PNC Financial Services Group Inc (PNC) 2008 Q1 法說會逐字稿

Good morning.

My name is Lisa and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the PNC Financial Services Group first quarter 2008 earnings conference call.

(OPERATOR INSTRUCTIONS) As a reminder, this call is being recorded.

I will now turn the call over to the Director of Investor Relations, Mr.

Bill Callihan.

Sir, please go ahead.

Thank you, and good morning.

Welcome to today's conference call for the PNC Financial Services Group.

Participating on this call will be PNC's Chairman and Chief Executive Officer, Jim Rohr, and Rick Johnson, the Company's Chief Financial Officer.

The following statements contain forward-looking information.

Actual results and future events could differ, possibly materially, from those that we anticipated in our statements, and from those our historical performance due to a variety of factors, including those described in today's conference call, our earnings release and related material, and in our 10-K and various other SEC reports available on our website.

These statements speak only as of April 17, 2008, and PNC undertakes no obligation to update them.

We also provide details of reconciliations to GAAP of non-GAAP financial measures, and we may discuss in today's conference call, our earnings release, our financial supplement and our presentation slides appendix for the call, and in various SEC reports and other documents.

These are all available on our corporate website at pnc.com in the Investor Relations section.

And now I would like to turn the call over to Jim Rohr.

Thank you, Bill.

Good morning, everyone.

Thank you for joining us today.

This was a solid quarter for PNC, as the fundamentals of our businesses performed very well.

In an extremely difficult market, we remained focused on our strategies for growth.

We grew average loans, deposits, and assets.

We saw a record in net interest income, strong fee income and our record -- and our margin improved.

Equally important, we grew our diverse revenue streams faster than expenses, creating positive operating leverage.

We strengthened our Tier One capital position in the first quarter through successful hybrid issuances and through retained earnings, as well.

And our strategic decision making continues to serve us well.

By maintaining a moderate risk profile, our credit quality is solid and our loan portfolio is performing as expected.

Most importantly, we continue to deepen our customer relationships.

That having been said, we are disappointed with the impact that the capital markets had on our commercial real estate loans held for sale and our trading activities.

We've spoken to you about our commercial real estate loans, and we mark these high quality assets to market, as we did not want to sell them in the first quarter and trade away our economic value.

However, I'm especially disappointed with the loss in our trading activities.

Similar to our commercial real estate loans, these assets were affected by market illiquidity and a lot of volatility in the hedging of these assets.

We've taken significant actions, and we've reduced our risk positions by over 50% in this area.

Losses were commercial real estate loans held for sale and trading activities were largely offset by gains from several other unusual items.

Most importantly, our business fundamentals are sound and PNC is well positioned for growth.

Given our business model and our ability to create positive operating leverage, we believe that we will continue to deliver solid results, even in this challenging environment.

Now Rick will discuss the details of our financial performance in a few minutes, but let me give you some highlights from our business segments.

Our retail banking segment continued to see a [flight to quality] as more customers are coming to PNC from weaker institutions.

We grew organic net new checking account relationships by more than 12,000 in the first quarter, a 50% higher growth rate than the same period a year ago.

Including the impact of acquisitions, our average non-interest bearing deposits grew 18% year-over-year.

And we're already seeing some excellent results from our investments in the Mercantile branches.

In the first quarter, consumer DDA new account production was up nearly 400% from the fourth quarter of 2007, and over 400% of our expectations, as well.

Merchant-originated accounts increased more than 300% from the first quarter a year ago.

And demographics of Maryland and Virginia markets are as favorable as we expected them to be.

In fact, the average consumer money market account is twice the average balance of PNC's legacy accounts.

Now let me move to corporate institutional banking.

They've posted a strong year-over-year net interest income growth due to loan and deposit growth.

Treasury management and capital markets revenues, our relationship-based activities, was up 18% year-over-year.

And at a time when M&A activity is down nationally, our Harris Williams subsidiary had a strong quarter, posting a $5 million increase in revenue compared with the fourth quarter of last year.

Now in this difficult market, an increasing number of business customers are using our liquidity management services, and some small and medium-sized banks are accessing our balance sheet management activities, as well.

Nonetheless, with C&IB, our performance was primarily offset by the valuation adjustment for commercial real estate loans held for sale, which I mentioned earlier.

At PFPC, our global fund services provider that reported servicing revenue growth of 14% in the first quarter compared to the same period last year.

The increase was driven primarily by the acquisitions of Albridge and Coates and the continued growth in the off-shore markets, as well as a robust sales pipeline.

Regarding Albridge and Coates, they continue to grow their client base, and the integration of both is on track and progressing well.

PFPC continues to expand internationally, as we are transforming this business segment from a domestic information provider -- information provider, to a cumulative -- a data provider to a cumulative information provider.

Last year, we also launched depository services in Luxembourg, we opened a sales office in London, and just recently established a processing center in Poland.

All three of these initiatives are performing well.

Total fund services by PFPC grew to 1 -- $2.6 trillion in the first quarter, up from $2.2 trillion the previous year.

Our fourth segment, BlackRock, yesterday reported another strong quarter of core earnings, with assets under management now at $1.4 trillion.

The strategic decisions to grow the distribution network, expand the product range and their overall focus on investment performance and client service should continue to benefit BlackRock and PNC.

Now clearly, there are challenges facing the financial services industry, both in terms of the credit environment and the U.S.

economy.

And as we have said before, we're not immune to all of those forces.

But as we look ahead, we see many more opportunities than obstacles.

We raised capital in the first quarter, we strategically strengthened our capital position.

We also announced an increase in our dividend, reflecting our confidence in the future.

And all of our acquisitions are now in-house.

We successfully integrated Yardville in March, adding them to our industry-leading technology platform, and we are delivering on the cost savings.

And earlier this month, we closed the acquisition of Sterling.

In this environment, it's important our asset quality is solid, and our NPA migration is manageable, and from a balance sheet perspective, we are benefiting significantly from the current yield curve.

With our diverse revenue mix, we expect continued positive operating leverage to offset the impact of these increases in credit cost.

Now, the capital markets will continue to be volatile, but we're actively working to limit the impact of this volatility, as I mentioned before.

At PNC, we remain focused on what we do best; growing our businesses, controlling expenses, managing risks and taking products and services to new and existing markets.

In summary, we believe we're well positioned for a good 2008.

Now Rick will provide you with more detail about the financial results and the strategies.

Thank you, Jim, and good morning, everyone.

The key takeaways from this quarter are our overall business model continued to deliver solid results, as we reported a $1.09 of earnings per share, with strong growth in net interest income and net interest margin resulted in strong revenue growth.

Good expense control resulted in positive operating leverage.

Asset quality performed as we expected, and we significantly improved our Tier One capital ratio.

All of this has positioned us well for the current market environment.

As slide six shows, we continue to grow high quality, diverse revenue streams.

Our first quarter revenue grew 13% year-over-year, and 12% compared to the linked quarter, a significant achievement in this environment.

Net interest income represents 47% of total revenue, and net interest income grew 8% linked quarter, and 37% on a year-over-year basis, substantial increases compared to both periods of comparison.

Our liability-sensitive balance sheet positioning has served us well in a period of aggressive rate reduction by the Federal Reserve.

Our margin has improved to 3.09%, and we expect continued improvement next quarter.

We also expect net interest income to grow next quarter as we pass these rate reductions to our deposit base and grow our balance sheet.

For the year, we still expect deposits and loan balances to organically grow in mid single-digits.

With acquisitions, we expect loan and deposit growth in the mid teens.

As a result, we expect year-over-year net interest income growth to exceed 20%.

Now, if you turn to slide seven, non-interest income represents 53% of total revenue, and declined 2% from the prior year, and increased 16% from the linked quarter.

As you can see on the slide, overall growth in non-interest income in both periods of comparison is significantly affected by other non-interest income.

So we thought slide seven would be of more use in understanding the performance of our core fee categories.

Fund servicing revenue grew 12% compared with the first quarter a year ago, driven by our emerging products, primarily off-shore activities, and our acquisition of Albridge.

Compared to the fourth quarter, revenues were up 6%, primarily due to the acquisition of Albridge.

Asset management revenue was up 28% compared to the same quarter last year, due to BlackRock and our wealth management businesses.

On a linked quarter basis, revenues were down 6% due to comparatively lower equity markets in the first quarter for our wealth management business, and lower results at BlackRock.

Our consumer service fees and deposit service charge revenue were up 8% year-over-year, but down 6% from the fourth quarter due to seasonality.

Corporate service revenue in the first quarter was up 3% year-over-year despite challenging market conditions, but down 9% linked quarter, primarily due to seasonally lower affordable housing revenue.

So all in all, our core fee income businesses continue to perform well.

We also sold securities during the quarter, generating a $41 million gain.

We replaced these securities with high-quality securities at equivalent or better yields, so there is no negative impact to net interest income.

Now, wrapping up our discussion on non-interest income, we did have a number of items reported in other non-interest income, and most of these items are highlighted on page six of the financial supplement.

As we discussed before, we expected losses in our commercial mortgage origination business.

And as you can see, we've reported losses of $177 million during the quarter due to portfolio valuations as spread widened from 86 basis points at year-end to almost 200 basis points at the end of the first quarter, with unprecedented interim volatility.

We continue to hold about $2.1 billion in held-for-sale loans.

Our held-for-sale commercial mortgage loans are high quality assets that are performing as expected.

In fact, none of these loans were delinquent the first quarter.

These have strong fundamentals, such as loan-to-value, debt service coverage and long-term leases on properties that are diverse in terms of both property type and geography.

We intended to reduce our inventory in the first quarter, as we talked about, but we elected not to participate in the few deals that were in the marketplace, as we believe the fundamentals of these loans are better than what the market is offering today.

While we did not expect spreads to widen more than two times beyond where these were at the end of the fourth quarter, we're not willing to forego the value we see in these assets.

It's important to note that we have recognized a market valuation adjustment here, but we have not realized a loss.

Our intent is to reduce our inventory, but only at the right price.

As such, we could see more volatility, positive or negative, in earnings going forward.

The loss in our trading businesses resides in our proprietary books, and is very similar to the commercial mortgage loans issue I just mentioned.

These are high quality, low-risk assets that were affected by very illiquid markets.

We believe the dislocation of the markets provided an excellent opportunity for relative value, but spreads moved against us.

In response to the first quarter volatility, we substantially reduced these positions and increased our hedges throughout the quarter.

Given the strength of our client-related trading activities and our reduced risk position and our proprietary activities, we expect to return to positive trading results next quarter.

That being said, these markets are very fickle and continue to be very volatile, and we could see further earnings volatility in the future.

We also generated a pretax gain of $114 million from the sale of Hilliard Lyons at quarter end.

The tax rate on this was high and as we had virtually no tax bases in this entity, resulting in a $23 million after tax gain.

As a result, our first quarter effective tax rate of 40% was much higher than what you normally expect of approximately 31%.

So, if any of you are trying to adjust our earnings by taking the table on page six of our supplement, and adjusting for tax rates, you'd probably be off by about $50 million of taxes, and you would be understating our earnings by about $0.15 per share.

Going forward, we expect a quarterly effective tax rate of around 31% through the remainder of the year.

We also had two items related to our Visa relationship.

One we reported, the $95 million gain related to a partial redemption by Visa of some of our stock following their IPO, which was recorded in other non-interest income.

And second, a $43 million expense reversal related to our share of Visa's litigation exposure, which was recorded in other non-interest expense.

We now hold 3.5 million class B Visa shares which currently would convert to 2.5 million class A shares, and based on a March 31 closing price of $62 per share, our ownership would be valued at $155 million.

Finally, in other non-interest income, the quarterly BlackRock LTIP mark-to-market adjustment was a $37 million gain, as the price of BlackRock stock declined from $217 at the end of the fourth quarter to $204 at the end of the first quarter, thereby reducing the valuation of our share [obligation].

As you can see on slide eight, we continue to create positive operating leverage on a quarter-over-quarter basis.

This has been accomplished with a 13% growth in revenue, and a 10% growth in expenses.

This reflects our success with growing revenue in new and existing markets, while continuing to manage expenses through our continuous improvement program.

In January, I said we expected full year total revenue growth to exceed 10%, driven by strong net interest income growth and growth in non-interest income.

Given the aggressive Fed fund rate cuts and our resulting expectations for non-interest income growth, we are more confident and are expecting revenue growth in the low teens on a year-over-year basis.

We also expect to continue creating positive operating leverage, with non-interest expense growth expected in the mid single-digit numbers.

This clearly benefits 3 percentage points from the Visa indemnification reversal.

From a risk management perspective, PNC is well positioned because of the strategic choices we have made and our operating discipline.

Let's start with asset quality.

Let's see if I can put our loan portfolio in context for you.

Our loan book represents $71 billion of our $140 billion balance sheet, so it's about half.

Of our $71 billion in loans outstanding, $29 billion is in consumer assets, which is primarily in high-quality home equity and residential mortgages, with net charge-offs levels less than half of industry averages, and $42 billion is in commercial lending with a high percentage of collateralization.

Of the $42 billion in commercial, $9 billion is in commercial real estate, of which only $2 billion is in residential residential real estate development.

On a strategic level, we've made decisions that enable us to avoid subprime mortgages, high yield bridge loans, leverage finance loans, and limit our commercial real estate exposures, products that continue to create challenges for the the industry.

On a daily basis we make credit decisions based on our assessment of risk-adjusted returns.

Our asset quality continues to be strong, with non-performing assets representing 0.42% of total assets at quarter end.

We did see an increase in NPAs compared to the fourth quarter, albeit at a slower pace than the prior quarter, which was primarily due to continued softening in residential real estate development.

Our exposure continues to be very granular.

Our largest non-performing assets is $20 million, and our average non-performing commercial loan is less than $500,000.

Our residential real estate development portfolio continues to be the primary source of stress.

It is very granular and manageable, as the average size of these exposures is about $1.4 million per loan.

These are primarily located in Maryland, Virginia, Delaware and New Jersey.

As we previously disclosed, we expected our first quarter provision would be modestly below the $188 million we recorded in the fourth quarter, which included a $45 million provision related to Yardville.

The provision of $151 million in the first quarter is a little bit better than our expectations.

In fact, if you back out the change in the charge-off policy as described in the release, the actual charge-offs would have been $44 million less, leading to a 31 basis point charge-off ratio versus the 57 we reported.

So we are not seeing a significant increase in charge-off levels.

We see the full year provision to be around $600 million, and this will include an additional $25 million reserve for Sterling when we complete -- as we've completed the closing here in April.

And obviously, the $600 million is highly dependent upon the strength and weaknesses of our economy as we move forward.

The other major portion of our balance sheet is the securities portfolio.

And as you can see, it declined by $1.6 billion on a linked quarter basis, primarily due to liquidity driven valuation adjustments in the current market environment.

However, the quality of the book remains very strong as we had no impairments during the quarter.

Next is balance sheet management, and I've already spoken about our balance sheet positioning and benefits, so let me focus now on liquidity and capital.

From a liquidity perspective, PNC's loan to deposit ratio of 88% is amongst the lowest of the peers.

And in addition to this, I've mentioned above we are very comfortable with our liquidity position given our ample unsecured borrowing capacity of $27 billion.

On capital, I said in January that we wanted to improve our capital ratios in 2008, and we are making good progress towards achieving that objective.

Through a combination of successful hybrid issuances and retained earnings in the first quarter, we grew our Tier One capital ratio to 7.7%, up from 6.8% at year-end.

We will continue to focus on enhancing our capital position to support our customers in this period of economic uncertainty.

We will accomplish this through a combination of earnings growth, balance sheet management, and accessing non-dilutive capital sources.

In summary, let me say we are pleased with our first quarter results.

We had a strong growth in net interest income and net interest margin, resulting in strong revenue growth.

Our expenses were well managed, resulting in positive operating leverage.

Our assets performed as expected, reflecting our moderate risk profile.

We raised capital and increased our dividend, and we've completed several strategic initiative.

We integrated Yardville, closed the sale of Hilliard Lyons, and earlier this month, we closed the acquisition of Sterling.

These accomplishments reflect the solid performance in a difficult market environment.

We believe that positions us well for the remainder of 2008.

With that, I'll turn it over to Jim.

Thank you, Rick.

Just in conclusion, I think we all know the industry is facing an extremely difficult time.

It's unusual from the point of view that many sectors of the economy are performing extremely well, but two aspects are clearly not.

There's a current capital markets liquidity crisis that we're all experiencing, and the residential housing industry is in a depression.

For PNC, we're pleased that we have limited exposure to residential housing, much less than many of our peers that are being affected by these difficulties.

But the illiquidity of capital markets has affected even our high-quality assets.

Going forward, we're going to continue to reduce the most volatile aspects of this balance sheet and manage them as aggressively as we can.

As Rick told you, our credit quality is solid and our outlook for revenue growth is very strong.

Given our diverse revenue mix and our moderate risk profile, especially on the credit side, and the way we're positioned for interest rates, we're very comfortable with the outlook for our performance for the rest of the year.

With that, we would be pleased to take your questions.

Operator, could you give our callers the instructions, please?

(OPERATOR INSTRUCTIONS) Betsy Graseck, Morgan Stanley.

A couple of questions, one on the CMBX.

You went into some detail to the marks, and I think we're all aware of the CMBX spreads having widened out in the quarter.

I think you had been pretty close to some transactions that might have reduced the balances this quarter.

Could you comment a little bit as to what led you to not pursue those transactions and give us some color on where those transactions potentially stand at this stage?

Yes, there were a couple that actually got done in the quarter in the marketplace, which we just didn't feel as comfortable with the asset quality in the pools or in terms of the pricing that was being afforded.

So we decided not to participate in one.

There are two other deals that we are very actively working with at the moment.

Challenge for us right now is just that these are taking a long time to find investors to participate in the market.

So that could take some time and I'm not expecting them to be closed any time in the near term.

Okay.

All right, so and what's the best index that you would lead us -- I mean it's just the CMBX that you would look at with regard to where your marks are as of today versus where they were at the end of the quarter?

I'd take a look at -- you have to look at two.

I think you have got a cash AAA index on the inventory portions that you can take a look at, and then separately you have got CMBX hedges, AAA 1.

I think if you look at the two of those and kind of track along there, you'll get a pretty good indication of how our inventory is pricing, and the only piece we haven't disclosed to you is just how much we have or have not hedged.

I will say that we have been hedging -- we did hedge all new originations in the fourth quarter of last year and the beginning of this quarter, but we have stopped originating at this point.

Okay, but that doesn't mean that your entire exposure is hedged, right?

The majority of your exposure is probably not hedged.

The challenge was hedging in this environment as there's so much basis risk between how the underlying and how the hedge move, and you could see them actually moving in different directions.

So you have to be very careful when you are putting those hedges on, otherwise you will actually cost yourself more money than you need to.

And on the NII comment looking for 20% increase year on year, is that correct?

At least 20, yes.

Okay.

So does that imply some slowdown in Q on Q increase?

Well, I didn't give any guidance specifically on how much Q1 to Q2 will be.

But I will tell you, I know net interest income will go up, and I know that the margin will go up.

There's just so many other factors involved I'm really not in a position to pinpoint.

I'm pretty confident it will go up by as much as it did from fourth quarter to first quarter.

In terms of dollar amount?

And margin.

Okay.

And is there -- could you just give us a sense as to the degree to which maybe yield curve swaps are driving that?

It's really -- it's not yield curve swaps.

It's more with what the Fed has done with rates and our ability to pass that through our deposit base.

And the fact that at the time this happened we were 2.2 years positive duration of equity.

So very liability sensitive, and as a result, as rates came down we were able to take advantage of that by keeping our assets invested while repricing our liabilities.

And that should get even better too, because I think if you look today LIBOR is way out at like 80 basis points over Fed funds.

And I think as that comes down, we expect to benefit from that as well.

Okay.

And then lastly on the trading line, I think there was a loss generated in the proprietary book, is that right?

Yes.

Could you comment a little bit on your changes that you might be making to risk management or your leverage that you might be taking in that business going forward?

Well I think we're very disappointed in the performance.

The spreads have widened out to a point where our traders felt that it was an attractive asset to own.

They acquired the assets, obviously the spreads widened out as they did with CMBS, most particularly in March.

And then the basis risk became even more of a problem as we began to hedge the portfolio.

So it was a unique -- it was clearly a unique market.

But that having been said, we're extraordinarily disappointed.

We've already reduced the risk profile by over 50%, and we're doing a number of other things to curtail our risk taking in this environment.

So, suffice it to say, we're extraordinarily disappointed in the trading performance and we're taking actions to deal with it.

Other thing is is that net interest income is going to grow so rapidly that, quite frankly, the need to take a great deal of risk is just inappropriate, in the trading mind.

All right, next question.

Mike Mayo, Deutsche Bank.

I have three questions.

First, as far as acquisitions, are you in the market for large acquisitions?

I mean you have a little bit in Ohio.

I think our plans for the rest of this year as far as I can see is to run our business.

We are doing extraordinarily well.

We're adding lots of new accounts in our western markets, as well as our eastern markets.

So, I think running the business is, in this environment, is our number one opportunity.

The second question relates to your NPAs which were up, I guess 23%.

Reserves to NPAs declined, and you did not provide quite as much as maybe you said in your regulatory release.

Could you give us some thoughts around what NPAs might do in future quarters?

I expect they're going to continue to go up.

But what I'm not saying yet is a significant increase in charge-offs.

I think as we showed in the release, when you adjust for the change in charge-off methodology that we have, charge-offs are still back at third quarter levels, at 31 basis points.

And so I think for the moment, we're very comfortable with how we're reserved.

We do expect NPAs to go up.

I think the question is really going to be what kind of non-performing assets are we going to have.

I think as you know, certainly we may see more in the residential development space.

We may see a little bit more in the suppliers to that business.

Most of our other businesses are doing fine, so we don't see increases there.

But then we also have a very large asset-based lending business, Business Credit, and that business was kind of made on non-performing assets.

So we expect them to be very active in this environment, and they already have a very large pipeline.

So that ratio for us is kind of a little bit misleading in terms of the expected loss that we may incur.

It looked like linked quarter, the biggest increase was commercial real estate, real estate projects?

Yes, residential development projects, correct.

And how much of that would be from Mercantile?

Well, just say that about half of all of our NPAs come out of that region.

Okay.

Also, one of the things, Mike, as you know, the average real estate non-performing loan is less than $1.5 million.

There are a number of personal guarantees, which were more typical of the Mercantile lending capability.

But that having been said, guarantees are not counted until cash is put up in terms of putting a credit on non-performing.

If you believe -- in our policy, if we believe that the asset doesn't repay you, then you have to put it on non-performing.

So even though there might be a strong guarantor.

So that's one of the reasons why the risk profile of some of those loans might not be the same as tract housing in Florida.

Okay.

And the third question relates to revenues.

Linked quarter, fourth quarter to first quarter revenue growth, I'm getting it actually being down or negative.

So if you could help educate me.

What I do is I take out Visa, I take out BlackRock, LTIP, I take out the Hilliard Lyons gain, and add back the trading losses and commercial mortgage valuation losses, and that gets me kind of flat.

And then if I take out something for Yardville, it would actually be down on a core basis revenues.

So am I missing something, or are you kind of thinking about year-over-year, that kind of momentum?

Year-over-year because what you have, particularly in the consumer space as well as in the affordable housing business that we have, is you've got a lot of seasonality in revenues.

So fourth quarter to first quarter is not typically a good comparison.

I think if you look year-over-year, I think you'll be very comfortable with the revenue growth.

Okay.

How much did Yardville add in spread revenues, fees, expenses?

I'll have that for you in a minute, Mike.

We can get that, Mike, I could just call you back with that.

Or at the end of the call if you get it by then.

Just because I look at core revenue growth stripping out deals, and I guess it added a little bit in the first quarter more than the second.

So I want to haircut revenues and give you credit on expenses.

Yes, Mike, Yardville's net interest income was about $16 million and fee income was around $6 million.

You're not talking about big numbers.

And expenses?

12.

Okay.

Thank you.

Matthew O'Connor, UBS.

A couple of questions here.

You mentioned about half of the NPAs were from Mercantile.

Is the same true for charge-offs?

No, much lower.

Actually about 20%.

Okay.

Secondly, the delinquency trends just across your portfolio, can you give some comments on that?

Well, home equity has ticked up a little bit in terms of -- delinquencies haven't ticked up at all, but charge-offs have gone from an average last year of about 24 to 26 basis points to this quarter about 35 basis points.

But quite frankly, that's still half the industry average.

So we're still feeling really good about that portfolio.

Charge-offs in our residential mortgage portfolio, which is really an asset and liability play, that's still in low single-digits.

Very low there.

High quality assets.

There's no delinquency at this point in our commercial mortgage book.

That's the good news about the commercial mortgage book, was that we did originate very, very high-quality assets.

It's the pricing on the liquidity is the difference there.

And that's a good point, Jim.

That's the same in the available-for-sale portfolio, been very careful about the credit quality we take into that book.

And as a result, we had no valuation adjustments related to credit in the quarter.

Okay, so on the delinquency trends, when we see the Y-9Cs, it will be relatively stable or -- ?

Should be, yes.

Okay.

That's helpful.

And then just third, just out of curiosity, the reserves for unfunded commitments went down a little bit, I think $18 million.

Is that from line reductions or line drawdowns?

Probably from drawdowns, because we have seen -- yes, drawdowns sounds like the right answer.

We've seen utilization rates go up in our corporate space.

Okay.

Next question.

Nancy Bush, NAB Research LLC.

Just a question about the Mercantile footprint.

I mean, we're seeing certainly a number of residential issues, residential real estate issues down there.

Are you seeing any sort of slopping over into the commercial sector down there?

If you could speak to sort of the economic trends outside of what we're seeing in residential real estate.

No, we've not seen any of it slop over into the commercial portfolio really at all.

So we're very, very pleased with the acquisition there.

Some of the -- really, we see residential real estate mostly on the eastern seaboard, out on the eastern shore being soft.

Baltimore's still a pretty strong market and all of those military jobs moving to Baltimore, that's going to be a good housing market for quite a while.

So it's really a little bit of the bank that they acquired in Virginia, and some of the eastern east coast assets.

And Jim, could you just repeat what you said at the first, I kind of missed it about demand deposits or about the retail banking environment down there being so much better than the legacy foot fingerprint.

Well, our average MMDA account down there is double the size of the average for PNC legacy.

So there's a lot of money in those hills.

A lot of money in those hills.

As you know, the Washington, D.C.

SMSA is the highest income per household in the United States, and that SMSA is now larger than Philadelphia.

So -- and it has the highest education per household, as well.

So it's a very, very wealthy marketplace and it's growing nicely.

Thanks very much.

Next question, please.

David Hilder, Bear Stearns.

Two sort of unrelated questions.

First, in your table on page nine of the supplement that talks about non-accrual loans, could you distinguish between the real estate related under commercial, and the real estate projects line?

Basically, are residential development loans in both of those categories, or in just one?

Residential development projects would be in the real estate projects category, but what you would also have in real estate-related, is we do have loans to national and regional home builders, and that would be about an outstandings of about $200 million.

We've managed that down pretty aggressively in terms of outstandings, so you might have some of that $63 million of non-performing loans could be related to that.

And the real estate projects line, at least in terms of non accruals, is primarily residential related.

Is that correct?

That is correct.

And then secondly, Jim, your language about reducing risk in the trading business, does that also suggest perhaps a change in strategy in terms of management's view of that business?

And if so, will there also be personnel changes related to that?

Well, I didn't say that.

I don't expect we will have personnel changes.

I would say that we're looking at the risk profile of our trading book.

We do a lot of trading for our customers, so you can't get out of the trading business.

We do a lot of hedging of our credit risk.

We make on average about $30 million a quarter just doing customer business, and so we have to be in the trading business just to have that activity.

The proprietary trading business helps us accomplish a number of those things, as well as hedge our credit risk, hedge our interest rate risk.

And quite frankly, if you look at how we've positioned the balance sheet and the net interest income going forward, it's the same group.

And so they've done quite an extraordinary job positioning as net interest income-wise going forward.

That having been said, this quarter we had a very disappointing experience in the proprietary trading book, which lost approximately $100 million.

And if you look at how it was done, I mean quite frankly, the spreads blew out toa very attractive rate.

We added those assets.

Others people may have added those assets in the AFS book and just enjoyed the spread.

We had them in the trading book.

When spreads blew out, we have a loss in trading book.

And those types of strategies I think we have to be much more thoughtful in terms of managing the volatility around our quarterly P&Ls.

Thanks very much, that's very helpful.

Next question.

Gerard Cassidy, RBC Capital Markets.

On your comments about the provision for this year, I think you guys mentioned that you think you might have a provision of $600 million.

Granted, that's obviously going to be impacted by what happens to the economy.

What's your outlook for the economy to come up with about a $600 million number?

Well, we think today we're effectively in a mild recession, right, in terms of that's something we see ourselves in for at least the first half of the year with a modest recovery from that through the end of the year.

If you look at -- if you look at it, it was a very unusual economy, quite frankly, with 5% unemployment which is a fabulous number historically.

Here we have a number of our businesses doing extraordinarily well.

You talk to technology people, aerospace people, commodities people, healthcare people, they don't know anything about recession.

Life is as good as it gets.

And you obviously talk to somebody who's in a housing or a housing-related business, they're not in a recession.

We are in the worst housing market in the recorded history of the United States.

You talk to a supplier in that space, and they're in a world of misery.

So we're just very glad that we're not in Florida and California, in Las Vegas, a number of those places that have those depressions going on.

So I think our loss experience I think reflects some of that.

In the listing of your top ten non-performing assets, it looks like eight out of the ten were construction credits, construction loan credits.

Of those eight, are they all residential development-type construction projects, or are there any strip malls or other types of construction projects in there?

No, there could be other construction.

Some of them are asset-based lending as well, in the construction industry.

But no, there wouldn't be any strip malls or anything of that sort.

Thank you.

Next question, please.

Bob Hughes, KBW.

I guess first question, just a little one.

Under your loan balances, I noticed that the real estate projects, I think balance was up over $300 million quarter-to-quarter.

I'm wondering if that has anything to do with funding.

What drove that growth?

And is there any incremental funding of interest reserves reflected in there?

No, that's just utilization growth and existing commitments.

Okay.

And Rick, previously I think you guys had suggested that based on your prior expectation for loan loss provisions over the course of the year that you thought provisioning the second half could be lower than that of the first half.

Have you changed your views on the trajectory?

Well, I think it might be slightly higher than where we are this quarter simply because we're going to take on Sterling in the quarter.

And that will be probably somewhere between a $20 million and $25 million additional reserve to get their reserve levels consistent with ours.

Got you.

And then I think yes, based on that I assume the rest of the year with tail off a little.

Okay.

That makes sense.

Is there anything to update us on with respect to Market Street?

Have there been any drawdowns liquidity commitments?

Is Market Street still a functionally rolling paper without too much difficulty?

We're having no issues with Market Street at the moment in terms of funding.

It's actually a lot better situation today than where we were at the end of the year.

It's a lot smoother.

Okay, great.

And then one final question.

In your discussion on the margin outlook, Rick, you mentioned that -- you mentioned LIBOR over Fed fund spread.

And if that spread were to tighten, that would provide some incremental benefits to you.

I think it's an interesting topic of discussion.

Obviously, there were some articles out yesterday, and this is something that's been talked about for a few weeks.

But that the quoted LIBOR rates are painting a much rosier picture than actually exists in the marketplace over there, and we've seen LIBOR gap up a little bit this morning.

To the extent that LIBOR were to continue, or the LIBOR fund spread were to continue to gap out, could you maybe talk about how that would impact you?

I'm very comfortable with the full year growth rate of over 20% taking that into consideration, as well.

One of the things is, the really bigger factor in our forecast.

So I'm very comfortable that even if LIBOR doesn't come in, we should be able to still achieve 20% plus.

But the bigger factor is the question right now market by market is how much do you cut rates to optimize the portfolio.

How much do you increase rates to take market share in this environment.

We're seeing potentially great opportunity to take market share, which will benefit us in the years to come.

Okay.

Thanks, guys.

Next question, please.

Collyn Gilbert, Stifel Nicolaus.

Most of my questions have been asked, but just a follow-up, I think, Rick, to something you had said when you talked about, while we may see material increases in NPAs that won't translate into net charge-offs.

Is that a function of the equity that's in some of these deals, or just a more aggressive workout policy?

Or what would lead you to say that net charge-offs may not materialize to the level that the NPAs have?

I think it's the latter.

I think when you look at the residential development space and average loans of $1.4 million, we're just going to take us some time and we're going to have to have the patience to work through them, and just have a hard time believing that the actual ultimate charge-offs will meet those levels.

As well as the fact of the asset-based lending business.

They have lower loss given default ratios in the (inaudible).

Okay.

So you're speaking as to what is in the portfolio today, not necessarily identifying trends that may be in the pipeline.

But in terms of what's on the portfolio today that would migrate to net charge-offs, it would be fairly minimal?

Well, I wouldn't say minimal.

Yes, that's a strong word, obviously.

I wouldn't say it wouldn't go directly from non-performing loans straight to charge-offs.

I think we'll have obviously good recoveries in a number of spots there.

Okay.

Great, that was all.

Thank you.

Next question, please.

Matt Schultheis, Ferris, Baker Watts.

I have a quick question that has very little bearing on PNC, but has some bearing on some of your counterparties.

When Sterling Financial was selling EFI loans, there were two types of frauds discovered that I'm aware of.

Vapor loans, which were loans with absolutely no backing, and then fraud loans that actually had somebody down in the Carolinas who was sort of playing along with the fraud.

Towards the end, Sterling was walking -- was buying back the vapor loans, but they were walking away from the loans that had anybody backing them and saying, well, it was a legitimate loan, we made it even if it was fraudulent, and we're not going to buy it back.

You're going to have collect against them.

And I was wondering what your intention is as far as repurchasing those back in.

Each and every one of those loan is a unique situation, and frankly, we really couldn't comment on what Sterling was doing or what we might do in the future.

I think that's a customer relationship loan by loan.

We really wouldn't have a comment on how that would be done.

Okay.

Thank you.

Next question, please.

Mike Mayo, Deutsche Bank.

A follow-up.

On one part of the call you said you had $100 million trading loss, and then in the release it says $76 million.

I didn't know if this simply rounding up or if there's something else there.

[It's none] of our customer business.

I'm sorry?

The proprietary trading was $100 million.

The trading loss was $76 million.

That was net of the profitability of the customer business.

Oh, okay.

And then so the $100 million was proprietary-related, and I'm just -- you pride yourself on a low-risk profile, you've done better than the industry.

Yet here we have a regional bank with $100 million proprietary trading loss that's not client-related.

I'm just trying to reconcile those two.

If you could help me.

Quite frankly, we're just not very -- we're very, very displeased about it, quite frankly.

And we've taken actions to reduce that position to make sure that the moderate risk profile that we believe that we should maintain and that we have on the credit side is maintained in the trading side, as well.

Is this group -- where is this group located?

Can you say that?

And are you backing away from proprietary trading generally, I don't know.

We've significantly reduced our proprietary trading as we speak.

All right, thank you.

And Mike, one thing that shouldn't minimize the situation at all, but there is a significant amount of carry on these positions and net interest income probably $20 million to $25 million that you're not seeing in the trading line.

All right, thanks.

I don't think we should minimize the unique quarter either, or the unique month of March.

I think this group, as I mentioned before, has done an extraordinary job on our balance sheet positioning and a number of other things in our credit hedging and other things.

So they've done an extraordinary job in most cases.

Quite frankly, this quarter showed remarkable volatility and also, even worse volatility in the ability to hedge the risk, shows us that this is not a place where we should be spending lot of time trading assets.

Operator we have time for one more question.

Bob Hughes, KBW.

I just had one follow-up, after digesting the prior answer.

Rick, if the LIBOR fund spread were to widen, I know you're comfortable with the guidance for net interest income.

Does it have any meaningful implications for other areas of the bank, perhaps trading positions or anything else, that you would be able to discuss?

Of course, if the credit spreads continue to widen from their already extraordinary wide levels today, then there's always risk that, as I mentioned CMBS portfolio trading positions, although we've reduced the risk dramatically, you still could have further impacts there.

You could have further impacts in our available-for-sale portfolio if spreads widen.

But again, I think those are all -- those are illiquid valuation adjustments as opposed to real credit losses.

Sure, sure.

So we're comfortable with that.

I was talking more specifically about the LIBOR Fed fund spread.

Not credit spreads in general.

Well, the other thing I think it's important to note, we're looking at credit spreads today that we haven't seen in 20 years.

And so the ability to add assets in this market and fund them at a very, very profitable spread with an excellent return on economic capital is unique today.

So I know we talk a lot about the difficulties we've had in the mark-to-market because spreads have widened, but quite frankly, on the other side of the balance sheet just on our loan portfolios and we've talked about how margin has increased this quarter, it will increase next quarter.

Net interest income is growing a lot.

These wider spreads have benefited us to a greater extent and a lot of our assets, the high-quality assets on the asset side of the book.

There's bad news that we talk about in the mark-to-market.

But there's good news in lots of other parts of the balance sheet.

True.

And we've had some discussion about this in the past, Jim -- .

Is that you?

Bob?

I guess we're finished.

Bob?

Operator?

Yes, sir, just one moment.

Hello?

Okay, sir, please proceed.

Bob, are you still there?

Well, I think we just need to go ahead and wrap up, Jim.

Okay.

Thank you very much for joining us this morning, and please feel free to call Bill or any of us if you have further questions.

Thank you.

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

You may now disconnect.