美國合眾銀行 (USB) 2008 Q2 法說會逐字稿

Welcome to U.S.

Bancorp second quarter 2008 earnings conference call.

Following a review of the results by Richard Davis, Chairman, President and Chief Executive Officer, and Andy Cecere, U.S.

Bancorp's Vice Chairman and Chief Financial Officer, there will be a formal question-and-answer session.

(OPERATOR INSTRUCTIONS) This call will be recorded and available for replay beginning today at approximately 400 Eastern time, through Tuesday, July 22, at 12:00 midnight Eastern time.

I will now turn the conference call over to Judy Murphy, Director of Investor Relations for U.S.

Bancorp.

Thank you, and good afternoon, to everyone on the call today.

Richard Davis, Andy Cecere and Bill Parker are here with me to review U.S.

Bancorp second quarter results and to answer your questions.

If you have not received a copy of our earnings release and supplemental analyst schedules, they are available on our website at USbank.com.

I would like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty.

Factors that could materially change our current forward-looking assumptions are detailed in our press release and in our Form 10-K report on file with the SEC.

I will now turn the call over to Richard.

Thank you, Judy and good afternoon, everyone and thank you for joining us this afternoon.

Andy and I would like to start the call today with a short review of our second quarter results.

After we have completed our formal remarks, we'll open the line to questions from the audience.

Our Company recorded net income of $950 million for the second quarter of 2008.

Reported earnings per diluted common share of $0.53 were $0.12 lower than the earnings better diluted common share in the same period of 2007 and $0.09 than the same period in prior quarters.

While the Company had very positive operating growth in operating income, reported decline in earnings from a year ago and the prior quarter was, simply put, the result of an increase in credit costs and the impact of a few significant items recognized in the first quarter of 2008.

In our view, this quarter's results reflected our Company's core strengths and building momentum.

The results demonstrated to us and we hope to all of you that our diversified business mix, our approach to risk management, our strong balance sheet, and our strong capital position have prepared this Company for the challenges of the current economic environment.

Further, we're very satisfied that our current investments in the revenue goals for the Company are on track and now beginning to show results.

Let me review a few highlights.

The second quarter results included two significant items which combined, reduced earnings per diluted common share by $0.11.

They included a $66 million impairment of certain structured investment securities, and a $200 million incremental provision for credit losses.

We achieved a return on average assets of 1.58% and a return on average common equity of 17.9% in the second quarter.

Both returns, although lower than prior quarters, remain well above the median returns for our peer group.

Our second quarter net interest margin of 3.61% was higher than the first quarter of 2008 by 6 basis points and 17 basis points higher than the same quarter of last year.

The improvement in our margin, in addition to the quarter's strong growth in average earning assets, resulted in an increase in net interest income of 15.6% year-over-year, and 4.3% unannualized on a linked quarter basis.

The growth in net interest income was a significant driver in the positive variance in second quarter core revenue growth and operating earnings.

This growth takes on more significance, however, when you look at the past.

The last full year our Company enjoyed an increase in net interest income was 2003.

This directional change provides significant momentum for revenue growth going forward.

Our fee-based businesses also continue to show excellent growth year-over-year with payment related categories, mortgage banking revenue, commercial products revenue and treasury management fees posting the strongest results.

Trust and investment management fees grew, but at a lower rate, as positive growth in transactions and new customers were partially offset by the impact of adverse equity market conditions.

Consistent with past years, linked quarter non interest income growth was seasonally very strong for the majority of our fee categories.

Significant items in both the current and prior quarters, however, somewhat masked the linked quarter trend for the total non interest income.

On an unannualized basis, payment related fees increased by 9.8%.

Treasury management increased by 10.5%.

Deposit service charges by 8.2% and both trust and investment management fees and commercial product revenue grow at 4.5%.

All of these categories represent ongoing revenue streams that will continue to benefit us in the future as we are challenged by a stressed economy and the credit issues that have ensued.

The growth in total revenue, net interest income plus fees, was 7.5% year-over-year.

Maybe more importantly, revenue growth excluding the net impact of asset valuation losses was more than 9% year-over-year.

This is significantly higher than our Company's experience in the past number of years, again providing a solid and growing revenue base to offset some of the increasing costs associated with the current economic cycle.

Non interest expense in the current quarter was $165 million higher than the second quarter of last year and $39 million higher than the previous quarter.

A large portion of the increase in expense year-over-year can be attributed to continued investment in both our fee-based businesses, and the banking franchise.

In addition, the other expense category has grown as a result of the higher credit related costs for other real estate owned and loan collection activities, in addition to fraud losses and investments in tax advantaged projects.

On a linked quarter basis, certain categories, such as legal and professional, were seasonally higher and business expansion and the timing of merit increases were responsible for higher compensation costs.

Credit related costs for other real estate and loan workout also contributed to linked quarter increase.

Our efficiency ratio as reported for the second quarter of 2008 was 47.5%.

Comparable to the 47.3% efficiency ratio in the second quarter of 2007.

The more favorable 43.5% efficiency ratio recorded in the first quarter of 2008 reflected several significant items, the largest impact of which came from the Visa IPO gain.

We continue to be one of the most efficient financial institutions in the industry.

We have always operated with a disciplined approach to expense control and our ability to maintain our efficiency is particularly important in this environment.

As a low cost provider we can and we will remain a very competitive player in the markets that we serve.

Turning to the balance sheet, total average loans grew by 12% year-over-year, led by solid growth in all the major categories.

On linked quarter basis, total average loans increased by $7.8 billion or 5% on an unannualized basis.

A portion of the increase, both year-over-year and quarter-over-quarter, was due to the reclassification of a number of federally insured student loans from loans held for sale to the portfolio.

As well as the purchase of a student loan portfolio.

In addition, growth specifically in commercial real estate was impacted by the acquisition of the Mellon First Business Bank.

On average, these items added $3.3 billion to average loan outstanding for the second quarter.

Extracting these items, our core average loan growth was 9.7% year-over-year and 2.9% unannualized on a linked quarter basis.

We continue to find that our Company is benefiting from uncertainty and the volatility in the financial markets.

As customers seek stability in their financial service provider, as well as they find the other providers are pulling back from the market.

Our bank is a benefactor of the flight to quality aspect of this challenging economic environment.

We have a strong capital structure.

And we are in the position to lend and to provide our customers with the high quality banking products and services.

That said, be assured that we will continue to concentrate on originating only high quality credits.

We can, and we will, compete for the best customers nationwide.

We also saw very favorable deposit trends this quarter.

Average total deposits increased by 14.1% over the same quarter of last year and 3.8% unannualized over the prior quarter.

This deposit growth was in part driven by higher broker/dealer, government and institutional trust balances, the acquisition of Mellon First Business Bank, as well as the Company's ability to attract low cost, wholesale funding in this volatile market.

In addition, the growth in deposits reflected our continued focus on our revenue initiatives, particularly in the corporate banking business line.

Extracting Mellon First Business Bank, average deposit growth was 13.5% year-over-year and 3.2% on a linked quarter basis.

Finally, and moving on to credit, as expected, credit costs were higher again this quarter.

Net chargeoffs were 98 basis points for the second quarter of 2008, above the 76 basis points of average loans in the first quarter of 2008.

The increase in net chargeoffs was the result of continued stress in the residential home and mortgage related industries, declining home prices in most geographic regions and the impact of the worsening economy on our commercial and consumer customers.

Within the consumer loan portfolio, credit card loan net chargeoffs accounted for the majority of the linked quarter and year-over-year increase.

The credit card chargeoff ratio of 4.84% this quarter, although still below the industry average, was higher than our Company has seen in the past five years and is indicative of the economic stress facing many consumers.

Note that there is some seasonality in credit card net chargeoffs.

Consequently, we expect the rate of increases in credit card net chargeoffs to moderate somewhat in the third quarter.

Given the high quality of this prime portfolio, we still expect that our credit card net chargeoff ratio will continue to be lower than the industry average.

As we indicated at a recent investor conference, the net chargeoff ratio on real estate related loans, including consumer first and second liens was expected to increase this quarter to approximately 1% of average loans outstanding.

First, residential mortgages were slightly lower than predicted with a net chargeoff ratio of 91 basis points.

While the net chargeoff ratio on home equity and second mortgages, reached 1.13% for this quarter.

Combined the net chargeoff ratio on the first and second mortgages this quarter was 1.01%.

The majority of the increase in both first and second mortgages can be attributed to loans originated through our consumer finance division, as our branch originated portfolio continues to perform very well.

A worsening economy, falling home prices and rising gas prices have more recently heightened concerns in the industry about auto loans and leases.

As many of you know, we offer auto loans through our branch network in addition to originating loans and leases through dealers across the country in our indirect auto business.

Our auto loan portfolio, which totaled $9.5 billion at June 30, is a very high quality portfolio.

And we've been in this business uninterrupted since 1953.

The net chargeoff ratio in the second quarter on that portfolio was 72 basis points.

And slightly lower than the 79 basis points we recorded in the first quarter of this year.

The portfolio is currently performing well.

And at June 30, our retail auto lease portfolio totaled $5.4 billion.

Again, this is a high quality portfolio.

The net chargeoff ratio was 58 basis points in the second quarter, compared with a net chargeoff ratio of 49 basis points in the first quarter of this year.

As many of you have heard me say in the past, we can generally see credit trends 90 days out but not much beyond.

And as we look 90 days ahead, taking into account the higher level of delinquencies in residential real estate and other consumer portfolios, taking into account the declining home values and other collateral, accounting for the continued stress in the home building and related industries, adding the impact of higher gas and commodity prices on consumers and businesses, and finally the general stress in the economy.

As a result, we do expect net chargeoffs to increase in the third quarter.

At a rate somewhat comparable or lower to the amount that we experienced between the first and second quarters of this year.

Given that expectation, the net chargeoff ratio will rise above 1% in the third quarter.

Also, as expected, non-performing assets climbed higher this quarter.

At June 30, total non-performing assets were $1.135 billion or 34.3% higher than at March 31.

Although the majority of the increase was driven by residential real estate, home building and related industries, the economic slowdown and rising commodity prices have had an impact on some of our commercial customers.

Given these conditions, we anticipate that our non performing assets will continue to rise.

As a result of the upward trends in both net chargeoffs and non-performing assets in addition to the economic concerns already mentioned, our second quarter results included an incremental provision for credit losses of $200 million.

With this addition to the allowance for credit losses, management believes that the Company's allowance was adequate at June 30, with the ratio of alowances to period end loans at 1.60% compared to 1.54% at March 31.

And the ratio of allowance to non-performing loans of 273%.

Going forward, we will of course continue to assess the adequacy of our reserves for loan losses and provide for credit losses to reflect portfolio and economic conditions.

I will now turn the call over to Andy who will make a few more comments about the quarter.

Thanks, Richard.

I would like to begin with a quick summary of the significant items that have impacted the comparison of our second quarter results to prior periods.

First, during the second quarter, an impairment charge of $66 million was recognized on the structured investment securities purchased in the fourth quarter of 2007 from an affiliate and as these assets are now part of our Company's investment portfolio, the impairment charge was recorded as a securities loss.

The impairment charge was driven this quarter by wider market spreads for these types of securities, caused by the continuing decline in houses prices and an increase in foreclosure activity.

During the first quarter of 2008, the Company booked $253 million in impairment charge on the same portfolio of structured investment securities.

The provision for credit losses recorded this quarter was $200 million in excess of net chargeoffs.

The first quarter of 2008 also included an incremental provision for credit losses of a similar amount, $192 million.

As you probably recall, the first quarter of 2008 also included several additional significant items that impacted the comparison of linked quarter results.

The other income line in the first quarter included a $492 million gain related to the Visa initial public offering and a $62 million reduction in revenue related to the adoption of a new accounting standard.

Total expense in the first quarter included a $25 million contribution to U.S.

Bancorp Foundation, and a $22 million accrual for certain litigation.

These significant items reduced our first quarter diluted earnings per common share by $0.02, while the impairment charge and incremental provision taken in the current quarter reduced diluted earnings per common share by $0.11.

Net interest income in the second quarter was higher on a year-over-year and linked quarter basis due to both strong earning asset growth and an expanded margin.

The improvement in margin on both a year-over-year and linked quarter basis was a result of growth in higher spread assets and the benefit of being liability sensitive in a declining rate environment.

We continue to benefit as well from our Company's ability to secure favorable short-term funding rates in this volatile market.

Our margin of 3.61% was slightly higher than we anticipated a few months ago, primarily because of our success in funding the balance sheet at favorable rates.

Going forward, assuming the current rate environment and yield curve, we expect to maintain a fairly stable net interest margin with a slight bias to the down side for the third quarter.

This assumption is based on steady to slightly improving credit spreads, continuing growth in higher spread products including credit card and other retail loans and a normalization of funding and liquidity in the overnight markets.

As a follow-on to our earlier discussion on the credit quality of our retail auto lease portfolio, I wanted to spend a moment on the lease residual values and the impact they have on non-interest income.

Particularly now that there's a growing concern surrounding the current value of used cars.

Although the incidents of loss has been fairly on track, and predictable over the past number of quarters, the severity of loss has grown.

As you may know, these residual losses result in charges to other non-interest income.

In fact, non-interest income decreased year-over-year by $42 million, as net gains in the second quarter of 2007 transition to net losses in the second quarter of this year.

We continue to carefully manage the residual risk on this portfolio by maintaining conservative upfront residual valuations, originating leases with longer lease terms and managing concentrations within the portfolio by type, make and model of car.

Recognizing impairment when necessary and finally, carrying catastrophic residual loss insurance to limit our overall loss exposure.

Given the current market for used cars, we continue to expect adverse market pressure on auto lease residual values but feel that they will be very manageable for our Company.

Our capital position remains strong.

Our Tier 1 and total capital ratios were 8.5% and 12.5% respectively at June 30, both right on target levels.

Although we have capacity in the current authorization to buy back additional shares, we do not anticipate to repurchase shares between now and the end of the year.

In summary, we are pleased with our second quarter operating results.

The Company posted solid loan and deposit growth on both a year-over-year and linked quarter basis, strong growth in net interest income of 15.6% year-over-year and 4.3% unannualized over the prior quarter.

Excluding significant items discussed, total revenue growth of over 9% year-over-year.

A manageable increase in credit costs and finally, we ended the quarter as we began, with a strong capital base and liquidity position.

Before turning the call back to Richard I want to take a moment to update you on the Company's investment in perpetual preferred stock issued by Fannie Mae and Freddie Mac.

The investment is held in the available for sale securities portfolio with a book value of $97 million.

At June 30, the value of this investment was $79 million.

As we do for all of our investments, the Company will continue to monitor the performance of the entities to determine if any impairment is necessary at a future date.

I will now turn the call back to Richard.

Thanks, Andy.

Before we take questions, I would like to spend a moment talking about a few business line highlights for the quarter.

First, the second quarter marked the end of the bidding process for the government's GSA smart pay two program.

U.S.

Bank through its corporate payments business line is one of four card issuers qualified to contract to the government agencies to provide travel, purchasing, fleet and integrated payment products as well as other payment management technologies.

The results are in and U.S.

Bank increased its share of the GSA transaction volume from 37% under SmartPay 1 to 48% under SmartPay 2.

This is great news for our Company and adds to the momentum already present while increasing the overall market share for this unique corporate payment business line.

Another highlight comes from our institutional trust and custody and corporate trust groups.

Over the past few months both have been enjoying the benefit of a flight to quality as new customers, specifically site U.S.

Bank's superior credit quality and service levels as they leave their current provider and bring their business to us.

Finally, and for the third year in a row, U.S.

Bank was ranked number one in the nation in the 2008 Privacy Trust study for retail banking conducted by the Ponemon Institute.

Customer privacy is a very important priority for our Company and we are proud to be recognized with this level of recognition once again.

In conclusion, during this call we have described the economic environment in which we are all operating as challenging and stressful.

I would add that it is also easy too describe it as unprecedented and even historic.

We are a bank.

Accordingly we are and will be affected by the challenges confronting the financial service industry today.

As such, we will continue to carefully manage the risks, but the more important message we want to deliver to our investors, our customers and our employees is that we remain focused on the opportunity to grow our business, to deepen our customer relationship and to acquire new customers.

As you have heard me say before, we are open for business.

And very mindful of the fact that this environment, although stressful, has presented our Company with a window of opportunity to solidify and grow our position in the markets we serve.

We are prepared to manage this Company through the cycle.

Our prudent approach to risk management has not changed.

Our business model is intact and we are in the position to utilize this Company's strong capital generation to invest in growth opportunities as well as in our community and in our employees.

We will rely on our earnings capacity to sustain our dividends and maintain our well capitalized position, all the while focusing on our responsibility to produce consistent, predictable, repeated results for our shareholders.

That concludes our formal remarks.

Andy, Bill, and I will now be happy to answer any questions from the audience.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Todd Hagerman with Credit Suisse.

Hi, Todd.

Good afternoon, everybody.

Richard, I guess just following those comments and talking about your outlook, particularly describing it as such in terms of challenging and stressful, how would you -- I mean, in terms of the business, you talked earlier in the year about the new revenue opportunities and the build-out as opposed to kind of rationalizing the business.

Kind of given the outlook and the updated credit outlook, how are you thinking about the business now kind of going forward, kind of given the change, particularly as it relates to credit?

Well, Todd, thanks for the question.

I think if one of the parts of that question is if we're going to change any of our current plans for the investments in the Company.

I'm not.

The current credit environment, while as I said, challenging and stressful and all those other things, is certainly diminishing our bottom line impact.

If you look above the line, before losses and before loan loss provision adds, the core Company is operating at levels as good as it has in the past two years, and in fact better in some cases.

Part of that is because we continue to stay on offense and stick to the basic business of banking and not been worried about any of the issues that have been focusing some of our peers.

But we've also been investing in these initiatives, many of which ask we have mentioned over the prior quarters and those are really coming through.

It would be, in a normal environment I would spend this whole conference call telling you about Power Bank and talking about wealth management and talking about corporate trust and payments and I would get into those details and I'm happy to do that at any time.

But given that the byline right now is credit quality, liquidity, and protection of the dividend, I don't want to lose the sight that this Company is still kind of working in the old fashioned scenario where losses are higher but we're operating just like we did a couple years ago on trying to grow the future of the Company through these revenue initiatives and 54,000 employees in the Company, 52,000 spend every day working on moving forward while maybe 2,000 of us worry about making sure that we're protecting where we got to this point in the cycle.

I'm actually quite optimistic about the benefits and you'll see them come through when the loan loss provision add stops and when loan losses start to moderate.

I think you'll see some really quality revenue benefits coming from this Company that you haven't seen in a generation past.

I appreciate that.

Then just secondarily, in terms of the payment business, again, very resilient in the quarter and again, given your outlook.

Can you give us a little better feel in terms of the pricing versus volume in the quarter and again, what the outlook would be there.

Again, as you talked about rising energy prices and the like, it seems like the payments business continues to deliver.

How are you thinking about that business in the second half?

And again, how would you think about or how should we think about it in terms of volume versus kind of the pricing changes that may have come through?

Good point.

I'm going to tell you that it has a slight negative bias to it at the bottom line because volume is probably going to come down a little bit more in the payment businesses than the margin will go up.

Simply because of the consumer recession that I think we're in.

And I do believe we're in one.

But having said that, you're going to find average ticket prices are higher, our volume will still moderate in some cases where people still need to buy the more necessity based items on their debit cards or credit cards.

The corporate space is primarily government or business related and those businesses are still spending it pretty much unfettered from the current environment.

So I think you'll see that we don't have much different second half than we had first half.

The thing that I might add, though, that I'm not sure to understand the impacts, is the financial stimulus.

I happen to be a believer that the stimulus actually did show itself in this economy but it didn't show itself at the bank as much as it showed itself at the gas pump or at the cash register.

And having said all that, I think that perhaps a more negative view of the stimulus checks is that they were perfectly timed.

They came in the last 90 days when people needed them the most to get through their daily living activities.

Now in a short month, they'll be gone.

Whether that translates to people needing to spend more on their debit or credit card, whether that creates additional stress in consumers ability to repay their debt, I think that's a question mark we're going to watch for the next 60 to 90 days.

So I think there's a slight negative bias toward that outcome as well because quarter three and quarter four don't have any of those benefits in them that will undoubtedly affect us somehow.

Your next question will be from the line of Matt O'Connor with UBS.

Hey, Matt.

You guys have a decent amount of exposure to the consumer auto loans as well as the auto leases that you addressed earlier.

Can you just give us more color on what are the loss rates right now?

Where do you think they go in the second half of the year,which if I recall correctly tend to be seasonally higher?

And I think you might have some insurance and residuals, if you care to remind us of that as well?

We do.

We're prepared for that because we know that's an area of concern for the market.

Bill, why don't you start with the performance and Andy, why don't you end with the insurance.

Again, we have about $5.5 billion of leasing portfolio.

We've been in that business for a long time.

It's an all prime portfolio, that ended the quarter at about a 58 basis point loss rate.

The balance of it is about $9.5 billion of loans, that's originated both indirect and through our branches.

The loss rates on that is about 74 basis points.

The first half of the year, if you add those two together, you had about $15 billion, first half of the year we had $25 million combined, $25 million of loss first quarter and $25 million of loss second quarter.

And as you mentioned, latter half of the year there will be a seasonal uptick.

There also is the issue of severity on some of the SUVs and trucks that are obviously -- when we go to auction with those, they're at a higher loss rate.

Right now we're in the 70s on this portfolio, all prime portfolio.

We don't expect a material deterioration.

Andy, you want to talk about the--?

Yes.

Matt, on the leasing side of the equation, we have about a $5.4 billion lease portfolio and about a $3.4 billion lease residual book.

We are experiencing is a normal rate of incidents but a higher loss per incidence and that loss is principally focused on the SUV category which represents around 41% of our total book, not unlike the total U.S.

SUV population.

We do expect this to continue but certainly manageable within the overall income statement.

We do have catastrophic insurance.

The catastrophic insurance has not come into play yet because some of the positives are offsetting some of the negatives and it's sort of a net insurance number.

But if things get very, very bad we will have insurance for that but to date that has not taken place.

So Matt, and this is for everybody, we talk about seeing 90 days out and we see that in terms of incidents of loss.

What's harder to predict is the amount per loss as cars come off lease and go to auction or we find other ways to dispose of them.

So that's why there's a bit of an uncertainty, even within the 90 day window.

If you had 25 million and $25 million per quarter of the combined portfolio, it's undoubtedly going to move up, but not material enough to really -- I wouldn't probably rank it in the worry spot of things that we're concerned about.

It's a prime portfolio and it's performing quite well.

The incidents of loss is very predictable.

The amount per car coming off lease is already substantially higher than it has in the past and I don't think it has a lot more to go.

The loss rates that we saw this quarter, my guess is will be among the lower of a lot of your peers as they come out with results.

Do you thing the big difference is simply that you are all prime while some had some other stuff in there or is there another thing that we should be focusing on here in terms of why the quality is a little bit better?

I think we've been very prudent in our underwriting.

I do think it's a better quality portfolio in terms of the lease side.

We have extended residuals, that's not something we do, we have extended lease terms.

I think overall the book is very conservative from an underwriting standpoint.

I think that's it.

Okay.

Just separately, your net interest margin ticked up a few bips this quarter and you're expecting it to be stable to down for the rest of the year.

Just a little more color on what's driving that?

You bet.

We are liability sensitive.

Rates have come down.

That's helped us a bit, Matt.

We expect it to be relatively stable, down just a little bit if anything, but relatively stable.

We are benefiting from the flight to quality that Richard talked about.

We are able to grow our loans at very good spreads.

We're able to gather deposits because of the flight to quality and we're able to gather wholesale funding in a favorable rate right now.

All those things are contributing to our net interest margin at 360 or so and I think we'll see that going forward.

I would agree with that.

We are not -- rest assured, everybody.

We are not growing our loans at twice the amount we did a year ago because we're reaching down on the quality spectrum.

This is absolutely what flight to quality looks like.

We are getting prime customers at higher levels at better spreads and better margins and we're being very selective.

As I said on the last call, our precious capital at first goes to our very best customers the next goes to everybody else's very best customers and there's none left over.

So we're really quite at damage right now.

Now that the flight to quality got stronger or continued that margin continues to be closer to where it is now with much less slight negative bias.

We just want to be realistic in case that were to stop.

Thank you.

Thanks, Matt.

Your next question will be from the line of Nancy Bush with NAB Research LLC.

Good afternoon, guys.

Hi, Nancy.

Just a question, if I may ask about sort of the trajectory of credit quality deterioration.

Is it continuing to accelerate?

Was it accelerating at the end of the quarter and any intrepid prediction or guess about when things start to level out?

Intrepid is a great word, by the way.

Write that down.

The best way to position it is back in the middle of May we saw that we would be in the mid-90s in our chargeoffs and here we came in at 98 basis points which I struggle with because I wanted to be exactly at the mid-90s.

The fact is that didn't change a lot since the last 60 days.

We're getting better at learning how to predict these outcomes and read the slopes of the curves.

But it's definitely continuing to get worse.

I mean, the world doesn't get better.

So the best way for me to portray it to you guys is non-performing assets and net chargeoffs.

If you look at the slope of the curve that we just experienced between data points quarter two and quarter one the slope going forward from quarter three as it compares to quarter two will be up but at a lesser slope and I know it sounds a little odd to say that way but it's not a straight line.

I'm actually -- we're seeing it starting to temper down a bit, our confidence in our ability to project is getting higher.

So on one hand, I don't want you guys to run out there and model a 1.5 basis point, 150 basis point net chargeoff.

Because that would be far in excess of anything we see.

But I also don't want you to model 1.00 because we're going to grow more than 0.02.

So for us -- you are going to find -- you can model that as you wish.

If you look at the slope in both categories from quarter two to quarter one it's going to be a decreasing slope for the next quarter so we're starting to feel a little bit more sanguine about it.

That's my word back for Intrepid.

My other question would be just about deposit pricing.

We've seen one sort of major national player, although I think you don't compete with them so much, who's out there with a 4.25% 12 month CD and I'm wondering if you're seeing sort of similar things, particularly in your Midwestern markets, how deposit pricing is sort of shaping up?

Yes, Nancy, this is Andy.

What we are seeing, I'm going to do retail and wholesale sort of separately.

On the wholesale side of the equation what we are seeing is a flight to quality, I think given our rating, our strong capital position and our balance sheet, we are seeing depositors on the wholesale, treasury management side, treasurers, municipalities and the like, going to us and that has certainly contributed to the growth in deposits we see in the second quarter.

On the retail side of the equation we are being a bit more aggressive in certain markets, both on the savings accounts, checking accounts, and certainly on the CD accounts are starting to experience growth.

We are not in certain markets at levels that some of our competitors are at that are well above us because of reasons they need to be.

We're not at that level but we're able to grow at levels that are still profitable to us and make sense, both deposits and core accounts.

And Andy, do you also have the impact, the downward impact on the net interest margin that the increase in non-performers had?

Yes, we do.

Do you know how much that was?

The amount for the second quarter was not a significant amount, Nancy.

Great.

Thanks very much.

Thanks, Nancy.

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

Richard, question with respect to M&A.

In the current environment, it looks like there could be a number of banks attempting to raise capital by selling non-core businesses, various types of fee businesses, what have you.

Importantly, a number of those businesses might require somewhat of a material purchase price but don't -- wouldn't use particularly a lot of capital.

What would be your appetite in the current environment to be a buyer of various types of fee businesses?

I would say the appetite is pretty high, actually because of what you just said.

First of all, it's a buyer's market in this case so we're going to be very deliberate in our reviews, our due diligence and we'll be opportunistic.

There's also a lot of value in keeping your powder dry at a time like this and protecting our capital.

You mentioned, and I'm going to pick up on your first comment that one of the reasons we're going to be very careful about traditional M&A activity is it because if it requires us to raise capital in a market like this, why would we put ourselves in that position when we worked so very hard to not be one of the companies that Easter egg capital.

On a wholesale base is, we're not going to be very interested in those kinds of transactions but where opportunity presents itself and where a seller has a need to get a fast cash, all cash or strong deal where they can get a fast decision, we are completely mobilized and ready to take advantage of that and I will seek those opportunities because market share moves at times like this to those who have the benefit and it doesn't show up just in organic growth, it shows up in sometimes opportunities to buy pieces and parts and we'll be available to do that.

As a follow-up on that, are there -- could you sort of maybe give us some sense of what of your fee businesses you're most interested in potentially growing in that fashion, asset management or what have you?

And then a little sense of what amount of quote, unquote, dry powder you feel like you might have in terms of, you know, excess room in some of your capital ratios?

I'll go first and Andy, you can pick up.

The business lines we like the most continue to be payment businesses.

We like corporate payments a lot because there's a continued high cost of entry to those who aren't in it.

There's a lot of non-bank and monolines that are starting to stress and need new forms of capital or just need a new partner.

So we're finding an attraction in corporate payments You may recall that we buy dozens of small bank credit card portfolios throughout the year.

Heretofore based on our ability to do the business for them and turn key business in many cases private label but now we're starting to see more banks think their credit card portfolio is something that they might sell away in order to raise some capital and there's an organics opportunity there.

Based on our prime only credit card portfolio, we continue to find that to be an attractive space.

Then finally, I would always be attracted to any small traditional branch activities or small bank activities where they make sense but we haven't seen a bank or a branch activity for sale that didn't have a lot of commercial real estate or high paying deposits around it that causes us to just step away and continue to look and walk to the other direction.

So in that case, we are attracted by the same things that you'll see in our last five-year history.

As regards to dry powder, I'll let Andy be technical but we are -- we did mention and noted that we've indicated no stock buyback for the rest of the year.

And we had our Board meeting today in fact and one of the questions was how do you guys think the market will react to that.

I said in the old days they would probably be negative about that, especially when the price is so unbelievably low.

Did I mention unbelievably low.

But at the same point, I do think that if we don't say that, then you might have reason to worry that we're not going to protect the dividend and U.S.

Bank is going to protect the dividend.

We understand how important that is.

And having said that, the dry powder comes between the difference of being able to protect the dividend, not needing to raise capital and being able to take advantage of some of these smaller deals that come along and let's just say there's plenty of room for all those to take place, but we're very careful and prudent not to put ourselves into a corner that we can't back out of.

Just following on that, what we see is our biggest -- our largest benefit is our tremendous internal capital generation.

We are able to take on Mellon First Business Bank and still achieve our 8.5 ratio here in quarter two.

And as we think about the future, the fact that we're protecting the dividend, don't anticipate raising capital is because of that internal capital generation.

As we look forward, that will really be what enables us to continue to be able to do small deals when the opportunity arises.

Thank you very much.

Thanks, Ed.

Your next question will be from the line of Viivek Juneja with JPMorgan.

Hi, Vivek.

Couple of questions.

On commercial leases, your losses are rising.

Can you talk a little bit about what's driving that?

Yes, we have a large small ticket lease portfolio, the biggest asset class in interest there is actually copiers, so these are leases that range anywhere from hundreds of dollars to a few thousands of dollars.

It's heavy in the small business area.

There has been some disruption to that where we had exposure into the mom and pop mortgage broker industry, so we have worked through that exposure on the small business side.

The balance of the portfolio is performing very well.

And then there's also the sort of large ticket leasing company that we have that's performing like a C&I portfolio and has had very low losses right now.

Okay.

So does that $6.4 billion commercial leasing, what percentage would you say is the small business piece?

About half of it.

Okay.

And can you talk a little bit about national corporate lending, that was up a lot this quarter, linked quarter, any color on what you're adding in that area since?

There we've seen very good demand as people have been unable to access the capital markets.

I would say that in the last nine months we've probably added the highest credit quality that we've seen over the last couple of years into that portfolio.

So there is that flight to quality.

The initiative there is investment grade credits that have good opportunity for building deeper relationships, whether it's in our corporate payments area, or emerging processing area or trust area.

Those are the type of clients that we focus on.

This is Richard.

You'll recall that probably a year ago on this call we talked about the corporate banking initiative where we opened our New York office and started bringing over a number of talented people from banks across the country.

This is part of that.

What comes along is the corporate payments and the treasury management activities that I highlighted as two of our strongest growth categories for the quarter.

When I say some of our initiatives that weren't present a year or two ago are starting to bear fruit are those kinds of things.

It shows up, perhaps in loan growth, but it also has a bit of it that accrue in other places.

And your merchant processing volume growth slowed to only about 6.5% year on year.

Any color on why it slowed that much, given that you've been running at double-digit for the last -- for a long time?

Vivek, Andy.

What we're seeing on the merchant portfolio is a combination of two things.

We're still seeing good, strong internal customer growth.

With same store sales essentially flat on a year over year basis.

So the same store sale slowing is offsetting the growth in customers.

So transaction volume?

Right.

Okay.

And then lastly, reserve commitments were down quite a bit linked quarter, given that you're seeing such good loan growth, any color on what's driving that down?

Part of it is just we are seeing higher utilizations out of most of our markets.

So that's in part what drove that down.

Okay.

Thanks.

Thanks, Vivek.

Your next question will be from the line of (inaudible).

Hi, Corey.

Hi, Richard.

Hey, question for you.

We were watching aggregated industry servicing data, looking at sub 30 day delinquencies in the residential mortgage portfolios by vintage.

And we're seeing peeking in those sub 30 day delinquencies.

We're also seeing the later vintages, the '06s and '07s dropping below the '05s and '04s, so a faster than normal seasoning of that book.

Can you comment on if you're seeing the same things in your residential mortgages?

We're not.

I could elaborate.

We're not.

Our mortgage portfolio is for the most part either prime based or it's near prime and the origination speeds at which we put them on the books from '04, '05, '06, '07 didn't change much.

We weren't growing a lot.

We weren't shrinking.

We weren't acquiring or adding any kind of volume.

You would find it to be a little different than some of the vintages you would look at that were either in the securitized market or the public space.

For us, Corey, consider it very predictable, very traditional and acting the old fashioned way, just a little bit at a higher level.

Great.

Thank you.

Your next question will be from the line of Betsy Graseck with Morgan Stanley.

I just had a question on the reserve allowance, you know, for just the reserves against regular loans.

How are you thinking about the historical -- I know there's several different inputs into that analysis.

Has the way you're looking at the historical analysis across the asset classes changed at all?

No, not really.

We have not changed our methodology.

What we always look at, though, what's driving it right now is the outlook on the retail side, specifically on the mortgage side where the decline in home values.

So we've had to factor that in on our outlook and that's been the major cause for the increase in this last quarter.

Okay.

And so -- I'm sorry, go ahead.

I was just saying, you should know, we build it from the bottom up every time.

In other words, we don't just take a iteration from the prior week, the prior month, the prior quarter.

We look at each loan category.

We look at the geography.

We look at the loan type.

We build it back up so that it's a calculated number that we confirm every time we launch it as opposed to a number that we just iterate based on changes.

As you might guess, it's got to be one of the most provocative and competent analytics that we have in the Company both for ourselves and for our regulators and it's an area that I would say we definitely perfected in the last probably 12 months.

How are you thinking bouts that collateral value of the house?

Is it point in time or do you have a forward look that's embedded in your analysis?

We have a forward look.

Right now it's showing probably about an additional 5% decline in values between now and the end of the year and that's on top of the roughly 15% that many markets have already experienced.

That relates to the mix of markets we have.

The five would be across the average.

We do run sensitivity analysis at higher levels and look at that as well.

Do you ever think about hedging the book at all?

I mean, there's obviously some indices out there now like the RPX that do provide potential for hedging the risk that you have.

Betsy, I think the cost of that and the basis risk on that would be offsetting the benefit of doing it.

So we do not plan on doing that.

Okay.

And then lastly, on the restructured loans that you highlighted in asset quality, could you just speak to what the composition of those are and if it's changed at all, Q on Q.

Obviously there was a significant uptick this quarter.

Yes, I mean the composition is roughly -- there's about half of it that is residential mortgages and that's the area where, I think we talked about that at the end of the year where we were offering programs, which we're continuing to offer, where we take adjustable rate mortgages and either freeze the rate, prior to a reset, or we'll cap their rate and in either case, those loans remain performing.

These are paying customers.

But we have to report them as restructured.

And in some cases we also have to calculate an additional reserve on those which is part of the overall allowance.

Then there's another piece, quarter-over-quarter, which was we did add about 100 million in restructuring on commercial real estate and there's a case where we have developers that we're continuing to work with.

They're current.

They have made all their payments but we've locked their rate at a rate that the accountants would say is less than the current market rate for a new loan.

So in the particular case, this was a rate that was actually prime.

I'd like to highlight that.

This is Richard.

This is another point in time where a Company's reputation gets permanently affected and there are a number of customers both in the consumer and the commercial space where a number of banks have just gone in and pulled the plug, pulled out the rug and said I don't have my capital, I don't have an interest, I'm not sticking with you.

We do have an advantage of not having to be one of those companies, and we're either protecting our current customers and believe me, they bank with a lot of other banks so they know the difference and we're attractive to a lot of other customers that over the cycle will give us their business and stay with us for another generation.

Because you forever remember who stuck with you in a rainy day and who didn't.

We're having the advantage right now of having to walk away with no one.

We're actually extending ourselves to more customers I think than our peers are to try to make it work.

By the way, for you all, as investors, that's a very smart move on our part.

Because I would rather keep the deal alive and keep people in their homes or in their property than to have a foreclosure or have a loss.

Finally, it builds and accrues very strong reputational benefits in the coming years.

So how do you see loans curing out of this category?

Well, either they continue to pay, a vast majority of them continue to pay.

Some of them refinance.

We've seen about a 50% refinance rate on our adjustable rate mortgages.

So it's either one of those two things.

They either--.

Right.

Or they fail.

Or they fail.

And they were going to fail anyway but we did our very best to keep that from happening but best efforts are proving right now that the failure rate is substantially lower than it would have been without having taken that interim step.

Thanks.

Your next question will be from the line of Jon Arfstrom with RBC Capital Markets.

Hey, Jon.

Hey, good afternoon.

Question for you on reserves.

In your prepared comments you said that after the incremental $200 million provision, you felt your reserve was adequate at June 30th.

I guess the question is does that include your outlook for higher non-performers and net chargeoffs?

What I'm getting at is the $200 million part of the near term provision run rate or do you feel like it's adequate based on what you see out the next 90 days.

This is Richard.

That's a good question.

That now is the art versus the science.

We feel it's very adequate right now as of June 30.

Not being able to see much further into the future, I have no reason to speculate whether or not it's going to be in the run rate.

But I will tell you that given the environment we're in and expecting chargeoffs to move up, I would expect us to be in lock step with that.

In other words, I want to start this cycle as one of the best balance sheets, most fortress protected balance sheets in banking and I intend that we will end this cycle in the same way.

So that interpretation means that if we continue to see the stress in the marketplace, we're going to meet it on a dollar for dollar chargeoff and we're going to reserve for the future to make sure that we don't corrupt what is otherwise a very very high quality Company, based on your reputation as a Company that's got a very high strong balance sheet.

So Jon, I think we're adequate now.

And that's as far as I should project because it actually would be imprudent for me to project.

But given the rule around here is we're going to start it and end it as one of the most strongly capitalized and reserved banks in the country.

You can count on that transaction to repeat itself as the loans continue to stress.

I noticed that the incremental provision runs through the treasury piece of your business.

Did they get allocated out to the balance sheet somewhere?

Or are they considered unallocated?

In the income statement, the business line results are reflective of chargeoffs, Jon, and then the excess goes in the treasury group.

When we allocate our reserve, that's allocated loan by loan, category by category.

One other -- two other questions here.

The construction and development loan balances were up about 1%.

I realize that's perhaps the slowest growing of your categories and up about 4% year-over-year.

I'm curious why you're growing that business and what kind of opportunities if any you're seeing in that business?

Well, we do have good opportunities.

I mean, we're fundamentally a relationship lender in the commercial real estate space.

So again, with the -- there's a number of transactions out there that we do and look at and fill, retail malls or multi-family projects.

We're active in that space.

These are with clients that we've been doing business with for years and years.

If you look at our residential construction book, that is declining and that's the area that we're experiencing the stress.

And then the last question, can you -- Bill, as long as you're front and center, can you talk a bit about the commercial non-performing increase and what category you saw that in and tell us more about the health?

On the commercial piece, that was really two areas.

One was building suppliers, in other words, in this case, some lumber yards.

And the other category was of all things, ag related.

There are certain feed -- the feed costs with corn at $7 a bushel, just did not work for certain of our clients.

Thank you.

Your next question will be from the line of (inaudible).

Thanks for taking my question.

I wanted to circle back to the dividend again.

I appreciate your comments on wanting to protect the dividend.

Can I take that to mean that you're committed to extending the Company's record of 36 years of annual dividend increases this year?

First off, it's a Board decision.

They have to make that decision.

But based on the current performance of the Company and based on the bias of myself, the management committee and the Board, yes, that is our intent.

Okay, great.

Now, I would have told you that U.S.

Bank's stock could never have dropped 9% yesterday either.

So how that happened I have no idea and why it didn't bounce back, I have no idea.

But given the fact that the fundamental core operating Company is as sound as it's been in the last decade, absent the overhang of credit, which I know is the real deal but it's not sustainable at this point I feel very comfortable, John, that the dividend is something you will see -- no bank will protect it harder and hang onto it more than this one.

Is there an upper limit that you guys have in mind in terms of the payout ratio?

We have not defined an upper limit, John.

What we really look at is the earnings, our projections, credit costs and our overall capital ratio in addition to the growth in the balance sheet.

Those are all factors we take into consideration when we make our recommendation to the Board in December.

As you know, there's really three components.

There's what you retain for yourself, it's what you put in stock buybacks and what you put in the dividend.

By taking the stock buybacks out of the picture for the rest of the year, that was code to let you guys know that we took one variable away.

Given that I expect we we'll continue to have plenty of retained earnings and core capital generation, that's why we're continuing to build the story around the logic of why we think we can be so assured that the dividend is safe.

Thank you.

Next question will be from the line of (inaudible).

Hi.

Hi, guys.

Just a quick question.

On the restructured loans you mentioned that some of it comes back.

Other banks have told us that they've seen increase, sort of people getting back into trouble, if you could talk about that on the residential side?

And then also you guys have a very diverse book in different markets, but just wondering if you could give us a heat map of any markets that you are more or less concerned about?

Sure.

I'll go with the last part first.

For us, this really began in the Michigan and Ohio region and that's still an extremely stressed area for us.

Then you look to California, Nevada, Arizona, very stressed markets, especially as you move out from the major metropolitan areas.

Also Florida, we don't have a lot of exposure in Florida but that's obviously an extremely stressed market.

With regard to the residential mortgages, when we do those we focus on customers that are current, so I mean, we have other programs for those that aren't current but a majority of the programs that we have are focused on those that have successfully made their payments for the past two to three years.

We contact them well in advance of any kind of payment change and offer them where they can keep the payment at the same level and none of these are negative amortizing or anything like that.

These are amortizing loans.

And with that, I mean, we have a substantial reduction in the types of loans that would go delinquent.

So our 90 days on that portfolio is a very small number.

It's 10s of millions of dollars on almost $0.5 billion of restructured residential mortgages.

Thanks.

We have time for one more question before we sign off.

Operator?

Your last question will be from the line of [Greg Gunther] with [Garden State Securities].

Hi, Greg.

Good afternoon, Richard, Andy, Bill.

I think Ed Najarian's question touched on this a bit earlier but given the fact that your second quarter results had higher than expected non-performing assets which are forecasted to climb higher moving forward, your strong stance on protecting the dividend and reluctance to put yourself in a position to raise capital at this point, you did mention your willingness to invest in growth opportunities.

So that being said, could you give me a little better feel for the current mentality of management with regard to the prospects of shopping for potentially accretive acquisition over the next quarter or two?

Yes, it's Richard.

Greg, everything you said by the way, nice summary.

We are not shopping.

But we're listening and we're open to anybody's overtures where they come to us and say we have a special deal, especially a non auction deal, a private deal where somebody wants a quick decision and looks like a really good deal.

We'll look at all of those.

So if you look at that -- remember, we made $950 million this quarter.

I mean, we're making a lot of money.

We're retaining a lot of capital and earning a lot of retained earnings.

So it's that combination of things that allows us to say that we're open to look for opportunities.

But searching, no.

Not going out, being an aggressor.

No reason to mess with what's really gotten us to this point which is really good, prudent and steady banking.

So we're just going to be opportunistic and I'll bet a lot of the deals that come by might be great but we still may pass on because they either are too rich or we don't see enough upside.

What I don't want to do and the message I want to leave is I don't want to introduce any risk into the Company that we would at this point in the cycle.

We've worked very hard to keep it as risk-free as possible and introducing someone else's problem is not good for our shareholders and sometimes catch a falling knife, catch a falling paring knife, they cut either way.

And we're just not going to put ourselves in that position.

Thanks, Richard.

Yes.

So Judy, before we close, I want to first of all thank you for your continued interest in our Company.

I do want to say that Andy, Bill and I have -- we want to be well regarded by you as being transparent, clear, logical, and I really want you to feel a sense of confidence from us.

We're not actors, we're bankers, so this is what we are.

But I am very, very comfortable with how this Company is managing through this difficult environment.

I am very, very confident about our ability to be on the other side of this as a stronger Company.

And I'm unabashed about telling you that while all of this is going on, we're continuing to invest in the core operating infrastructure of this Company and we are moving forward on every single direction that we can to build a stronger Company because this is a cycle, we'll come out of it.

I want to come out of it stronger and I want you to know us as not only the great defensive stock that you've known us for a long time but a great offensive stock because of what we can do in the future.

So I'm quite robust about this environment.

I'm discouraged that we continue to be brought down with the contagion of the industry.

I understand it but I'm frustrated by it.

I appreciate the fact that you know we're not immune but we are doing quite well and if you look at the numbers and you look at really what's core and occurring and operating income and results, I don't think in the seven years that any aspect has been together I don't remember a quarter I've been more proud of.

Over the course of time that will sell itself in the story.

I want you to know how confident we are and how much we want to be known by you as transparent and clear and open.

If there's anything you don't have or you don't have a good answer for, call me, call Andy, call Bill or call Judy because we want to make sure you have all the answers you need.

In my mind, the better you understand us, the better you'll like us and that's important to me.

Judy.

Thank you for listening to our review of the second quarter results.

If you do have any questions, feel free to call me directly at 612-303-0783.

And thank you, operator.

Thanks, everybody.

This concludes today's conference call.

Thank you for participating.

You may now disconnect.