Oct 18, 2007
Executives
Dave Miller - Director of IR Jerry Baker - CEO Bryan Jordan - CFO
Analysts
Tony Davis - Stifel Nicolaus Christopher Marinac - Fig Partner Eric Wasserstrom - UBS Heather Wolf - Merrill Lynch Fred Cannon - Keefe, Bruyette& Woods Bob Patten - Morgan Keegan Chris Sideman - OT Capital
Operator
Good day, everyone and welcome toFirst Horizon National Corporation's Third Quarter Earnings Call. Today's callis being recorded.
In addition, you can listen to this conferencesimultaneously at www.fhnc.com. Again, that is www.fhnc.com at the InvestorRelations link.
Hosting the call today from FirstHorizon National Corporation are Jerry Baker, Chief Executive Officer, andBryan Jordan, Chief Financial Officer. They are joined by Dave Miller, Directorof Investor Relations for First Horizon.
At this time, all participantshave been placed in a listen-only mode. But later, the floor will be opened foryour questions.
Mr. Miller, you may begin, sir.
Dave Miller
Thank you, Operator. Before webegin, we need to inform you that this conference call contains forward-lookingstatements involving significant risks and uncertainties.
A number of factorscould cause actual results to differ materially from those in forward-lookinginformation. Those factors are outlined in the recent earnings press release,and more details are provided in the most current 10-Q and 10-K.
First HorizonNational Corporation disclaims any obligation to update any forward-lookingstatements that are made from time to time to reflect future events ordevelopments. Also, please remember that this audio webcast on our website atwww.fhnc.com is the only authorized record of this call.
Now, I would like to turn it overto our CEO, Jerry Baker.
Gerry Baker
Good morning and thank you for joiningthe call. Let me start by saying that we faced market pressures this quarter,some large and many other financial services companies.
We also did some solidwork in further establishing our foundation for profitable growth. Our reportedloss of $0.11 per share this quarter includes approximately $30 million or$0.20 per share and charges for restructuring, repositioning and efficiency initiatives.We also had roughly $65 billion of unusual impacts, from credit marketdisruptions to our businesses.
Bryan will go through the details with youshortly. Since I believe it will be helpful for us to spend some time revealingthis quarter's market impacts.
In response to market conditions,we have adjusted pricing of mortgage originations and concentrated onconforming products. We have managed down inventories and commitments incapital markets and positioned the balance sheet well.
I believe thesechallenges are temporary and we continue to take actions that will have along-term positive impact on the profitability of First Horizon. We are making investments in our Tennessee bankingfranchise.
We are committed to building new financial centers in thehigh-growth markets in the state and expect to open ten or so a year for thenext several years. We are focused on gathering deposits and adding top-talentand we have increased our emphasis on sales and marketing to expand our alreadyleading market share in the state.
We are already experiencing a near-term liftfrom this effort. But the long-term goal to move our Tennessee market share above 30%.
Our banking success in Tennessee is beingrecognized externally as well. First Tennessee'sbusiness banking was recently given the Overall Banking Services award forexcellence in serving small business customers by Greenwich Associates.
First Tennessee was one ofonly 22 banks recognized with this top honor and one of only 15 banks haverepeated as a winner this year. Additionally, we are continuingour careful review of all aspects of our business to identifying areas forimprovement.
This ongoing review has already led to a series of meaningfulactions that will improve near-term results and long-term return on capital. First, we announced recently thatwe have agreements to sell our First Horizon Bank branches.
These transactionsinclude all 34 full service locations and we expect that to be concluded byearly next year. We were pleased with the outcome and believe that it is atestament for the quality of our people and operations in those markets.
Second, as we announced inSeptember, we are reducing our dependency on real estate related businesses, bysignificantly cutting our national sales forces and related support costs.These actions should reduce earnings volatility and free up capital for higherreturn businesses or share repurchase, as we shrink our homebuilder one-timeclose and home equity national portfolios by over $2 billion over the nextyear. We will also look foropportunities to sell mortgage servicing rights, when market conditionsimprove.
Explore other avenues to further reduce our exposure to the mortgagebusiness. Third, we are taking other stepsto adjust our business operations to improve profitability.
These includeshutting down our small business program out of Tennessee. We are focusing on our nationaldeposit gathering on remote delivery via the internet and exiting the foreplanned lending business in our traditional markets.
We will realize otheropportunities to improve our businesses as we continue our systematic review. Finally, we are still on track toachieve our targeted $175 billion in annual efficiency and productivitybenefits by first quarter of 2008.
That means, permanently reducing ourheadcount and expense run rate. Once we reach our goal, we will continue reviewother expenses.
I believe there is more we can do. The impact of these actions Ijust outlined is significant.
Our total FTE employees are now about 11,000,down more than a 1,000 from a year ago. We expect that number to declinefurther in 2008 probably to around 10,000 or less.
Our objective has been toretain our top sales people for consolidating back office functions resultingin a substantial improvement in productivity. With this approach, we believe wecan sustain and actually enhance our competitive advantage to our people.
Financial benefit of theseefforts is also substantial. As I said, we are on track to execute a $175billion of productivity in efficiency improvements.
As of the end of the thirdquarter, we would estimate that roughly a $115 million of that annual benefitis in our run rate. Additionally, the sale of the FirstHorizon Bank branches will improve pre-tax income by $30 million to $40 millionannually and the restructure of mortgage on our national specialty businesseswill improve profitability by another $30 million to $40 million.
Our real estate businesses arechanging and we remain focused on the management and quality of our currentportfolios. In today's environment, we're directing additional resources tomanage problem loans which remain a relatively small portion of our totalportfolio.
As the economy slows and the housing market weakens further, we areseeing excepted deterioration in real estate loans. And so, we added toreserves again in third quarter as provision for loan losses exceeded chargeoffs.
I am sure there will be some unpredictability going forward. But weexpect asset quality cost to remain manageable as we move into next year.
Let me recap. We are committed tothe process of evaluating all opportunities to make our company better and totaking swift action when these opportunities present themselves.
We expectthere will be some further efficiency and restructuring charges in the fourthquarter and first quarter of 2008. But there should also be gains associatedwith the sale of the First Horizon Bank branches.
I believe the changes I haveoutlined today will significantly improve return on equity and the book valueand we will reward shareholders accordingly. In the meantime, we arecomfortable that our capital position will support us as we make the necessaryimprovements to our business.
On another note, our Board ofDirectors have recently authorized the repurchase of up to 7.5 million sharesover the next three years, giving us flexibility to redeploy the excess capitalthat will be freed up over the course of our business restructuring efforts.They also approved the quarterly dividend of $0.45. Over the past few months, we havebeen asked several times about the sustainability of our current dividend.
Ourrecommendation to the Board regarding dividends each quarter takes into accountmany factors. We believe that our current capital position for operatingresults and initiatives to improve efficiency and rebalance our business mixalong with capital freed up as we reduce national lending portfolios, providesufficient capital to sustain our current dividend and enable us to makeinvestments in the near term.
As these factors change, we willfactor them into our recommendations to the Board. But our efforts are focusedon improving earnings and as a result, reducing our dividend payout ratio belowthe current level.
Now, I will turn it over to Bryan for his commentsand later, we will take your questions.
Bryan Jordan
Thanks, Jerry. Good morning,everyone.
Our reported results this quarter were a loss of $14 million or $0.11per share, reflecting several unusual items, including disruptions in thecredit markets. We incurred charges of $33million dollars this quarter from restructuring, repositioning and efficiencyinitiatives.
These charges are related to our efficiency efforts, First HorizonBank divestitures, restructuring of our mortgage business and the downsizing ofnational specialty business. All charges are recorded in ourcorporate segment and we have again provided a detailed schedule in ourfinancial supplement to explain which line items these charges impact on aconsolidated income segment.
My detailed comments this morningwill be divided into three main parts. First, the impact of the credit markets wehad during the quarter and how we responded.
Next, I will the review theprogress being made with our restructuring, repositioning and efficiencyefforts and then, the highlights from each of our business. Based on the number of details,Dave and I will be glad to follow up with you after the call to review thespecifics.
As you know, we are in a number of businesses that are subject toinherent market related risks. In the third quarter, we experiencedapproximately $65 million of aggregate negative pre-tax impact to our Mortgage;Capital Markets and Consumer Lending businesses as a result of widening creditspreads and associated market illiquidity.
First, in Mortgage Banking,interim mortgage spread widened out substantially during the third quarter. Although,the majority of our production has always been GSE eligible for governments,the value of prime non-conforming loans in our warehouse and locked pipelines aremanaged significantly.
The widening of mortgage swapsspreads help to improve MSR hedging results and servicing run-off has alsoslowed providing additional offsetting benefit. In total, the negative mark-to-market and lower cost of market or LOCOM impacts in the net hedging and run offbenefits, reduced profitability in our Mortgage business by approximately $45million during the quarter.
Second, in Capital Markets,disruptions in the CDO market significantly decreased demand for pooled trustpreferred securities in the third quarter. Accordingly, we completed a smallerissuance of $330 million this quarter in the disrupted environment.
The impactof this disruption on our pooled trust preferred product reduced CapitalMarkets' profitability by approximately $15 million in the third quarter. While our structured financebusiness will remain with quarterly fluctuations, we believe the market willcome back as it is an important source of capital for smaller banks.
In National Consumer Lending, ourquarterly sales of consume loans was also disrupted in the third quarter asinvestor demand for even high quality home equity product dried out. As aresult, we incurred approximately $5 million of increased LOCOM in our retail/commercialbanking segment this quarter and have significantly diminished revenue fromloan sales.
We are not certain when or if thesecondary market for consumer home equity loans will come back and haveadjusted our operations to reflect this outlook. We responded to these marketconditions throughout our businesses.
In Mortgage, we significantly adjustedpricing and product mix and sold rather than balance sheeting $1.3 billion ofour prime non-conforming production, leveraging our capital marketsdistribution system. We did retain $19 million of subordinated bonds at the endof the quarter, since they have attractive yields and solid credit metrics.
In Capital Markets, we reducedour total average earning assets by approximately $900 million in the thirdquarter compared to second quarter, primarily due to a reduction in averagefixed income trading inventory from $ 2.5 billion in the second quarter to $1.8billion in the third quarter. During the third quarter, we alsodesignated a small amount of trust preferred loans with good underlying creditcharacteristics as held to maturity.
We also managed our trust preferredwarehouse to mitigate risk in the current market environment. While, theoverall deal size of the pooled trust preferred transactions we have completedover the past two years has ranged from approximately $600 million to $1.6billion, typically less than 50% of the underlying collateral, mixedtransaction has been pre-funded on our balance sheet.
Additionally, as market conditionhas changed this quarter, we slowed the rate of pre-funding commitments andadjusted our price in our funding that we did make. As a result, we incurredonly a minimal LOCOM adjustment on our trust preferred warehouse quarter end.
In our National Consumer Lending business,we have eliminated originations of standalone products. We held $300 million ofconsumer loans that would otherwise have been sold or considered held for salein prior quarters.
These consumer loans have good yields and strong underlyingcredit risk with an average FICO score of nearly 740 and average CLTV of 86%. Our overall liquidity position issolid.
We have adjusted our funding strategies throughout the quarter accordingto market conditions. As a result, we have reduced liquidity and higherborrowing costs in the consumer CD market.
We shifted $2 billion in wholesalefunding from short-term CDs to lower cost Federal home loan bank advances. During the quarter, we soldsubstantially all our current mortgage, HELOC and other productions to maximizefuture balance sheet flexibility.
Our loans to core deposit ratio was 163% atthe end of the third quarter, nearly in line with the second quarter at 157%. As we continue to implementchanges in our national real estate construction and national home equitylending businesses, we expect this ratio to improve going forward.
As we have seen market conditionsstabilize somewhat since mid-September, while we do not see the market fornon-conforming mortgage product improving significantly in the near term. We don't expect the great deal offurther spread widening and this production has been priced accordingly.
Andalthough, it's difficult to predict, the pooled trust preferred markets shouldbegin to stabilize over the next few months. Now move on to our repositioning,restructuring and efficiency initiatives.
We are focused on improving returnson capital, despite a challenging market, by moving to further reduce costs andrestructure certain businesses. We should see substantial annual pre-taxbenefits from theses efforts across four broad areas.
First, with our enterprise wideefficiency initiatives, we continue to execute on our efficiencies andproductivity improvements. Combined with 2006 initiatives, the 2007 efforts areexpected to produce about $175 million of annual benefit by the first quarterof 2008.
We are currently tracking over 75 individual projects to make up theseefficiency initiatives. We do not expect these cost reduction efforts to have ameaningful adverse impact on revenues or customer service.
You will note that our operatingexpenses decreased $36 million from second to third quarter driven by therealization of lower variable costs and roughly $12 million in additionalefficiencies related to these initiatives. As Jerry pointed out, our thirdquarter run rate reflects approximately $115 million of annualized benefit ofour targeted $175 million of annualized cost reductions.
Second, the sale of the FirstHorizon Bank should improve pre-tax income by approximately $30 million to $40million annually. Some benefit will be realized late in the fourth quarter of thisyear, but the majority will be late in the first quarter 2008, as we completethe divestitures.
Please not that since we havesigned definitive agreement in September for the sale of First Horizon Bankbranches, we moved $511 million of deposits and $165 million of loans into heldfor sale categories as of the end of the third quarter. We have broken these outfor you on a consolidated balance sheet in our financial supplement.
Third, we are restructuring ourmortgage business. We are eliminating the lower 50% of our retail sales force, reducingwholesale account executives and management, closing 50 to 60 offices,decreasing wage support staff and cutting other back office costs such astechnology.
We expect to have the majority of savings in place by the middle ofthe fourth quarter. Fourth, we are downsizing our nationalspecialty businesses.
We will reduce our sales forces in construction lendingand consumer lending as we pair back originations and focus on currentrelationships. We will also eliminate our national small business program and aresignificantly downsizing our network of national FSMs.
We expect to have manyof these savings accomplished by year end, although some will be faced in over2008 as we manage down existing construction commitments. The net impact of restructuringour mortgage and national specialty business should add an additional $30million to $40 million to our annualized pre-tax run rate over the next severalquarters.
Over the next two quarters, we would expect to incur additionalcharges associated with this efficiency and restructuring initiatives. Inaddition, we currently expect up to $40 million in gains from divestitures.
We have again provided a detailedschedule in the financial supplement to explain these restructuring initiativesas clearly as possible including charges and their impact on the consolidatedincome statement, estimated benefits by segment and an estimated benefitrealization table. Now, I will move on to highlightsfrom each of our business lines.
In the Retail/Commercial Bank, we are focusingon improving profitability and growing market share in our Tennessee full-service banking operation. Wehave adjusted our deposit pricing to competitive levels and we have alsoincreased marketing spending as we launched a major statewide campaign toengage our sales force to bring in new customers, especially in light ofongoing competitive consolidation.
Our activities are particularlyfocused on bringing in deposits as well as primary consumer and businessrelationship. The results of these efforts appear to be paying off.
During thethird quarter, net consumer checking account increase by 9,000 accounts, up 35%from last quarter and more than doubled the net growth experienced in thirdquarter of 2006. Business customer growth has beenencouraging as well.
As a result of these actions, direct contribution fromFirst Tennessee Bank increased 4% sequentially. We expect growth to continue inthe quarters ahead, as we reap the benefits of our investments and the openingof new financial centers in Tennessee.
The pre-tax income for the totalRetail/Commercial Bank segment declined 4% sequentially to $78 million in thethird quarter. This decline was driven mainly by increased provision expensesfor our national construction businesses and reduced consumer loan sales in ournational consumer lending business.
Deposits in the Retail/CommercialBank grew slightly over second quarter and 2% year-over-year. And deposit feesincreased 4% sequentially, driven by primary account growth and highertransaction fees.
Loans declined 1% sequentially over second quarter andincreased 2% year-over-year. As we've mentioned, we expect tighter underwritingand sales force reductions to shrink our real estate loans by $2 billion overthe next year.
The net interest margin in theRetail/Commercial Bank was relatively flat compared to the second quarter at3.88% in the third quarter, driven largely by improved spreads in Tennessee, offsettingcontinued pricing pressure on consumer and construction loans in our nationalmarkets. Expenses declined 6% sequentiallyand the efficiency ratio improved by over 200 basis points, as we had lowervariable compensation costs and we continue to realize the benefit of ourongoing restructuring, repositioning and efficiency efforts.
In the mortgage business, pre-taxincome for the third quarter was a loss of $46 million, $30 million below the secondquarter levels. Originations declined 8% over second quarter to $6.7 billion inthe third quarter.
72% of volume was from conventional or government product upfrom 66% last quarter. However, based on changes made inmidway through the quarter, we would expect 85% of new production going forwardto be GSE eligible as non-conforming origination volumes decline.
Gain on salemargins declined from 76 basis points in the second quarter to negative 33basis points in the third quarter driven by the market impacts alreadydiscussed. MSR run-off declined to $49million in the third quarter from $63 million in the second quarter drivenprimarily by increased coupon rates on non-conforming loans and disruptions inthe mortgage market.
MSR net hedging performance improved significantly to apositive $22 million in the third quarter, $37 million better than the $15million loss last quarter. As spreads between mortgage and swap rates widened,option volatility increased and seasonality moved in our favor.
We do notexpect to sustain this level of positive hedge performance going forward. Expenses in mortgage bankingdecreased $7 million from second to third quarter, primarily driven by theimpact of efficiency and restructuring initiatives and lower legal expenses,which will partially offset by the timing of origination costs.
Going forward,we expect volume to slow and pricing to remain challenging in the mortgagebusiness. Absent further incremental disruptions to the mortgage market, webelieve that our product and cost structure changes should enable the mortgagesegment to return to around breakeven in the fourth quarter.
In the capital markets segment, pre-taxincome declined sequentially from $13 million in the second quarter to a lossof $8 million in third quarter. Fixed income revenues were $46 million thisquarter as compared to $48 million in the second quarter.
As Fed fund rates andthe yield curve steepened, we did see a pick up late in the fourth quarter. Other product revenues declinedsignificantly from $42 million in the second quarter to $16 million in thethird quarter.
As our structured finance business was significantly impacted bycredit market disruptions, namely, pooled trust preferred issuances. Goingforward, we expect continued demand from our institutional client based to raisecapital through trust preferred issuances.
While we believe that investordemand for these securities will return, it is difficult to predict when this mightoccur. Capital markets expenses declined$7 million from second quarter to third quarter, as lower revenues drove lower variable compensationcosts and we remain focused on expense control in a challenging environment.
Turning to our consolidatedfinancials, the tax benefit of $9 million this quarter primarily reflects anormal statutory Federal and state rights, and permanent tax benefits of $7million, offset by 7 $million of increased taxes of non-deductible goodwillincluded in our restructuring charges. Corporate net interest marginincreased from 2.79% last quarter to 2.87% in the third quarter, primarilydriven by lower trading assets in capital markets, a smaller mortgage warehouseand a decrease in wholesale funding costs from a lower effective Fed funds rate.
Going forward, we expect themargin to improve somewhat, would steep the yield curve and the reduction oflower margin businesses, including the First Horizon Bank branches and nationalconsumer lending. Given the slowing economy and theweakening housing market, we are particularly focused on managing asset quality.We have committed additional resources to managing problem loans.
Overall, ourC&I and consumer lending portfolios remain healthy and our greatest detentionremains focused on our national construction businesses. Charge-offs in the third quarterincreased to 57 basis points versus 41 basis points experienced in the secondquarter.
Deterioration of problem construction loans were a key driver in thecharge-off increase. And we also addressed a few individual C&I loans inour full-service bank markets.
NPAs increased from 81 basispoints last quarter to 113 basis points in the third quarter, primarilyreflecting the downward migration of home builder and condominium constructionloans. One-time close loans also contributed to the increase.
Our allowance to loan ratioincreased from 103 basis points last quarter to 108 basis points in the thirdquarter, as we provisioned in excess of charge-offs again this quarter.Provision expenses were relatively flat sequentially at $43 million, but roseexcluding the $8 million of additional provision last quarter associated withthe divestiture of some national loans. In the OTC portfolio, we areaggressively managing weakening credits.
Issues were magnified in specificmarkets, like Florida,or home loan buyers have declined and where real estate speculation was wide spread.We have made significant changes to the way we approach this business,including equity requirements, product channels and process management. And weare confident in the quality of current production.
However, problem asset levels andresulting in charge-offs, this portfolio is likely to increase somewhatthroughout 2008. Inflow to non-performing is expected to remain near currentlevels while outflow with remediation and disposition will continue to be aslower process.
Problem loans and our home builder finance portfolio increasedin third quarter as well. Our pressure was evident acrossseveral markets, other markets and specific segments remain largely unaffected.We are focused on portfolio management and are leveraging the experience of ourbankers' prior cycles to manage us both.
We continue to have confidence in ourapproach to this business. But we expect pressure on portfolio metrics goingforward.
Our home equity portfolioperformance remains steady, favorable to the industry and better than expected.We except some deterioration of this portfolio overtime due to marketconditions, but continue to expect our performance to be favorable relative topeers. We attribute this to high quality borrowers, predominantly retailoriginations and underwriters.
While, we expect continuedchallenges within our construction portfolios and may experience some bleedover to home equity and C&I for credit cost are expected to remainmanageable as we move into 2008. Of course, we may continue to see quarterlyvariations caused by lumpiness from individual credits.
In summary, given the difficultmarkets of the third quarter, we are pleased with the progress we are making torebalance our business mix, realize efficiencies and build a more predictableearnings space. We still have additional work to do, but our core franchise isstrong and we are executing on the steps necessary to drive long-termshareholder value creation.
With that, I will turn it backover to Jerry for his closing comments.
Jerry Baker
Thanks Bryan. That was a lot to cover.
Inconclusion, we expect the operating environment to continue to have itschallenge, although, we should see some improvement over the turbulent eventsof the third quarter. We expect continued weakening of the housing market assome inventories decline, prices soften and some buyers are removed from themarketplace by less availability of credit.
However, conditions will clearlyvary by market and price point and we have seen many of pressurized end-marketsremaining stable. Credit markets appear to be returning towards more rationalbehavior.
The Fed rate cuts and modernization of Federal loan programs shouldhelp some borrowers. The yield curve has steepened somewhat, although, thespread between LIBOR and Fed Funds remains elevated.
I do no want to use the market asan excuse for performance. We must continue to make changes to improve ourability to perform well in many different environments.
To that end, we remainfocused on investing on our Tennessee banking franchise, while completing thedivestiture of our First Horizon banks, downsizing our national mortgage andspecialty banking businesses, executing many efficiency initiatives wepreviously outlined, maintaining asset quality and reviewing all business areasfor further opportunities to improve returns. We have more work to do and moreopportunities to improve our profitability.
We will substantially increaseshareholder value by reducing our real estate exposure, borrowing, earningsvolatility and paying up capital that can be redeployed for higher returnactivities or use for share repurchases. We believe the decisions we are makingwill reward our shareholders over the long term.
Now, let me turn it back over tothe operator and open it up for your questions.
Tony Davis - Stifel Nicolaus
Jerry, Bryan, good morning.
Jerry Baker
Hi, Tony.
Bryan Jordan
Good morning, Tony.
Tony Davis - Stifel Nicolaus
It is a difficult time out there.The last time I remember you caught with disclosing this I think was probablyback in March. And I think the number at that point was around 4%.
But I wonderif you could give us some idea of what the watch list looks like right nowrelative to total loans? And, could you give us a little more color on the riskclassification migrations you have seen outside of residential andconstruction?
Jerry Baker
I think that watch listpercentage is down about 3.5%. Our detailed red and yellow and green are stillthe same.
Suspects that you have seen the past, it's Florida, around Georgia,Atlanta marketplace, Washington DC, a little bit in California. Bryan, I wantyou to add to that.
Bryan Jordan
All right, the thing I would addis that in terms of our risk rating, we have seen a little bit pressure ondownward migration. We would expect that to continue in this part of the cycle.In some sense, the depth and severity of what we are seeing in the markets willcontinue to pull it down, if this persists.
And so, we are very activelymonitoring it. And we have got a tremendous amount of resources dedicated tomanaging problem assets.
But at this point in the cycle, although, watch listis down a little bit, we think credit risk ratings will probably have more of anegative bias in the near term than a positive bias.
Tony Davis - Stifel Nicolaus
And Bryan, what's the average LTVon the commercial real estate right now?
Bryan Jordan
Commercial real estate, I am notsure you are going to express it that way, because you have got so much on aspread across so many different categories. I would suggest that in average,it's going to be, I don't know, Jerry, we might get back to him on this.
Jerry Baker
Yeah. We can follow up with youTony.
Probably, it's going to be very clear where you are going to have -- whatwe do in LTVs on land and LTV on vertical constructions might go up to an 80%level. But we'll follow up with you, Tony.
Bryan Jordan
That portfolio has beenperforming very well. And we feel very comfortable with what we are seeingthere.
It's more in the residential construction side that we have bigger concern.
Tony Davis - Stifel Nicolaus
Right, yes, I was speaking aboutthe construction side.
Jerry Baker
And Tony, I would add one otherthing. It might be a good point.
It would be of interest to others as well thatI see some discussion in the news that the housing crunch might last a quarteror so. I think our review is that it goes well into 2008.
I don't think it'sgoing to be short term. And in many ways, the residential marketplace is drivenby the lack of the availability of financing for home buyers.
On both ends ofthe spectrum, there's a fair amount of availability for conforming product, butnot for nonconforming, even for good creditworthy borrowers. And so, until thateases some, I think it's going to have continued pressures on the absorption ofalready build or soon to be build homes.
Operator
We go next to Christopher Marinacwith FIG Partner.
Jerry Baker
Hey, Chris.
Christopher Marinac - Fig Partner
Hi. Good morning.
Jerry, I justwant to clarify. On the dividend review, is that done monthly, quarterly, andwhen was the last time the Board visited that?
Jerry Baker
We review that every quarter andpresent it to the Board quarterly. And that was done several days ago as wewent through our Board meeting.
Christopher Marinac - Fig Partner
Okay. So the next time whenthat's up on the agenda, will be January.
Jerry Baker
That's correct.
Christopher Marinac - Fig Partner
Okay. And then the follow-upquestion, I guess is in general.
What would be your goals for the depositfranchise in 2008, just focused on Tennessee and kind of back to basics there?
Bryan Jordan
Chris, this is Bryan. Goodmorning.
As we focus on the Tennessee market over the next year, we are reallyexpecting very attractive growth rate. We think that the advertising andmarketing we put in to the market, the steps we have taken around competitivepricing and segments to the market, coupled with our ["power of can"]campaign, which is designed to engage our sales force in growing both theconsumer and the business, commercial type deposits in our footprint.
We seesignificant transactions starting to build. So, we would expect something inthe low-to-mid single digits in terms of the deposit growth next year in theState of Tennessee.
From a quarter perspective that will be masked by the saleof the deposits which we have talked about in the First Horizon branches. Butwe expect pretty attractive growth in the state of Tennessee next year.
Jerry Baker
I might add too. We typicallyhave experienced about 50 basis points in market share growth in Tennessee, alittle better in the last year.
And we would expect it to be strong above 50basis points, may be as much as 100 basis points improvement, theconsolidations in the state as well as what Bryan said, our focus on marketingand communications in the state on, what we call, "the power of can"and the engagement of our, not just our ground staff, but all of ourrelationship management and wealth management teams are focused together ongrowing deposits and increasing new customers.
Operator
We go on next to Eric Wasserstromwith UBS
Eric Wasserstrom - UBS
Thanks. Good morning, gentlemen.
Bryan Jordan
Hey, Eric.
Eric Wasserstrom - UBS
I was wondering if you could helpme and sort of prioritize your usage of capital. There seems like there's a lotof conflicting pressures on capital, on the one hand, obviously, a very highdividend on compressed earnings.
You also made the announcement about the sharerepurchase authorization. It seems like there could be some benefits from costsavings conversely, credit pressures are also mounting.
Can you just help meunderstand where you prioritize the use of capitals right now?
Bryan Jordan
Eric, this is Bryan. In terms ofpriorities right now, we feel like we have adequate capital to support thegrowth that we see in the balance sheet and what we need to invest in thebusiness over the near term.
As we shrink the portfolios that Jerry enumeratedin the comments and I touched on as well, we should free up a significantamount of capital over the next year. That coupled with our improvementinitiatives around efficiency, restructuring the mortgage business and drivinggreater profitability there, we think drives the payout ratio on the dividenddown by increased earnings.
And so, in the near term, wewouldn't expect to be active in share repurchase. We do think it’s important,given the shrinking that we expect in certain portfolios in the balance sheet,to have the flexibility over the next two or three years to purchase the stockwhen it is attractive.
So, in the near term, I think we have adequate capital.It's designed to support the dividend, to drive, to enhance earnings and drivethat payout ratio down.
Eric Wasserstrom - UBS
Thanks very much.
Bryan Jordan
Sure.
Operator
And for our next question we goto Heather Wolf with Merrill Lynch.
Bryan Jordan
Hi, Heather.
Heather Wolf - Merrill Lynch
Hi. Good morning.
I was justtaking a look at the charge-offs that you have taken in the two constructionportfolios, relative to the non-performing loans, and it doesn't appear thatyou are expecting material loss severity. I was wondering if I have interpretedthat correctly and if you can put any numbers behind it?
Bryan Jordan
Hi. Heather, this is Bryan.
Iwould say material is a term of art rather than science. Again we have seenthose losses tick up substantially all of the growth in our losses or in theone time close and the homebuilder finance product.
We expect that they should remainelevated for a period of time. I think in the one time close product we hadabout well over $6 million in losses, and about $5 million or so in thehomebuilder finance.
So, on an annualized basis that's higher than we wouldhope for run rate. But as we said, until we get clarity about the depths in theseverity of what goes on in housing, we feel like they are sustained at theselevels, and maybe a little bit upper pressure, but we think its manageable.
Heather Wolf - Merrill Lynch
Okay and just a quick follow-upto that, does your capital plan assume that there isn't a substantial pressureto your credit cost over the next year?
Bryan Jordan
As we look at the capital plan,we factor in credit cost, and as I said, we assume that credit costs will beelevated, and maybe up somewhat from here. But in terms of severity we've notput clearly, we haven't elevated it significantly because we think at thislevel, we think it's manageable, and we can work through it.
Operator
We go next to Fred Cannon withKeefe, Bruyette & Woods.
Fred Cannon - Keefe, Bruyette & Woods
Thanks and good morning. And thisquestion is really for Jerry.
Really the question is, what is the national"Outside of Tennessee" strategy for the company at this point intime, I mean after over a decade, I believe kind of expanding based onfollowing mortgage up with branch banking. It would appear you are scaling backsignificantly in branch levels in mortgage, and in national asset gatheringstrategies.
I was wondering, are we evolving back to a Tennessee bank, awayfrom the national strategy or what exactly are you planning on in nationallymoving forward?
Jerry Baker
Fred, I would say that we are abank that is community focused and that focus is primarily in markets that arein and around Tennessee and in the Southeast. Yes, we have a national businessin our middle market lending, and asset based lending, of course, our capitalmarket's activity in mortgage, and in many markets around the country.
But interms of banking, I think that our best focus for certainly the short-term andover the next year or two is around and in Tennesseeand in the markets adjacent to Tennessee.
Fred Cannon - Keefe, Bruyette & Woods
Okay. And then are those nationalbusinesses that you also mentioned, credit quality, your strategy movingforward or are you essentially re-evaluating?
Jerry Baker
Well, I think there are positivecompliments to our strategy. In many ways these businesses intersect andintertwined together, certainly capital markets with our banking activity, andwith mortgage and vice-versa.
And I think we're getting better at having ourvarious specialty businesses work together. But I think it's clear with thesize of our organization that we'll do best, focused on a broader regional basis,not just in Tennesseebut on a broader regional basis, then national.
Operator
We go next to Bob Patten withMorgan Keegan.
Bob Patten - Morgan Keegan
Good morning guys.
Jerry Baker
Hey Bob.
Bob Patten - Morgan Keegan
Most of my questions have beenasked. I guess just on a bigger picture, Bryan and Jerry, where are you in theoverall business review.
I would assume you have completed at this point, andthen if you have completed, and when it's about execution, what is left or whatelse can you do in terms of business rationalization here that you don't thinkyou've done? What stones are left unturned?
Jerry Baker
I think Bob, one of the thingsthat we're focused on heavily is how do we maximize the businesses that we arein today? Are we in the right segments in terms of our customer activity, arewe maximizing it between different segments of customer relationships andbusiness relationships?
How de we fine tune, both our pricing in thosedifferent aspects of what we do, and we are going through that. And so there is a little morework to do in that area.
There are few businesses that we are watching to seeif they perform as we expect, I expect that they will, but we still want tocontinue to watch those, because our game is to make sure that we aredelivering as much value from the businesses we're in. So, we're getting to thepoint as certainly as we enter 2008, its execution.
Bob Patten - Morgan Keegan
Can you give us a sense of themoving parts over the next two quarters, because now we are talking aboutcharges going in to '08 in terms of gains and charges left and where they areattributed to?
Bryan Jordan
Yeah, Bob, this is Bryan. I thinkthe bulk of the charges will be realized in the fourth quarter, and we arestill within the original framework that we said, some where between $90million and $100 million, so, probably another $20 million maybe $30 million incharges.
That will be offset by the premiums on the sale of the First Horizonbranches. The bulk of that will be in the first quarter, because that's whenthose divestitures close.
We'll have a little bit in November that offsets thecharges. But we expect up to $40 million of net premium, they are offset by alittle bit of severance and costs, whether we have yet to accrue it.
Bob Patten - Morgan Keegan
Alright, thanks Bryan. And thenlast question, obviously with your dividend payout ratio, peaking and youryield now at 7.5%, people are getting very uncomfortable in terms of how thisCompany can sustain this dividend.
Obviously with still the capital markets andmortgage businesses under stress, what is the dialogue that you go through withyour Board in terms of justifying that dividend?
Bryan Jordan
Yeah, in Jerry's comments, andthen I guess in mine, Bob, listen we are very attuned to the need to drive thatpayout ratio down by increasing our earnings level. We think the initiativesthat we have in place will do that, if you remove the market dislocations andthe one-time costs from this quarter, we think our core earnings rate isapproaching the level of this dividend.
And you take into the account, theadditional efficiency initiatives we have, the opportunities, we think werealize from the actions in the mortgage, in the national business as well as,the divestiture of First Horizon banks. We think we can get to a placewhere we reduce that payout ratio below a 100%.
As we talk to the Board, wemake that as a very clear point. And we also really talk about the issues thatJerry has enumerated.
Can we support the growth and the investments that weneed to make in the business? And make the right kind of investments forlong-term?
So, as Jerry said, it's a quarter-to-quarter evaluation and we aregetting ample of it, stay very focused on it.
Operator
And we go next to [Chris Sidemen]with [OT] Capital.
Chris Sideman - OT Capital
Hi, good morning, not to beat adead horse here, but with respect to the dividends, could you maybe walk usthrough the constraints on the parent's ability to upstream cash from the bankand also from the non-bank subsidiaries, which apparently turned in losses thisquarter. And maybe could you also comment as to whether or not the regulatorshave sort of blessed your calculations in terms of the sustainability of thatdividend.
Let's say going into next year?
Bryan Jordan
Chris, this is Bryan again. In broad terms, it's not quietthis simple, but in broad terms you have available earnings from the twoprevious years, plus earnings from the current year available in the regulatorycalculation.
There is also a provision to make a request from the regulators.It's not a computation that the regulators would bless, they are mindful of ourneed for capital in the bank. And as we look at the capital ratios in thebanking organization, we want to maintain very strong capital levels there.
Butthe big limitation on cash flow to pay dividend for the holding company doescome out of the banking franchise that's because that's where the bulk of theearnings exist. Now, we feel like we haveadequate liquidity as a holding company, and we have adequate dividendavailability as we move into 2008 to sustain the dividend.
If we can deliver onthese things that we have said, which are the improved earnings initiatives andthe gains we expect to get out of First Horizon divestures, and the mortgage innational markets activity. So, at the end of the day, the calculation is goingto be greatly influenced by our ability to do the things that we have said weare doing to improve that earnings right from.
No matter how you define thethird quarter in terms of a core rate, but to get that up above the 45 andgreater level to drive that payout ratio down.
Operator
And with a follow-up question, wereturn to Bob Patt with Morgan Keegan
Bob Patten - Morgan Keegan
Hi, I got to ask a question. I amlooking at the capital markets business and I am looking at, the trustpreferred business which was a great business of yours for a long time, butthat's a CDO business and that market is closed.
And I think everybody is optimisticthat it’s going to get better, but how do you sort of weigh the value ofcapital markets in this environment, if we are sitting here a year from now andwe could be, with a market that's locked up and versus the cost and the carry?
Bryan Jordon
Bob, this is Bryan. Again, theCDO market has been slow.
We did get a small issue. It has done about $330million in the quarter.
There is still a very strong demand from issuers toissue products, it's an important part of the capital structure for the relativefinancial services industry. And ultimately we think that that market willcomeback.
We think it's an important part of the capital structure. So, we'renot sure whether it's the fourth quarter or the first quarter.
We're encouragedBob, that it moved a little bit in the third quarter. And we hope that it willstart to move in the fourth quarter.
We think capital markets as abusiness is an important part of our business, its important that we integrateit further into the banking business over the next year or so. And we havetaken steps to do that in the past, it's been an important part of ourdistribution network for product.
It was originated in other channels, it hasevolved in our banking businesses, and so it's an important business. We think thatthe CDO, the pool trust preferred business will comeback.
And we think the actions thatwe've got in place to further integrate that into our customer service model toenable us to be effective and serving broad customer needs. It's veryimportant.
Including continued improvement in fixed income business that wehave [stopped this] last two or three months that we have seen in a long time,besides continued activity in the other aspects of what it really had balancedbroker dealing.
Jerry Baker
In two or three weeks.
Bob Patten - Morgan Keegan
Okay. Thanks.
Jerry Baker
Thanks Bob.
Operator
And with that ladies andgentlemen we have no further questions on our roster. Therefore, Mr.
Baker Iwill turn the conference back over to you for any closing remarks.
Jerry Baker
Thank you very much. We had goodquestions.
We appreciate the opportunity to have dialogue with you. We feellike we're making the changes that need to be made, we are confident in actionswe're taking, and what we're doing as we go forward here.
And we will beanxious to be back with you in January and share with you the progress we'vemade over the intervening several months here. So, thank you very much and havea great rest of the day.
Operator
And ladies and gentlemen this doesconclude the First Horizon National Corporation conference call. We doappreciate your participation, and you may disconnect at this time.