Earnings Transcript for CBH - Q4 Fiscal Year 2007

Operator: Good day and welcome to the Commerce Bancorp fourth quarter 2007 investors conference call. Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the director of investor relations, Mr. Edward Jordan. Please go ahead sir.

Edward Jordan: Good morning ladies and gentlemen, this is Ed Jordan, director of investor relations. I would like to welcome you to Commerce Bancorp’s fourth quarter 2007 earnings conference call. We hope that everyone has had an opportunity to read over the detailed press release which we issued earlier this morning. I would like to remind you that today’s conference is governed by the forward looking language appearing at the end of today’s press release. With us today are the company’s CEO, Robert Falese and CFO, Douglas Pauls. Doug will make some opening remarks on our financial performance, Bob will report on our commercial lending activities and the credit environment and then we will open the call for Q&A. As previously announced on October 2, 2007, TD Bank Financial Group and the company announced they signed a definitive agreement for TD Bank Financial Group to acquire Commerce in a 75% stock and 25% cash transaction. The company has called for a shareholder’s meeting on February 6, 2008 at 4

Douglas Pauls: Thank you Ed and good morning everyone. I would like to spend a few minutes discussing our financial performance in the fourth quarter of 2007. For the year of 2007, our strong growth continued with assets up 9%, loans up 14% and deposits up 12% year over year. In the fourth quarter itself we were basically flat in terms of assets and deposits with 5% linked quarter growth in loans versus September 30, 2007. During the quarter a number of factors contributed to the loss of approximately $1.5 billion in higher priced deposits, primarily in the commercial cash management, public now and public time deposit categories. Those factors included the volatile interest rate environment, given the elevated level of LIBOR throughout the quarter we saw some of the money center banks using the retail deposit market as an alternative source to supplement the huge increase in their required wholesale funding. Another factor was the overall economic environment, we had several large corporate customers who changed their investment policies to limit or exclude bank deposits as permissible investments. And another factor was a change in the company’s investment strategy. With all our excess funds now being reinvested in the floating rate securities versus the former strategy of primarily fixed rate investments, the company chose to run off some higher cost, less profitable deposit relationships. With the sale of approximately $7.5 billion of primarily fixed rate securities early during the fourth quarter, as we discussed in our third quarter earnings release and with the reinvestment of those proceeds in floating rate securities, the company has eliminated its negative balance sheet gap and reduced its exposure to rising interest rates. Although this may limit margin expansion for the company given the current economic environment, it better positions us going forward to reach our long term goal of minimizing interest rate risk on our balance sheet. For the fourth quarter, the reduction in short term interest rates primarily the three month T-bill and the elimination of some higher cost deposits as noted previously, resulted in a significant drop in the company’s cost of funds to 265 from 296 in the third quarter. As a result, our net interest margin increased from 313 in the third quarter to 332 in the fourth quarter. On a year over year basis, the fourth quarter 2007 margin increased 7 basis points from 325 in the fourth quarter of 2006. This marks the first time since the third quarter of 2004 the company has had a year over year increase in its quarterly margin percentage. We currently project our margin to be relatively flat in the first quarter of 2008 and depending on the level of short term interest rates and decisions made regarding the company’s investment portfolio post merger with TD Bank Financial Group, we would project our margin to narrow if LIBOR decreases throughout 2008. Despite the loss of a significant amount of higher costing deposits in the fourth quarter as discussed, same store sales growth was 11%, our 41st consecutive quarter with double digit same store sales growth. During the quarter we opened 13 new stores bringing our total for the year to 42. For 2008 we currently project 30-35 new store openings. Loan growth was again strong for the quarter with year over year growth of 14% and linked quarter growth of 5%. In a few minutes Bob Falese will discuss our loan portfolio and the current credit environment. Regarding the income statement, it was a noisy quarter. We recorded a $55 million provision for credit losses versus $26 million in the third quarter and $10.2 million in the fourth quarter of 2006. We also completed the sale of the company’s insurance brokerage subsidiary which resulted in a pretax gain of approximately $22 million prior to the recording of certain onetime pretax expenditures related to the transaction of approximately $8.3 million. Also included in the fourth quarter results are pretax losses of approximately $6.7 million related to the company’s equity method investments. I should note that as of December 31, we have eliminated our position in the most volatile of those investments. These items along with the resulting impact to the company’s effective tax rate effected the fourth quarter results. Net income totaled $33.4 million for the fourth quarter of 2007 or $0.17 per diluted share versus $62.8 million or $0.32 per diluted share in the fourth quarter of 2006. Taking out all the noise, we estimate a $0.39 quarter. Net income totaled $140.3 million or $0.71 per diluted share for the year as compared to $299.3 million or $1.55 per diluted share for 2006. The company’s 2007 results were impacted by the restructuring of the company’s investment portfolio in the third quarter as well as the fourth quarter items we discussed previously. Non-interest income excluding net securities losses was up 21% for the fourth quarter, driven by a 23% increase for the quarter in deposit charges and service fees. Our check card revenue continues to grow with a 27% increase for the year of 2007. We continue to review our non-interest expense growth in this volatile interest rate environment. Excluding the impact of the incremental FDIC premium for 2007, which was $21 million for us and onetime costs related to the sale of the insurance subsidiary, non-interest expenses were up 17% for 2007. We are working on a plan to lower this rate of growth in non-interest expenses in 2008. At December 31, 2007, we remained well capitalized by regulatory standards with our leverage ratio at 6.01%. Before turning it over to Bob I would like to spend a few minutes discussing the company’s investment portfolio. All of our mortgage backed securities are either agency backed or triple A rated. At December 31, our portfolio totals $26.5 billion of which $6.6 billion is in triple A rated floating rate asset backed securities and $18.5 billion is in mortgage backed securities which are primarily fixed rate. The mortgage backed securities of $18.5 billion include agency backed securities of $7.6 billion and non-agency mortgage backs of $10.9 billion. The non-agency mortgage backs are further broken down into securities backed by jumbo residential loans of $6.2 billion and securities backed by alt-A loans of $4.7 billion. We have zero CDOs in our investment portfolio. We have zero exposure to subprime loans in our investment portfolio. No bonds have been downgraded. Commerce as an independent entity continues to enjoy sufficient liquidity and earnings power to hold all bonds to maturity. Concerning the valuation of our portfolio at December 31, I would note the following. Historically our portfolio pricing has been provided by an independent leading global provider financial market data. At December 31, 2007 we concluded that their pricing represented reasonable market values for agency backed securities but was not adequately reflecting the market illiquidity for non-agency securities. So, we decided to obtain trader quotes for our non-agency securities in order to more reasonably reflect the impact of the current market illiquidity on the market value of our non-agency bonds. As a result, the mark to market unrealized losses on the entire portfolio at December 31, 2007 totaled $1.1 billion, approximately $460 million for the available for sale portfolio and $615 million for the held to maturity portfolio. My understanding is that TD had that kind of number in their acquisition model in terms of a valuation on the portfolio. None of the unrealized losses represents anything other than temporary impairment. The losses relate to interest rates and or market illiquidity, not impairments due to underlying credit concerns. Specifically, concerning our alt-A portfolio, we have approximately $4.7 billion of non-agency securities backed by alt-A loans. Our alt-A exposure is focused on high quality borrowers with documentation issues that don’t lead to performance status as opposed to scratch and dent properties. The underlying loans are fixed rate and do not have scheduled rate resets. At December 31, 2007, our alt-A securities are backed by loans with average FICO scores of 713 and average LTVs of 71%. At origination, alt-A securities are priced with higher subordination levels than other securities with the more recent deals being priced at 7% subordination levels. Our portfolio of alt-A securities currently has an average subordination level of 9.4%. Delinquency rates in the portfolio have risen only slightly over the last six months. Based on all of these factors, we remain very comfortable with the credit quality of the bonds from our alt-A portfolio. And at this time I would like to turn things over to Bob Falese.

Bob Falese: Good morning ladies and gentlemen. Regarding our lending activities for 2007, I would note that loans grew overall about 14% with consumer loans primarily home equity fixed rate growing 14% and commercial loans growing 18%. Investor developer commercial real estate loans grew 7% as we tightened our underwriting parameters for commercial real estate and construction lending. Non-performing assets, total assets remains within our previously announced range at 22 basis points. During the fourth quarter we recorded a $55 million provision to cover charge offs and we continued to build reserves. Reserve coverage to non-performing loans grew to 204% on the reserve to gross loans grew to 120% from 103% at 12/31/06. Our net charge offs for the year amounted to 31 basis points, inclusive of a large charge off in the fourth quarter, primarily driven by a $12.5 million write down associated with a $25 million loan participation in a Northern New Jersey real estate development loan which we had placed on not accrual in the third quarter. The remaining charge offs were focused on small real estate developers, regional commercial borrowers and several jumbo residential mortgages. All of those by the way were within our designated market areas. No broker transactions were involved. We are certainly in a challenging credit environment. With regards to segments of potential weakness, residential real estate construction in general, the Florida market in particular continued to be areas of concern. 23% of our increase in non-performing loans during 2007 came out of the Florida market. We entered Florida two years ago through acquisition, over the last two years we have responded to the market conditions again by tightening our underwriting standards and increasing reserves. Overall our portfolio of residential real estate development amounts to roughly $1 billion in commitments and about $600 million in outstandings. Over 94% is located in our core marketplace including Pennsylvania, New Jersey and New York. Absorption particularly in these areas continues to be satisfactory. Given the credit environment, we do continue to go through and reevaluate our risk. Accordingly we are building reserves even though we have not experienced major non-performing problems in our core markets. We are certainly well within our peer group regarding non-performing assets, provisions and charge offs as we have always been at Commerce. We continue to evaluate the market for residential construction over the next couple of quarters. At this point, we’re very satisfied with our position and short of a recession we would anticipate full capability to deal with any problems that we currently foresee. We have always been a lender on a secured basis, looking for strong sponsorship and conservative loan to value and nothing has changed in that regard. The result has been low charge offs over the years relative to our peers, good recoveries as a result of our evaluation of risk going through the credit cycles. With that, I’ll turn it back to Doug and for any questions that anyone might have.

Douglas Pauls: Yeah, at this time we would open it up for questions.

Operator: Thank you sir. At this time if you would like to ask a question please register by pressing the star key followed by the digit one on your touchtone telephone. If you’re using a speakerphone, please make sure your mute function has been turned off to allow your signal to reach our equipment. Once again, please press star one to ask a question. We’ll pause for one moment to allow everyone a chance to signal. We’ll take our first question from Rob Rutschow with Deutsche Bank.

Rob Rutschow: Hey good morning guys. I guess I was wondering if you could tell us which geographies you’re seeing weakness in with a little more specificity. I understand Florida is a problem but are you seeing any problems in your mid-Atlantic region, DC, Philly or New York in terms of the commercial real estate?

Robert Falese: Not systemic. One off issues but not systemic.

Rob Rutschow: Okay and do you have NPAs in the mid-Atlantic and what geographies are those coming from?

Robert Falese: Yeah, we do have NPAs, it is probably about 75-80 million and again nothing systemic, they’re coming out of Washington, Philly, New Jersey, both southern and northern New Jersey and New York. Again, spread out, commercial, some investor developer, some jumbo mortgage, that kind of thing, but not again systemic in any one particular area.

Rob Rutschow: And is there any vintage for the loans that are going to NPA, any specific vintage or is it sort of broad based as well?

Robert Falese: Again, broad based.

Rob Rutschow: Okay. I was wondering if you might be able to comment on deposit competition in your markets also.

Douglas Pauls: Well, Robert, I think we certainly saw deposit competition. As I mentioned at the beginning of my remarks, especially on some of the cash management and public now type products. The big banks who either couldn’t obtain LIBOR funding or couldn’t obtain it at a rate that they were interested in, chose to pay some very high deposits in order to bring in those dollars to help fund their wholesale activities. And we made a decision that we were not going to compete with some of those rates. In terms of the other types of deposit products, I wouldn’t say the competition is that much different than it’s been for the last couple of years. We continue to see good account opening, growth rates for our lower cost deposits in our stores and I think we’re holding our own very well there.

Rob Rutschow: Okay and did you say $0.39 as your calculation of core for the quarter?

Douglas Pauls: That’s what we estimate, yes.

Rob Rutschow: Can you just kind of lay out the one time items?

Douglas Pauls: The provision is much higher than, again not too many are following us for first call purposes anymore, but, we really haven’t commented too much since the second quarter, but whatever people had in their models at that point I believe would have been much lower than the net provision we recorded. You’ve got the one time stuff related to the insurance brokerage and then just had some overall I’ll call it accounting cleanup in the fourth quarter, getting the balance sheet where we needed it to be.

Rob Rutschow: Okay. I guess last question for our guys out there, can you give us on a scale of one to ten your confidence that the TD deal will close on time and as anticipated?

Robert Falese: I’m not going to get into a rating but I would tell you that we know of no reason why it won’t close as expected.

Rob Rutschow: Okay, thanks a lot guys.

Operator: We’ll go next to Mario Mendonca from Genuity Capital Markets.

Mario Mendonca: Good morning, on the deposits side, the $1.5 billion that you referred to in lost deposits. Was there one particular large deposit that was lost or was this sort of spread out across a series of clients?

Douglas Pauls: It was spread out across a series of clients Mario.

Mario Mendonca: Would there be any reason to believe that the lost clients, certainly competition played a role here as you suggested, any reason to believe that the acquisition by TD could have played a part?

Douglas Pauls: I don’t think so, you know that’s obviously a very tough thing to quantify but I think what we saw, as I said were some of the bigger banks really paying rates we didn’t want to compete with. And we also made a decision frankly that we were going to re-price some of these deposits and if those relationships weren’t willing to re-price then they went elsewhere. I don’t think that had anything to do with TD, I think it had everything to do with what was going on in the market in terms of interest rates and also we obviously have a different investment strategy which forced us to look at some of these higher costing deposit relationships.

Mario Mendonca: And were the lost deposits in the, I think you called them indexed deposits in the past, the $12-$13 billion of indexed deposits?

Douglas Pauls: Yes, they were in our commercial cash management and public now accounts, both of which are primarily index based. And then also our public time deposits which, they’re not index based but those types of deposits as we’ve said in the past Mario are very rate sensitive, so we chose not to offer as high rates for some of those monies and they went elsewhere.

Mario Mendonca: And just a final question, the total amount of index deposits that would be $12-$13 billion? Or probably something lower I suppose.

Douglas Pauls: A little bit lower. Yeah, probably around there Mario, I’m looking for my report here but I think that’s a good number to use.

Mario Mendonca: And just finally on the securities portfolio, you did a good job, better than I’ve seen in the past, it makes sense now given what’s happened in the environment to be that fulsome, I guess I’m surprised that the unrealized loss has held in so well, just given what’s happened with credit spreads. Are we just essentially, the way you look at your, maybe the question I’m asking is what sort of approaches are you using to value those securities? Is there some independent valuations service you use or is this really just sort of cash flow analysis that the bank does on their own?

Douglas Pauls: We historically have used, its independent pricing, not our own models. We historically had used an independent service to do the whole portfolio. At December 31 for the non-agency stuff we actually went out and got trader quotes. We just thought that the pricing service was just not capturing the illiquidity in the market. And that’s really what I think we’re looking at here Mario. We’re looking at a discount because of illiquidity because of, we’ll call it the crisis, or you know the concern in the market or whatever. You know we are as I’ve said we’re very comfortable with the quality of our portfolio. We’ve certainly looked at different situations and done stress testing and we’re very comfortable with the credit quality. This is not a credit issue by any means.

Mario Mendonca: Yeah it sounds like that and just finally on the deposit competition, I don’t imagine it’s really abated much since the end of the fourth quarter? Is this sort of the new pattern we should become accustomed to, deposits flat to down sequentially until the environment becomes more accommodating?

Douglas Pauls: I think what we’re looking at, likely is lower growth rates than we might have gotten in the past. I mean if you go back you know a year or two, historically we were looking at 18-20% growth rates. I think our rates of growth will be lower than that, but I also think you know there will be a greater composition of lower cost deposits. So I think it’s going to be probably some lower rates of growth, but the kind of growth that we want. You know, as I’ve said, some of these relationships were very high cost and marginally profitable. And that’s not the way we’re going to operate going forward.

Mario Mendonca: That was very helpful, thank you so much.

Operator: Once again, to ask a question please press star one on your touchtone telephone. And we’ll go next [Hegan Wayne] from Millennium Partners.

[Hegan Wayne]: Hi good morning. Just one follow up question the non-agency portfolio valuation. When you discussed the mark to market on realized loss of $1.1 billion you mentioned that that is kind of consistent with what TD had assumed in their model. Could you just confirm that both your team and TD team are in agreement as to that’s the correct way to value and that’s the right mark?

Douglas Pauls: I think what I would say is we are both in agreement that the traditional pricing services just are not capturing the reality of the marketplace right now and obtaining trader quotes or broker quotes was really the right thing to do. As I said it’s my understanding that their model includes a similar mark and I’m sure as we go forward, I would think they would shed some more color on this as we get closer to the deal.

Operator: Once again, please press star one to ask a question. I’ll pause one moment to give everyone a chance to signal. We have a follow up question from Mario Mendonca with Genuity Capital Markets.

Mario Mendonca: I’m sorry to do this, but the reference to the $1.1 billion, I got on the call a little bit late, I was getting back from something else. Could you just clarify the $1.1 billion in the different services? You must have said something in your opening comments that I missed I think.

Douglas Pauls: Yeah, we used a pricing service for the agency, mortgage backs, for the non-agency which would include the jumbo and which would include bonds backed by jumbo loans and also the alt-A loans, we actually went out and got trader quotes. So the total unrealized losses in the portfolio is reflected in our financial statements at December 31 is $1.1 billion, about $460 million is the available for sale on pretax basis and about $600 and some odd million is held to maturity.

Mario Mendonca: Got it, thank you very much. And that would be up from $400 million last quarter?

Douglas Pauls: It would be Mario and the one thing I would point out is as I said, we’ve had this discussion before, but at September 30 we used the outside pricing service for the entire portfolio. Now things have certainly gotten a little jumbled in the marketplace which is why at December 31 we got trader quotes on the non-agency stuff.

Mario Mendonca: That really clarifies it, thank you.

Operator: We’ll take our next from [Mekel] Goldberg with [Dajornine] Securities.

[Mekel] Goldberg: Thanks. I just wonder if you’re seeing any market reaction on the deposit or lending side to the planned merger with TD?

Robert Falese: Speaking on the lending side of the business, we have seen no market reaction. We continue to do business and grow our business and the activities around the merger have no interrupted any of that growth. So nothing on the loan side of the business.

Douglas Pauls: And I think I spoke earlier about the deposit side. We don’t attribute anything going on or not going on to the planned merger with TD.

[Mekel] Goldberg: Okay and on the 30-35 new stores that you talked about for 2008. Is that consistent with what’s expected in TD’s mind also and do you have a regional breakdown of where those stores would be?

Douglas Pauls: In terms of the regional breakdown, it will be, yeah it’s around all of our regions. You know some in Washington, some in Florida, certainly some in metro New York and a couple in metro Philadelphia. You know again, I’ll leave it to TD to comment but I believe that they are comfortable with that number for us.

[Mekel] Goldberg: Thank you.

Operator: We have no additional questions at this time, I’d like to turn the call back over to our speakers for closing remarks.

Robert Falese: Well, thank you very much and take care.

Operator: This does conclude today’s conference, we thank everyone for their participation and you may now disconnect your lines.