Texas Capital Bancshares Inc (TCBI) 2006 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Texas Capital second quarter 2006 conference call.

My name is Shaquana, and I will be your coordinator for today.

At this time, all participants are in a listen-only mode.

We will be conducting a question and answer session towards the end of this conference.

If at any time during the call you require assistance, please press star, followed by a zero, and a coordinator will be happy to assist you.

I would now like to turn the presentation over to the host for today's call, Ms. Myrna Vance.

Please proceed, ma'am.

Shaquana, thank you very much.

And good afternoon to all of you.

We're glad you could join us today to discuss our results for the second quarter of 2006.

As Shaquana said, I'm Myrna Vance, Director of Investor Relations, and I invite any of you with follow-up questions to give me a call at 214-932-6646.

Before we begin our discussion today, I'd like to read the following statement.

Certain matters discussed on this call may contain forward-looking statements which are subject to risks and uncertainties.

A number of factors, many of which are beyond Texas Capital Bancshares control, could cause actual results to differ materially from future results expressed or implied by such forward-looking statements.

These risks and uncertainties include the risk of adverse impact from general economic conditions, competition, interest rate sensitivity, and exposure to regulatory and legislative changes.

These and other factors that could cause results to differ materially from those described in the forward-looking statements can be found in our Annual Report on Form 10-K for the year ended December 31st, 2005 and other filings made by Texas Capital Bancshares with the Securities & Exchange Commission.

Now, let's begin the quarter.

With me on the call today are Jody Grant, our Chairman and CEO, George Jones, President of Texas Capital Bank, and our CFO, Peter Bartholow.

After our prepared remarks, our Operator, Shaquana, will facilitate a q and a session.

Now, at this time, I'll turn the call over to Jody.

Thank you, Myrna.

Good afternoon, ladies and gentlemen.

On behalf of Myrna, George, and Peter, let me welcome all of you to the conference call.

We continue to appreciate your interest in our company, and those of you who are investors or analysts who recommend us or follow us, we appreciate you very, very much.

This quarter I would characterize as having been a very solid quarter, if not an excellent quarter in many, many respects.

This is particularly true given the interest rate environment that we're in.

Everybody is aware of the inverted yield curve that we have, and that presents issues for nearly every bank in the country, ours included.

And, also, the competitive environment in Texas continues to be very robust.

Fortunately, we're in a space where we're not as affected as many of our competitors, but nonetheless it's an ongoing issue and something we watch very carefully.

When we look at the quarter we believe that the positives far outweigh the negatives, and, therefore, I'm going to begin with the highlights on the positive side.

In the first place, the Company comes out of the quarter with a lot of momentum.

We're positioned we believe for strong results in the future, and we think that the long-term prospects for Texas Capital are excellent.

We were particularly pleased with our loan growth during the quarter.

The Texas economy is hitting virtually on all cylinders and loan growth is exceptional if not almost remarkable.

I can't remember a quarter when we've had growth that has been any more robust than this, unless you look back to the early, early days of the Company when we were reporting, you know, gains of 200% and 300%.

But looking at the second quarter, in particular, our average loan growth was up 40% on an annual basis, linked quarter to the first quarter.

If you look at the components of that loan growth it was pretty much across the board.

I guess the standout was our Commercial Lending Divisions, and when I say 'Divisions', I mean Dallas, Ft. Worth, Austin, Houston, and San Antonio.

Loans for the quarter on average were up 416 million – I'm sorry, for the half, up 416 million.

That's 227 million in the second quarter and 189 million in the first quarter, and that includes in the second quarter having to overcome or rather in the half having to overcome $87 million in pay-downs from two customers who sold their companies.

Turning to deposit growth, it also is a highlight for us, deposit growth being up 20% on a linked quarter basis.

And we were very gratified to see our demand deposit growth also increasing 20% on a linked quarter basis.

You will remember that we had an exceptionally strong fourth quarter in terms of demand deposit growth last year, and then we lost some of those deposits during the first quarter of 2006.

I'm pleased to say that we're seeing this growth resume and the outlook we believe for the future is favorable.

In short, the engine of growth which drives the franchise in terms of results and future franchise value, we believe is alive, well, and very, very robust.

Turning to net interest margin, another highlight over the last several years.

Our net interest margin was up one basis point on a linked quarter basis, and 22 basis points from the same quarter last year.

I think notable is the fact that net revenue on a linked quarter basis grew 9%.

This is not an annualized number, and it exceeded our non-interest expense growth of 5.7% materially.

Obviously, one of the keys to our success in the future is controlling expenses.

And, as we've said in the past, we've invested a lot in the new business activities we've started.

And so we're gratified to see our revenue growth running well ahead of the growth in non-interest expense.

The issue with regard to earnings is one that I'd like to spend a few minutes on.

Peter Bartholow is going to go into more depth as it relates to this.

But let me just say at the outset, the provision and the loan loss that we took in this quarter are both consistent with the annual guidance that we gave during the January conference call.

Those of you who were on that call may remember that we said that as – based upon the best knowledge we had that the mean of the provisions of the analysts that had showed us their models was about $4 million in terms of provision, and this is consistent with our own internal forecast which exceeded the analysts' guidance or the analysts' models by a slight margin.

Looking at the quarter, in particular, one of the realities of our business is that we're not like a retail bank, where you can almost calculate your loan losses on an actuarial basis.

Ours are inclined to be lumpy.

And, unfortunately, both the provision and the loss fell disproportionately in the second quarter, which accounts for the shortfall in our earnings during the quarter.

Now, I will remind everybody that we don't give quarterly guidance.

Nonetheless, we are aware of what the Street expectations are, and we've watched those very carefully.

Parenthetically, I might also say that we do have additional provision and additional losses built into our forecast for the remainder of 2006.

Turning to our new and developing businesses, I'd like to put these in two categories.

One are those that are underperforming, and those that we would call developing.

In the underperforming category would be our RML business, that's residential mortgage lending, our mortgage origination activity.

It would come as no surprise to anybody to know that we've had slowness in this segment of our business simply because the housing markets across the country are being affected by higher interest rates and somewhat weaker demand as a consequence.

This has impacted the originations that we have been able to realize and, you know, we're looking at this very carefully, and it certainly is getting our attention.

The other underperforming line of business right now is insurance services.

You recall, we did a rather large startup in the fourth quarter of last year.

We've been building that part of our business throughout the first half of this year.

It was profitable in the second quarter, and we expect to have a good experience from insurance services in the second half of the year.

In the developing category place, our Bank Direct, consumer finance business, in that, which is the premium finance company that we bought a little over a year ago.

It is a little bit behind plan, but was ahead of plan in the second quarter.

It's a little bit behind plan for the first half of the year but was ahead in the second quarter.

And we would expect the second half of the year to be very, very gratifying as it relates to that activity.

Leasing is another developing business.

We don't have a large amount on the books at the present time in terms of our lease portfolio.

I think it's between $40 million and $50 million.

One thing we have discovered, however, though, is that the emphasis of our lease portfolio and our leasing activities needs to be on financial leases as opposed to operating leases in that the operating leases, at least at the offset, produce negative results due to the depreciation that we have to realize on those leases.

Turning to earnings guidance, our previous guidance that we had given you was $30.5 million to $33 million, which translated including the affects of 123R to $1.15 to $1.24.

And looking at the remainder of 2006 based upon what we see today and taking a cautious approach, we don't believe we'll be able to recover the roughly nickel that the underperforming and developing businesses cost us in the first half and, therefore, we've decided that it would be prudent for us to lower guidance in the second half of the year to $29 million to $31 million for the year, as a whole.

And that translates to $1.09 to $1.17 per share.

The assumptions behind that, just to cover them with you very briefly, we assume that growth in loans and deposits will continue at 20% or above.

We think the margin will be essentially flat.

We would like to see the DDA component of our deposit increase improve, and it did improve in the second quarter and we believe that the prospects for that continuing are very, very good.

Our provision in net charge-offs will be consistent with the guidance that we've previously given and which I previously mentioned in my previous comments.

We do expect substantial improvement in the underperforming and the developing lines of business.

And, again, those have our complete focus.

We also will continue to allocate resources to the most profitable lines of business and those that we believe have the greatest prospects for growth in profitability.

We do not plan any new initiatives during the second half of the year.

Therefore, there should be no startup expenses associated with new initiatives, although sometimes things happen that one doesn't contemplate or one doesn't see.

And we won't guarantee you that an opportunity won't come along that we'd like to take advantage of.

But right now, we don't see it.

My closing comments, before I turn it over to Peter, are that we think the Company again emerged from the second quarter in a very strong position.

We think the second half will be a good half for Texas Capital, and we think that the long-term prospects are excellent.

We have a lot of confidence in our ability to produce strong results in the future.

I might just make one comment about the cost of the economy before passing on.

The economy is very, very strong.

If you look at the economic indicators they're up in every category.

We created 259,000 new jobs in the State last year, or in the last 12 months, 72,000 of those, which is a disproportionate amount, were created in Dallas and another 17 in Ft. Worth, which means 92,000 of the 259 occurred in our principal markets.

The other markets, Houston, Austin, San Antonio did well, also, but Dallas and Ft. Worth seemed to be leading the way.

So when we look again at the future we look at it with a great deal of optimism.

With that, I'll turn it over to Peter Bartholow, who is going to go into a little more depth on the financials.

Jody, thank you.

If you'll turn to the slide 6, we can begin the commentary there.

Jody mentioned the disproportionate, what we believe is the disproportionate amount of provision and charge-off in the second quarter relative to the guidance for the full year, which we gave in January and which we still confirm for provision and charge-offs.

That weakness or that impact and those of the underperforming and developing businesses representing roughly a nickel a share at the first half, obviously, had an affect on net income and an adverse affect on the key measures of profitability.

We saw stability in net interest margin in the quarter, which we'll talk more about in a moment.

We saw a reduction, of course, in ROA and ROE due to the reduced net income.

The increase in provision, as I mentioned, is consistent with the full year guidance provided in January and was also driven by exceptional growth in the portfolio and the application of our methodology, which George will cover in more detail later.

The increase in non-interest income was driven by RML and leasing who contributed together a substantial portion of the increase on the linked quarter basis.

Net income, however, given the nature of their business models and level of performance was largely offset by directly related expenses and, therefore, the non-interest expense and deficiency ratios were affected by the growth in those businesses and the fact that their business models by virtue of how they earn money and pay for sales, commissions, and so forth have an adverse affect on efficiency ratio.

Jody mentioned leasing activity, where we have good growth in rental income but it's offset by depreciation expense, that in the early stages of operating leases does have an adverse affect near-term on income.

Turning to the next slide, what we'll describe as performance evaluation and subscription for performance drivers.

Jody mentioned that net revenue growth was up 9.2% for the first quarter.

That is one of the largest linked quarter increases that we've experienced, especially compared to the operating expense growth of 5.7% about which I'll comment more in just a moment.

The net interest income growth, of course, was driven by Jody's reference to the very substantial, really exceptional growth in the portfolio.

Net interest margin is improved but today we find is somewhat constrained.

The limitation on further improvement constrained by the impact of rapid growth, as we saw in the first quarter, on funding composition, competitive pricing pressure, which Jody alluded to and George can cover in more detail, and the spreads on loans to prime rate which are a function not only of the competitive pressures but also the affect of the minor portion of our portfolio which is fixed rate.

We also, of course, have contraction in net interest income due to the decline of the securities portfolio and the fact that during the quarter we were just above breakeven on somewhere in excess of 575 million average balances of those assets.

So and the fact that rates have grown faster and farther than we projected within our initial guidance means that those have become more of a drag than we could have originally contemplated.

Operating expenses, I mentioned grew by a 5.7% from the previous quarter.

The efficiency ratio on a total basis did improve slightly from Q1.

The expense growth for the core operations of the bank was actually nominal.

The expense growth was nominal, excluding RML, insurance services, FAS 123, and other incentives.

The expense to earning asset ratio is still very favorable factoring in those elements.

FAS 123 expense increased in the second quarter to $0.02 per share from $0.01 per share after tax in the first quarter.

A major impact on the nature of the business models for RML, insurance services, and leasing, those things affect dramatically the efficiency ratio.

We have high commission and sales expenses from RML and insurance services.

We have the impact of depreciation expense and operating leases, which we've mentioned.

The expenses from these lines of businesses are, however, covered directly by income.

And over 50% of the expense growth from Q1 was represented by RML commissions and the depreciation from leases.

A vast majority of the balance was reflected in 123R costs and other incentives that are built into our business model.

Net of these lines of business, the efficiency ratio today is approximately 58%, a full 10 percentage points below the consolidated level.

In its building phase while BDCF today is very profitable it also has a minor adverse affect on efficiency ratio.

And all of our LOBs, many, most of our LOBs are still building out in a way that has an affect on their operations, as well.

So adjusting for the affect of buildout and BDCF on top of the adjustments that I mentioned earlier, we are now, we believe, in the 55% to 57% range and we see quite a bit of improvement there.

Turning to slide 8, as of quarter end Jody mentioned deposit growth was actually much greater than loan growth.

We had the impact of a single customer relationship related to the sale of this business, which had a dramatic affect on quarter end balances.

That transaction occurred very near the end of the quarter.

In fact, George, next to the last day.

DDA growth of 51 million was not affected at all by that transaction, and, as we'll comment in a minute, neither were the average balances for either demand deposit or interest bearing deposit growth.

Earning asset composition continued to improve with a run-off for securities.

At quarter end we saw securities now at only 18% of earning assets, compared to 27% a year ago, and over 30% just two years ago.

And by definition then loans are now 82% of earning assets.

Jody mentioned the loan growth of 191 million to 2.58 billion, a linked quarter increase of 8% on a date statement basis.

We saw very strong loan growth and loans held for investment and we saw very, very strong growth also in the mortgage warehouse component of loans held for sale.

To slide 9, building on the very strong growth in Q1, we saw average loan totals grow by $227 million, $230 million actually including leased assets that are classified as furniture and fixtures.

And, as Jody mentioned, that's net of very substantial pay-down that occurred in connection with a customer transaction that he mentioned.

Loan growth of 10%, although that did not have a significant affect on the average it did have a big affect on the quarter end totals.

The mortgage warehouse group is expanding its customer base and has produced very strong growth in loans held for sale after a seasonally weak first quarter.

Loans held for investment growth of 9% and YOY of 34%.

Clearly an indication of very strong market share improvement.

We've seen some of the early announcements and the rate of growth here is obviously substantially higher.

Average deposit balances were also, represented a very good [presumption] of growth, more indicative, of course, then the date statement numbers.

No impact, as I mentioned, on the averages for the transactions, either the pay-off of loans or the dramatic increase in deposits.

But on an average basis we had 5% linked quarter growth, 20% annualized, and 18% from the prior year. 30% prior year versus prior year total growth, 5% linked quarter.

Strong growth of 118 million in deposits but it simply was not strong enough to overcome or to fund all of 227 million in loans plus 3 million in additional lease transactions.

Growth in loans then required us to shift, further shift composition of funding to interest bearing liabilities.

All of which, by the way, except for our downstream correspondents from whom we buy daily, were paid-off at quarter end.

And at quarter end we had also reduced all, to eliminated, all but the term borrowings.

Turning to the next slide, 10, we saw expansion of loan and earning asset yields.

The value of DDA and shareholder equity continued to improve.

The exceptional growth, as I mentioned, caused interest bearing funds and, in particular, your dollar deposits could place an increase to become a bigger share of total funding.

We saw good expansion from the second quarter of '05, and a slight increase from Q1 2006 in margin.

But as I mentioned, again, earlier, it's now more constrained by compression than loan spread prime because of fixed rate earning assets, including loans which are only 11% of earning assets excluding Bank Direct Capital Finance.

The expansion of net interest margin in the future will remain very dependent on DDA funding.

We have experienced very good DDA growth in the final half of the year historically.

Weak securities portfolio spreads, funding cost, obviously, as I mentioned, has been exacerbated by the level of rates and the speed with which they got there compared to the guidance where we had, which was based on a 4 3/4% Fed Funds rate of sometime midyear.

With that, I'll turn it over to George to talk more about loan and deposit growth and credit quality.

Thanks, Peter.

Turn to slide 11.

Again, you'll see excellent growth in deposits and loans historically and in Q2, as we've discussed previously.

Our compound annual growth rate for deposits at 30% slightly outpaces our growth rate for loans held for investment at about 26%, but as you've noted, in looking through the Webcast, our recent loan growth is actually greater than the CAGR.

Period end Q2 loans held for investment grew 7% linked quarter and 34% YOY.

Total deposits grew 19%, again linked quarter, and 48% YOY.

Again, while period end deposit growth was overstated somewhat by one large customer deposit at quarter end, average deposits grew in excess of 30%.

Period end demand deposits grew 11% linked quarter and 12% YOY.

As we've talked before, you will remember that total deposits remained somewhat flat in Q1.

That coming off an extremely strong growth in fourth quarter '05, but we resumed that good growth, as you can see, in Q2 of this year.

We believe both loan and deposit growth rates are much larger than market and peer bank growth.

If you'll turn to slide 12, we won't spend really any time on that.

It's been discussed.

It illustrates, of course, good historical revenue growth exceeding expense growth.

Slide 13 relates to credit quality.

Credit quality remains strong.

Net charge-offs for the quarter were $1.5 million, as we've said, and they were not inconsistent with full year guidance given in January of 2006.

As you recall, we've always said that losses and provisions to the reserve will vary on a quarterly basis.

Because of our business model they simply don't occur in even monthly installments, like a more consumer oriented bank that we've discussed earlier.

The losses were confined basically to two credits, and they're not indicative of any general weakness in our loan portfolio.

As a matter of fact, our classified loans continue to remain at a very low level.

Even with this loss, our net charge-off ratio is only 7 basis points for the past 12 months.

Total charge-offs for the past two years of roughly 1.5 million represents less than four basis points.

And losses since the bank's inception are approximately 10 basis points.

The quarterly provision we took to the reserve of 2,250,000 really was supporting our quarterly charge-offs and the excellent loan growth we've talked about.

It does not represent an increase in problem loans or other weaknesses in our portfolio.

Our process for reserving remains consistent with our historical methodology.

We've said this before, and it remains that way.

Our reserve posture remains high as a multiple of historical charge-offs and, of course, non-performing loans.

Non-accrual loans remain low at 21 basis points.

If you'll turn to slide 14, you'll see the graph that does graph our net charge-offs compared to average loans over a four-year period plus Q2 '06.

And you'll see the charge-offs in Q2 were 13 basis points YTD annualized.

As stated earlier, we believe non-performing loan ratios and other coverage ratios really are quite good.

Jody.

Okay.

Thank you, George.

I gave the earnings guidance out of sequence, and I'm not going to repeat that.

Obviously, if you have any questions I'm sure you won't hesitate to answer them.

Again, we just think we had a very solid quarter and the stage is set for a very solid second half of the year.

With that, let's turn it over to questions, and we'll turn it back to the Operator.

[OPERATOR INSTRUCTIONS.]

Your first question comes from the line of John Martinez.

Please proceed, sir.

John?

Peter?

Yes, John.

Sorry, I had a headset issue.

Hey, I just – I wanted to ask you a couple of questions about the charge-off.

If you could maybe give us a little bit more detail on, you know, the business line of industry that you had this problem with?

And if you've seen any other weaknesses in any other loans in a similar industry or business line?

John, this is George Jones.

Let me take that, if okay with you?

Yes.

The charge-offs, as I mentioned, were represented by two loans.

One, a commercial customer, and the other was an individual.

The commercial loan is secured by assets of the company, primarily accounts receivable, and the company is in bankruptcy.

This is a company that is related to the real estate business, contracting business.

The problem arose unexpectedly when the company's largest relationship abruptly cancelled its largest contract midstream, causing severe financial problems that the company simply could not, could not overcome.

The loss, it is our best estimate of the collateral impairment at this time, and the balance of the loan we believe is properly reserved to protect against any possible future loss.

The second loan was to an individual, and we charged that loan off entirely, and we're hoping that there'll be some recovery in the future.

John, I think it's fair to say we do not think those two issues are representative of anything else that's happening in the portfolio.

No, the portfolio is, we believe, in good shape.

As I mentioned earlier, our classifications are at a very low level, and we do not see that as an issue.

Got you.

Just another quick question then.

In the Houston market, you know, how have you progressed as far as either as a percentage of total business that was booked here during the quarter?

And I think before it was clear that Dallas is the lead, Houston was the best next growth area.

Do you see that continuing to come along?

Yes, Houston continues to be, you know, from an economic point of view, a terrific market.

A lot of the consolidations that have occurred lately have occurred in the Houston area.

We think that's an advantage for us.

Obviously, we're, you know, looking for opportunities to bring new people onboard and are doing so as those opportunities present themselves.

In terms of loan production, Houston just by virtue of I think the law of numbers has slowed a little bit, but I don't think that's reflective of the economy.

It still accounts for solid growth, both in the energy sector and other sectors there.

John, Houston was one of the drivers of loan growth in Q2.

There were about four areas that, four to five areas that were leaders in loan growth, and Houston was one of those.

Got you.

Okay.

I think that's all my questions for now, guys.

Thanks a lot.

Thank you.

Your next question comes from the line of Brent Christ.

Please proceed, sir.

Good afternoon.

A couple of quick questions.

Okay.

First, you mentioned with an increased emphasis on some of these underperforming businesses.

Is there any thought at all to paring back any of those, particularly the RML given where we are?

We already have pared back RML, and from the first quarter to the second quarter we had 41 less employees than we did before, 28 of those are salaried, 13 of them are commission.

I will have to tell you that some of that relates to industry dynamics.

People who are on commission, in particular, recognizing the slow-down in the market and seeking opportunities elsewhere.

But we're looking at, you know, all of these businesses in terms of trying to find improvements in terms of greater efficiency and also increased production.

Do you expect that trend to continue in terms of the reduction of employees and RML?

I would say in RML that given the headwinds of interest rates and the housing market that that is most likely to happen.

In the case of insurance, our insurance services business, we're very optimistic about the second half of the year.

In the case of Bank Direct, our premium finance business, we're very optimistic about that, as well.

And leasing is not, you know, in terms of its total impact on the Company it doesn't have that great an impact.

Again, the fact that we have put operating leases on the books that are accompanied by depreciation we'd like to change that emphasis and have more financial leases on the books than operating.

So, hopefully, the dynamics and mix of that will change in the second half, but I think if you look long term leasing is a very viable business.

The yields in the leasing business generally are higher than in other lines of business or some other lines of business.

And we hope will be one of the emphasis for us going forward.

Brent, I think Jody made it clear that that was a business that we regard as developing.

It's early in its stage of development, it's in a growth stage, and it's not a business that is showing the kinds of stress that Jody alluded to at say in the mortgage origination business.

Okay.

The next question I guess is somewhat similar.

In terms of the loan growth and margin dynamic, obviously, you've had very strong loan growth, you know, recently.

But, you know, kind of seeing the margins [plateau] I guess is there any thought to maybe curbing your loan growth to an extent?

And to the extent you're able to fund it with low cost deposits?

Well, to the extent we get more low cost deposits, it's good whether we curtail loan growth or not.

I think when you're talking about the kind of growth we have, there's nobody, there's no bank that we're aware of anywhere that can step-up low cost deposit to meet that kind of funding requirement.

Right.

But just by nature of what's happening to us, if you're essentially asking would we not make those loans in order to not increase the funding mix, the answer is no.

No one would do that given what's happening with this bank and with this market.

Okay.

I think the second part of that answer relates to the quality of the credits that we're putting on the books.

In this environment we're being more selective than we have been in the past.

That notwithstanding, we see this kind of loan demand that's been manifested in loan growth.

When you have excellent customers knocking on your door, plus the embedded customer base increasing and using the lines of credit, we need to accommodate those customers.

You know, the customers are our future and that's one of the reasons we look to the future with such great optimism.

Okay, one last quick one, and then I'll let other people have time.

In terms of the two loans you had charge-offs on in the quarter, what's the remaining outstanding balance on the commercial credit?

And how much do you guys have specifically reserved for that?

You know, that's really something we don't want to get into on a specific basis.

It's not something that we talk about.

We'd prefer not to give that information.

Okay.

All right.

Thanks a lot.

Your next question comes from the line of Charlie Ernst.

Please proceed.

Good afternoon.

Hello, Charlie.

Hi, Charlie.

Can you guys talk about the reserve a little bit more?

And in the context of, I mean your charge-offs being maybe a little bit more volatile and a little bit more lumpy than a lot of other banks which you've kind of alluded to?

Does that kind of suggest that maybe you should be holding more reserves versus the industry, which you're not today or how do you feel about that?

Well, Charlie, you know, there's an ongoing debate in the, among the regulators, the SEC, and the accounting profession with regard, particularly to how the unallocated portion of the reserve is looked at.

It's our impression based upon recent conversations we've had with regulators that you're going to have to be able to justify the unallocated portion of the reserve.

And this is going to be a challenge for all banks.

It can be largely subjective, but an example would be introducing a new line of business would be rationale for keeping unallocated reserves or increasing your percentage of unallocated.

We think the reserve that we have today is appropriate given our loss history, given the methodology that we use.

George cited the numbers were .10 since the inception of the bank in terms of net charge-offs.

That's got to put us in the top 1% of the banks in the country.

We feel very confident about our credit policies and our credit procedures, and we will have from time to time, as we did this quarter, a loan that, you know, we're going to have to address and charge-off but we hope it's going to be the exception.

And, hopefully, in my – at least for me, the rare exception.

We've now gone, this is the first significant charge-off we've had since 2002, and, you know, we're proud of our record and we put that record just about up against anybody.

Charlie, one of the – the methodology does deal with the fact that we have, the nature of our portfolio.

That doesn't mean that it won't occur, as Jody mentioned earlier, in kind of a disproportionate way.

But it does not by itself imply that the reserve levels as a percent of the portfolio should be higher.

Okay.

And then, secondly, can you just say 90 days past due last quarter, how much of those loans were premium finance related?

Just over 2.5 million.

That was this quarter, though, right?

Didn't you say that?

I'm asking for last quarter.

It's about the same for each quarter.

And do you think that that's sort of a natural level that we'll see within that line?

I do, yes.

Okay.

So it's not – there's no changes that happened in the quarter?

No.

Okay, great.

Thanks.

The bank’s 90 days past due accruing is now under 225,000.

Thanks a lot.

Thank you, Charlie.

Next question?

Your next question comes from the line of Brad Milsaps.

Please proceed.

Hey, good afternoon.

Hi, Brad.

Hey, just quickly.

I sort of got a little lost in the woods when you were reconciling the operating expenses.

I know you talked about some of the underperforming businesses, you know, hurting, hurting the bottom line this quarter, but then you also talked about higher commissions at some of those businesses.

Am I thinking about that correctly, and is that just more the more scale you have the less impact that's going to have there?

Is that how to think about that?

There's two ways to think about it.

One, there's a non-interest income line item that's directly associated with those and mortgage origination it's gain on sales.

There's also a very high margin in net interest income.

And, second, you have insurance commissions, income and commission expense.

And in leasing it's rental income and depreciation expense.

Those things, by their nature, are going to always be detrimental to the consolidated efficiency ratio.

It doesn't mean they're not profitable or can't be very profitable, it's just the nature of those activities.

It means they won't be helping your efficiency ratio.

And then when I tried to reconcile and say if you exclude those elements our efficiency ratio today is right about 58%, and if you wait further the factors of the buildout that's occurring in other lines of business and the developing and building business at Bank Direct Capital Finance, you're down in the 55% to 57% ratio range.

Okay.

So is it fair to say that those, that maybe those lesser margin businesses are having a bigger impact and so it's not falling all the way to the bottom line.

It's the nature of the business.

Insurance commissions, you get very nice income.

You're looking on average to a 30% or 35%, 25% to 35% gross profit margin.

If a bank is, by its nature or let's say if we were at 66%, in order to improve on that in the insurance business, the insurance business margin would have to be more than 50%, and it just can't do that.

So it's not a negative for the business, it's not a negative on profitability.

That business should be very high ROE, ROA, but it won't be as good a result on the efficiency ratio as the core bank.

Okay.

And then, secondly, can you give us a sense of where or what the total balances are on the premium finance loans at June 30?

That's a competitive issue.

We've had nice growth, to put it mildly, over the last year.

Have you – are you seeing any, from a competitive standpoint some of the other companies I follow that also participate in this business are talking about really some real competitive pressures out there in terms of pricing.

What are you seeing in that regard?

Can you…

I think this business by its nature is competitive, but there's a lot of business.

The business produces very good margins for us.

It is a fixed rate asset, even though it's of short duration.

So in a rising rate environment on loans that are less than four months old we've been squeezed a little bit, but at the levels of those yields it's not a big issue.

Okay, great.

Thank you.

[multiple speakers]

Your next question comes from the line of Bain Slack.

Please proceed.

Good afternoon.

Hello.

Hey, I've got a couple of questions.

One, with the gain on sale this quarter, it looks like it was in the line of about 2.2 million.

I wonder if you all had any data you could give us either on terms of the volume of the mortgages sold or the margin?

The margin, and I don't have data on the volume.

The margin is down a little bit, but – and because of what Jody mentioned the volumes are down also a little bit.

But they did have good throughput.

They had relative to the – they had a building balance at the end of the third quarter that produced pretty good gains this quarter.

And the first quarter?

In the second quarter from build-up of portfolio that was occurring, beginning at the end of the first quarter.

Okay.

And, all right, so, and when you say 'margins are down and volume is down,' that's from the first quarter, as well?

Margins are down from the first quarter.

Balances are not down from the first quarter, they're flat to up very slightly.

Okay.

But I mean do you have numbers for either one?

I don't.

Okay.

The second thing I wanted to see was with OCI it looked like it increased from a loss of 9.4 million to 14, roughly, million?

Right.

I mean it's just a function of the higher rates, or I guess if you could give a little more color there?

It's just unrealized loss of a securities portfolio.

We've not bought a security in – since the end of '04.

Okay.

I guess anything in that portfolio that's driving that?

No, just market rates.

But, Bain, the portfolio continues to run-off at about $10 million a month, and we think that we can allow that to continue until the portfolio gets down to close to 300 million, and that's a level that we need for pledging requirements.

So, you know, unless the yield curve changes and changes significantly I don't see us buying any securities probably for at least the next year, if not two years.

Okay.

Hopefully, the markets will change sometime within the next two years.

There are a lot of banks hoping for that.

Right!

I guess if you don't mind, I've got two quick more things.

One, I was looking on the net charge-offs, you had, you said one was an individual but in the press release it looked like they're all categorized as commercial?

Well, the loan to the individual was classified as a commercial loan as opposed to a consumer loan, Bain.

It's housed in the commercial loan portfolio, it was not a consumer driven loan.

Oh, okay.

I guess…

A private client type relationship, Bain.

Okay.

And I guess how was that backed?

Pardon?

I'm just trying to figure out how – why – well, I guess it doesn't matter, I just wondering how the loan, how it was collateralized?

That maybe that was affecting the classification?

Well, we charged it off.

I mean it was weakly collateralized by collateral that we had not been able to realize upon at this point in time.

We are still looking at it, we are still trying to do that, but at this point we have not been able to realize on it.

Okay.

And just to further comment, you know, all these loans are good when you make them, obviously.

This was an individual who owned a business and the business went south on him.

It was his principal asset.

And, you know, we suffered accordingly with him.

Okay.

And last one, the loan growth, I mean it was just very good this quarter.

I was wondering, on a linked quarter basis if you could break it down by category and, or if possible geography?

Well, we could.

I'm not sure it'd be productive to try to do it on this call.

Peter?

The C&I portfolio still drives the growth, Bain, about 55% of the growth is C&I.

We've got about five or six specific lines of business that drove that growth.

The corporate banking group leads the pack in Dallas in terms of core generation.

Houston is a big contributor to that.

Actually, Austin was a good producer in the second quarter which typically has not been as strong a loan production area as some of the other areas.

But corporate, Austin, Houston, and some of the related areas in Dallas.

Bain, I think a positive is that our real estate loans as a category are down as a percentage of the total.

You know, given where we are in the real estate cycle we think that's where we ought to be.

And I think we're looking, you know, very carefully at any new real estate loans that go on the books.

We've said before that, you know, generally, well, specifically we don't make high rise condominium loans.

We have none of that on our books.

We have few, if any, garden apartments.

We don't make high rise office building loans.

We're – we try to be very selective and well diversified, and yet with rates rising we're appropriately cautious.

Real estate is probably a smaller percentage of our loan portfolio today than it's ever been.

Could you quantify that?

In the 30s.

Yes.

30%, okay.

It's more than 30%.

It's around 38%, something like that.

Great.

But that's down from almost 50% at its peak.

Okay.

Great.

Thanks.

Thank you.

Your next question comes from the line of [Greg Lapin].

Please proceed.

Hello, Greg.

Hi, how are you doing?

Very well, thanks.

it sounds like on the – I mean when the competitive forces intensify, you'll lean on pricing versus structure, is that accurate?

That's accurate.

And structure, can you comment on that?

Is it more competitive there that you're not, you know, changing that or modifying that part?

No, you're exactly right.

What we see first is pricing competition, and that has been very, very strong for the last 12 to 18 months, at least in our part of the world.

And we, obviously, would rather give up some pricing than structure.

And we have seen compression of yields, there's no question about it.

Fortunately, our growth has overcome a lot of that, but we are seeing compression, compression in yield.

On the structure side, we are much more careful in terms of how we negotiate that.

You'll never say that you wouldn't negotiate somewhat on a structure, but we are very cautious, very careful, and believe that we really need to hang tough with our policies, our procedures, and the way we underwrite credit.

It's a culture around our Company.

Got it.

And then on the, regardless of the two charge-offs this would have been the quarter that you would have established a provision, 750,000 or the excess?

That's probably true.

Probably right.

Just the methodology and what growth does for the reserve.

Right.

In fact, since year end that's the significant majority of the provision.

So the 750 is not correlated with the charge-off…

Well, it doesn't work quite that way, but it starts first with just the application of the methodology, and then you go back and look at the sources, and most of it's growth.

Okay.

Because you have pretty strong growth in the first quarter.

We did.

But we had also a large unallocated in the first quarter.

And still has good unallocated.

What we have, that just implies that a portion of the charge-offs were obviously, had specific allocations before the end, at the end of the third, the first quarter, excuse me.

Okay.

They probably started sliding down, the accounts or the classified credit scale?

Yes.

All right.

There was a very edifying article in the American Banker within the last week on the whole subject of loan loss reserve and provision.

And anyone that hasn't seen it, I'd recommend that you pull it up on your computer and look at it, because it, it pretty well sets out what the issues are and the dilemma that all banks find themselves facing today, and that is, again, justifying the levels of their reserves, particularly when you look at the unallocated portion of that reserve.

Okay.

That's helpful.

Thanks, guys.

[OPERATOR INSTRUCTIONS.]

At this time, there are no further questions.

Well, if there are no further questions, on behalf of the Company, Myrna, George, Peter, and myself, and the rest of the dedicated people who make things happen around here, we appreciate very much the level of interest today.

Again, we think we had a very solid quarter.

We're looking forward to a solid second half and continued growth opportunities as we go forward in the future.

I would encourage again any of you have any questions please direct them to Myrna Vance.

We're all available, and Myrna will direct whatever questions she needs to to us.

Nothing is more important than our relationship with the analysts and the investment community.

Again, on behalf of all of you, thank you very much for your time today.

And that concludes the conference call.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.