美國合眾銀行 (USB) 2004 Q3 法說會逐字稿

Welcome to U.S. Bancorp's third-quarter 2004 earnings conference call. Following a review of the results by Jerry Grunhofer, Chairman and CEO, and David Moffett, Vice Chairman and Chief Financial Officer, there will be a formal question and answer session. (OPERATOR INSTRUCTIONS) I will now turn the conference call over to Mac McCullough, Senior Vice President of Investor Relations.

Thank you, operator, and thanks to everyone for joining our call this afternoon. If you have not yet received a copy of our earnings release and supplemental analyst schedules, they are available under the financial information and news and event section of our website at usbank.com.

Jerry Grundhofer, our CEO, will open the call and then David Moffett, our CFO will provide details covering third-quarter performance. I would 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 change our current forward-look assumptions are detailed in our press release. I will now turn the call over to Jerry.

Good afternoon. Thanks for joining us today.

On a GAAP basis, third-quarter earnings per share increased 14.3% from the same period of last year, and an annualized 14.8% from the second-quarter of 2004.

Adjusting the third-quarter of 2003, for the December 31, 2003 spinoff of Piper Jaffray, third-quarter 2004 earnings per share from continuing operations were up 16.7% from last year. Third-quarter's high-quality earnings were driven by strong fee revenue growth and improved credit quality.

Excluding security gains and losses, noninterest income increase 11.7% from last year. The payment fee categories increased 20.1%, reflecting recent investments and increased customer penetration with merchant processing increasing 28.2%, credit and debit card revenue increasing 19.4%, and corporate payments increasing 13.4%. Deposit service charges increased 10.9%, driven by net new account growth which continued to gain momentum in the quarter. Mortgage banking revenue increased 8.6% compared to last year, driven by higher servicing revenue.

As expected, credit quality continued to show improvement. Third-quarter net charge-offs declined 19.3% from the second quarter, coming in at 53 basis points of average loans. The majority of the improvement in net charge-offs was driven by higher commercial loan recoveries which are not likely to reoccur and recur in the fourth quarter. The expected reduction in commercial loan recovery plus seasonally higher retail net charge-offs will likely result in modestly higher total net charge-offs in quarter 4. Nonperforming assets continued their decline in the third quarter, registering 106 million or 12% reduction. We expect nonperforming assets to continue to decline modestly in the coming quarters.

Average commercial and commercial real estate loan outstandings were flat in the third quarter. Our view is that corporate America is uncertain about the strength of the economy as it -- and is in the wait-and-see mode regarding the impact of higher oil prices, higher inventory levels, lower consumer confidence and lower sales might have on the economy going forward.

Perhaps reflecting the cautious approach being taken corporate America, $38.7 billion of stock repurchases were announced in July 2004, a 20-year high. While this level of commitment to stock repurchases should give you some comfort about the health of corporate America, it also indicates a clear reluctance to undertake new business expansion at this point in time.

We continue to see weak demand and aggressive pricing for commercial loans in our market. While we don't believe we're going to see a reduction in outstandings from our current levels, it now looks like a material commercial loan growth will be a 2005 event. Average retail loans, including first lien home equity loans grew around 9% compared to the third quarter 2003, driven by growth in leasing, credit card, and home equity products.

We set an all-time record in the quarter, growing net new checking accounts in excess of 100,000, a 7.9% annualized growth rate in net new checking accounts during the quarter. If you look at branch-based deposit performance, noninterest-bearing deposits are up 4.9% year-over-year, and interest checking deposits are up 8.5% over the same time frame, again indicating the success that we have had driving high-value account and deposit growth in the branches.

We continue to be very disciplined in our approach to pricing deposits, which has resulted in some reductions in deposits due to competitive bid situations. For example, low-cost deposits defined as noninterest-bearing interest checking, money market and savings in our government banking units, declined $3.2 billion from last year. This was primarily due to increased competition for those deposits, with the winning bidders offering rates that we view as excessive, relative to the cost of our wholesale funding.

We are also seeing some deposit outflows in business units that have customers that are sensitive to the interest rate environment. An example of this is the impact that rising rates have had on low-cost deposits in our business unit that focuses on mortgage banking companies. Low-cost deposits in this business unit have declined approximately $500 million from last year as rising rates have slowed mortgage originations across the industry.

We continue to aggressively repurchase our stock, buying back almost 20 million shares in the quarter. This combined with our normal quarterly dividend resulted in a 94% return of earnings to our shareholders in the quarter.

Going forward, our primary goal is to demonstrate that our Company's uniquely positioned to achieve consistent 10%+ EPS growth, as a result of our balanced business mix, advantage scale, industry-leading returns, reduced risk profile, low-cost leadership position, and emphasis on customer service. We believe that there are significant opportunities to further penetrate our 24-state footprint and our diverse customer base with our broad array of industry-leading products and services.

We are committed to investing in the franchise, having invested almost $500 million in revenue-enhancing projects over the past three years, with approximately one-third of this investment in our retail distribution and branch system over the past one and a half years.

Our in-store branch initiative is proceeding on schedule. We expect in 2004 to end with 460 in-grocery store locations, an increase of 143 from the end of 2003. Financial results for the initiative are exceeding our expectation.

Transaction volumes in our payment businesses continue to show strong growth, as our investments in merchant processing and card issuing are starting to gain traction. We also have a number of payment product initiatives under way to penetrate our existing commercial customer base that are contributing to growth as well.

Finally, we are making investments in our brand and continue to focus on improving the level of service that we provide to our customers. In conclusion, we continue to build momentum in the quarter, as evidenced by a 16.7% increase in earnings per share from continuing operations, a 5.4% increase in total revenue per share, an 11.7 increase in fee revenue, a 53 basis-point in net charge-offs and our loan portfolios, a level we have not seen on a full-year basis in this Company since 1998. The number of new -- of net new checking accounts generated in the quarter was at an all-time high.

The four straight quarters of returning 80%+ of earnings to shareholders. And we know what we need to add to this list in future quarters, moderate commercial loan growth that will result in higher net interest margins and moderate growth in earning assets, leading to growth and net interest income. With a little help from the economy, we should see this in 2005.

Let me turn this over to David to give you more details on the quarter.

Thanks, Jerry.

Today we reported first-quarter earnings of 1,065,000,000 or 56 cents per share on a diluted basis, meeting the first call consensus estimate. This was a 14.3% increase over the third quarter of 2003 and an annualized 14.8% increase over the second quarter of 2004. Compared to the third quarter 2003, revenue growth was mixed as a 21-basis point decline in the net interest margin and a less than 1% increase in earning assets resulted in a 2.4% decline in net interest income. The year-over-year margin decline was primarily due to a slight increase in the percent of earning assets funded by wholesale sources of funds, and higher rates paid on wholesale funds.

Offsetting the decline in net interest income was an 11.7% increase in fee income, led by merchant processing, credit and debit card, corporate payments, deposit service charges and mortgage banking. On a lien quarter basis, the net interest margin declined 6 basis points to 4.22%. We expect the net interest margin to trend modestly lower in the fourth quarter. We ended the the quarter relatively neutral from a rate perspective.

Going forward, we expect growing net interest income assuming modest commercial loan demand and a continuation of current retail loan growth trends. Excluding the impact of mortgage servicing rights impairment and repairment, noninterest expense increased 5.2% from the third quarter of 2003, driven primarily by operating expenses associated with the merchant process expansion in Europe, including integration expense as well as higher pension, marketing, and insurance expenses.

Credit quality continues to show improvement once again exceeding our expectations for the quarter. During the quarter we recognized mortgage servicing rights impairment of approximately $87 million, based on increases in market rates of interest. We booked this impairment as an increase in intangible amortization expense and offset the expense with approximately $87 million of investment securities sales gains.

Taking a quick look -- quick look at the business unit results compared to the third quarter of last year. Wholesale Banking, which accounted for 18% of revenue in the quarter, increased net operating earnings by 30.4%, driven by improved credit quality and reduced noninterest expense, reflecting a 6.5% decline in average loan balances and lower treasury management fees in government banking. Total revenue declined 4.3% from last year. Noninterest expense declined 6.7%, primarily due to reduced expenses associated with treasury management processing.

Wholesale Banking recorded a net recovery of approximately $13 million in the quarter as the business unit experienced strong commercial loan recoveries. Excluding the impact of mortgage servicing rights impairment and security gains, the Consumer Banking group, which accounted for 43% of the revenue in the quarter, increased net operating earnings by 15.2% compared to the third quarter of 2003. Revenue increased 5.2%, primarily due to an 18% increase in fee revenue that was driven by deposit service charges, mortgage banking revenue, a residual value insurance recovery, and lower residual losses on end-of-term leases. Deposit growth remained strong as noninterest-bearing deposits in the branches increased 4.9% from last year.

Noninterest expense is flat despite having 145 more branches at the end of the third quarter of 2004, compared to the third quarter of 2003. Total net charge-offs declined 71 basis points in the third quarter of 2003 to 54 basis points in the third quarter of 2004.

In the private client trust and asset management area, which accounts for 10% of revenue in the quarter, recorded a 11.6% increase in net operating earnings from last year, driven by 4.1% increase in revenue, and 1.7% decline in noninterest expense. While total average loans increased just under 4%, low-cost core deposits increased 1.4 billion or 14.2% from the third quarter of last year, due to growth in the corporate trust, institutional trust and the private client group.

Finally, Payment Services, which accounts for 20% of the revenue in the quarter increased net operating earnings by 20.4% from the -- from last year, driven by fee revenue growth of 21.2% and 8.8% decline in net charge-offs. Total revenue grew 13.6%, as tighter spreads on credit card receivables reduced net interest income 7.4% from last year. The 21.2% increase in fee revenue was driven by a 28 point percent increase in merchant processing fees, 19.4% increase in retail credit and debit card fees, and 13.4% increase in corporate payment fees.

Transaction volumes and merchant processing, retail, debit, and credit card, corporate payments, continue to show very strong growth. Total debt charge-offs declined from 387 basis points in the third quarter of '03 to 334 basis points in the third quarter of '04.

Turning to the consolidated credit picture, we continue to make good progress at reducing both not performing assets and net charge-offs. Nonperforming assets declined just under $106 million or approximately 12% during the quarter to $805 million at September 30 or 64 basis points of loans and [OREO]. We expect nonperforming assets to continue to climb modestly in the coming quarter. Net charge-offs fell on a link quarter basis to $165 million or 53 basis points of average loans, as commercial loan recoveries were very strong in the quarter. And as Jerry mentioned earlier, the expected reduction in commercial loan recoveries plus seasonally high net retail charge-offs will likely result in modestly higher total net charge-offs in the fourth quarter.

Our asset coverage ratios continue to show strong improvement. The allowance for credit losses to nonperforming loans was 337% at September 30. The allowance for credit losses to period end loans at September 30 was 1.9%. Our capital ratios remain strong as well. We are comfortably above the minimum regulatory targets to achieve well capitalized status, with a tier one capital ratio of 8.7% and total capital ratio of 12.7%. The tangible common ratio ended the quarter at 6.4%.

In conclusion, we continue to make good progress in the quarter and the quality of our earnings remains high. For the year 2004, we expect to report EPS of approximately $2.18 to $2.19, depending on the level of commercial loan recoveries in the fourth quarter. Our high value, fee-generating businesses continue to show strong growth. We are adding distribution and high-growth markets and investing in our capital efficient payment businesses. In addition, we never stop investing in customer service. We have a number of initiatives under way, in systems and in people, which will allow us to continue to make progress on this front. We believe that our balanced business mix, our advantage scale, our reduced risk profile, low-cost leadership position, and emphasis on customer service will allow us to consistently achieve this goal in 2004 and beyond.

This now concludes our prepared remarks. We will now take questions from institutional investors and analysts.

Very good. (OPERATOR INSTRUCTIONS) We will go first to the line of John Mcdonald with Banc of America. Please go ahead.

Hi, good afternoon. I was wondering, David, if you could comment on reserve release. We've seen a number of your peers release reserves -- most of them in fact -- and you guys have not done that despite strong credit quality and what appear to be very high reserve levels. And could you comment on whether your guidance that you just gave incorporates any expectations of reserve release.

First of all, our expectation does not include reserve release, number one. As I think we stated, it really is reflective of the extent of the commercial loan recoveries, number one.

We believe and continue to believe that our reserves for allowance for loan loss are adequate. We -- as you know, we re-evaluate the reserves every quarter continuously and looking at all categories and looking at all the internal risk classifications, and at the end of the quarter, we believe that the reserve is appropriate and adequate for our loan portfolio.

Okay. And also on the margin, David, could you give us a little more color on how much compression you might expect in the fourth quarter and how things might trend in '05 if CNI remains sluggish?

Yeah, the key determinant to the change in our margin is going to be commercial loan growth and the continuation of our retail loan growth. As we pointed out, we -- we see a mixed bag. We continue to see strong consumer growth, and we are beginning to see some signs of commercial revitalization, but we don't think it is going to be that impactful in the fourth quarter, as Jerry pointed out. We believe it's really going to be a 2005 driver.

But I really believe that what we would expect is some -- some sort of modest reduction in the margin, in the fourth quarter, absent any specifically large commercial loan growth, and that, as I said, that's modest. So I would say it is more in line or less than what we saw less this quarter.

Okay. Thanks.

We will move next to the line of Nancy Bush with NAB Research LLC. Please go ahead.

Good afternoon, guys.

Hi, Nancy.

Hi, Nancy.

David or Jerry, if could you talk qualitatively about the trends or, you know, sort of general trends versus the second quarter. You did a lot of sort of third quarter over third quarter stuff, but if you could just kind of give us an idea looking at the third quarter how it contrasted with the second quarter. What got better, what got worse.

Yeah, let me -- let me follow up on this. Overall, the way I would assess the quarter, Nancy, is we continue to see very strong fee-income growth, really across the board, and as you would expect, mortgage banking was lower because originations gains are lower. But I feel very, very positive so I would rate our fee-income growth really very broad-based and very solid.

On the expense side, I consider our quarterly expenses basically flat, and I don't -- and I am not concerned about expense growth in this Company going forward at all. The concern I have in which we have seen over the last several quarters is net interest income growth has been weak. It is reflective of quite frankly our -- the loan growth that we've experienced over the last several quarters. We are optimistic that we are going to see loan growth in the next several quarters on the commercial side. But I would agree that our revenue growth on the net interest income side is definitely -- has impacted our overall revenue growth.

Now keep in mind, however, that we have been buying back a lot of stock, and that is going to affect net interest income. If you look at our overall revenue per share growth or revenue on a per share basis, it's over 5%. On a stated basis it is around 3.4, 3.5. So it definitely has an impact on our revenue growth, and as we have said, we are going to continue to buy back our stock as we have been, and we are committed to returning at least 80% or more of our earnings to our shareholders, and in this case, we've actually done more throughout the year. So that's going to affect the net interest income growth rate for sure.

On the credit quality side, Nancy, we feel very good about it. As you know it has been a long, hard road for the last two years, and we have done a lot to improve the overall risk profile of the Company and reduce credit losses and nonperformers. This particular quarter, we had a high-level recoveries, and I don't -- we don't expect those kind of high-level recoveries to continue into the fourth quarter or next year. So we think we have sort of hit the bottom with regard to charge-off levels, and we don't see any -- any sign that charge-offs are going to go up at all, but we do -- we have experienced a lot of recoveries in the process.

So I think we have -- I think we had a good -- a very good quarter. Our return on equity is at record levels, and our return on asset are at record levels. So I feel good -- good about the profitability of the Company. We just need to grow the net interest income, and as I think Jerry and I both pointed out, it's really going to be loan volume and commercial loan volume dependent.

And Nancy -- David talked about it. It's really for this Company getting loan growth going. We are focused on it. We -- and we are going to make that happen. It's going to come -- it is going to come, we just don't know when, and -- and that is really the -- the one challenge that we have.

Overall the quality of earnings that we reported today and have been reporting, I believe, is very good, and we just have that issue. I mean our fee income continues to -- fee-based businesses continue to respond very, very well. Credit quality is under control. We've got a quality balance sheet, quality earnings, and it's just a matter of getting this loan volume, and we are going to get it, and it's just a matter of time.

And we are seeing a little bit of uptick, but, again, I said that last quarter. I said I expected -- well, I have got to be honest with you. I told you all that we expected it to be, I think, in the 6% to 8% range. I'd say that again, and -- but I -- I'm going to wait and see.

Yeah, David, just the deposit trends, 3Q versus 2Q.

Yeah, Nancy, I am not concerned about the deposit trends. If you look at the businesses and really look at where the deposit trends are going, first of all, on the consumer side, as we've stated, we've had growth, in the noninterest-bearing side, the money market side, and the interest checking product side. So the consumer side and the branch side is absolutely doing the right thing. They're really focused on growing deposits, setting up new accounts, and all their initiatives are working to grow the deposit side. That is not an issue.

Where we've had deposit reductions are in the institutional side which, quite frankly, are a pricing decision on our part. We've seen it, as Jerry mentioned, in our efforts in the mortgage banking. We provide services to a lot of mortgage bankers, and they, hence, leave a lot of compensating balances and depository relationships with us. Those balances have dropped and they have dropped considerably both this quarter and last quarter. In the government banking area, we've also seen reduction in deposits because many state governments are under pressure and we have seen an outflow of deposits across the board in the related government side. Some of it's pricing. Some of it's pricing, and where we have decided we're just not going to pay way over our cost of wholesale funds for the purposes of gaining those deposits.

We have seen reductions in corporate trust, as an example as well, where corporate trustees are using balances and reinvesting balances and drawing down balances across the board. So it's all institutional. It is all decisions that we've made with regard to pricing, and quite frankly, it -- it doesn't concern me.

It's the retail side that is the core, is the -- is the key ingredient to growing the deposits long-term in this Company and we are doing it. We're also doing it on the small business side, the small business side and the commercial middle market side as well. So those deposits will come and go, and I'm -- I'm not concerned.

I mean, to really -- this is Jerry again. If you look at it, the decline in deposits -- we had the option to keep or not keep. And wholesale funding for us was cheaper than that, than what we had to pay for them so we let them go. That's frankly the answer to that. Where our basic core business, which we believe is our consumer banking business in particular, continues to show nice growth.

Thank you for the clarification.

We will move next to the line of Mike Mayo with Prudential. Please go ahead.

Hi.

Hi, Mike.

Can you give some more color on your investment spending? You're opening up all these branches and have all these initiatives. What's the dollar amount of your investment spending and how does that compare to where it's been? Thanks.

It is about half a billion dollars in -- in fee-based revenue producing kinds of investments over the last three years, in the last year and a half, they -- you know about a third of it has been in -- in the -- in the branch-based world. And the others have been throughout our Company in merchant processing and corporate trust areas and in other areas. We have focused on revenue-producing kinds of -- of investments. And we have a very -- very intricate and precise process to do that, and we believe we are making the right kinds of investments in these revenue-producing businesses.

Now, having said that, we have invested, gee, another $700 million to $800 million in just our overall systems in the same period of time. So it has been a substantial investment, Mike, in not only systems to support those sales, but also on the sales side and the revenue-generating side. So it's substantial. I mean, treasury management, we'll be rolling out a new treasury management product for our commercial and corporate customers called SinglePoint, beginning of this year, which is a $30 million investment.

Our MEH processing or -- image -- you know, on the consumer side for our Internet banking, was a $60 million, $70 million investment. So we've invested in all the products and services that we've had that are going to grow [inaudible-background noise] and we feel comfortable with that. And it does show you -- I think we have the scale, obviously, to invest, when you think about the numbers that I have thrown around here, Mike.

I guess for all the investing, the revenue's growth still isn't that strong and you gave some reasons, and I guess you need some help from the economy.

Mike, can I -- I am sorry, you go ahead.

No, please do. Correct me, because the last few quarters -- you have -- there's lots of explanations there, but deposit growth is a little bit stronger at some other companies, and I guess -- are they doing stuff you just don't want to do and therefore you are being smart about how you get the revenues? Or --

Mike, let me -- let me really rephrase it. Really, all the investment, or 90% of the investment that we have been talking about, have been in the fee-based businesses, and you have seen for the last several quarters very solid growth in the payments businesses and we believe those investments we're making are going to continue to perpetuate those payment growth in businesses.

The deposit side, again, is really -- is really institutionally based, and it's a pricing decision. It has nothing to do with investment in any of the core products like treasury management, or corporate or institutional trust at all. So they're really unrelated. They're really pricing decisions that we're making on the margin, given our cost of funds and our ability to access the wholesale markets and we've made the decisions that that is not -- doesn't make sense to basically pay up for deposits when we quite frankly don't need to. Has nothing to do with the underlying relationships or the services that we provide to any of those -- in any of those businesses at all.

And, Mike, principle -- you know -- principal investment on the branch side, you're not going to see that for 24 to 36 months. That's just normal. You know this business and we've invested a hell of a lot of money over the last year on our in-stores, and that is an investment that's going to come to fruition at the end of '05, beginning of '06, '07 and beyond, and that's a fact. It takes time for that investment to -- to come to fruition.

Just last follow-up. Is there some behavior in the industry that disturbs you, that's causing you to hold back?

Hold back in what, Mike.

Well, you say it 's a pricing decision on deposits, I guess I am -- on the institutional side, are other competitors doing irrational things and you're choosing not to do them?

Mike, let me say it this way, there are going to be times when some of our competitors decide that they want to pay up for deposit versus where they can raise money in other places.

I mean, there are people in banks, like myself, who are making those trade-offs all the time. I don't think they're being irrational, they just have to view it vis-a-vis what their other alternatives are and how bad they want to show overall deposit growth.

If we wanted just to show overall deposit growth, we could pay for it without any problem, but we don't think those are reasonable decisions to make on the margin, and we make those decisions every day, and we've just made, in this particular case, in this quarter, a number of accounts we're not just going to chase.

Another area, though, that, Mike, part of this deposit is also driven by the fact that state and local governments are spending money, number one, and number two, mortgage banking companies, who we have a big business with, quite frankly have less originations and therefore they're going to have less deposits to keep with us. So part of it's just, there's fewer deposits in the businesses where we are in, and then the other part of it is just related to pricing.

Thanks for the clarification.

Thank you.

Our next question comes from the line of Tom McCandless with Deutsche Bank. Please go ahead

Good afternoon.

Hi, Tom

A couple of questions if I may.

Jerry, the topic of commercial loan growth is front and center. I know you all are focused very heavily on it. I know that you all have made a number of changeovers, David has mentioned some changes to help stimulate better growth during the past year.

In your financial packet, under wholesale banking, there are a couple of categories of loans that seem to have shown some sluggish trends. Not that I don't anticipate sluggish trends continuing, but they're actually declining. Equipment finance is noted, asset based lending is noted, lease financing is also noted. It's unclear to me that all the -- your relevant competitors are showing the same trends, and I am just wondering if you can elaborate as to whether or not there is some geographic concentration or if there's some restructuring going on or if you've had some turnover.

Are there opportunities there? New pricing strategies? Just trying to get a little better understanding of some of those trends.

Yeah, Tom, to some extent, you're right. Let me explain what I mean by that. If you look at equipment finance, for example. You see this declining trend. Basically there is a portfolio in excess of $2 billion when we started, well in excess of $2 billion, more like 3.5, a portfolio that we really have been reducing over the last three and a half years that continues to reduce at about $150 million a quarter. Now if you -- and, again, it's not an excuse, it is what it is. I mean, we'd be about flat. We need to grow our outstandings there, and this is on the wholesale level. Our -- our consumer equipment leasing is doing very, very well and has nice growth.

Right.

So that is something that we decided to get out of over time. We now are down -- we believe that within the next year that will start showing some growth again, because we have an investment there. So that is the thing on that one.

David go ahead.

Tom, I know the page you're looking at. We really -- if you look at equipment finance, specialized industries, national corporate asset-based lending, all of those businesses, when we began to have credit problems post-9/11, there were several actions taken, in actually all four of those, to deliberately begin to reduce our exposure.

For instance, you've heard us talk about "leveraged lending" which was also -- in several of these groups, we began to get out of and have actually liquidated a lot of that portfolio.

Number two, there were portfolios when the companies came together that, quite frankly, we have had too much overall single borrower exposure. We reduced and sold down a lot of those credits.

Jerry talked about particular portfolios in the equipment finance where we have reduced our exposure and exited. So there were very specific actions that we took in all four of those portfolios to deliberately reduce our exposure. That's not an excuse for where we are today. The charge we have today is to grow from where we are today in all those businesses. Every one of them. And we're doing a lot across-the-board. Both Richard, Joe Hasten, a number of other people are working hard in all those particular markets, but those trends you are citing are -- some of that is deliberate.

I understand that. I just thought that at some point we should see this -- these balances begin to bottom out here. So, maybe that's the question, when do you anticipate some of these categories bottoming out? Jerry, you answered me on equipment financing.

I think if you look, you look at middle market, which is a focus of ours now, you are starting to see a little bit of an uptick. Not exactly what I would like to see as robust but that is starting to turn.

We started to see a little bit of line utilization increase as well, toward the end of the quarter, which is good. If you -- if you look at national corporate, which we've cleaned up, you see there is increases there.

Again, not -- not anything to write home about, but there is -- there is increases there. And so I think the -- the portfolios that we have decided to really play in, you are starting to see some progress in, and I think you will continue to see that.

Could I -- that's great. Can I switch gears -- just a sec on two other subjects. Your -- the instore branch expansion efforts. Since it's -- I know it's run as a separate line of business, and I know that you all are pleased with the rollout. I know it's early days, et cetera, et cetera, but are there any other type of metrics that you can share with us to help us understand the progress that's being made? In growing that business?

Tom, I don't have that. I mean, Mac can get that to you but as far as net account -- it leads our Company in net new accounts, for example, checking accounts. Its fee -- its fee percentage of income is substantially higher than our branches obviously, and it is -- as I said it is beating all our expectations.

I will be happy to get that to you. I just don't have that in front of me.

Yeah, Tom, one thing I can say that probably is important is we should finish these by the end of this year, but more importantly, the time to what we call "breakeven" has been traditionally around two years, and it is -- they are on -- on par with those expectations with our own history.

So none of the metrics with regard to earnings, whether it be driven from deposits and loans or fees, all those metrics in place, the cost of these branches are very in line with what we have experienced before, so our own model basically suggests that we begin to breakeven in two years and there's nothing in the numbers that would suggest that that's any different than that, but I'll make sure Mac gets back with you on that but there's nothing with regard to those performers that would suggest any change.

One last final tiny question. With respect to the payment services and the statistics that are provided in terms of acquiring volume, number of transactions, and number of merchants, can you give us some kind of feel for the degree of improvement from quarter to quarter that is attributable to boosting your ownership in EuroConex?

Yeah, with regard to the revenue, the improvement is around about $20 million for the quarter, which -- which is both EuroConex itself and then the two portfolios that we've acquired as part of that.

But that's basically the -- the difference in the quarter-to-quarter differences.

But organic EuroConex is over 30% increase in revenues. And it's growing very, very nicely.

And -- and the -- the volume and transaction volumes quarter-to-quarter is all of the increase attributable to -- to EuroConex?

Yes -- well, no, no, it's not. Remember, we have the domestic piece. [NovadSouth] And EuroConex. We've had volume increases in both the organic side of it, on the domestic side, and we've signed additional banks during the quarter, and then -- but the big large increase in the revenue really results in the EuroConex improvement.

Yes, Tom, the domestic revenue growth and transaction growth is about 10% year-over-year. So, you know, we are still getting double-digit growth in the domestic business, and then the Europe business is layered on top of that.

Great, thank you.

Thanks, Tom.

Our next question comes from the line of Ben Crabtree from Piper Jaffray. Please go ahead.

Yes, thank you. Just a couple of questions. If I look at the loan portfolio, it looks like residential mortgages are contributing a reasonable amount of the growth in the portfolio. I guess that kind of catches me a little bit by surprise.

I wonder if you can talk about that strategically going forward, whether that's going to continue to grow and then I don't know if you could give us an update, within your total leasing portfolio, how much would be to the airlines?

Yeah. First of all, the residential portfolio, we are booking from the mortgage company only variable-rate product mortgages, which are 1/1 ARMs, 3/1 ARMs and a little bit of 5/1 ARMs. We will continue to do that over course of the next several quarters. We've continued to believe that the mortgage product is an attractive product in this kind of market, where we don't have alternative -- where we have not seen alternative growth in commercial. That's a supplement to our revenue to earnings.

As time goes on and as commercial picks up, you would expect to see a decline, both in the bond portfolio and the slowdown of the growth in the residential portfolio over time. But in this climate, we are going to continue to originate and hold just the adjustables that we are originating.

In addition to that, your question with regard to the -- another part of the mortgage banking question. Remember, when we report residential, we are also reporting first liens on home equity, which is also part of that growth as well.

Right.

So it's really -- it's really both of them.

With regard to the merchant servicing on the airlines, the portfolio really hasn't changed quarter to quarter. As you know, we continue to be believers that the airline industry is -- is going to -- to continue to honor their -- their tickets. We believe that they'll continue to fly, and even in the event of bankruptcy, our experience has been that -- people -- airlines continue to honor the tickets and people continue to fly, and, therefore, we don't believe there is any increase in risk.

As you know, the second quarter, we added $30 million to our merchant processing reserve associated with airlines. And so we believe that reserve is adequate as well. We don't really see any new exposure that we are not -- not aware of or have not considered in that reserve.

And if I could ask one other unrelated question. The management change announced today with Richard Davis becoming President and Chief Operating Officer, I don't know if there are any follow-on announcements to be made, but does that imply that some of his direct business line reports will go elsewhere?

Gee, I don't think so, Ben. I was -- Richard is an outstanding executive and he's really earned my trust and the Board's trust and customers' and shareholders' and all our constituencies.

We're going to have Richard focus on the revenue -- the revenue-producing businesses, and that's real important, because in today's world with, you know, super-charged corporate governance and regulatory environment and also just strategic issues, all CEOs, including me, I just have to spend an enormous amount of time and energy on governance and regulatory pieces, and that's just the facts. And I don't believe any CEO that you talk to would say anything different. Richard is going to focus on those along with me.

I'm not changing the way that I do business, and I tend to be very hands-on. The regimen is going to stay the same because that's what Richard and me and David and our whole management team are familiar with, from a -- from a standpoint of -- of following the numbers. But there is going to be somebody that is going to focus on it 100% of time.

Frankly, if you look at over the last four years, three years, I probably cut in half the time I've spent with customers because of all the issues I just talked to you about.

And so that's the meaning of that. Richard is an outstanding executive. But I am the CEO of this Company.

Okay. Thank you.

Thank you.

Our next question comes from the line of Ed Nagerian from Merrill Lynch. Please go ahead.

Good afternoon. My questions have been answered. Thank you.

Thanks, Ed.

Thanks, Ed

Move next to the line of John Balkind from Fox-Pitt.

Good afternoon guys.

Hi, Jon.

Just a nit-pick question. The reserve -- or the insurance recovery on residuals: what was the dollar amount of that?

It was $17 million, but let me elaborate a little bit on that. As you know and have known for years, we have insurance on our residuals, particularly on our auto leasing area, and this was a payment received from our insurer, based on the claims that we submitted over the course of the last six months to a year. And so that's really what that represents, is that one-time payment.

Great, thank you.

Again, if you would like to ask a question, please press the star and 1 on your touch-tone phone. We will go next to the line of Denis LaPlante from KBW. Please go ahead.

Thank you. Good afternoon. Two things. I just want to come back to the deposit question. If I am looking at your traditional consumer-based balances -- interest checking, money market, savings -- those balances are down about $3 billion link quarter. How much of the institutional money you talked about were in those categories?

Well, let me -- let me give you the -- the -- we have broken it down, quite frankly, by the different line groups that I've talked about before, but in the branch system -- overall in the branch system, which includes noninterest-bearing accounts, money-market accounts and interest checking accounts, let me give you some detail.

For instance, in the noninterest-bearing in the branch system, the second to third quarter, our deposits are up 206 million or 1.6%. In money market, the branches, you're right, are down about half a billion dollars or about -- about 3%.

In the interest checking, we're up 138 million or about 1% on a link quarter basis. So we have them spread out in all the products but we generally have increases. Again, where you have seen the reductions have been largely in the institutional-based areas.

For example, Denis, our government banking is down third quarter this -- third quarter '04 to '03, down almost $2.6 billion. That's all competitive bid that we have decided to fund because our wholesale bar, and it's cheaper than what we can get from our government-sponsored businesses.

But that's year-over-year. I guess what -- I guess what I am looking at is the categories on the liability side of the balance sheet that has increased this quarter by roughly about 4 billion. Time deposits over 100 and long-term debt. I assume that's largely medium-term notes. And the average cost of those are something over 2%. And -- and -- in the interest checking, money market, and savings are, you know, under 100 basis points.

So basically you've had a funding shift from low-cost money up into the higher cost money, and -- and -- and I notice that probably among all the companies that have reported this quarter, that your deposit pricing has moved the least. And so I just kind of -- I am just trying to square all of these developments here.

Well, Denis, all your observations are exactly right. What we've been doing on the funding side is lengthening in the Capital Markets by issuing senior debt in the Capital Markets and extending our liabilities from short to long.

And as a result of that, we are definitely going to give up earnings, but we are also moving our interest rate position where we are much more favorably going to be impacted as we -- as we expect rates rise over time.

For instance, the bond portfolio is an example. The bond portfolio, when we sold the securities, we -- the $2.6 billion we sold for the gain which offset the impairment, we reinvested in floating rate securities.

So we are doing two things; We are continuing to invest shorter and shorter on the -- on the investment portfolio side. The duration came down from 3.9 years and 3.2 years, and we are lengthening the overall debt structure and locking in what we think are very attractive rates in the senior debt markets. That's exactly what we have been doing.

And there is going to be some give-up in earnings as a result of that, but we think that is the most appropriate stance to take, given the fact that rates are low and our own view is that rates will rise over time, and we should be in a good position to take advantage of that.

So exactly where is your rate sensitivity position today, say compared to June 30?

Well, we are more asset sensitive than we were June 30.

Can you quantify, given the same disclosures that you provide in the Q?

Yeah, basically I believe our simulation with regard to up 50 basis points showed that our net interest income would be negatively impacted by about $42 million over the course of one year. It has calmed down to at the end of this quarter down to what we'll report somewhere around $8 million to $7 million.

So you're pretty neutral.

Yeah.

Thank you for your time.

Thank you.

We have no further questions at this time. I would like to turn the call back over to management.

That's great. Thank you for joining us on the call today. And please give me a call if you have any questions.