美國合眾銀行 (USB) 2003 Q3 法說會逐字稿

Welcome to the U.S.

Bancorp's third quarter 2003 earnings conference call.

Following a review of the results by Jerry Grundhofer, Chairman, President and Chief Executive Officer, and David Moffett, 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 10 AM Eastern time through Tuesday, October 28, at Midnight Eastern time.

I will now turn the conference call over to Matt McCullough, Senior Vice President of Investor Relations.

Go ahead, please.

Thank you operator, and thanks to everyone for joining our call this morning.

If you have not yet received a copy of our earnings release and supplemental analyst schedules, they are available under the financial and news release section of our website at www.usbank.com.

Jerry Grundhofer, our CEO, will make some opening comments before handing the call off to David Moffett, our CFO, to provide more details about the quarter.

Michael Doyle, our Chief Credit Officer, is also here with us today.

You will notice that our earnings press release has been re-designed to eliminate discussion of non-GAAP financial measures, including operating earnings and per-share information that exclude the impact of merger and restructuring related items.

However, we will continue to talk about operating earnings on this and future conference calls because operating measures of profitability provide more transparent financial information about the Company and highlight important trends in the Company's core financial results.

Before we begin, I'd like to remind you that any forward-looking statements made during today's conference call are subject to risks and uncertainty.

Factors that could materially changed our current forward-looking assumptions are detailed in our press release.

I will now turn the conference over to Jerry.

Good morning.

Thanks for joining us today to discuss our third quarter results.

We continued to make very good progress in the quarter against a number of objectives and commitments, while producing industry-leading financial results.

We reported record operating earnings of $991.6 million, or 51 cents per diluted share, matching First Call consensus estimates.

This represents an 8.5 percent increase in the third quarter of 2002.

GAAP earnings as well per diluted share were also 51 cents, a 13.3 percent increase from the third quarter of 2002.

Third quarter financial ratios on an operating basis continue to lead the industry with 2.07 percent return on assets, a 20.7 percent return on equity and a 41.5 percent tangible efficiency ratio.

During the quarter, as interest rates increased we had a repairment of our mortgage servicing rights.

Therefore, we wrote our mortgage servicing rights up by $109 million based on increases in those rates of interest.

We booked this repairment as a reduction in intangible amortization expense and offset the benefit with a corresponding $109 million of investment portfolios security losses.

This is the exact opposite of what you saw in previous quarters, as we experienced reductions in the interest rate environment, resulting in write-downs of our mortgage servicing rights, which we offset with securities gains.

We continue to believe that the use of our investment securities portfolio as an economic hedge against our mortgage servicing assets is much more transparent that hard to value derivative strategies used by many.

Looking more closely at third quarter results, the strength of our business model becomes apparent.

We're committed to the creation of operating leverage, which means that we grow revenues faster than expense.

Compared to the second quarter of 2003, revenue, excluding the impact of security gains and losses, increased 1.8 percent, or 7.1 percent annually.

Non-interest expense, excluding the impact of mortgage servicing rights, impairment and repairment, increased 0.4 percent, or 1.8 percent annualized.

This results in tremendous operating leverage.

Add to this the additional leverage from an improving credit picture and after-tax operating income increased 3.2 percent, or 12.8 percent annualized.

This is the strength of our business model.

In a very challenging environment for high-quality, sustainable revenue growth we can make revenue growth of 5 to 7 percent turn into double-digit earnings growth through this disciplined cost control.

Let me also mention that the revenue increase in the third quarter was broad-based, with all business units participating in that growth.

Wholesale banking grew revenues 1.9 percent, or an annualized 7.6 percent, driven by strong growth in cash management fees and deposits.

Loan demand is still weak, though.

But there are signs among our commercial customers that they're feeling better about the direction and sustainability of economic activity.

Consumer banking saw revenue increase 2.9 percent, or 11.6 percent annualized, as total loans were an annualized 10.1 percent and low cost core deposits grew an annualized 12.2 percent.

Net new checking accounts increased by approximately 65,000 in the quarter, a 32 percent increase over the third quarter of 2002.

Private client, trust and asset management registered an increase of 2.4 percent, or 9.6 percent annualized, driven by strong deposit growth in institutional trust and corporate trust.

In addition, trust and investment management fees grew at a near 20 percent annualized rate in asset management, institutional trust, corporate trust and funds services.

Trust and investment management fees in the private client group registered a decline in the quarter due to annual fees recorded in the second quarter for tax preparation rules (ph).

Payment services grew revenue by 1.5 percent, or 6 percent annualized, which is normal growth for this business unit based on historic quarterly revenue trends.

Corporate payment product fees revenues grew an annualized 21.1 percent, while merger processing fee revenue grew an annualized 12.7 percent.

One area that I'd like to highlight is the broad-based increase in transaction volumes in the third quarter.

Retail card dollar transaction volume grew at an annualized 18.6 percent rate.

Debit card dollar transaction volume grew at an annualized 20.2 percent.

Broker payments dollar transaction volume grew at an annualized 21 percent rate.

And the number of merchant processing transactions grew at an annualized 32 percent rate.

Now let me briefly mention our progress in the quarter against certain objectives that we discussed in the past, as well as commitments that we made to you, our shareholders.

First, our multi-year focus on reducing the risk profile of this organization is starting to have a meaningful impact on our financial results.

Net charge-offs for the third quarter were 1.02 percent of average loans, a reduction of 8 basis points from the second quarter and the lowest level since the fourth quarter of 2001.

Non-performing assets declined 3 percent from the second quarter and are at their lowest level since the second quarter of 2002.

Both net charge-offs and non-performing assets are expected to continue to trend lower.

Second, our tangible common equity to assets ratio ended the quarter at 6.4 percent, comfortably above our target of 6.25 percent.

This not only resulted in positive debt rating changes by the rating agencies as we fulfilled our commitments, but it now gives us added balance sheet flexibility and the opportunity to resume our stock buyback program.

Third, with the substantial completion of all integration efforts related to NOVA and other smaller acquisitions in the third quarter, 100 percent of our net income is available to support organic growth, pay dividends and fund share buybacks.

Our top priority as it relates to capital management will be to return approximately 80 percent of our annual earnings to shareholders through dividends and share buybacks.

Finally, we're going to continue to make investments and enhance our organic revenue growth.

Our in-store expansion partnership with Safeway is a perfect example of this type of investment.

The Safeway opportunity is low cost, low risk, increases distribution in very high growth markets and further leverages our successful consumer banking model.

Of the 163 new full-service in-store branches that we are opening over the next two years, 33 will be open by the end of 2003, with an additional 38 opening by the end of the first quarter of 2004.

This is the type of investment that we have always made and will continue to make to drive organic revenue growth.

In closing, let me make two additional points.

First, we're continuing to emphasize the importance of service quality throughout the franchise and we are seeing the benefit of that in terms of net new account growth and account retention.

Service is our brand and we continue to make progress to improve the quality of service that we provide to our customers.

Second, I believe we are now in a position to deliver on the tremendous potential that our franchise holds.

Credit trends are improving, capital levels exceed all targets; revenue is growing faster than expense and we are the industry leader in the generation of capital.

Our objectives going forward remain unchanged -- grow revenues faster than expense; continue to improve the risk profile of this organization; provide industry-leading service to our customers; and maximize returns to our shareholders.

And we're going to do that through efficient use and return of capital, and remain disciplined in achieving our stated financial goals.

Now let me turn it over to David to give you more details on this quarter.

Thanks, Jerry.

As Jerry mentioned earlier, third quarter operating earnings were a record $991.6 million, or 51 cents per share on a diluted basis, meeting First Call consensus estimates.

On a link quarter basis, all business units displayed improving trends in most (indiscernible) revenue growth, expense control and credit quality.

Let me briefly give you the highlights.

Keep in mind that the percentage (technical difficulty) for changes in revenue expense, transaction volumes, loans, deposits and earnings are not annualized.

Wholesale banking recorded operating earnings of $316.1 million in the second quarter, or a 6.4 percent increase over the second quarter of 2003.

Revenue increased 1.9 percent, driven by strong deposit growth, despite a change in the federal government's payment methodology for treasury management services for compensating balances to fees.

And a 19.4 percent increase in cash management fees, again driven by the federal government's change in payment methodology.

Non-interest expense declined 9.3 percent due to reductions in litigation and write-down on lease residuals and net charge-offs to clients from 0.98 percent of average loans to 0.89 percent of average loans.

Commercial loans continued to decline on a linked-quarter basis.

As a reminder, we brought our commercial loan conduit back on balance sheet this quarter, adding 2.2 billion to the average balance sheet.

Adjusting for the conduit, average commercial loans, including commercial real estate, declined 1.6 billion from the second quarter.

Some of the reduction was our own doing, as we continue to exit certain asset classes and relationships that do not meet our return objectives, and some of the reduction was due to better customer liquidity.

As Jerry mentioned, our customers do seem to be feeling better about the economy, and in general we're seeing improvement in the fundamentals of their businesses.

Second quarter operating earnings in consumer banking increased 4.7 percent from the second quarter of 2003 to $446.4 million.

Total revenue, excluding securities gains and losses, increased 2.9 percent, as average retail loans and residential mortgage loans increased 3.5 percent and low-cost deposits increased 3.1 percent, with non-interest-bearing increasing 4 percent.

Looking at the fee income side of consumer banking for a second, deposit service charges increased 4.4 percent, driven by account growth and better account retention.

Mortgage banking revenue was flat.

Excluding impact of MSR impairment and repairment, non-interest expense increased 0.9 percent due to higher personnel expense.

Net charge-offs have improved from 0.75 percent in the second quarter to 0.73 percent in the third quarter of 2003.

Private client, trust and asset management recorded operating earnings of $131.9 million in the third quarter, a 2.6 percent increase over the second quarter of 2003.

Revenue grew 2.4 percent, due to strong deposit growth in institutional trust and corporate trust.

Fee income was flat, but excluding trust and investment management fees in the private client group it declined in the quarter due to annual fees recorded in the second quarter for tax preparation services, fee income increased 5.4 percent.

In addition, equity assets under management increased 2.3 billion, or 5.5 percent, from the second quarter.

Expense control was outstanding, with virtually no increase in non-interest expense from the second quarter.

Third quarter operating earnings in payment services increased 5.4 percent from the second quarter of 2003 to $192 million.

Revenue increased 1.5 percent due to a 5.3 percent increase in corporate payment product revenue and a 3.2 percent increase in merchant processing service revenue.

Illustrating the leverage that we have in this business, non-interest expense was flat.

Net charge-offs declined 3.8 percent of average loans in the third quarter and 4.25 percent in the second quarter, driven by improvements in retail credit card net charge-offs.

As Jerry mentioned earlier, transaction volumes in this business improved across the board.

Other items I'd like to note during the third quarter include the fact that net interest margin decreased 9 basis points from the second quarter of 2003 to 4.41 percent.

Approximately 4 basis points of the decline was due to the consolidation of our high quality, low margin commercial loan conduit during the third quarter, and the impact of the change in the federal government's methodology for treasury management services.

The remainder of the decline was due to higher balances of low yielding investment securities and a reduction in the value of net free funds due to lower average long-term rates.

The Company expects the net interest margin to remain relatively unchanged in the fourth quarter of 2003.

Retail loan growth, including residential mortgages, remains strong.

It increased an annualized 13 percent from the second quarter.

Including the impact of the reduction due to the change in the federal government's payment methodology for treasury management services, third quarter average non-interest-bearing deposits increase an annualized 8.5 percent from the second quarter, with consumer non-interest-bearing increasing an annualized 15.9 percent.

Savings now in money market accounts also displayed outstanding growth in the quarter, increasing an annualized 43.1 percent from the second quarter.

Non-performing assets declined $41 million, or 3 percent, during the quarter to 1.3 billion at September 30, 2003, or 110 basis points percent of loan, and OREO.

As Jerry mentioned earlier, we're expecting non-performing assets to continue to trend lower.

Net charge-offs fell on a linked-quarter basis to $310 million, as the dollar amount of retail net charge-offs declined for the fifth consecutive quarter, despite higher retail loan balances.

Total commercial net charge-offs including C&I commercial leasing and commercial real estate, also fell on a lined-quarter basis.

Total loan delinquency trends continue to improve.

And again, as Jerry mentioned earlier we expect net charge-offs to trend lower.

Our asset coverage ratios remain strong.

The allowance for credit losses to non-performing loans was 2.02 percent at September 30th.

The allowance for credit losses to carried-in loans at September 30th was 1.98 percent.

Our capital ratios remain strong as well.

We're comfortably above the minimum regulatory targets for G well (ph) capitalized data with a Tier 1 capital ratio of 8.8 percent and total capital ratio of 13.3 percent.

Tangible common ratio ended the quarter at 6.4 percent, comfortably above our 6.25 percent target.

The Company booked approximately $10 million of pre-tax merger restructuring expense in the quarter, most of it relating to the completion of the integration of NOVA.

In closing, let me say that we were very pleased with third quarter results.

Revenue met our expectations, matching historical trends despite the weak economy, credit quality is trending in the right direction and cost control remains strong.

As 2003 progresses we remain focused on certain objectives -- first, we will continue to focus on organic growth and the creation of operating leverage; second, we will continue to enhance our already high levels of customer service; and finally, we will remain disciplined in our desire to reduce volatility and in improving the risk profile of the organization.

This concludes our prepared comments; we will now take questions from institutional investors and analysts.

John McDonald, UBS.

I was wondering if you'd could comment on the target for the normalized charge-off rate.

You talked over time about getting towards an 85 basis point charge-off ratio.

Wondering if that's still the target, and any sense in how long it might take to get there.

Thank you for the question.

Yes, that 85 basis points is that target and we're making progress on it.

But we really don't have a time frame.

And in the context of the Safeway stores, could you give us a sense of the probability of your in-store operations and how that compares to the probability of your full-service branches?

It's a much smaller part, but it is a growing profitability.

I just don't have that right off hand.

They're smaller, they get to probability faster.

But over the long-term -- over the 10 to 15 year period -- a brick and mortar branch has historically been more profitable because it just seems to have more capacity.

Historically, if you look at the in-store branches, it's about a quarter of the expense of a full-service branch and usually it takes about two years to break even.

Traditionally that revenue growth is driven by the deposit growth, which creates balances, and therefore revenue.

And then it is followed on by generally loan growth.

But it takes about two years to get to the profitability on a break even basis.

And then after that they continually improve their profitability.

Thanks.

Jason Goldberg, Lehman Brothers.

Good morning.

Jerry, both you and Dave mentioned that you expect both NPs and net charge-offs to trend lower in the coming quarters.

I guess maybe give us more color in terms of what drives your confidence in making that prediction.

We believe we have a very good handle on what is out there.

And we're confident that the actions that we have taken over the last 2.5 years in understanding what our portfolio is made of and where it's going, we feel confident that those trends will continue lower.

And we look at that radar screen and we feel fine with that.

Michael Doyle is here.

Mike, do you want to comment on that?

What we kind of did in looking forwards is look at trends in the portfolio overall.

And what we're seeing right now is a slowing of migration on the commercial side of the portfolio, a slowing in migration from the pass or watch buckets into the more severe criticize classified bucket.

Based on that, then you can extrapolate out what type of migration you would expect into non-performings and charge-offs.

Based on the trends that we're seeing right now, we're definitely seeing continued improvement.

When you couple that with delinquencies -- what's going on with the delinquency buckets, as David commented to earlier -- the overall picture is very positive.

So that's the reason for Jerry and David's outlook going forward.

That's helpful.

An unrelated question, I guess give us more color surrounding your appetite for share repurchase.

You have a fairly substantial authorization, which I believe expires by year-end.

Should we expect a new one?

And given you're over the 6.25 capital ratio target currently, are you currently in the market?

The answer to the latter is yes.

We've been repurchasing or buying shares back since the beginning of October.

I am nodding to David, and asking him, and he says, "yes, we are."

I think October the 3rd or 4th.

And as far as authorization, we do have an authorization that will be coming.

I believe it expires in December.

And the plan would be to talk with the Board -- and it is obviously up to them -- but to re-authorize that when it comes due before the December timeframe.

But we're committed to returning in the form of, as I have said, the form of dividends and/or repurchase.

That target is 80 percent of the capital that we do generate.

Great.

Thank you.

Tom MacCandless, Deutsche Banc.

Good morning.

I wanted to ask two questions related to your balance sheet.

One, could you talk a little bit more about the drop in the average commercial loans, if you strip out the commercial loan conduit?

The second question is, I don't want to misconstrue the numbers as I see them -- and maybe you touched on this earlier and I missed this -- but U.S.

Bancorp appears a little bit unique in not growing or seeing any net growth in its home equity and second mortgages, and maybe flushing of the strategy there.

And third, would you talk a little bit more about your investment portfolio restructuring?

What kind of securities and yields were sold?

And what did you buy in duration rate sensitivity kind of questions to boot?

That's a lot, but that's it for me.

Let me start with the investment portfolio.

During the quarter, as you know, we sold $3.1 billion of primarily fixed-rate MBS securities with around a four-year duration.

That created a $109 million loss on the sale of those securities.

We essentially re-invested back in a very similar duration security.

And we picked up primarily about 120 basis points in the yield on the bond portfolio.

Our strategy is to continue to remain between three to five-year duration, and that's what we've consistently done.

On the commercial -- on the loan side, let me talk about that for a second.

As we have told you, our commercial loan conduit came back on balance sheet during the quarter, which had an impact of about $2.2 billion on the average balances.

If you strip that out for a second, the overall commercial component was down on a linked-quarter basis about 1 billion 9, or about 4.4 percent.

The commercial real estate side was actually up 308 million, or about 1.1 percent; retail was up 371 million, or about 1 percent; and then the residential mortgage portfolio was up 1.2 billion.

So on an apples-to-apples basis, adjusted for the conduit, basically total loans were essentially flat for the quarter.

As far as home equity, again it's massed in our residential mortgage portfolios, really because the first trust deeds (ph) that are really second.

And so we were up by in excess of 11 percent for the quarter in home equity.

Just to follow up, if I may, I'm trying to understand how much work is left to be done to downsize your commercial loan portfolio or your customer base to your liking.

Should we another 1 to $2 billion in the fourth quarter?

Is quarter highly unusual?

Trying to understand the comments about perhaps improving the customer demand profile with the declining loan volumes and when the line should cross.

I think that you will not see that kind of reduction.

As far as the customers we want to do business with, I don't think we will see that continued culling; we're there for the most part.

And I don't think you'll see that kind of reduction again.

Thank you Jerry.

Mike Mayo, Prudential Securities.

Actually it's Prudential Equity Group.

Good morning.

First, the outlook for expenses.

You talked about opening up I guess 38 in-store branches by the first quarter.

Should we expect expenses to go up or are there offsets?

I think you would see a moderate increase in expenses.

But again, our model is to grow revenues faster than expenses, and you will see that occur again.

Could you give us some more color on the securities portfolio?

On the one hand, a greater percentage of lower yielding securities I guess hurt the margin; on the other hand, you said you got a pick up by selling the $3 billion of securities.

Have you got a pick up of 120 basis points?

Just reconcile what's going on in the securities portfolio.

You were leveraging up the first part of the year?

Do you still want to leverage up securities?

And what's your unrealized gain or loss there now?

Let me respond to that.

First of all, of the securities were actually sold at the very end of the quarter, so you won't see the pick up in the bond portfolio yield until the beginning of the fourth quarter.

Our strategy is continue to maintain an investment portfolio as we basically have.

I don't expect you to see it increase at all from this level.

As it is it's going to be a very slight increase.

We continue to maintain a very balanced position with regard to that.

As I said, we're trying to maintain a duration, a relatively short duration between three and five years.

And we've been successful essentially in doing that.

So I don't think you'll see much change from the level it is.

But again, you won't see the improvement in the yield until this fourth quarter.

Should we expect the margin to go up in the fourth quarter, then?

If I were you, Mike, I would assume it would be relatively flat for the quarter.

We do expect this quarter to be the low, and over the course of next year we expect some improvements in margin.

Lastly, as far as acquisitions, your name is thrown about from time to time.

What's your appetite?

That is not a high priority for us.

It is not a high priority at all.

We're going to grow this company organically and show just what we showed this quarter -- we're going to grow revenues faster than expenses, that takes care of what we need to have happen; and get credit quality under control, give it back to our shareholders in the form of dividends and a share buyback.

Thanks.

Nancy Bush, NAB Research.

A couple of questions here.

Could you just update us on sort of the mortgage metrics right now -- how the pipeline looks, how much apps (ph) are down, etc.?

And on the issue, could you just breakout middle market trends from the rest of commercial and tell us how utilization, etc. are going there?

Let me talk a little bit about the metrics. on the home mortgage portfolio.

Essentially, if you look on the revenues side, our revenue was actually flat, although we had a very, very slight pick in to actually loan servicing revenue.

The production pipeline actually ended the quarter up, but that volume has actually slowed as the quarter progressed.

So our expectation is that mortgage banking revenue would be relatively flat going into the fourth quarter.

But we have had continuing opportunities to grow volume.

As you may know, we are also expanding the offices of the mortgage banking group throughout the West.

As you might recall, former U.S.

Bank really had eliminated that product.

But we're in the process of opening new offices, particularly in Northwest part of the United States, as well as California.

So we would expect to see ongoing production from those groups.

If you're looking at the value of the mortgage servicing rights, we ended up at 123 or 1.23 percent, as a result the current mix of mortgage servicing rights.

With regard to the middle market, as Jerry pointed out, we are beginning to see some discussions and more positive reality in the middle market.

And that's, we think, very positive.

With regard to line utilization, it's essentially flat.

We haven't seen much change in that.

Again, I think a lot of our comments are the result of direct discussions with customers.

And clearly they're feeling better about their prospects, but I think they are reluctant to commit to any major capital spending supported by debt until they are confident that the economy is going to continue to improve and that their business is going to continue to improve.

A lot of businesses continue to focus on cost control.

That is to some degree why the overall credit quality is getting better.

They're continuing to build cash balances, which is a reflection of our overall commercial loan balances. (multiple speakers) yes, positive deposit balances.

And I think overall they're beginning to establish and assess prospects for spending in business.

But I don't think they're quite there yet.

That's across our 24 states.

It just is not utilization.

They are not borrowing for inventory yet.

So we're not seeing that, which would be the first sign.

But as I said, or mentioned, and as Mike Mayo asked, I think that -- or maybe it was Tom -- you're not going to see substantial decline like we saw this quarter in balances.

David, let me just make sure on the mortgage that I understand that at least in the near-term the results are not going to fall off a cliff; that you're going to be relatively steady state in mortgage.

We don't think so.

We don't think so.

Right now, if you actually had the value -- the value of the mortgage servicing rights are basically neutral.

So at this point in time, if you actually valued them today, it's pretty well flat.

But we don't expect the business to drop off, no.

Thank you.

Alan Strauss (ph), Lord Abbott.

Just on the share repurchase, my formulary calculations show that you will be able to purchase over $1 billion worth next year.

Any comments on that?

And what is the expiring authorization?

The authorization expires 100 million shares and we will be formulating a proposal to the Board in December based on our overall business plan for next year.

And as Jerry alluded, our target is to basically return 80 percent of the earnings into your buyback or a dividends.

And as you know, we've been very disciplined with regard to growing dividends appropriately in line with earnings.

So I think your math is directionally right; we should be able to buy back of fair amount of stock.

As you know, one of the things that separates our company from most companies is the level of internal capital generation.

We're going to have very limited balance sheet growth, so we won't need a lot of capital to support that.

Another factor that we're considering in that is although our tangible common ratio is above 6.25, implied in that 80 percent is obviously a 20 percent that we will retain to continue to strengthen the Company and build capital and build financial flexibility as well.

So we're going to try to accomplish all that next year.

Great.

It sounds like that won't be a problem with all this capital you're going to generate.

Thanks.

That is right.

Chris Mutascio, Legg Mason.

I have somewhat a similar question.

Jerry, you had mentioned a payout of 80 percent net income to shareholders.

Is there any idea of what timeframe you look to achieve that?

And also what the mix would be between dividend payout and share repurchase?

Yes, basically flat.

And we will begin doing that.

We're starting now, and certainly next year, and that's in the foreseeable future that's how we're going to run this company.

As we've talked about before, we will be more balanced.

And we do have the flexibility now that we have met our capital ratios that we committed to the rating agencies.

So you can expect that.

Again, it's starting this quarter, and will accelerate to sort of a flat -- I would assume a flat -- I would have you assume flat over the year.

And the level between dividend and buyback, that really is up to the Board.

But we're committed to make sure that we will make that 80 -- accomplish that 80 percent.

Thank you.

Fred Cummings, McDonald.

Nice quarter.

First question is for Mike.

Mike, can you give us an update on the level of non-performing assets (technical difficulty) this quarter?

I'm sorry, you cut out a little bit.

Could you repeat that question?

Can you give us an update on the level of non performing assets sold, if any, this quarter?

Sold, I'm sorry.

I'm with you, yes.

We sold about $84 million worth of non-performings this quarter in two really major components.

One had to do with our commercial leasing portfolio; we sold a number of small non-performing notes there.

And we also had another pool of small C&I that we sold during the quarter as well.

So the total of those two combined was around 63, 64 million and we had some other one-off type of sales to come up to about 84.

Secondly, David, what's the (technical difficulty) of your MSR valuation reserve?

I'm sorry, I seem to maybe have a connection problem here.

That's all right.

As you know, over the course of last year, or actually this year, we had write-downs of some level to $300 million.

In this quarter we basically reversed in this quarter 108 million of that.

But of that 300, probably a good 100 million of that is basically related to what we would refer to as permanent impairment, or actually a write-down of the extra (ph) servicing right.

So the again, that leaves about $100 million that in the event that rates rise and prepayments follow on with that by slowing down, then that would indicate that improving valuations back up the mortgage servicing rights.

So we have to sort of believe that over the course of time, that if rates do rise, then you will see that improvement in the valuation.

One last question for Jerry.

Jerry, historically (technical difficulty) Star Bank First Star, clearly a leader in middle market lending.

Do you expect U.S.

Bancorp to grow in line with industry or grow faster than industry once loan growth picks up in your middle market business?

I think we have terrific people in our middle market.

We have markets leading positions in most of them.

I would expect us to do better.

And that is our expectation.

As you know, this reports to Richard now and he's on top of this, as you know Richard is and can be.

And I am too, and we're focusing on this and we're going to make something happen here.

But you're right.

And alluding back to the old Star Bank is sort of where I see this company right now.

It's a little longer than I had hoped, but I feel very satisfied with where we sit today, and what our prospects are and how we're going to run this company going forward.

Thanks.

Ron Mandel (ph), GIC.

My question was in regard outside (ph) of capital.

If you're keeping 20 percent, that implies about 4 percent growth for the balance sheet.

And you said, you're not going to grow the balance sheet that much near-term.

But over the intermediate-term, I'm just wondering how you can generate the upper single digit revenue growth with the balance sheet growth of the kind of numbers that your figures imply.

I think there's two things that are going to happen.

One is, we're assuming that, one, our margin improves by essentially a change of the mix of the assets, which we think will be driven by, obviously, retail lending.

But we do believe commercial lending over the course of next year is going to bounce back.

So we're confident that the margin is going to help basically lead net interest income.

But the more important aspect of this is not necessarily net interest income, but the fee-based businesses.

We're in a position today, if you look at the volumes in the supplemental schedule in all the different payments businesses, as well as the fiduciary businesses and cash management, a lot of that growth in revenue is going to be driven by the fee-based businesses.

And as you're right, we're going to limit the growth in the overall balance sheet.

But again, we think a more efficient balance sheet will raise margin and raise net interest income.

And of course fee-based businesses we're expecting to see significant growth next year.

The way to look at it is I believe we're unique with our payments businesses.

They generate very high risk-adjusted returns -- very high.

And our job, and the job that we're going to accomplish for our shareholders, is make sure that we don't throw it on the asset side.

We're not going to.

We're going to be disciplined in that.

And as I have said, and mentioned, you will see in the next recession, in the next downturn, we're going to be at the upper end, at the top end of credit performance.

And that's where we're headed.

Just to finish your thought, again because we are in a position to buy back our stock, because of the attainment of the capital ratios, we really feel like -- and as we have said, I think, in a number of discussions with investors -- we feel that a balanced approach supporting some balance sheet growth, but dedicating a lot of capital generation to buying back our stock is the most economical use of the capital supporting the balance sheet.

So we really feel that that's really the right course to be on.

One additional comment.

The fact that we feel this sanguine about the payments businesses is because in this downturn, as we have gotten credit under control to our satisfaction, we have really done a very good job and on the commercial banking side-- in particular the larger corporate -- in selling our products which is value added for our customers.

And they are selling it, and we feel good about it.

And that's driving, frankly, a lot of the earnings that we're seeing now.

But our job is to grow revenues faster than expenses, and that's what we're going to do.

If I can follow up with a related question.

With your anticipation of margin improvement next year, could you just give us an outline of what your interest rate sensitivity position is now?

We are essentially neutral with regard to rates.

Over the course of the year, our own expectation is that short-term rates will not rise until somewhere in the second half, maybe midsummer.

So we're not expecting much of an increase in short-term rates.

We do think, obviously, the yield curve is obviously a very positive condition in banking, and we think that will continue.

But over the course of next year, we're basically aligning the balance sheet and setting up the rate position so that as the middle part of next year begins to come closer to us, we will be more asset sensitive going into next year.

But again, it's a slow migration from essentially where we are today to slightly asset sensitive.

Okay, thanks.

Steven Wharton, Loomis Sayles.

Good morning.

Just two quick follow-up questions.

First of all, David, did you say the dollar amount that your payment fees were affected by the re-negotiation of interchange?

Yes, it's actually $8 million, Steve, quarter-to-quarter.

This was the first quarter we've actually seen that.

And just the last question was on the securities portfolio again.

What's the average duration of the portfolio as it currently stands?

About 4.2 years.

And the unrealized gains and losses?

It is essentially flat at this point.

That's all I have.

David Hilder, Bear Stearns.

Good morning.

In past quarters or past years we've seen a fair amount of seasonality in sequential revenue growth, especially in the core banking fees.

You obviously had a good quarter this time.

I was wondering what your outlook might be for the fourth quarter and the first quarter.

And again, when I say core banking fees, I'm excluding the credit card and payments businesses, and just looking at things that come from your basic retail and commercial customers.

Let me answer the first part and (indiscernible) answer the second.

We should expect the seasonality in the fourth quarter maybe to be 1 percent, 1.5 percent higher than the third.

And then the second part of that, David?

I was just trying to define what I was looking at in terms of core banking, again just excluding the credit card, payment systems, merchant processing businesses.

The deposit business is very good, obviously.

And on our cross selling to our other payments businesses, which is really a strategy of ours, is working very well.

We can always get better at it, but we're doing a good job at that.

Loan demand is weak, and we've got to get that moving.

But we're not going to get it moving and make the traditional mistake that you go out and balloon the balance sheet, and you have substantial revenue growth from marginal credit.

We're not going to let that happen.

So that's the state of the bank.

In the wholesale banking area, in the cash management side of it, I think you should continue to see positive trends in that area.

In retail I would expect the same.

Mortgage banking is going to be relatively flat.

So excluding the payments oriented business, I think the P (ph) trends should continue.

Thanks very much.

(OPERATOR INSTRUCTIONS) Dennis Leplant (ph), KFKBW (ph).

I just want to try to make sure, you seem pretty upbeat on your processing businesses.

When I compare the revenue growth, even if I adjust for the debit card shortfall this quarter, your overall fee income excluding acquisitions and security gains were up less than 1 percent versus a year ago and your numbers aren't particularly robust.

Is there something you're seeing in the underlying volumes that particularly give you some confidence going into fourth quarter into next year?

When you're looking at year-over-year, one thing that you have to go back to is the fact that last year we sold a portfolio of Midwest Express which is basically $21 million delta in the revenue side.

That was a gain booked back then.

So going back over last year, we were still re-positioning the businesses, re-positioning the portfolios.

That came out of the payment side because it was part of a co-branded portfolio.

So you've got to sort of strip that piece out.

Dennis, we do feel good about it -- about these businesses.

What's going on in the pricing between corporate payments and the other card businesses?

Any sense on trends?

I think overall their fairly flat, except there is pressure on the merchant processing side.

But we have value added business there from the standpoint that we've got managers that are going to make the numbers whether revenue is growing or not.

They are very, very disciplined.

So I feel very good about that.

But other than that, it's fairly flat.

Again, if you have a debit card issue (multiple speakers) an interchange issue, which has affected us.

But we will grind through that and make our numbers.

I would also add a couple more comments.

The payments businesses we approach very much like we approach the rest of the Company.

One thing we know that in a business that is highly sensitive to pricing pressure, we are very disciplined in all those businesses to maintain a very tough and competitive cost structure.

As you know, that's an important leverage in that business.

And we know that in different times and different products we're going to come under pricing pressure from competitors.

But that plays right into our strategy because, one, we first emphasize and always emphasize the quality of service.

And in all those businesses the ability to basically operate on a 24 hour basis with no down time, redundant backup systems such that the quality that we deliver is really critical to the merchants and the customers we provide.

And I think that has won us customers.

And the we are seeing it and we're seeing it across all the different areas.

And we're prepared, if need be, to compete on price.

That's something we do quite well.

We recognize that there are a number of providers.

But we think in the end customers will pay for better service.

And we think that will (indiscernible) revenues.

We have that flexibility because we are the low cost provider.

I have one follow up, if I may.

On your 80-20 rule related to returning 80 percent of your retained earnings to shareholders, how much flexibility are you building into that?

Is your priority to do -- you said, "we don't want to do acquisitions," but small fill in deal using capital that way?

Could you maybe square that with buyback?

Within that 20 percent we're retaining, we would have ample opportunity and cash available to do small cash acquisitions.

We're not out looking for any, but as you know they come up from time to time.

But that 20 percent is dedicated to the balance sheet growth that Ron talked about and/or small cash acquisitions.

And as you know, it's not a lot of money.

Acquisitions just aren't a high priority.

Thank you very much.

It appears we have no more questions at this time.

I will turn the call back to Matt McCullough for any concluding remarks.

Thank you, operator, and thanks to everyone for joining us today.

Please give me a call if you have any questions.

Now I would like to turn it over to Jerry for a few closing comments.

Thanks for joining us today, and thanks for the questions for those people that asked us questions.

We feel very good about where we sit today as a company -- credit trends are improving; capital level exceed all targets; revenues are growing faster than expenses; and we're the industry leader in the generation of capital.

We made great progress this quarter against the commitments we made to you in the past, and we will continue to make progress going forward.

We will remain disciplined in the efficient use and return of our capital and the achievement of our stated financial goals.

Thanks for your support.

Please call Matt (indiscernible) and any questions or David or me.

Thank you.