrictions with the closing of the CBNV deal, or was it more market price?

No, it was CBNV.

And as you know, we have always been very cautious and very conservative whenever we have had a deal or the closing of a deal pending.

The other thing I would point out is that our tangible ratio was at the end of period roughly 9.25, and that ended up being slightly higher than we would have thought it would when we went through the pro formas when we did the deal.

Given the conversations we've had in the past, that obviously gives us some room.

The other thing that I would note that I know you're aware of is that we increased the dividend by roughly 9% in May in advance of the closing, but we're constantly looking at the capital position.

Great, that was all I had.

Thanks.

Jennifer Demba, Suntrust Robinson.

Questions about IWM.

I know Jay has been there six months now and you been struggling to kind of curtail your terminations and improve net new sales.

I was just wondering if you could give us some more color on where you think you are there in that process and how you'd score the efforts so far.

A couple of things.

I think terminations actually have improved on a linked-quarter basis as I've mentioned.

Sales; that is gross sales, have not been as strong as I'd like them to be, although as I said in the latter part of the second quarter, they did get stronger.

So to some extent, if you just look at it on a linked-quarter basis, we had some success in stemming the terminations.

The other thing that I think I mentioned in the first with call and would repeat here, it is in part the terminations the institutional side actually represented reflected a couple of large accounts that were in equities that were performance-based, consultant-driven, completely understandable.

We continue to work hard.

I am loath to give the group a grade, although as I said over the past year or so frankly, given what they have done with the performance and economics of it, that I would have to give them an A. I think the reception that Jay has actually been quite positive and I'm confident that we will continue to drive the client side of it and get the gross sales to a level that makes sense while continuing to mitigate terminations, which as I said, we had some success in in the second quarter.

Thank you very much, good quarter.

Chris Mutascio, CSFB.

I have done a pretty poor job of estimating your non-marketable investment income.

I realize they were down from first-quarter levels, but they're still relatively high.

Any thoughts you can provide on how I should go about estimating that going forward would be helpful.

Is this a normal run rate we saw in the quarter.

I know it varies, given the market conditions, but any thoughts you have on that?

Chris, as you know, it has a couple of moving parts which generate the volatility.

And one of the things that's very difficult to estimate is harvesting of the private equity investments, which were pretty strong in the second quarter.

They were up rough numbers 2.1 million, which is generated I think by a couple of IPOs, in particular.

We've actually been doing that for a number of years, making those investments, and we're now at a stage where we are beginning to harvest some of the gains.

What gives me comfort if you will from a predictability standpoint is that that was more than offset as I mentioned by the swing in the hedge fund investments, which on a linked-quarter basis, essentially swung 3.2 million, which ultimately drove the $1 million decline.

And if you look back over the hedge fund returns over the prior quarters, you can pick sort of the midpoint, but it's somewhere in the million-dollar range, would be my guess, just in terms of the hedge funds.

They have been considerably higher than that, they've sometimes been lower.

But if you just look at the base of return associated with that, my sense is that, while there will still be volatility, given the inherent nature of those investments and to some extent, they wash each other out.

Now if we get really lucky, we'll have a great hedge fund month and great private equity investments.

Frankly, we're not counting on that, but that line to some extent at least over the last four or five quarters -- I put second quarter of last year as an outlier -- had been pretty steady.

It does move around and I appreciate the difficulties in prediction, but there do seem to be moving parts which are non-correlated.

Fair enough.

If I could ask a follow-up question unrelated.

You had mentioned that you had hoped I guess for a bit stronger C&I, pure C&I loan growth.

What's happening in the markets?

Is it just that the competition and you're not willing to meet the pricing and the terms being given?

Or is it just that -- I've seen that commercial real estate has been strong and I see that has been taking the bulk of the growth.

But I think sequentially, C&I loan growth, if you back out the acquisition, was roughly around 1% or so?

Yes.

CBNV contributed a lot to the C&I growth linked-quarter, end of period, in particular.

And I think what it is -- I think, Chris, you put your finger on it.

Again, it's very difficult to be scientific about it, but I do think that there has been, and I don't want to say relaxation -- let's just say that the standards with respect to terms in price have been ones that at times, we have not wanted to meet.

And I think the differentiation between that and commercial real estate and construction, as you know, we are blessed with having an extraordinarily strong client base on that front, you know, people we've known for a long time who have been very good and have been very good to us.

I think that helps us.

On the C&I front, we have a similar client base, but to some extent, I guess one could argue that it may be more price-sensitive.

It's not that we're not growing it, we're just not growing it as fast as we're going some other categories.

But anecdotally, and again, I haven't done market surveys, but anecdotally what we hear from our bankers is that competition on that front and price and terms has intensified.

And as you can see, reflected in our credit quality numbers and in our general aversion to risk, we are not generally willing to stretch.

Having said that, as you know, we've had an effort underway to think about how it is that we can be more price discriminatory with respect to various credits and their quality.

You know, we continue to work away at that to make sure that we are not turning good credits that have good risk-adjusted pricing away at the door.

Is there any differences in the C&I loan growth you're seeing on the D.C. markets versus the Baltimore market?

Very early days.

I think in general growth, no question it's stronger in D.C. than in Northern Virginia.

And obviously one of the reasons that we did Community Bank, which had a very good presence there and particularly in combination with as you know our people at Mercantile Potomac have done a great job over the years, is precisely to get at that market, small and middle market businesses where I think we frankly have a competitive advantage given our experience and our willingness to focus on that sector.

Thank you, Ned.

Adam Barkstrom, Legg Mason.

I wondered if you could give us some further color on credit quality, and especially the charge-offs and the net recovery, and what drove the net recovery for the period?

The recovery came out of the community banking.

Fredericksburg had the majority of the recovery and that threw us at a net recovery for the full year to date.

That was about (multiple speakers).

That recovery itself.

The net recovery was $1 million, but I think that recovery itself was about a million, Adam.

The interesting thing is that my recollection, Terry, is that that is a very old credit.

It was a charged-off loan from years ago.

Right, which reflects the fact that we continue to work harder for (indiscernible).

So it would be safe to say that that was somewhat of a specialized situation for this particular quarter?

That would be correct, yes.

I mean, look, as you know, our charge-offs as I mentioned last year were 520,000 first quarter, 740,000; we now have a $1 million recovery.

As you know historically, we've been fortunate enough except in very special circumstances not to lose very much money.

But I agree with you in that recovery in general, given where we start from, is pretty remarkable.

Gerard asked a question about I guess reserve levels, and I was curious kind of the same question here toward capital levels.

Any thought process at this time at looking at capital levels, looking at how good credit is here?

Any thoughts of trying to lever off that capital to some degree?

Any color on that front?

I certainly don't have any thoughts about levering it up.

And as you know, we've resisted that.

It depends what you mean by levering up.

Maybe we should tighten that up a little bit.

I don't mean layering on a leveraged securities trade.

That's what I was addressing.

If you mean leveraged by eliminating capital, which is a separate question, or by reducing your capital, that's something we look at all the time.

And I think as many of you have heard me say, I think when I first arrived, the comparable ratios were probably mid-11's, if not 12.

They declined to the point where they are mid-9's and at end of period, were at 9.25.

I have said and I continue to think that there is some premium associated with Mercantile being perceived to be for better or worse less risky than other firms in part because of its reserve levels historically and in part because of its capital levels.

I don't view them as unrelated in one sense.

The fact is that we do have to deal with a new accounting and regulatory regime that is requiring a much different analysis of reserves than was required historically, and it's simply not acceptable any more I think it's fair to say to arrive at a reserve number and essentially plug numbers in necessary to justify it.

You do have to go through this analysis and I think industrywide, it's driving reserve levels lower.

If you press or if you read what the SEC says about it, I think they would be very expressed about the fact that they're trying to generate more volatility in bank earnings going forward by requiring a bottom-up analysis of the reserve and lower reserves in good times and higher reserves in bad times, which inevitably is going to generate volatility.

I think you and I could argue forever about whether that's a good thing or a bad thing.

My bias would be that it's not a particularly good thing, but it's a reality that we have to deal with at this stage as expressed by the SEC.

Having said that, you might imagine that in a circumstance where reserve levels are declining, do I feel better about having higher capital ratios than others?

Absolutely.

Do I also feel that we're going to have the opportunity over time to deploy that capital in a way that makes sense?

For sure.

And I think we have actually demonstrated over the last four or five years that we're not going to do anything, at least in my view and I hope and you're as crazy (ph) on the acquisition front.

But I do think that there is some premium associated with Mercantile being perceived to have very strong capital ratios and the ability to leverage that as it makes sense.

Okay, great, thank you.

Chris Marinac, FIG Partners.

I wanted to ask, just to delve into more details on your key (ph) now in Northern Virginia and how many folks you have?

And then also, if you could, just talk about what it takes to retain people in this environment?

I think -- Kaye, do you know what the numbers are?

There are 133 folks at (multiple speakers).

There are 133 at CBNV, Chris.

And then obviously, there must be some additional ones from Merc-Potomac.

So I would guess, what would say, 200? (multiple speakers) Somewhere between 200, 250, Chris combined with CBNV.

And I think one of the things that we've been able to do, I think we have actually been pretty good at retaining people.

I think we were pretty good at retaining people in connection with the CBNV acquisition.

Those where there were overlaps essentially, I think we've done a pretty good job of finding them places elsewhere in the organizations.

As you know, one of the things I've always said about deals is that a crucial part is finding the right people because at the end of the day, this is very much a people business.

People are at a premium, it's difficult to find them.

If you can acquire them and hold them, I think you are far better off.

We work very hard at retaining them.

Obviously, there are going to be people presumably that are trying to poach all of the time, and I guess you see stories in the paper from time to time about people moving around.

Fortunately, we have not been subject to that as much.

And in part, I think we've been helped a little bit by the dislocation in that market.

Obviously, the rig (ph) sale, the effect that P&C has entered, the fact that commerce is coming -- there's a fair amount of uncertainty in the sense that people were with a firm that they believe had the future and prospect, but I think they are more inclined to hang on than they might have been in the past, notwithstanding the competition for them.

So I actually feel pretty good at least from an HR standpoint with respect to what we're doing down there.

There seem to be a lot of examples of the bigger banks throwing around retention dollars, and I was curious if you feel the need to do that, or if you even think that works?

It works for awhile.

The question is, whether it works over the longer-term and whether you're generating a return on it.

We've not had to do that there.

Obviously, we have done it in connection with CBNV, and that is, as you know, a standard part of a merger exercise where we set aside a certain amount to do that.

But with respect to our own people, I'm not aware of our having done that in any material way.

Last question is I guess bigger picture.

Do you think there's ever a point in time when an acquisition outside of your immediate footprint makes sense?

Very difficult to conceive, Chris.

The fact is that, if you look at the list of potential -- and I use the word target loosely to include firms that are either our size or slightly larger or close to our size -- there are not a lot of possibilities nationwide, let alone in contiguous markets, other than much smaller banks.

Obviously for reasons that I know you'd understand, I don't want to ever rule anything out in its entirety.

But we're clearly focused on trying to build what we think is a stronger footprint in one of the better markets in the United States, in Maryland, Virginia and Delaware.

I think that there's plenty that we can do here.

I think there's some add-ons that we can do over time.

Unpredictable as to when they might be, but as I've often said, it may not be the best market in the United States, but it's one of the best.

Great, thanks Ned.

Claire Percarpio, Janney Montgomery Scott.

Ned, forgive me if you've answered this already, but can you clarify for me if the combination of the building gain and the securities gains, how much has been sort of offset and how much has --?

Essentially, Claire, we were at $0.84, and it's the building gain which is really it.

The securities gain was tiny, as I recall -- 90,000 pretax or something.

So the securities gain was 3.4 million, after-tax rounds up to $0.03, so that takes the 84 to 81.

Does that makes sense?

Yes.

Todd Hagerman, Fox-Pitt, Kelton.

A couple question for you, Ned.

One, I was wondering if you could just give us a little bit more detail on the deposit flows this quarter, kind of stripping away some of the noise from the acquisition.

If you could just give us a better sense of kind of, one, what the intentions were in the quarter.

You lengthened the direction a little bit on the funding side -- just kind of how you see that over the back half of the year?

I'm not sure -- I'll come back to your first point.

But on the latter point, if anything frankly, I think we have shortened on the funding side.

I was thinking in terms of the time deposits.

They were under one year.

They were under one year.

Under one year?

Okay.

And part of what is -- and I don't mean to bore you -- but obviously, I have been, as I'm sure others have, a little bit worried about the interest rate environment, and that creates to some extent some uncertainty in my own mind about how we ought to deal with it from a funding standpoint.

As a default, which is what I had mentioned earlier in the conversation, we've decided to fund short in the CDs in order to frankly buy some time to see how things sort out, is what it amounts to.

But in general, I think it's fair to say that we have not lengthened; we've actually -- because I've been loath to lengthen on any front, as you can see, from the securities portfolio, in particular.

The fact is, we stayed a little bit shorter.

With respect to deposit flows, I can tell you actually, because I've focused on this as well as you might imagine -- if you look at the average balances, which were up 8.4% year-over-year and 5.2% linked-quarter; roughly a third of that was CBNV on a year-over-year basis and roughly half of it on a linked-quarter basis, of those growth numbers.

Okay, that's helpful.

Do you feel better or worse in terms of just like the non-interest-bearing piece, just in terms -- granted, it's very competitive out there.

But with kind of your decentralized model, if you will, is that something that you feel you're gaining some momentum there, feeling a little bit better about the second half of the year?

Well, non-interest bearing, as you know, we're up 11% -- this is average -- we're up 11% year-over-year and 3.7 percent linked-quarter.

CBNV was about 35 to 40% of that year-over-year, and about 45% linked-quarter.

So, again, our organic growth frankly was not too bad.

Now having said that, as you know, I've been saying for some time you know that I'm worried about deposit growth, and in particular, non-interest-bearing deposit growth, given what's going on.

But one of the reasons that I gave you those numbers at the end focused on the percentage of our non-interest-bearing deposits as a percentage of total deposits, was that I actually found it sort of encouraging.

It was at 27.8% at the end of this quarter with 28.2 last quarter.

But having said that, it was 27.2% last year.

And if you look at the numbers, it has held relatively constant, which I think is actually a pretty good news story.

That's helpful.

And then just a follow-up to your discussion on the C&I loan trends.

Could you just give us an update in terms of how Merc-Safe is doing, just if they're seeing any improvement in terms of demand levels out there?

That's frankly other than reports that I see from time to time, that's most of what I see close up.

And as I said, I think they're feeling pretty good about the strength of the pipeline at this stage.

Again, so it's easy to feel good about the strength of the pipeline, realizing it's a separate question, but I think they're feeling pretty optimistic right now.

Okay, thanks very much.

Matthew Schultheis, Ferris, Baker, Watts.

A couple of quick questions.

I noticed on a linked-quarter basis, you had about a $1 million increase in your mortgage servicing rights.

And I was wondering if that was put through the income statement on a mark-to-market, or if that was a result of the acquisition?

It was not a result of the acquisition.

Half of it was roughly through purchased mortgage servicing rights on the residential side, and the other part would've been commercial servicing originated.

Okay.

Which did go through -- the latter went through the income statement.

Okay.

Are they near cost, in total?

Yes.

Related to loan pricing, would you guys ever consider adopting Basil 2 (ph) when it comes out, which may allow you to be a little more aggressive on the loan pricing, and given your commercial bent, may actually help you with your capital position some as far as just truing-up a little bit more?

I'd have to admit that I'm not as familiar with Basil 2 as I should be.

Having said that, I think what drives us on the loan front -- and I know on one level, this is going to sound strange -- but what drives us on the loan front at the end of the day is being comfortable that we have the right risk-adjusted price.

Now almost irrespective -- this is what sounds strange -- almost irrespective of what the implicit return might be relative to equity.

So what we do is we have customers, we look at them, we underwrite loans I think in the right sort of way; price them, if anything, conservatively, at least historically, and are comfortable that we're able to sleep at night and that we're going to get our money back.

I think we've done a pretty good job at that.

I think it's not going to be capital-driven that ultimately changes what we do on that front.

It's going to be an increase-ability and willingness on our part to distinguish between different credits.

So I don't think that economic engineering at the margin is going to have any impact on what we do on the loan front.

To do some extent, it's going to be a cultural relaxation with respect to being comfortable that I can charge client A less because in fact, he's a better client, a better credit, than client B.

Okay, that makes sense to me.

And one last question -- if the opportunity arose, would you require an investment bank, or is that something you'd just rather stay away from?

I would've said that, based on the history of this firm and what it is that we've done historically and what we view as our core competencies, that that would be extremely unlikely.

Okay, alright, well thanks for your time.

Thank you very much.

David Honold, KBW.

I was wondering if you could just follow-up maybe a little bit more in two areas.

Specifically, new commercial real estate and construction loans, where the pricing is relative to prime compared with a quarter ago, a year ago?

And then as a follow-up, early in the year, you talked about a run rate in expense guidance that obviously has been impacted by the CBNV acquisition.

But just maybe getting back to you, what we should be looking for in non-interest expenses going forward?

On the first one, my understanding is (indiscernible) tell me having focused on it that it's about the same.

And I think it's fair to say that as you know, the spreads have actually help up pretty well in that business.

And we're doing it, and obviously we're doing it because we think that there are returns there related to risk for them to make sense.

On the noninterest expense front, I'm going to have to spend frankly some more time on that as we go through CBNV.

I think I gave you some gruesome detail with respect to this quarter relative to the last.

Last, we were at 100.2.

I think if you take out CBNV, we were at 101.6 for this quarter, which I think is roughly consistent with the guidance that we've given you at the beginning of the year.

And then I think I took you through the reconciliation.

We had $2.3 million in CBNV costs for the second quarter.

Kaye, correct me quickly if I'm wrong, but rough numbers, that would be a $5 million run rate, on the non-interest expense?

4 million.

Oh, 4 million, I'm sorry.

And we plan ultimately to get out about $4 million of those costs.

Part of those costs as I said will come out this year; the bulk of them will come out next year.

I think if you add the CBN, the run rate and then deduct the costs that we're thinking about getting out, and then go back to my general guidance, which is that we were trying essentially to keep things as close away from volume-driven and performance-driven things to 5% increases as we could on the noninterest expense front.

I think you could probably get somewhere near that number.

But again, it's not one that I have focused on in particular, given the relative recency of the CBNV acquisition.

What we did focus on during the second quarter was making sure that we achieved greater operating leverage, which as you know, we did based on the book to GAAP and the cash efficiency ratio.

And that's a discussion, as everybody here will attest, we have if not once a day, at least once every couple of days or possibly every time each of us gets together to make sure that we do have the right view with respect to what we're trying to do on expenses.

Thanks.

K.C.

Ambrecht (ph), Millennium (ph).

Ned, thank you so much for taking the question.

It took awhile to get on.

Just one suggestion.

Maybe you guys can sprinkle in some buy-siders along with the q&a, just because we actually own the stock.

We will take under very close (multiple speakers).

Just a couple of quick questions.

On the NEM (ph), I know you went over, but I just wanted to -- maybe you could just drill down a little bit more.

The margin, the margin, the 446 -- did that see any benefit or compression from CBNV?

Yes, a basis point, K.C.

Of what?

Of compression.

So CBNV cost you a basis point?

That's right.

Okay, great.

And where did the margin end the quarter?

I know, but frankly, I'm not inclined to disclose it just because we haven't disclosed it historically and we haven't been giving (ph) month-by-month numbers, so I'd rather not do it.

And then separately, but kind of still related, can you give us some thoughts on how you think about the flattening of the yield curve here?

I wish it were steepening.

Having said that, I don't wish that as dearly as some of my peers.

The fact is that a slight yield curve, as long as the short end is rising, it's fine for us.

We're okay.

Do we derive the full benefit that we would if the yield curve were more normalized?

No.

But as you can see we do alright.

And in particular, you can see that with a 17-basis-point expansion year-over-year, even including CBNV in the margin and a couple of basis points on a linked-quarter basis.

What we've done is essentially is because -- look, I'm no genius, the fact is we've stayed very short on the securities portfolio.

Pending developments, as I mentioned earlier, we've tried to put a placeholder in on the funding front.

So (inaudible) it's not clear to me frankly at this stage where things are going to go.

I could imagine circumstances where the yield curve is does steepen.

I could also imagine circumstances where it inverts.

But the fact is, we're okay where it is.

We would be if better off if it were someplace else, but we're just fine where it is.

Okay.

And then just kind of back of the envelope, I don't know if you give NIM (ph) guidance, but we should still kind of expect a general trend up?

Yes.

Okay, great.

Whether it's going to be -- obviously order of magnitude is a separate question, but in general, yes.

What's the benefit coming from -- (multiple speakers).

The non-interest-bearing funds.

As you know, K.C., as we said before, that topped out at some point I think late '90s, early 2000 at over 100 basis points.

I think it was 51 basis points at the end of the second quarter.

Okay.

Thanks very much.

Gary Townsend, FBR.

The questions have been asked and answered, and I thank you for your time.

Thank you.

Heather Wolf, Merrill Lynch.

One housekeeping item.

Can you give us the actual tax bill on the gain on the sale of the building?

I can tell you, actually.

It was $3.4 million pretax.

And I can tell you, if you look at page 15, you will find that it's 2.48 million after-tax, which you do the math, that is the tax bill.

Got it, thank you.

And lastly, if I remember correctly, there was a small bank that was acquired in Charlottesville recently.

And I know you've talked about that being one area that you would like to expand to.

Can you comment on your interest level?

My interest level in Virginia, as you know, is quite strong.

My interest level in paying prices like the one associated with that is quite weak.

Fair enough.

So you are still interested in Charlottesville at the right price?

I am.

Okay, thank you.

David West, Davenport & Company.

Good morning.

Your service charge on the deposits line was just up marginal year-over-year.

I wondered if you could talk about any changes in your consumer behavior or -- and if you have done any fee price changes regarding the deposit charges?

As you know, it was up by -- my recollection, it was up 1% year-over-year, actually up 6.3% linked-quarter, and that reflected as you know more market decline in the first quarter.

We were actually somewhat encouraged by the fact that it was up on a linked-quarter basis.

I have not actually focused on that line with others, but I think the general trend has them for them to be down, although they may have recovered in the second quarter.

If I could just add that, on the consumer side, that's where you're seeing some pickup in growth on the corporate side, the trend has been slightly downward.

So basically, the compensating balance is on the commercial accounts is kind of offsetting -- .

The earnings credits --

As rates rise, exactly.

And then lastly, a clarification.

As far as your merger-related expenses, is that going to be roughly 25% of your estimates this year, or is it 75%?

No, the merger-related expenses will be -- as I said, we've taken 300, we'll have rough numbers 2.5, 2.6 left for this year.

Our merger-related savings will be $4 million, our projection is 1.2 million of them this year and the balance next.

Okay.

So the bulk of expenses are very definitely coming in '06?

'05.

No, let me -- the expenses are coming in '05 third and fourth quarter.

The savings, 25% is coming this year, 75% '06.

Thank you very much.

Sure.

Mr. Kelly, that was our final question.

Thank you very much.