WaFd Inc (WAFD) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the First Mutual Bancshares third-quarter 2005 conference call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded Wednesday, October 26, 2005. I would now like to turn the conference over to Mr. John Valaas, President and Chief Executive Officer. Please go ahead, sir.

Good morning, everybody. I'd like to introduce who's with me in the room today. We have Scott Harlan, who runs our residential and consumer lending business lines; Charles Smith, a financial analyst, with us; and we are anticipating that Roger Mandery, our CFO, will join us. We understand there is a traffic jam on Interstate 405 just north of Bellevue, so he may be a little delayed.

I'll begin by reading the forward-looking statements disclaimer. This presentation may include some statements regarding the Company's trends, objectives, anticipated growth, credit quality and other expectations which will be forward-looking statements for the purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from those expressed or implied in this presentation. Additional information concerning the risks and uncertainties are discussed from time to time in filings made by the Company with the Securities and Exchange Commission. These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. The Company does not have any obligation to update any such forward-looking statements.

I'm going to be very brief and then I'll turn it over to questions. It was our 52nd consecutive quarter of record year-over-year earnings. Our return on equity was up sequentially, from 16% to 16.7% for the third quarter. Net interest margin came in just a smidge below our forecast -- we were forecasting 4.05 to 4.1, and we came in at 4.03 -- but up sequentially from 4.01 in the second quarter.

Credit quality continues to be excellent. NPAs declined to $635,000 or about 6 basis points. So overall, a very solid quarter. It remains a very competitive environment on the deposit side and the loan growth side, and we were very pleased with the results.

And operator, now I will turn it over to you for questions.

(Operator Instructions). Matthew Clark, Keefe, Bruyette & Woods.

Just a few questions. I guess the first off, on commercial gain on sale, can you just discuss the significant drop-off in the gain on sale margin there despite selling more loans?

Bear with me, I'm --

And I guess as a follow-on, related question, I guess what is the expectation for commercial-related gain on sale margins in the fourth quarter? It sounds like sales are going to be up in the fourth quarter. I'm just trying to get an idea of the magnitude.

Yes. Actually, the commercial loans sold declined from the same quarter a year ago. They were up 4.8 million in 2004, and they dropped to 3.3 million in this third quarter of 2005. And I think the decline in (multiple speakers)

I guess I'm talking about relative to the last quarter. I'm sorry.

Charles, do you have an observation on that?

It sounded like there from the release that there were some sizable loan sales last quarter, and I'm just curious as to--?

We had in the second quarter a fairly large loan sold that was a construction loan and wasn't entirely booked on our books at the time -- it wasn't entirely drawn down at the time of the sale, although the gain was recognized in the second quarter. And then that's subsequently being drawn down over time. So I think that accounts for -- it was quite a large loan. I think that accounts for the variance there, where you're looking at the slight increase in loans sold from Q2 to Q3. But it had fairly sizable gains attached to that construction loan.

And I'm just curious about the limited amount of gain on sale fees this quarter relative to the amount sold. Can you just talk about why?

Roger just walked into the room. I might ask Roger to comment on that. Of course, he doesn't know what the question is. You'll have to repeat it for him. Roger, the question is why the relatively -- well, actually negative commercial loan sale gains relative to the amount sold.

Yes, the commercial loan sales are calculated based on spread and how much we may have had in the way of deferred costs that were capitalized when we first made the loan. So sometimes when we just settle up on this, you'll get maybe a flat or negative return, which is what happened in this particular case.

Okay, and the expectation that that goes up, though, in the fourth quarter, I guess, what is your basis of reasoning why we should expect to see margins up, or just the absolute level of gains up?

Typically, our spreads on commercial loan sales will be more attractive, normally along the same lines that we would see residential loan sales. Rarely would they be as lucrative as we would see with consumer loan sales, where we get larger spreads. But our anticipation for fourth quarter would be that the spreads would be positive, and like I say, would be comparable to what we see in the residential loan area.

Matthew, I'd also point out that as happened in the second quarter, the character of the commercial loans that we're selling will drive quite a wide swing in the gains we recognize. For example, as we did in the second quarter, if we do sell participations in a large commercial construction loan, the gains on those tend to be relatively rich, as opposed to -- and of course, very little of those loans typically, when we sell large participations in a construction loan, show up as bookings on our own books. Straightforward sale of participation in what I will call just a straightforward portfolio term loan typically produces relatively less in the way of gains than a commercial construction loan that we have participated in.

Is that the type of loans you may be selling in the fourth quarter -- the larger construction participations?

We expect to sell a variety of commercial loans in the fourth quarter.

A follow-on, still related to gain of sale, but in the resi area. The I/O sale that you're expecting to do in November -- is that built into your fee guidance?

Yes, it is.

Okay. On the net interest margin, your guidance for the fourth quarter assumes that your transaction balances I guess remain stable or up. I guess my first question is how are they tracking I guess quarter to date?

Second, follow-on to that, is what makes you believe you won't have to materially raise your rates in the fourth quarter, despite what it looks like, to be two more Fed rate increases?

And I guess if you can just maybe discuss the magnitude of adjustable-rate loans -- you know, the buckets that are coming that are repricing -- expected to reprice in the fourth quarter relative to your CD baskets? Sorry about the multiple questions there.

I'll try to remember all your questions there. I think I'll start with the last one there, what we expect. I believe that about 15% of our portfolio is prime-based, so that would react immediately whenever we had a prime rate increase. The rest of the portfolio is pretty much divided into the four quarters. So we'll get about a fourth of whatever is out there, will reprice each quarter.

In regards to our deposit repricing, a couple things happened in third quarter. One, we needed to be responsive to the local market in terms of having some promotional time deposit promotions that were kind of rich, and that of course had an impact on the quarter. And then we also needed to be more responsive on money market accounts and some of the -- they call extreme checking accounts, and I guess other terms they use for that. But anyway, they are the large-balance checking accounts that are being priced a lot like money market accounts.

But, in talking to the fellow that heads up our pricing community, he's optimistic, and of course all bets are off until the quarter's over, but he's optimistic that we can probably hold the line in fourth quarter and we'll see the margin probably come in pretty much along the same lines that we had in third quarter.

Okay, and then lastly, the -- I guess how are things tracking on the transaction account balances?

Unfortunately, we normally don't comment on what's occurring in the fourth quarter.

Fair enough. Final question, and then I will get out of the way here. The run rate of expense is expected to bounce back to about 7.3 million. It sounds like part of that you expect that bonus accrual to maybe come back, and I'm just curious as to what else is driving that increase from third to fourth?

Yes, on bonus accrual, of course, I guess we'll have to wait and see how the year shapes up and see whether or not we're deserving of a larger bonus than what's already been accrued. But one thing that factors into that is the increased insurance premium as far as sales finance loans. We have about $10 million of loans that are insured that are right now, if you will, double-insured. And I think there was some discussion on that in the sales finance loan area. So that's about $75,000.

And also, fourth quarter is a quarter where kind of all our expenses are trued up if we're, for example, contributions is an area that if we can afford it, we will maybe catch up on some of the stuff that we hope to be appropriately used for the local community and things that nature. So fourth quarter, like I say, is usually a little stronger in expenses, and I'm just sort of anticipating all of that occurring in fourth quarter.

And Matthew, this is John. I just might follow up with a brief comment on the bonus accrual. The key constituents for the management bonus accrual are earnings per share -- growth therein, return on equity and deposit growth. And deposit growth is almost entirely focused on transaction account growth. And as you can see from our numbers, that's been disappointing this year, and we're not quite where we think we should be on return on equity, either, although it's certainly, at 16.7%, nothing to be ashamed of. But it's not where we want to the. But that kind of -- those are the drivers on the management bonus accrual.

Jim Bradshaw, D.A. Davidson.

First question I had, I would have anticipated that there might be a surge in charge-off activity or loss rates in the insured piece, too, from the bankruptcy law change in the quarter. I don't see it in the number. I just wonder what your thoughts were there.

This is Scott. That activity is, as everybody out there knows, started to -- in terms of the bankruptcy law started to pick up about 15 minutes after Bush signed it -- signed the law six months before implementation and ramped up slowly but surely over those six months. And there is -- the effect is in there in that bankruptcy filings did increase throughout the quarter.

But really, a lion's share of the bankruptcy filings that we received prior to the implementation date, as you can imagine, came in closer to the implementation date than in prior. So yes, there are bankruptcy charge-offs and claims against the insurance policy in the numbers that you see there. And as you get closer to October 17, that number will increase.

You probably saw the lines on TV news on -- like October 14, the lines around various courthouses around the U.S. on October 17, so there was just this huge surge in bankruptcy filings after the close of the quarter.

Jim, I would just add one last note on that, and that is a lot of those bankruptcy claims that have come in were covered underneath the claims that we made on insured portfolio.

Got it. So the model you use worked pretty well, then, it sounds like, that stuff that -- with more risk was in the insured component rather than the uninsured pieces?

That's our belief and experience so far, at least through the end of the third quarter.

Okay, good, thanks. The other question I had, can you talk a little bit about insurer number two compared to number one -- maybe what the AM Best rating difference is between the companies and maybe is there much in the way of pricing disparity between the two or discrepancy between the two companies from the old contract to the new?

Second question first. The pricing is virtually identical to insurer number one, and then, sorry, I forgot the -- oh, the Best rating. I'm going off the top of my head here, and I believe this is correct, but insurer number one is rated A+, which has the tag line of superior, and insurer number two is rated A, which has the tag line of excellent. To the best of my memory, those are the two numbers -- labels.

And the supplemental policy, is your intention going forward -- I guess it depends a little bit on probably what loss rates turn out to be -- but is your thinking going forward that you won't want to use that -- you all want to share things going forward on the supplemental policy; it's just really that older vintage that had the more loss severity in it?

That would be the case at this point in time, without being able to predict the future, obviously.

That's what you're paid for, right?

Scott got worried when I read the forward-looking statement disclaimer.

Louis Feldman, Hoefer & Arnett.

I thought you accused us of having that job, of looking into the future?

Lou, congratulations on Noah.

Thank you. A couple of questions, kind of a follow-up with Jim and following along on the insurance companies. Scott, can you comment on your thoughts of going back to insurer one, or is that relationship essentially done at some point in the future?

As I mentioned in the write-up, we have -- we continue to have a relationship with insurer number one on other products that we offer -- not sales finance. And my anticipation would be -- in a couple years, after we have a better track record or more -- a longer track record on history on loans that were insured after we tightened up our underwriting criteria roughly a year and a half, a year and three quarters ago, they have said that they would be thrilled to take another look at it in a couple of years. But they want to see -- they just want to see more history. And they were obviously a party to the experience that we had in that first policy year, and that is what is forefront in their memories right now. So they want to see what's (multiple speakers)

Because I certainly know that we have discussed this on this call in the past about concerns over pricing. Yet the quote, unquote, breakup -- I assume this was due to pricing? In fact, it states it right here -- did not reach an agreement on the pricing. I assume that their expectations became significantly higher based on their loss exposure?

Yes. When their loss exposure -- when you take into account their loss exposure included that entire first policy year, they had sort of a different bogey to hit than somebody who was just insuring on a prospective basis. So that's where we could not come to agreement, was on their expectation of overall premium.

Is there the possibility of an insurer number three?

I really can't comment on that in that I just don't know necessarily who is out there and who's not out there offering this particular product.

I've got more questions, but I will step back.

Bill Dezellem, Tieton Capital Management.

Might as well continue on the insurer line of questioning. Do you believe that in any way, shape or form that the capital that came out of the insurance system or is coming out due to the hurricanes, that that impacted pricing at all, or do you believe it was entirely experience based on that -- specifically that first year of portfolios?

The answer is the latter.

Okay, thank you. And then continuing on relative to sales finance, the delinquency rates actually have been increasing for the last couple of quarters in the uninsured portfolio. And actually, for the last four quarters, it appears in the insured portion of the portfolio. Would you walk us through what you think is behind that rise and just the dynamics that you are experiencing?

I think there are two things driving it. One is hopefully the short-term effect of the change in the bankruptcy law, and the other is that as time goes by, the loans that are in the portfolio become more and more seasoned as the level of production has leveled off and the new loans going in become obviously a smaller percentage of the overall balances. So I think what you're seeing there is just an overall seasoning as the higher percentage of the loans are older rather than newer.

Okay. I'm sorry. I think that I missed something here, because what I thought I heard you say was as the loans mature, they end up being more stable or more credit-worthy, and yet what we thought we saw in the press release was where the delinquency rates were actually increasing, which seems counter to the maturation perspective.

As a loan -- as a portfolio becomes older and more seasoned, the delinquency rises early in the formation of the portfolio. In other words, new loans that go into the portfolio are rarely delinquent right after you make them. They are on the books six, eight, 10, 12, 18 months -- that's typically when -- if a delinquency is going to happen, that's typically when it starts to happen. So as -- certainly in the few first few years of this portfolio, as the portfolio gets a little bit older, one would expect the delinquency to rise.

Bill, this is John. I also -- this is purely speculative, but I also think that these are all homeowners, and those who are capable of refinancing are going to do that early on, and they tend to pay off and probably leave those in the more mature portfolios, Scott is suggesting, who are less capable of refinancing their house and paying off the sales finance loan.

Thank you. And then finally, shifting to the difference that you highlighted in the release between the GAAP model and the simulation model, really, they came out with what appears to be two pretty different answers. Would you walk us through kind of how you view those two models and interest rate sensitivity going forward and your comfort with having a negative GAAP at this point in the cycle?

Bill, this is Roger. Charles Smith, who is the genius in the bank here and runs all our simulation models, he and I were talking about this the other evening, and I said this question will probably come up and probably come from Bill himself. So, Charles is all primed to answer that.

Thank you for your preparation.

The answer is yes, we are aware of the two, and just kind of a couple of thoughts on the GAAP. We really don't rely on the GAAP. If you take a look at the interest rate risk section that we write up for our 10-Qs and 10-Ks, it's a lot more expanded than what you see in the press release. We kind of briefly comment on a number of shortcomings with GAAP analysis, which is one reason why we don't rely on it.

Another issue that we've had with regards to the GAAP report is just the assumptions we make in terms of how we present certain things in the GAAP, among them the treatment that we apply to money market accounts, which we consider within one-year liabilities. So in looking at our GAAP ratio, it's actually been declining for several quarters. And not so much this last quarter, but previously, a lot of that was attributable to growth in money market accounts.

Basically between the issues just inherent in GAAP, the limitations of the report and the way we treat certain things, the GAAP number itself is not terribly significant. We don't look at it as a very good predictor in terms of what's going on in terms of our interest rate risk picture. We spend a lot more time looking at the income simulation, which we think represents the most accurate possible look at our interest rate risk position, kind of looking out in the short to intermediate term, one year or so.

And then as we also comment in the 10-Qs and 10-Ks, we run longer-term simulations in the form of EVE and duration analysis. And in looking at the short-term income simulation and the longer-term EVE and duration analysis, the results tend to be more consistent, relatively consistent with one another, and in my opinion probably a much better reflection of what our actual interest rate risk position is.

And would you agree with the statement that that income simulation model works well until you end up in a quarter like the third quarter of '05 here, where you had to match competition on the deposit front?

Bill, I would just add a comment here. That is by and large, the net interest margin has been pretty rock solid, right around 4%, even though we've had a big spike-up in the last year in rates. We've had a flat yield curve -- so conditions that are pretty tough in terms of bank margins, but it's been rock solid.

The simulation model indicates that if rates were to rise a couple hundred basis points from where we are, we wouldn't expect a whole lot of degradation to the margin. Yet, the GAAP shows a concern, and that was kind of the question that I posed to Charles the other day. And said one of the problems you have with GAAP is that -- just take prime rates loans, for example, and that's about 15% of the portfolio. The GAAP assumes that you're going to get one repricing. And yet in reality, if rates rise a couple hundred basis points, that prime rate will go up two or three times, each time the Fed kicks in another quarter percent.

So that just shows one limitation. But so kind of our expectation is that things will change and we'll get little surprises, like we did in the third quarter, but by and large we would expect our margin to be pretty steady.

Bill, I also think if you go back and look over the last few quarters at our press releases and Qs that the comments and the conclusions that we got -- obtained from the simulation models have been reasonably predictive.

I mean, we're only off a couple of -- I mean, our prediction was 5 to 10 point -- I'm sorry, 0.405 to 0.410, and we are at 0.403. So we're only 2 basis points off of the bottom end of that range. And that's also sort of been the hit that we took to repricing on our retail deposits.

Right. If you would allow me to change the question slightly to a little bit different direction, long-term rates have been reasonably flat over this recent period of time, and it's been the short end of the curve that's come up. As we see the longer end of the curve increase, assuming that it does, what can you do or are you limited in your ability to reprice -- not reprice -- well, maybe actually two questions -- reprice the existing consumer finance loans, and then secondarily, increase the rates on those in the future?

This is Scott. First of all, the loans that are on the portfolio are fixed. So those rates can't be changed. Going forward, certainly, when I price the new loans we put on the books, those -- I tend to use roughly the five-year Federal Home Loan Bank advance as kind of a proxy for what I want to do with rates. And in fact, you know, rates have -- I have adjusted those rates a couple times over the last several months to reflect the increase in those rates.

Okay, so you are feeling it, even though we're talking a double-digit rate here on those loans, that you still do have the ability -- the consumer will accept you raising the rate, not a problem?

Correct, yes.

Ross Haberman, Haberman Funds.

Solid quarter. I was wondering if, John, you talked about additional I guess expenses relating to some of your real estate; you're moving around some of your operations. Could you tell us a little bit more about that and the incremental additional costs related to that? And overall, are you using all of your building now or are you continuing to sublet parts of it? And I didn't quite catch the income related to that.

I'll let Roger response to the expenses and the income, but let me just tell you about our building here. We're occupying currently about 60% -- 55%, I'd say, of the building. I ran into the movers last night. We just finished a week ago or two weeks ago the last of the moves of our own internal departments within this building after the completion of the remodeling for our space.

So I think virtually all, maybe with a few very minor exceptions, virtually all our employees are where they are destined to be in the building. And that left us with one entirely clear floorplate on the sixth floor of the building. And the movers were in last night cleaning that out, so it will be gutted down to essentially pretty much a shell space. Then we have pockets of other space available throughout the building.

Now that we're settled, we're really focused on leasing the remainder of the building. The office market in Bellevue has become white hot. Class A vacancy is around 8% now. There are several new office towers going up. The City Hall is moving in across the street from us, and we think that we will have lots of opportunities to lease the space. We have interested prospective tenants, including a law firm, that may potentially take most of that sixth-floor floorplate. But we don't have any commitments yet.

So that's kind of where we are on the building, Ross, and maybe Roger wants to respond on expenses or income. Obviously, income will only come to the extent that we get some of that empty space leased up. And do you want to comment on the expenses associated with the remodeling?

Yes. Ross, your question was income and expenses related to the corporate headquarters.

Yes.

A lot of the space that would have normally been available for leasing was taken as temporary space for our staff as we moved them into those spaces. And then the floors that the staff now are now occupying were gutted and remodeled. And in fact, they just finished remodeling the lobby area. So we virtually have not done any leasing other than some of the pockets that have been filled by tenants that were here long before we bought the building.

But we're now expecting something along those lines next year, where we can fill this out and rent those spaces up. Part of the operating expenses that are shared in the common area maintenance cost, and so if we can get some of this leased up, then some of the operating costs will be borne by those tenants. And so things should improve for us next year.

We haven't really tried to quantify that yet, and perhaps we will do some of that when we get to the budgeting for next year. But that would all certainly improve our fee income and help our operating costs if we can get this stuff leased up.

As John indicates, the rental market has improved dramatically in the last few years. If you'll recall, it wasn't too long ago that we had something in the order of 30% vacancy rate here in this area. John indicated a second ago it's down to about 8%. So things are looking up and we should have a better year next year.

And just one additional question. Given the various pieces of your mortgage portfolio, which I guess you are hoping to sell and/or are in the process of selling I guess on a flow basis, do you expect much better loan -- net loan growth in light of I guess the different pieces of the portfolio which you want to sell than you saw this quarter?

Ross, are you focused on residential, you said?

No, no. Overall. I mean, I was looking at that section -- I guess you are selling some of your I/Os. You want to sell pieces of I guess the commercial. And I guess the one portion I guess you are keeping is I guess the consumer piece of it. You're not selling those as fast as you historically had. I'm just trying to get an overall sense of your thoughts on overall loan growth in light of the sales.

Ross, this is Roger. The I/O sale is just kind of a response to the general market concern over interest-only loans, and rightfully so. And we didn't have a whole lot -- it was like 11 million, I think, at the end of second quarter, and we're down to about 8 million now, somewhere in that range. And so that's not a lot, and those have performed well. But we decided it's probably a good, conservative move on our part to sell that.

But normally, we do not sell loans out of residential loans other than fixed-rate loans that come in over the tranche (ph) and that are the kind of product we would normally -- would not normally keep on our portfolio.

The real big change is that we have kind of shifted away when we can from selling consumer loans to selling commercial loans, and now not a lot of that occurred in second quarter -- I'm sorry, third quarter. It was our intention that we'd have more sales in third quarter. It just didn't happen. We think that we'll probably see more in fourth quarter.

One of the characteristics of those commercial loans is that they have a long lag time from the moment that you sit down and fill out the application until the time they actually close the loan because they are big loans that take a long time, and so they tend to bunch from one quarter to the next. And they are not nice even flow like you might see in consumer loans or in residential loans.

So we think we'll see periodically bunching as we go forward. But the big reason for the move is that the pricing and some of the other comments regarding credit I think John's made over the last couple of quarters are right on in terms of it's just a less-desirable product for us. And so we're kind of backing away. And we're in the business and as active as we ever have been in originations, but instead of portfolioing those loans, we're kind of acting as an agent and selling them to other folks that have an appetite for them.

The growth in the portfolio for the last few quarters and actually well beyond that has largely come in the consumer loan area and in the residential loan area that -- the niche products, particularly the custom construction loans and what we call nonconforming residential loans. So that has been a real -- that has been steady, and our expectation is that we would continue to see asset growth and loan growth in those areas.

Ross, John. Also, an additional comment on commercial loan sales. Starting a year or so ago, we started to develop additional markets for loans because of the concern that Roger mentioned that we had about pricing and credit structure. But there's still a hunger in the market for a lot of these loans. And so we started developing markets for loans that typically we had not been going after before. And now we're going after those that we still like the credit characteristics of, but maybe not the pricing.

And so we're expanding our origination, particularly in the commercial real estate area, but selling more. So it's not as though our origination capability is flat and we're talking about selling more loans, therefore there's less going into the portfolio. We like to think that we're expanding our origination capability, and therefore generating that quantity of loans that can be sold.

Just one final question. I think you'd said you expect to grow 5 to 10 million net I think for the fourth-quarter loans in your verbiage. Would you expect the overall portfolio to shrink given that loan growth and how quickly the mortgage-backs are basically running down?

No. We would expect our portfolio asset growth, which most of it is coming out of the -- is coming from loan growth, to continue in fourth quarter and throughout next year. We do have run-off in the securities portfolio, and periodically we will add new securities to bring that back up. But like I say, our expectation would be that we would continue to have asset growth along the lines that we've seen this year.

Even though we have this flat yield curve?

Yes.

Sara Hasan, McAdams, Wright, Regan.

I'm just wondering if you're seeing any shift in the demand in the secondary market for commercial loans? Are people looking for different types of products, or are things pretty steady?

This is Scott. Our experience so far is that it remained -- the buyers out there have a voracious appetite for commercial real estate loans and the demand really hasn't changed, either in terms of their appetite for it nor the time kinds of products that they are looking for.

I'd have to say that it's actually to me somewhat astonishing how voracious the appetite is and how little in yield many lenders are willing to accept.

And then kind of shifting gears, I think you might have talked about this in the last conference call, but I had forgotten. Your cash balance has been building up a little bit. Are you planning to do anything with it, or will you put it into securities coming up soon?

This is Roger. Our cash balance is really just sales being settled and money that's in transit. We're normally a net borrower on short-term funding. So we rarely have any idle cash that's available. So that's mostly an accounting entry where money is just pending transit, really.

(Operator Instructions). Louis Feldman, Hoefer & Arnett.

A couple of questions. Given the increase -- if I understood the text correctly, you're increasing the servicing portfolio certainly on the sales of the commercial loans, and to a certain extent on the residential, even though you had gotten rid of all your residential mortgage loan servicing a couple of years ago. Is there a risk of a servicing right revaluation or devaluation on this other servicing portfolio?

This is Roger. Yes, I mean, it's always a concern to us that we will have an impairment on a servicing portfolio -- excuse me, on the mortgage servicing rights and deferred servicing rights that are on the balance sheet. It's something we look at every quarter and trying to make sure that we're following all the rules and that we have it properly valued. But yes, that's always a risk out there.

In the case of our consumer loan portfolio and our commercial loan portfolio, that's servicing that there's not a ready market for, and quite frankly, most people who buy that really want us to service those loans, particularly consumer loans, which are small loans and you have to be set up to administer that particular type of servicing.

So, we find that we normally retain the servicing, and I guess we also retain the relationship with the customer, which has some merit. But you are right. I mean, it's a concern right now. I think I don't have the numbers exactly in front of me, but the last time I looked, it's a couple of million dollars that's on the balance sheet. And as a percentage of our income and that sort of thing, it's not particularly alarming right now, but it's something we keep an eye on and we're very concerned about making sure that we don't have an unexpected surprise with the revaluation of the servicing portfolio.

Given how some of the other institutions have had some fairly significant jump-arounds in their servicing rights valuations, how is it that you haven't had any -- or at least that you've indicated in any of the many MD&As or 10-Qs?

So far, we've been right on on our projections for amortization. Each quarter, we reevaluate what the prepayment experience has been and projected for the next three months, and we look at all of our assumptions and run it through all the various models and come up with the amortization that we need to apply for that quarter against the mortgage servicing rights. And so far, all our work has been right on and we haven't had an impairment.

This is Scott. I might just add for a more typical mortgage banking operation, where they're putting performing loans on the book, they're probably putting those assets -- servicing rights assets on the books at a fairly modest prepayment speed, considering that at the time they are made, they are market-rate, fixed-rate loans.

Our loans tend to prepay faster, so there's that assumption is inherent in the value that's put on the books as a fairly fast prepayment speed, too. It eliminates a lot of -- or at least a certain amount of the variance that you can kind of get on them, quarter-to-quarter basis, when you use fairly fast prepayment speeds to begin with.

So if I understand this correctly, given the 35-45% prepayment rate on the consumer portfolio, that is reducing the variability because you anticipate the high prepayment rate, whereas a typical mortgage servicing right is running out over 30 years and has a much -- like most loan bonds has a much wider variance.

Exactly.

Okay. Second question I have is, there are references within the MD&A over deferred fees on the commercial real estate, of which on the first set of questions from my colleague from KBW, you referred to the change in your gain based on some of those deferred fees. What is the risk of some of those fees hitting in Q4 or Q1? Is there an acceleration potential here?

This is Roger. No, I don't think that we're going to see anything of significance occurring in the future quarters here. If we happen to have a loan sale that has a narrow spread on it, and sometimes that occurs because we have a customer that we'll just loan it up to and we need to sell off a loan, so occasionally, we may have a small spread between what gets sold.

So then when we sell that loan, if there are any deferred costs -- what we call FAS 91 costs -- that are remaining on the books, when we settle up, we calculate the present value of whatever the spread happens to be and then from that we subtract any remaining capitalized costs that are associated with that loan and net it out and resold as net gain on loan sale.

So occasionally, you can have kind of a skinny deal where you may have a small loss on it, just because of the way you net everything out. But that's not typical. Typically, we have spreads that are more normal spreads and the gain will be a positive gain.

Okay, and then we generally lob this in there; you rarely answer it. But can you tell us what the pipeline is looking like at this point in time?

How about those Mariners?

No, no. How about those White Sox? The longest game on the day that there's the early conference call.

Still playing inning 15?

Bill Dezellem.

Circling back to the space that you now have available in the First Mutual Center to lease to third parties, how many square feet are there roughly that you will be at some point leasing?

I think the building, Bill, is about 70,000 feet. I think each floorplate is -- I don't know, something like 10,000 feet. And so we've got, let's say, 50, 60% of it, so 42,000. I can't tell you off the top of my head how much else is leased, but just a guess, we're probably looking at 10 to 16,000 -- probably somewhere around 16,000 square feet. But that's just a wild guess. I don't have the numbers. But that's approximate.

Okay, and then I will just -- because I don't do math very well, call it 15,000 square feet -- what's the range of lease rates out there at this point that would be reasonable to apply to that?

You know, that's -- Bill, that's (multiple speakers)

If you're not interested from a competitive or a lease rate disclosure perspective, maybe just share with us kind of the range between Class C and Class A, what's out there and then we can use our own judgment.

You know, I think Class A space is going anywhere in Bellevue from triple net $25 to somewhere north of $30, probably more -- I'm guessing more in the 25 to 30 range, triple net.

That's including the CAM charges?

Excluding.

Excluding. All right. And CAM is roughly how much?

Oh, I don't know. $6.00, $7.00. Somewhere in that range. But we're not Class A space, Bill.

And then the Class C?

$1.50 a square foot.

Well, that may be more in the -- now I'm talking fully loaded, maybe more in the range of $20 all-inclusive, not triple net.

Rob Osten, Etticott (ph).

Sorry if I missed this because I got on early. But can you guys talk about target capital levels and where you are targeting to run the bank at this point?

This is Roger. We normally focus in on risk-adjusted capital. Our Tier 1 capital is well above the well-capitalized rates of 5%. We're in the mid-7s. Currently, our capital ratio is a little north of 12% -- the risk-adjusted capital ratio. Our target range is 11.5%. That's a soft number. We try to make sure that we're well above 10%, which is the well-capitalized risk-adjusted ratio. So I would probably suggest that somewhere in 11 to 12% range, we try to operate in, depending on what our investment opportunities are.

And as you know, we have had a history in new states (ph) that one of our objectives is to manage our capital fairly intensively, and we have bought back 20% of our shares in a single transaction a few years ago and paid a few special cash dividends historically.

At some point, obviously, it helps the margin, but at some point it's going to hurt the ROE. And that was just wondering if -- are you getting to that point, and why risk-adjusted versus Tier 1 are you targeting?

Because we seem to have plenty of Tier 1 capital. For example, if we were to run down to the 10% floor, our Tier 1 capital would still be well above the 5% threshold. So it is just not an operating concern for us. Normally, we are looking at risk-adjusted capital. And that's because the less favorable capital treatments occur with commercial loans and consumer loans and construction loans, which is kind of our bread-and-butter loan. The more favorable capital treatment occurs with conformed -- I mean with permanent house loans. And although that represents about 20-some percent of our portfolio, it's still a small portion compared to the overall portfolio.

So we're mostly focused in on a risk-adjusted ratio, and that's the ratio that we look at to determine whether or not we think we have, quote, excess capital, unquote, and whether or not we need to use that capital to support asset growth if we think that that's going to occur anytime in the near future. And if we don't see that happening, so for example, if we see capital accumulating a lot faster than our asset growth is occurring, then we will look to doing something with that capital, such as special dividends, which will occur from time to time for us, just because we have such thin float. And occasionally, if we get an opportunity to buy back shares that are not part of the public float, so that we don't affect the public float, we'll take a look at that from time to time.

And the last time, I mean, there are a couple of components, obviously, to the risk-adjusted capital. Where are you in terms of your trust-preferred to limitations? I assume you have some room there because the last time you did that was when you did the buyback, right?

Yes, that's correct. We have 17 million of trust-preferred securities on the books right now. And we're capable of adding much more of that. Not a whole lot more in terms of Tier 1 capital, but again, Tier 1 capital is not a serious concern for us. We're mostly worried about our Tier 2 capital, and in that case, we have quite a bit of capacity to add more trust-preferred securities if we had an opportunity to do something with it.

Louis Feldman.

I noticed the slight change down in the footnotes -- variable-rate loans declined as a percentage of total loans. Can you comment on that?

Lou, it's Roger. I will let John and maybe someone else might want to comment on that. But not a whole lot. I mean, it's 88% and I think we were like 90% (multiple speakers)

We were 89 or 90.

Yes, so (multiple speakers)

90 last quarter. It just surprise -- that just caught me off guard.

Yes. A little bit of that would be because the consumer loans, although they had a very rapid prepayment speed on them, they are fixed-rate loans. And so to the extent that we're keeping more of the consumer loans and selling less of them, you would see a little blip up -- or excuse me, a little blip down in that figure.

Management, at this time, we have no further questions. Please continue with any further remarks that you would like to make.

Okay. We would like to thank you all for joining the conference call today, and again, I think we had a real solid quarter for the third quarter. We look forward to talking to you again in three months. Goodbye.

Ladies and gentlemen, this concludes the First Mutual Bancshares third-quarter 2005 conference. We thank you for your participation. You may now disconnect, and thank you for using ACT Teleconferencing.