Truist Financial Corp (TFC) 2002 Q3 法說會逐字稿

Good morning.

I'm Amy and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the third quarter earnings conference call.

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

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

Instructions will be given at that time.

I would now like to introduce Mr. Tom Nicholson, Director of Investor Relations.

Mr. Nicholson, you may begin your conference.

Thank you, Amy.

And thank you all for joining us today.

This call is being broadcast on the Internet from our website at www.bbandt.com.

We are pleased, once again, to announce another quarter of record earnings for BB&T.

This morning we have with us our Chairman and Chief Executive Officer, John Allison and our Chief Financial Officer, Scott Reed.

They will review the financial results for the third quarter of 2002 and provide a look ahead.

After John and Scott have made their remarks, we'll pause, and Amy will come back on the line and explain how those who have dialed into the call may participate in the question-and-answer session.

Before we begin, I'll give my usual reminder notice about forward-looking statements.

During today's call, there may be statements made which express management's intentions, beliefs or expectations.

BB&T's actual results in future periods may differ materially from those contemplated by these forward-looking statements.

Additional information concerning factors that could cause actual results to be different is contained in the company's SEC filings including the company's report on Form 10-K for the year ended December 31st, 2001.

Copies of this filing may be obtained through a link on the BB&T's website, www.bbandt.com or by contacting the SEC.

BB&T undertakes no responsibility to update the information presented in this conference call, as facts and circumstances may change in the future.

Now, it's my pleasure to introduce our Chairman and CEO, John Allison.

Thank you, Tom.

And good morning to all of you.

Thank you for joining us.

I'd like to outline the areas that I will discuss.

We'll talk about our financial results for the third quarter and year to date with the special emphasis on what's happening in our mortgage business and asset quality.

And we'll try to bring you up to date on M&A activity and our expectations in that regard.

Next I'll share with you our thoughts on the future earnings expectations.

Scott will cover in depth a number of issues, including the margin and what's happening with non-interest spends our capital position, share buy back, and taxes and then we'll have time for questions.

As Tom said, we are pleased with the overall financial results, particularly in light of the very challenging economic environment we're in.

Looking at the third quarter on a GAAP basis, we had net income of 328.2 million, which is an increase of 47.8 percent.

If you exclude merger-related charges from both periods, which were 7.8 million after tax in 2003, net income was 336 million an increase of 18.5 percent.

Again, excluding merger related charges, diluted EPS was 70 cents, which was a 12.9 increase compared to the third quarter of last year.

It was equal to the consensus estimate. 2 cents better than the second quarter of 68 cents.

Or 11.7 percent annualized growth rate quarter to quarter.

And it was also 12.9 percent increase over the originally reported third quarter number of 62 cents.

On a cash basis, EPS was 71 cents, which was an increase of 9.2 percent over the third quarter last year. 11.5 percent annualized growth rate over the second quarter when we made 69 cents.

And again, 9.2 percent over the originally reported cash basis EPS last year.

ROA was 172, ROE 18.09 percent.

On a cash basis, ROA was 178 and ROE was 2372.

Very good numbers.

The 9 months GAAP earnings were 965.8 million, up 38.8 percent.

Excluding merger related charges, which were 18.2 million for the whole period of time, and were partially offset by a $9.8 million positive change in accounting, we made net income of $974 million, up 19.9 percent.

EPS was 204, up 15.3 percent.

And that's the same 15.3 percent over originally reported EPS of $1.77 last year.

Cash basis we made $2.06, up 9.6 percent, and again 9.6 percent over the originally reported cash basis last year.

Our ROA was 174.

ROE 18.60.

Cash basis ROA 179, cash basis ROE 2371.

Again, all very, very good numbers.

If you look at the factors driving earnings, we had a slight decline in margin that Scott's going to talk about, but if you look over the last year, our margin has been relatively stable.

We were pleased with our non-interest income growth.

If you take out purchase acquisition, annualized 2nd to 3rd, non-interest grew 14.7 percent.

Third quarter this year to third quarter last year grew 11.1 percent.

And year-to-date 2001 to 2002 grew 11.6 percent.

The number of components of non-interest income did very well.

We had very healthy growth rate, internal growth rate in service charges, again, taking out purchase, of 10.7 percent.

And investment banking up 9 percent, primarily driven by our fixed income business and our bank-based investment banking services.

Insurance remained very strong.

Total revenues insurance were up 73.4 percent.

A good bit of that was acquisitions, but the internal growth rate in insurance was 11.4 percent.

So pretty healthy growth rate numbers in our non-interest income businesses.

I think primarily driven by our sales system and cross-over getting out of merger acquisitions done in recent years.

The biggest issue in the numbers would be what's happening in our mortgage business, which is clearly a mixed bag.

We're having a phenomenal amount of activity in terms of originations.

In fact, year to date, we have originated $8.6 billion and we're projecting we are going to do over $12 billion in originations this year, which is a huge number for us.

In fact, if you take out the cost of impairment, mortgage revenues from origination are up 37.1 percent.

However, the refinance market is obviously measuring negative impact on our mortgage servicing business and the value of mortgage servicing rights.

We did take a writedown of 130.8 million on mortgage servicing rights.

We offset that with $135 million bond gain.

The difference is the normal bond portfolio management strategy that we have used in the past.

We have said on a number of occasions that we maintain a larger bond portfolio than our competitors, and part of that is the hedge against some mortgage servicing right, which has worked very well.

It's interesting to look at where we are.

Our mortgage servicing rights now have a net value of only 280.8 million.

We have a total servicing portfolio of 33 billion dollars.

We service 23.5 billion for others.

Or if you look at the ratio of mortgage servicing rights to servicing for others, it's only 1.2 percent.

My personal opinion is the mortgage servicing rights are undervalued because the mortgages we are putting on the books now are probably the most valuable we ever put on the books from a servicing perspective due to the very low level of rates.

We continue to primarily hedge our mortgage servicing right with our bond portfolio.

We are doing some hedges with derivatives.

You'll note, we had a pretty significant increase in our derivative portfolio, and it really has three basic purposes.

Small portion of it is to arbitrage mortgage servicing rights.

Another portion is just derivatives related to our mortgage warehouse.

Our mortgage warehouse is at an all-time high.

Those derivatives are naturally self-liquidating, and then we put on some derivatives as down side protection against falling interest rates.

I wish we would go back to a cash basis on mortgage servicing rights, which we did 7 or 8 years ago.

Up to 7 or 8 years ago was a much better accounting system.

I think the accountants have really fouled it up and made it confusing.

But anyway... we try to play by their rules.

Looking back at net revenue growth, annualized second to third quarter net revenues grew 9.2 percent.

Third quarter of this year to third quarter of last year up 6.3 percent, and year-to-date 8.3 percent, again taking out purchase accounting.

Non-interest expenses were only up 2.5 percent, taking out purchase accounting, and Scott will discuss that in some detail in a minute.

Our revenue growth then was 8.3.

Our expenses were 2.5, without purchase accounting, which is a very healthy position to be in.

Loan growth continues to be a challenge.

If you take out purchase acquisitions second to third commercial loans grew 2.9.

Consumer loans actually had a very healthy growth rate, 11.4 percent.

Mortgage grew 15.5.

But that is basically the warehouse, which is up $950 million and will self-liquidate.

The total loans were up 7.5 percent, but that's not a sustainable growth rate because the mortgage warehouse.

Third quarter to third quarter, commercial loans 2.7, consumer at 5.1, mortgage actually down 6.6 percent, and the total up 1.3 percent.

And year-to-date commercial 3.5, consumer 3.6, mortgage down 5.3, and the total up 1.6 percent.

What we're continuing to experience, and this has really been going on for probably about six to nine months now, is a very slow growth on the commercial side of our business across all commercial spectrums, not just commercial loan growth, and reasonable to healthy growth on the retail side of the business.

This is a kind of a general reminder, we are by design about 50 percent commercial and 50 percent retail in terms of our total revenue streams.

We do that from a risk management perspective.

There are some times commercial is better, some times retail is better.

Right now, I'm glad we're diversified.

Our retail business is okay.

On the other hand, our commercial business in general was pretty weak, pretty weak.

Positive growth was good.

Our non-interest bearing deposits, again take out purchase accounting third over third, was up 8.7 percent.

The annualized growth rate, second to third in non-interest bearing deposits, was 15.5 percent.

Very healthy.

And year-over-year, 9 percent.

Total deposits, again taking out purchase accounting, up 4.1 percent.

Annualized growth rate, second to third was 7.2 percent.

Year-over-year 2.9.

What we're seeing in our deposits is very strong transaction deposit growth.

And on the other hand, we are not pushing CD growth, but frankly we don't need the money.

So we have become very concerned about controlling our CD pricing and we can get all CDs we want by raising price and it would be easy to do in today's market.

But what's happening to us is our deposit mix is improving because transaction deposits are growing in a much healthier, faster rate than CDs.

Asset quality is, of course, the biggest issue in the industry.

The good news is our asset quality remains extremely strong compared to peers in the overall industry.

But we are not seeing improvement that we had hoped for.

If you look at non-performers, they rose from 400 million to 425 million in the end of the second quarter to the end of the third quarter.

About 6.5 million of that was Regional Financial which we did as a purchase acquisition and therefore doesn't go in the history.

So a part of the increase was the acquisition of Regional Financial.

If you look as a percentage of total assets, the third quarter of 2001, non-performers were .45.

They were .52 at the end of the second quarter and rose slightly to .54 at the end of the third quarter, still a very good number, but a slight increase.

Same kind of trends in charge-offs.

In the second quarter, we charged off 58 million, in the third quarter we charged off 63 million.

Charge-offs went up from .46 to .49.

Year-to-date charge-offs have been .48, compared to .35 last year.

Still very good numbers.

But, you know, some increase -- slight increase in charge-offs.

If you take out our specialty lending businesses, loan losses in the third quarter were .40 and year-to-date .38.

If you think of that, a .38 loss ratio is extremely good in this environment and particularly given just the general mix of our businesses.

Looking at our provision in the quarter, we provided 64 million, we charged off 63.6 million, so charge-offs in provision about equal to each other, and year-to-date we have provided 179 million and charged off 178 million.

So we have been basically keeping the provision flat and we have had basically flat growth.

The reserve did decline a little bit compared to the second quarter.

It's basically -- it's up from last year when we were 135 to 136.

But it fell from 140 at the end of the second quarter.

However, almost all the decline in the reserve was caused by the $950 million increase in the mortgage warehouse, which we don't need to keep a reserve for but that stuff sold.

We have never had a loss in the mortgage warehouse from a credit perspective.

If you take out the warehouse, the reserve would have been 139, as compared to 140.

So the reserve was basically flat, except for the rise in the warehouse, which is a self-liquidating asset.

We expect to maintain the loan loss reserve at the current level until we see some improvement in non-performers, see them start declining.

We were very hopeful last time we talked that we might see charge-offs and non-performers had peaked.

Frankly, the economy has been weaker than we expected since then.

It's not bad.

It's just not as strong as we had hoped.

We have seen some increase, and expect to see some increase, in both charge-offs and non-performers in the four quarters.

However, we don't think the increase will be a big number.

We think charge-offs might be up maybe 5 million compared to the third quarter, non-performers up slightly.

There is no evidence of any significant jump in either charge-offs or non-performers, but they continue to kind of creep up, and I think when they will head down is when we actually see a turn in the economy, which is has not happened yet.

So again, the good news is the overall quality of numbers remains extremely good and we don't see any reason to believe for any significant changes, although the bad news is we're not seeing a turnaround and getting better.

One important thing to hold in context on our numbers is our long-term trends.

We use our merger of equals as kind of a pivotal date, which is 7.75 years ago.

And on an originally reported basis, excluding merger charges, over the last 7.75 years, the compound annual growth rate in earnings per share has been 14.1 percent, and on cash basis has been 13.8 percent.

Very few companies can match that trend through the kind of environment we have been in recent years.

Leaving the financial numbers, talk a little bit about mergers and acquisitions, we had a very good quarter in our M&A businesses.

We have successfully converted AREA which is a $3 billion company and MidAmerica a $2 billion company.

AREA was statewide in Kentucky and MidAmerica is focused in the Louisville area in Kentucky.

We had very few problems, very high retention of clients, the whole process went extremely well and a think we have a great opportunity in the future in the Kentucky marketplace.

We did incur a merger related cost of about $7.8 million after tax in the systems conversions in the quarter.

That was considerably less than we had expected.

We had told you last time we thought we would have about 13 million after tax in merger-related charges.

So we were way under what we expected.

If you look at the year, our original estimate, plus Regional Financial cost that we didn't estimate Regional Financial, which we are going to convert this year, would have totaled about $36.5 million after tax in merger related costs.

We're now projecting that we will incur about $11 million after tax in the fourth quarter, which would include converting Regional, and that would end up at about 29.5 for the year.

So we would be about $7 million less after tax than we expected in merger-related costs.

We had a period there where our merger-related costs exceeded our estimates and we weren't happy with that, and now, fortunately, we have been able to run under the estimates in our actual cost of conversions.

We did complete the acquisition of Regional Financial which operates First South, a $1.6 billion bank in Tallahassee, Florida.

Primarily focused on the construction and mortgage business.

We're expecting to convert them in November.

They are doing extremely well.

It's a great time to be in the mortgage and construction lending business in Florida, and we're very optimistic about our future with First South.

We recently announced an agreement to acquire Equitable Bank, a $477 million company in Wheaton, Maryland, which is a very fast-growing market and will integrate well with our metro D.C. operation.

And we also announced an agreement to acquire FloridaFirst, an $812 million institution in Lakeland, Florida, which is another great market and takes our second step in building a franchise in Florida.

We also announced three very high quality insurance agency acquisitions and one employee benefit consulting firm that are all very good fits.

In the future, we think our acquisition activity will look like it's looked in the past.

We are still focused on companies in the $250 million to $10 billion range in our footprint and contiguous states.

Activity remains unpredictable, but over the last 15 years, we have averaged 4 or 5 mergers a year with some ups and downs, and I suspect that's what we'll do over the next several years.

Continue to acquire insurance agencies, which is really become a great mix for us.

We are still looking for asset managers, although that's a little tougher because people's expectations regarding revenue growth and our expectations sometimes aren't in harmony, but we are talking to a number of smaller niche asset managers.

Okay.

Let me share with you our future earnings expectations.

Particularly talk about the remainder of 2002 and 2003.

First, let me strongly reinforce all the caveats that Tom expressed.

Certainly, anything we say about the future may be wrong.

The biggest issue we face is the state of the economy.

The economy is clearly slower than we expected it to be.

After the first quarter, we thought we were headed towards recovery.

Recovery pace slowed in the second quarter and continued to slow in the third quarter.

We're seeing a very uneven level of activity.

Some of the markets we're in, like metro D.C. are booming.

Florida is booming!

On the other hand, the rural Southeast is very slow.

Textiles, furniture, big industries are still struggling.

Our current expectations are based on the assumption the economy does not slow any further.

Not that it just simply doesn't get any worth.

Current consensus estimates for the fourth quarter is that we will earn 72 cents a share.

Frankly, we would have to be fortunate to do that.

It's possible, but we would have to be fortunate.

A more likely number is probably 71 cents a share.

Again, trying to be accurate within a penny is a tough thing to do but we would have to have a lot of good things happen to make the 72 cents.

If we did make the 71 cents in the fourth quarter, then for the year we would make 275, compared to the consensus estimate of 276.

It is even more difficult to project 2003 given the many uncertainties in the world.

The current consensus estimate is $3.06.

We're in the process of completing our financial plans so we are kind of at a preliminary stage.

Our current expectations are that we'll make something in the range of $3 to $3.10.

And that really depends on the economic environment.

The $3.06 consensus is near the midpoint of the range of 3 to 3.10.

So how you feel about the $3.06 depends on what you think about is going to happen with the economy.

And I think that will be a big driver in the level of activity.

But I don't think the consensus is off a long way from what is possible, assuming the economy doesn't get any worse.

One just general comment.

The market does appear to be rationally reacting to problems of some banks and extrapolating that to the whole industry.

We have a very diversified retail and commercial business with a focus on small business on purpose.

We are not like a number of the banks that had have had some big-time credit problems.

We did not have significant credit problems last recession, nor the one before that, nor the one before that.

Also, I would hope our dividends should be a downside price protector, and for a while people discounted dividends.

I have been in the business long enough to know that dividends are real important.

Our current dividend's $1.16 per year, which based on yesterday's stock price created a yield of 3.5 percent.

While the fed fund rates is 175, the 10-year treasury is about 3.5 percent.

We paid a cash dividend every year since 1920, including paying one during the great depression, and we have increased our dividend for 31 consecutive years.

Over the last 10 years, the compound annual growth rate in the dividend has been 15.9 percent.

We have a very solid basic banking institution so our business is fundamentally sound.

Our dividend's not at risk, and rapidly growing.

I think it's important to note that the dividend should be, and I think will be, a downside protector on our stock price because of the return.

In summary, given what is clearly a challenging economic environment, we are very pleased with the third quarter results.

While our business is dependent on the economy, we remain optimistic about 2003, assuming some level of economic growth.

Our dividend should provide a floor on the stock price.

And we are a very fundamental company with a long history of strong performance.

The kind of stock that's nice to own in tough times.

That said, let me now turn it over to Scott for some more information.

Thank you, John.

And good morning to everybody.

I'll follow up on John's comments by elaborating on our net interest income and margin, to begin with.

In the third quarter, our net interest income on a tax equivalent basis was $743 million.

An 11.1 percent increase over the third quarter of 2001.

And even eliminating purchase acquisitions, it was a 4 percent increase in comparable quarters.

Those growth rates compare to earning asset growth, and this is average earning assets, being up 9.5 percent, or $6 billion third to third quarter.

And 1.2 percent or $825 million, adjusting for acquisitions and mortgage loan securitizations.

Certainly, that growth of 1.2 percent is reflective of what John has just reviewed with you, much lower loan growth primarily.

Looking at linked quarters, 8.4 percent growth in net interest income, 6.5 percent without purchase acquisitions, compared to average earning asset growth of 8.4 percent annualized, $1.4 billion.

And 5.2 percent, or $914 million, of linked quarter earning asset growth adjusting for purchase accounting.

Through the first nine months of the year, we have produced $2,155,000,000 of net interest income.

Up 10.4 percent over the prior year, 6.6 percent excluding purchase acquisitions, average earning assets have grown a little bit slower at 8.1 percent.

Year-over-year, a $5 billion increase and 1.9 percent, or $1.3 billion growth, adjusting for acquisitions and securitization.

The net interest margin, we have been very pleased with the results, as we have had very stable margins pretty much throughout the year.

We are up 6 basis points from 419 margin in the third quarter of 2001, to 425 margin in the third quarter of this year.

We have seen some spread enhancement.

Some examples: loans and leases have decreased 133 basis points, third to third quarter.

However, securities and other earning assets have fallen only 89 basis points producing a total earning asset fall of 121 basis points.

However, that compares to interest bearing deposits falling 162 basis points, and total interest bearing liabilities, 143 basis points.

The margin compared to the second quarter of this year did fall 2 basis points.

There really was not much change to really talk about there.

More importantly, for the full year, our margin is up 9 basis points, 4.26 percent, compared to 4.17 through the first 9 months of 2001.

Again, we have seen total earning assets fall, but 144 basis points compared to interest bearing deposits falling 192 basis points, and all interesting bearing liabilities falling 171 basis points.

In terms of the future, in regard to our margin and net interest income, we are still positioned slightly, from an asset/liability perspective, for rise in interest rates.

However, as John described through the use of derivatives as well as our bond portfolio, we have moved to a more neutral position.

And given our rate forecast, which we now think we might see a 50 basis points fall in the Fed fund's target rate in November, and since we were slightly positive GAAP, we decided that was a conservative scenario to look at.

With that scenario and then no increase in rates until July of 2003, and 125 basis points increase from July through December of next year, we really have very little impact to speak of on '03 earnings from a net interest income standpoint.

About a 1 percent fall in net interest income, if that scenario were to take place, only about $30 million pre-tax.

We think our margin will remain about 4.25 percent in the fourth quarter of this year and will be somewhere 4.20 to 4.21, .22, as an average for 2003.

Turning next to non-interest expenses, we continued, we believe, to show very strong expense control.

We continued to realize cost savings from acquisitions.

As we have mentioned numerous times, we have met or exceeded projections on practically all of our transactions, and certainly in total, over the years.

An example of that is the AREA in MidAmerica.

Acquisitions we have just completed and finished the conversions.

Our cost savings are about $5 million in the aggregate than previously announced.

I wanted to point out in our press release, we have added two new pages to page 11 and 12 to our release, which shows all of our non-interest income major categories and expense categories, looking at full nine-month results, as well as three months results for the quarter.

We also have balance sheet information and averages for nine months and three months, and then linked quarter comparisons on page 12 of the release, all exclusive of merger related charges and also exclusive of purchase accounting.

So you can get a good feel for individual growth rates without purchase acquisitions.

Looking at the third quarter comparison on expenses, about 15.3 percent quarter to quarter, but only 2.1 percent, excluding purchase acquisitions, virtually flat on personnel expense, third to third.

Also on occupancy and equipment expense, virtually flat.

Did have some increase, 7.3 percent, in other operating expenses, a few items there of interest.

Amortization of servicing rights for mortgages increased $16 million in comparable quarters.

Foreclosed property expense was up $2.2 million.

Data processing software expense up $3.8 million.

Operating charge-offs up $2.6 million.

The big driver, of course, being the amortization of mortgage servicing rights.

On a linked quarter basis, we're showing 12.5 percent annualized increase in non-interest expense.

That's 9.7 exclusive of purchase acquisitions.

Big driver there, again, pretty flat, only up a couple of percent in terms of personnel expense as well as occupancy and equipment.

However, we have a 28.4 percent increase in other operating expense, and almost all of that increase can be traced back to the mortgage servicing right amortization, which on linked quarters is up $9.6 million.

Turning to year-to-date numbers, 12.8 percent growth year-over-year, and as John mentioned only 2.5 percent growth, eliminating purchases.

Really, nothing to talk about in any category. 3.9 percent growth in occupancy and equipment.

Only 3.3 in other expense categories, which is all other expenses.

And then personnel expense only up 1.7 percent year-to-date.

I did want to mention here briefly that we are in the decision-making process, that we have made no final decision regarding the expensing of stock options.

We have looked at the cost of that and if we implement it beginning in 2003, the expensing of stock options, based on historic mix of ISOs and non-qualified stock options that have been issued and our current vesting of three years, we would only have a 3 cents per share cost, which is 1 percent or less of projected earnings.

So BB&T has been pretty conservative on the issuance of stock options and it would not be a big impact, or not nearly as much as what I have seen announced by some others.

Taxes, we continue to work diligently to search for and find strategies to reduce our federal and state tax burdens.

As I have mentioned previously, we have used a number of vehicles to minimize our state taxes through a state tax minimization program that's been in place for a number of years.

We have had a very stable, effective tax rate for the last five quarters, between 28 and 29 percent.

We think the effective tax rate will be about 29 percent in the fourth quarter of this year.

And then we'll probably jump up to between 30 and 31 percent next year as a few of our federal strategies will expire, if you will, and we won't have that benefit in '03.

Our capital remains very solid.

In fact, improving our equity-to-asset ratio at the end of the third quarter has jumped up to 9.6 percent.

Certainly, impacted by strong earnings, but also by purchase accounting.

Risk-base capital tier one remains very strong at 9.7 percent at the end of the quarter.

We saw a sizable increase in the total capital ratio, up to 13.5 percent.

We did do a debt issue in the quarter.

It was a half a billion dollars 4.75 percent global subordinated note, a 10-year note.

I never thought I would see a 10-year piece of paper issued by BB&T at 475.

All in cost was 493, however, we have swapped that note to a LIBOR-plus roughly 53 basis point instrument.

So our total cost is now running about 4.40 percent.

The leverage capital ratio, which we tried to stay close to and keep between 7 and 8 percent, closed out the quarter at 7.3 percent.

We have been been in doing share buybacks.

We bought back 3.5 million shares in the third quarter for $132 million cost.

Year to date, we bought back 10.5 million shares, just under $400 million in costs.

We will continue periodic repurchases.

We hope in the fourth quarter of this year to be in the market pretty heavily. 10 to 13 million shares targeted for repurchase.

Next year, 2003, we will also continue to manage our leverage ratio to that lower end of our range or 7 percent.

To do that, we project that we'll have to buy back 20 to 22 million shares.

So we will continue to be in the market buying back shares as we're able to.

John and Tom, that's my additional elaboration.

And I think it's time for questions and answers.

All right.

Thank you, Scott.

Before we move to the question and answer segment, I'll request as I have in previous calls that we structure this portion of the call in a way that gives fair access to all the participants.

Please limit your questions to one primary inquiry and one follow-up.

And then if you have further questions, re-enter the queue so that others will also have an opportunity to participate.

Amy, would you come back on the line and explain, please, how these folks may submit their questions.

Ladies and gentlemen, at this time, if you would like to ask a question, please press Star 1 on your telephone keypad.

If you would like to withdraw your question, press Star 2.

If you are using a speaker phone, please pick up your handset before asking your questions.

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

Your first question comes from Jason Goldberg of Lehman Brothers.

Thank you, good morning.

Good morning.

John, you know, I guess you -- at this time last quarter were you looking to do 71 cents this quarter.

You did 70.

Obviously, mortgage came in a bit stronger than expected.

If you had to pick out one or two line items that came in kind of below what you were thinking about at that time, what would they be?

Loan growth and credit quality.

We had more charge-offs than I expected and slower growth.

We -- our experience is the economy is doing a lot slower than we expected it to be doing the last time we were talking.

And I guess when you kind of just look at the demand for loans, did it kind of weaken as the quarter progressed or do you think it was more stabilized, towards end of the quarter?

I guess maybe talk about the trends you saw kind of month by month for the quarter, given what the fourth quarter may look like in that area?

I would say on the retail side, activity slowed a little bit as we moved to the quarter, but it still remained okay.

On the commercial side, early part of the quarter was slower than we expected.

July/August, we did a little better in September.

But I don't think we are going to have a lot better growth in the fourth quarter commercially than we had in the third, unless something happens from here.

And we're kind of at the same kind of pace.

All the numbers I have seen from the industry, we're growing a lot faster than the industry on the commercial side.

But a lot slower than we're used to growing commercially.

The commercial real estate market, while fortunately, not having material credit quality problems, growth rate is slowed considerably because people, even though rates are low, can't justify new commercial real estate projects.

So you have had a slowing marginal demand there.

Some people going long, obviously, with rates being so low, that the level of activity in commercial real estate has been less.

Also, interestingly enough, while we were very big residential construction lenders, the houses have been turning over so fast that your construction loan portfolio is -- there is a lot of churn in it, but the outstandings aren't growing that fast because the houses are selling so quickly.

So I think that that's kind of been the level of activity.

Thank you.

Yes, sir.

Your next question comes from the line of Chris Marinac with SunTrust Robinson Humphrey.

Good morning, John and Scott.

Hey, Chris.

I had a question just to get some more color on the swaps portfolio, and particularly, just to get at the sense of how and when will the gain on, or the fair value gain in the derivatives portfolio be accredited to income going forward.

John, I'll be glad to begin to address that.

If you look at where we were at the end of September, we were roughly 9.5 billion in derivatives, by far the most of that is cash flow hedges, forward commitments representing almost a third of it, $3.4 million, and that's the build-up of the warehouse and the hedging of that warehouse and our commitments.

We also had just straight swaps, about 1.65 billion in floors and caps of about 1.25.

Those are the largest categories making up the 9.5 billion dollars.

We do have an unrealized gain in the portfolio at the end of the quarter.

Hopefully, it will be realized, as we either see rates start to rise at some point.

Even if we move to an unrealized loss in the derivatives, we'll see great growth in net interest income and return, if you will, to somewhat to prosperity.

The average maturity in our swaps right now is between 4 and 5 years.

And as John said, we've layered these on, trying to get ourselves partially back to a neutral position and also to hedge a little bit against mortgage servicing rights.

Scott, in terms of the forward commitments on the warehouse line, does any of that come into income as your mortgages are closing in the fourth quarter and early next year?

Come into income as the mortgages are closing....

Yes.

Yes.

Part of the gain and loss that we take, I was -- I can find out for you the gain on that separately.

See if I can find that.

Chris, I don't have that right in front of me.

That has a nice gain on it unto itself, that 3.4 or .5 billion-dollar forward commitment.

And it is part of the gains and losses that should flow in.

I would imagine that warehouse will, you know, hopefully begin to clear itself out in the first part of next year.

And by the middle of next year, we should have brought all that back into income.

Okay.

And that's something that's factored into your numbers in the model from the fourth quarter.

Yes, it is.

Yes.

Okay.

Very well.

Thank you guys.

Sure.

One comment, back to Jason's questions.

I was looking back at my notes when we talked the last time.

This is interesting how your expectations change.

I think we were reflecting the consensus.

We did this in July.

Our expectations, and I think the market's expectations, with interest rates would begin rising in October and would increase by 75 basis points by year end.

Scott said now we are expecting interest rates to go down by 50 basis points by year end.

So it's an interesting how all of our expectations have changed in that period of time.

Your next question comes from the line of Mike Mayo with Prudential.

Good morning.

Good morning, Mike.

Just to understand your thought process, you did say the tax rate might be a little higher next year, the margin might be a little lower, stock options could hurt by 3 cents.

But you said you're still okay with consensus.

So where do you see the offsets to those slightly negative factors?

Mike, we didn't -- we said the stock options, we're not assuming one way or the other.

We haven't made a decision on whether to expense options.

So that wouldn't be a factor.

In terms of offsetting the slightly lower margin, et cetera, our main consideration will be very heavy focus on expenses.

And we are going to try to keep our expenses growth rate in the 1 percent range.

So, to get in the consensus estimate, with the whole set of economic factors we consider, we have to be very tight on expenses.

Any new programs in that area?

No.

You know, we've done a lot of acquisitions in recent years and they've gone very well for us.

But when you grow as fast as we have, we think that gives us some opportunity to go back and look at how we're organized in different areas, and there are opportunities over time to improve some efficiencies but we don't have -- we've always tried to run our business efficiently.

We have very good efficiency ratio but we are -- we don't have a program, but we are going to discipline ourselves, which we have been able to do, over time, in our budgeting process.

And lastly, you made the distinction between urban markets, which are doing well, as compared to the rural markets.

Just what's the rough breakdown in revenues or assets between your urban franchise versus your rural franchise?

I don't know if I know that off the top of my head, Scott?

Uhm... let me think here.

We have some numbers, John...

Mike, maybe what would be better, is for us to give you a call.

I have to add up each of the regions.

I only have it by region.

And --

That is fine.

Or if you want to announce it later in the call or just give me a call.

Thanks.

Okay.

Thanks.

Your next question comes from the line of Ed Najarian with Merrill Lynch.

Good morning, John and Scott.

Good morning.

Just a question on your margin outlook, a little bit.

You talked about, I guess, a pretty stable fourth quarter margin and didn't sound like you are expecting too much pressure in '03, even if we get a 50 basis point Fed funds cut which I -- obviously, would put most of your asset yields under some pressure, especially assuming if prime, as it always has, moves in lock step with the Fed funds target.

Can you just give us a sense of where you see the offset on the funding side?

Is it CD repricing?

Do you feel like you have a lot of room in terms of other deposit areas for repricing?

I guess we have, obviously, alluded to various derivatives positions but sort of in aggregate, are your derivatives going to help you there?

Or just give us sort of an impression of why you can, you know, sort of absorb the asset yield pressure and feel like you can offset it and sustain the margin.

Yeah.

I'd be glad to, Ed.

It is a combination of some of the layered derivatives that we've put on the hedge against falling rates.

If rates fall, we are going to do better and better in terms of the cash flows from those derivatives.

We also have been looking at the competitive market and how aggressive we could be, given a 50 basis point decline in interest rates in basically all of our deposit products.

And we're looking at an interest checking that's anywhere from 25 to 50 basis points today in our various markets, and it varies from state to state and market to market, that we could drop to 10 to 25 basis points, proposed rate.

Savings are running us 60 to 75 basis points, and we think we could drop them all to 50 basis points, pick up 10 to 25 basis points cushion there.

Our money rate savings, which is fairly large, about $3 billion in balances, we're sitting -- in all of our markets at 75 basis points.

We would be looking to take that down to 65 basis points.

You can kind of go through all of our rates.

We have had a 13-month CD special at 2.25 to 2.50 percent.

We bring that down to 2.

So as you can see, we would just go across the board and begin to skinny down rates.

Quite candidly, rates are so low, I don't know if the consumer cares a whole lot about 25 basis points when you are only getting 50 to begin with.

So, you know, part of it is the action we would take to stay in step from a liability and a deposit standpoint, lowering those rates somewhat in concert with declines that we would see in earning assets.

Do you see a lot of CDs that are older CDs that are maturing and repricing lower?

Is there a lot of that coming in the next couple of quarters?

I don't know if I would say a lot.

It isn't like when rates were dropping so rapidly earlier in the year and late in 2001.

We have seen month-to-month drop of 3, 4, 5 basis points in our average CD cost as higher-rate CDs mature and are replaced with lower-rate CDs or move into other type of an account.

So, yeah, we're continuing to see CD costs drift down periodically as I was discussing -- if you look at even the third quarter to third quarter, interest bearing deposits down 162 basis points, where earning assets have only fallen 121.

So you get some prop-up from the securities portfolio, some of your other earning assets, loans are not falling as fast as interest bearing deposits.

And then we also have a good chunk of our funding coming from the federal home loan bank.

In short and long-term debt issues.

And that's falling fairly rapidly as those turn over.

So again, it's being, if you look at it in the aggregate, it's being somewhat balanced from an asset liability prospective, and it should, kind of, fall in tandem.

And one other thing, when we thought rates were going up this summer, which wasn't that long ago, everybody thought rates were going up.

We, along with the market, got more aggressive in CD pricing, both in terms of our, quote, stated rates and our willingness to allow exceptions, i.e., higher prices, to get CDs, because we all thought rates were going up.

We backed away from that now and, not just in our stated rates, but in the percentage of our CDs that we allow to go over our stated rates is falling pretty significantly because we just don't need the money.

And I think that is actually, as a percentage at low rates, is a pretty big number, i.e. whether you allow 50 percent or 25 percent or 10 percent of your CDs to be above your stated rates has a big effect on your actual cost of CD funding.

Okay.

This still sounds like a pretty good chunk of your protection is coming from various hedged positions that you have in place with derivatives.

Would that be true?

Yeah.

I think it's, you know, significant.

It wouldn't be anywhere near, you know a majority of the position.

But I think it's significant.

It's grown -- we've used -- we have wanted to use derivatives to help cushion ourselves from potential falling rates more than adding more securities because the spreads are better in the derivatives and, you add on securities, the balance sheet grows, and prevents us from buying back stock, and yet still keeping our leverage ratio at 7 percent.

We would rather have a combination of derivatives and stock buy-backs, because that's much better from an EPS standpoint than adding marginal securities that don't have much spread in them.

Okay.

Thanks.

And could you just quickly indicate the valuation -- I know, you did this.

I just missed the numbers of your mortgage servicing portfolio and what that is as a ratio of mortgage servicing?

The assets net on our books for 280.8 million, and that's 1.2 percent of the amount of servicing we do for others, which is 23.5 billion.

Okay.

Thank you.

Yes, sir.

Your next question comes from the line of Bob Patton with UBS Warburg.

Good morning, guys.

Good morning, Bob.

Could you just touch base on a little color on the inflows and outflows to NPAs and charge-offs, and answer, was there any impact to the exam?

And then second question is, just a little update on what the M&A for psychology is right now in terms of pricing from the small banks that had risen to, sort o,f unpalatable levels and you guys have come out with a couple of deals, what's going on right now in the environment?

In terms of the composition of the non-performers, we -- we're not seeing any particular industry that's dramatically changing, and our increases are kind of across the spectrum.

Probably the one area that's doing better would be real estate lending, probably is running a lower level of non-performers.

We did have one credit that was on the share national credit risk, the company that we actually have a local relationship, but we do, we just- participation is -- that was a coal company and it was about $18 million that went on nonperforming status.

So that was a consideration in the rise of non-performers.

The good news, we are not seeing a lot of new problems, you know, companies that are going on to our watch list or actually diminishing.

But what we're also not seeing is a lot of our problems get well.

There was a point there in the early part of the year through most of the second quarter where we saw a lot of people getting better, and particularly in the manufacturing side, that kind of flipped around pretty suddenly and companies that were getting better started getting worse, and so you are having people that were already in the problem category that might have gotten well, not getting well.

And that's more the kind of issue we have seen.

But... we're not -- again, looking at our watch list, which is a big future indicator, we're not seeing any dramatic numbers there.

And we are just seeing a little slow creep to worse, instead of a little slow creep to better is what's happening to us.

In terms of mergers and acquisitions, the numbers have gotten interesting on some of the deals.

Our two deals, you may note, were very low book multiples which we -- our models are driven by earnings multiples but when you can acquire a company at a low book multiple, our experience has been a lot of times there is an opportunity to quickly improve performance in those cases.

We can see pretty dramatic improvements in performance and that's what we hope to happen.

We're using the same models we have been using for 15 years.

Using the same criteria on the internal rate of return, what it does to earnings per share, et cetera, that we have used for a long period of time.

The two particular acquisitions we did met the criteria.

There are several other deals that other people announced that we were way away, in terms of the prices that some people paid.

That probably will continue to happen.

I don't know why some of the acquisitions, frankly, have been done at the prices they have been done, particularly when you get a combination of very high earnings and very high book multiple, because the odds of improving somebody that's got a high earnings and a higher book multiple, to me, is very small.

Sometimes when you have higher earnings multiples below book multiples there is a big improvement potential there.

I don't know if people are just doing small strategic deals or why some of the pricing has been what it has been.

We're not seeing a huge increase in the interest that people potentially are selling, but I would say it's probably picked up some.

I think some of the community banks (indiscernible) their stock prices and they are having some performance problems.

The falling rate is starting to squeeze them.

Some of them are having a few more credit problems.

So we're seeing a little more interest than we saw, say, 90 days ago in people interested in talking about mergers and acquisitions.

John, just an update.

What size of a deal is too big for BB&T to do?

Well, we've defined 10 billion as kind of our maximum criteria.

We might do an $11 billion deal, but we aren't -- certainly aren't looking at, or considering, anything in the $20 billion category, for example.

Most of our effort and energy, frankly, is focused on companies in the 500 million to $3, $4 billion range.

There is a handful of companies in the $10 billion range that would be great fits for us, for a variety of reasons, that we're talking to, but we're not talking to anybody that's bigger than that.

Now, obviously, mergers and acquisitions are opportunistic.

Something could change.

Something could really stand out.

But we, basically, have done small acquisitions for a long period of time and we don't like the risk in bigger deals.

Okay.

And just one last quick one.

In terms of charge-offs and NPAs, are you seeing any differentiation between the small business customers who are still trolling along, and more problems in the larger upper-middle market, or are you seeing the smaller-middle market and smaller business continuing to perform?

Are you seeing any differentiation there?

We're having some increase in our small business portfolio.

It's like the larger businesses started first and the smaller businesses are having more problems now.

I would say our loss ratios in our small business portfolio are higher than we normally have, still a lot better than the industry, but higher than we normally have, and have increased quicker than the large -- we're not -- you know, we don't do many large business, but the middle market kind of companies do hardly any large business, but the middle market companies deteriorated earlier and we're certainly not seeing, in terms of problems, the increases in the middle market that we were seeing at one point.

But there are more increases in the small business area.

Okay.

Thanks, John.

Yes, sir.

Your next question comes from the line of Jefferson Harrelson with KBW.

Good morning.

Hey, Jefferson.

My question revolves around the mortgage company.

You talked about the huge backlog in originations that you have there.

Should we expect another mortgage MSR writedown if rates are unchanged?

Should we expect that loan growth goes negative next quarter as the loans held for sale shrinks?

Also, it's like you had a huge mortgage fee income quarter ex the MSR writedowns.

Do you expect another 75 million-ish there?

And if I can just follow up with the -- on the question of the unrealized derivative gains, do you expect some of that the 9.5 billion to make its way into earnings, or is this just going to kind of gyrate back and forth on the unrealized category?

Let me try to answer the mortgage and I'll let Scott answer the derivative.

On the mortgage side, if rates were to remain in the current category, we might have a small additional writedown.

If rates were to go down any further we would have some additional -- we would have some additional writedown.

We try to clean it up at the end of the quarter.

That's why we took such a large writedown.

But there's been some reduction in long-term rates as of a few days ago, since the end of the quarter, and you could get another $20 million in writedown.

I think all that's pretty subject to rates bouncing around.

In terms of the warehouse, we will have another great production month and great non-mortgage servicing right revenues in the fourth quarter.

How much that carries over into next year depends on how low rates stay and -- we'll still have some inventory in process, because we are still getting huge amount of applications into our mortgage business.

So it will certainly carry over into the first quarter of next year.

We will have gains in the warehouse because rates have -- we would have gains today in the warehouse if rates stay down.

And because those hedges were put on at higher rates and as rates have moved down, we've got gains in that.

That washes through as part of your mortgage banking revenues.

Now, the flip side of mortgage servicing rights, we now have over a $200 million reserve.

And if rates were to go up next year, for example, we could recapture up to $200 million of that reserve and in which case we would blow by the EPS numbers that we have out there.

So it wouldn't take a lot of rise in long term rates for us to get a real windfall in terms of mortgage servicing rights, which we, would then, be offset in the revenues we have lost on the bond portfolio we have had to liquidate in order to cover the losses of the mortgage servicing portfolio.

As I mentioned earlier, in my opinion, our mortgage servicing rights are grossly undervalued.

The whole system is backwards.

FASB got it backwards.

They tend to be very highly when rates are high, and very lowly when rates are low, and the truth is, the mortgages that we are putting out today, are probably the most valuable servicing rights we have ever had, because the probability of being refinanced is much less, since we're at a 40-something year low in mortgage interest rates.

But the accounting system is kind of backwards.

And the way you get to account for it bring it back into revenues if rates start rising.

Would you take securities losses as rates are rising?

Not necessarily because we've already taken the losses.

And we've already lost the revenue from those securities.

You know, uhm, we -- we're going to have $45 million less -- this has to do in revenue this year, because of the losses we took in our security portfolio to offset the mortgage servicing rights.

So, no, I don't think we would want to take losses to offset the rises that would'nt -- I don't think that would make any sense because we've already taken them.

We've already taken the losses.

Just a follow-on to that, John, you are right, the gains we have taken so far this year have hurt cash flow earnings net interest income by about 45 million.

Next year, our numbers say it's about 90 million dollars for a full year of impact that's already in all of our numbers and all of our projections.

But as you take gains, you lose future cash flows.

So we've already taken a $90 million hit next year.

So if we get to recapture part of this impairment reserve, again, we've really kind of offset it by lower cash flows.

Do you want to answer the derivatives question?

Yes.

Jefferson, these derivatives, of course, we're receiving cash flows continually, and we buy these things at a spread.

And we're protecting ourselves from flat to down rates.

If rates stay where they are or go lower, we will have an enhanced spread in these derivatives.

And they're flowing into cash received every month.

So it is finding its way into the income statement.

And they are designed to help us in this low rate environment and move us more to a neutral position.

Given that our typical asset liability mix, at this point, was positioned for rising rates, beyond balance sheet mix.

Obviously, if rates start to rise, they are going to have to go up from most of our derivatives much more than 125 to 50 basis points before we start to break even and lose money on the derivatives.

We'll either unwind the derivatives at those points if we, you know, forecast rising interest rates, or we'll hang on to them and we'll be paying net to the third party holders of the derivatives.

But we'll be doing so well in the rest of our portfolio, and that would be a climate of economic recovery and health.

We ought to see loan growth pick up and all of our prime rate and LIBOR priced loans will start to produce more yield.

So again, that's part of the asset liability management process that we go through and derivatives now that we're buying our design to help us on the down side and, yes, they do contribute, and if rates fall they will contribute more to our bottom line.

Thanks very much.

Thank you.

Your next question comes from the line of David West with Davenport & Company.

Good morning.

Hey, David.

This is a little bit of, I guess, a change of pace here, something that I think will kind of face corporate America but I'm curious as you enter your planning for 2003, what are your thoughts regarding changes -- possible changes regarding pension assumptions?

Ha, that's a goodie. [ Laughter ] We're going to pay a lot more in pension expense.

We ran, kind of, the numbers based on what we're seeing -- what's happened to our investments basically.

We've gone from big gains to big losses, obviously, in the investment part of our pension fund.

And our pension expense is probably going up about $30 million next year?

Yeah, that's about right.

It's going to be about 27 million this year and somewhere in the 50s next year.

We're not exactly certain.

But 50 to 57 million next year.

Okay.

Very good.

And that's all in our projections based on our assumptions on salary increases and returns and the like.

Discount rate.

Fortunately, we've used relatively conservative assumptions, so our total pension costs remains very favorable.

It's only like, even at the raised level, it's only like 5.7 percent or 5.5 percent, or something of salary.

So... even though we got a dollar increase we would rather not have, our costs is not a huge number for us.

Thanks very much.

Yes, sir.

Your next question comes from the line of Nancy Segton (phonetic) with [indiscernible] Capital.

Hi.

I was wondering if you could tell us what your policy is on auto loans, repossessed autos, when do they go into nonperforming assets and when do you charge them off?

Auto loans.

I don't know if I know that off the top of my head.

There have been two banks that have said that they're changing their accounting, uhm, one was SunTrust, which, uhm, previously had not included repossessed autos as part of nonperforming assets and --

We --

Go ahead.

We do include repossessed auto as part of non-performers, so they are included as non performers and we write them off relatively early.

In fact, they changed the rules for that a year or two ago.

And we were ahead of the rules.

So we're -- I can't remember how many, you know, however long you're supposed to do and all that under the rules.

But we're on the very conservative side.

We put them in non-performers and we charge them off relatively early and we don't have any plans to change our policies.

I don't literally remember what they are, though.

Okay.

So you put them in nonperforming assets at the time they are repossessed?

Yes.

Yes.

Yes.

Okay.

Great.

That's all I needed to know.

Mm-hm.

Thank you.

Thank you.

We have reached allotted time for the questions.

Mr. Nicholson, do you have any closing remarks?

Yes, I do, Amy.

I want to thank everyone who has participated in our call today and thank you for the questions that you have raised.

If any of you need clarification on any of the information presented during this call, I invite to you call BB&T's Investor Relations department.

Have a good day.

Thank you for participating in today's BB&T conference call.

You may now disconnect.

Thank you.