Jan 17, 2008
Executives
Dave Miller - Director of Investor Relations Gerald Baker - Chief Executive Officer Bryan Jordan - Chief Financial Officer
Analysts
Steven [Alexopoulis] – JP Morgan Paul Miller – FBR Capital Markets Christopher Marinac – FIG Partners Heather Wolf – Merrill Lynch Robert Patten – Morgan Keegan Fred Cannon – KBW Alex Lopez – Tallis Partners Kevin Fitzsimmons – Sandler O’Neill Gary Tenner – Suntrust Robinson Humphrey
Operator
Welcome to the First Horizon National Corporation Fourth Quarter Earnings Conference Call. [Operator Instructions] Hosting the call today for First Horizon National Corporation is Jerry Baker, Chief Executive Officer and Bryan Jordan, Chief Financial Officer.
They are joined by Dave Miller, Director of Investor Relations for First Horizon. [Operator Instructions] Mr.
Miller you may begin.
Dave Miller
Before we begin we need to inform you that this conference call contains forward looking statements involving significant risks and uncertainties. A number of factors could cause actual results to differ materially from those in forward looking information.
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 Horizon National Corporation disclaims any obligation to update any forward looking statements that are made from time to time to reflect future events or developments.
In addition, non-GAAP financial information may be noted in this conference call. A reconciliation of that non-GAAP information through comparable GAAP information will be provided as needed in the investor relations area of the company’s website at www.fhnc.com.
Listeners are encouraged to review any such reconciliations after this call. Also please remember that this audio webcast is on our website at www.fhnc.com is the only authorized record of this call.
With that I’ll turn it over to our CEO Jerry Baker.
Jerry Baker
Good morning and thank you for joining the call. I’m sure you’ve all seen our news release this morning regarding our fourth quarter earnings and our dividend reduction.
I’ll cover the dividend in a few minutes but I’ll begin with our reported earnings which were a loss of $1.97 per share in the fourth quarter. This quarter’s results reflect several significant changes net of some small gains.
They also reflect the continuing impact of challenges facing financial services companies as housing markets across the country continue to weaken, interest rates remain highly volatile and we continue to face illepent markets for credit based products. Brian will cover the detail in a few minutes and I will focus this morning on the actions we are taking as well as the core fundamental strengths we see in our businesses as we move forward.
The market environment continues to require definitive management actions across several areas; the adequacy of reserves for loan losses, maintenance of adequate capital and liquidity, elimination of unprofitable or low return businesses and achieving meaningful cost reductions. Accordingly we have taken the following measures to improve performance; first as we announced in December we conducted a comprehensive review of our residential construction portfolios including an assessment of our reserves.
As a result we increased reserves by over $100 million in the fourth quarter mainly reflecting inherent losses in our Construction Lending businesses related to deteriorating market conditions. In contrast our CNI and Home Equity portfolios continue to perform as expected.
We will of course continue to monitor all of our portfolios carefully. Second we completed the sale of 15 First Horizon bank branch locations in the fourth quarter generating a small gain.
We expect the sale of the remaining locations to be completed in the first quarter of this year. Third, we are reducing our mortgage and national real estate exposure.
Despite our competitive advantages we continue to downsize these businesses which we view as lower return and more volatile, where we see market conditions remaining difficult into 2009. As a result we substantially reduced headcount and costs in the fourth quarter.
We also sold $7.3 billion of mortgage servicing and believe that further reductions and the size of our servicing portfolio are warranted. Accordingly we recorded a $135 million reduction in the value of our mortgage servicing assets this quarter reflecting more emphasis on broker price discovery to determine marketable value in the current environment.
We also took other charges in response to the current difficult real estate market including writing off of our $71 million mortgage goodwill and making some low com adjustments in our warehouse. After tightening underwriting significantly and reducing our sales force and costs to the fourth quarter we are making further changes in our Construction Lending business.
We have eliminated wholesale, one time close and virtually all home builder lending and high risk national markets and will continue to reduce originations. In all markets we focus experience resources to work out roles.
This should result in a $2 billion or more contraction in these portfolios by the end of 2008 for a net capital and requiring less ongoing positioning. Fourth, we continue to improve our efficiency and productivity including the initiatives that will achieve our $170 million annual target.
We will pursue significant additional cuts over 2008 as we shrink our national business. As we acted throughout the quarter to improve performance and made adjustments to reflect current market conditions the magnitude of negative impacts on our financials increased and our capital levels were diminished.
This constraint led us to one last meaningful decision; our decision to reduce our dividend from $0.45 per share to $0.20 per share. We clearly understand the importance of our dividend to many shareholders and did not make this decision lightly.
As we considered the continued challenges we face in the current environment we believe a lower dividend is in the long term best interest of the company and shareholders. Combined with our actions to shrink our balance sheet and improve earnings, reduced dividend should improve capital ratios and provide us additional flexibility during 2008 and into 2009, including the ability to make continued investments in growing our strong regional banking franchise.
The $0.20 dividend should reduce our payout ratio closer to our targeted 45% to 50% range and as we focus on improving earnings and our capital position this should provide the longer term flexibility to adjust the payout or repurchase shares. While these changes are not easy to make our management team and employees together with the leadership of our Board have proactively moved to respond to changing market conditions.
At the same time we are positioning the company for improved 2008 results, better long term returns on capital and a more stable business mix. Now I’ll turn it over to Bryan for his comments and be back with some closing thoughts before we take your questions.
Bryan Jordan
Good morning everyone. As Gerry said earlier reported earnings were a loss of $1.97 per share in the fourth quarter.
There are a number of pieces to the results which we’ve again tried to simplify to the extent possible with materials in our financial supplement combining detailed schedules to explain which line item and business segments these charges impact. Dave and I will be available after the call to answer questions you may have.
I’ll begin with the rundown of this quarters significant items which we’ve summarized on page three of our financial supplement. We incurred net charges of $27 million this quarter from restructuring, repositioning and efficiency initiative charges.
This amount includes $36 million in expenses from severance and technology projects and $7 million in servicing sales transaction costs which were partially offset by $16 million gain associated with the sale of 15 First Horizon bank branches. All of these charges are recorded in our Corporate segment.
There were four items that impacted the Mortgage Banking and National Lending businesses including the following; goodwill impairment of $71 million reflecting an update evaluation of the business based principally on strategic cash flow projections and mark to book values. Reduction of mortgage servicing asset carrying values of $135 million, lower of cost or market, or low com adjustment on non-conforming loans in our warehouse and other valuation reductions totaling $19 million.
Finally, a legal settlement accrual of $5 million. Other items include $56 million of accruals related to our proportionate share in Visa and American Express and other outstanding litigation matters.
There are a handful of smaller items that total roughly $4 million which are detailed on the summary page in the supplement. With respect asset quality as pre-announced we incurred $157 million in provision expenses in the fourth quarter, significantly exceeding net charge of $51 million.
As a result reserves increased by $106 million over third quarter to $342 million at the end of the fourth quarter or 1.55% of total loans outstanding. Net charge offs increased to 93 basis points in the fourth quarter from 57 basis points experienced in the third quarter, driven primarily by a one time close and home builder loans in our national footprint.
Non-performing assets increased from 113 basis last quarter to 166 basis points in the fourth quarter, also largely reflecting construction loan curation in the national markets. We’ve again provided detailed disclosure by portfolio in our financial supplement this quarter.
As we disclosed in late December the additional reserves primarily reflect higher inherent losses in segments of our national one time close and home builder portfolios, which together represent $4.1 billion or about 19% of our total loan portfolio. In Home Builder Finance we continue to see the greatest problems in weak national housing markets such as Florida, California, Arizona, Nevada, Virginia and Georgia.
Where falling home prices are driving entire loss severities and where a large supplies of unsold homes are pressuring builders and consumers. Florida and California alone represent about 22% of our total $2.1 billion builder portfolio but account for over 50% of our non-performers in this portfolio.
Our one time close portfolio is also experiencing significant pressures in these national markets. In addition we’ve seen greater loss rates on product structures that we discontinued in 2006 and 2007 that have higher risk origination parameters and were structured as stated income and low documentation loans.
These loans represent approximately 24% of OTC commitments but accounted for 75% of charge offs in 2007. Our non-construction loan portfolio represented approximately 80% of total loans continue to perform well in the fourth quarter.
In our home equity portfolio delinquencies rose from 1.14% of loans 30 days past due in the third quarter to 1.36% in the fourth quarter, reflecting general maturation of the portfolio and continued environmental pressure. Annualized charge offs increased 60 basis points in the fourth quarter from 33 basis point in the third quarter.
The increase was primarily driven by addressing a group of fraudulent loans in Virginia. We attribute this portfolios relatively good continued performance to our credit worthy borrowers, geographic diversity and high mix of retail origination.
In the CNI portfolio which is mainly Tennessee based, non-performers improved from 32 basis points in the third quarter to 24 basis points in the fourth quarter. Net charge offs decreased as well to 20 basis points annualized in the fourth quarter.
Management continues to take actions to limit, identify and manage problem loans. First we are reducing our national real estate portfolio significantly, curtailing new origination, tightening underwriting; eliminating certain product structures and pulling back in higher risk national markets.
As we’ve said the relatively short life of these loans will also generate meaningful reductions in these portfolios over 2008. Second, we are proactively identifying problem assets through a more intensive watch list process and comprehensive portfolio reviews.
In the fourth quarter these reviews touched substantially all loans in higher risk markets and approximately 70% of the entire commercial real estate portfolio. Third, we are ensuring adequacy of reserves, in the fourth quarter we conducted a thorough review of our reserve methodology refining loss probabilities and severities in certain segments of our portfolio to reflect more recent historical losses and deteriorating conditions.
Finally, we are remediating problem assets by deploying additional work out resources including an enhanced central work out function. We have brought in outside seasoned staff for selected new positions and have moved experienced relationship managers to work out roles.
Going forward we generally expect asset quality indicators and market conditions to weaken further in 2008 but also believe that we have moved aggressively to address problem loans. Non-performers should continue to increase.
We currently expect provision expenses in the range of $50 million per quarter for 2008 and our reserve coverage of total loans to increase somewhat as our national portfolios shrink. Next I will update you on our progress in executing our efficiency and productivity improvements; we have completed roughly 50 individual projects that should drive $175 million of annual pre-tax benefits and there are a handful of remaining projects that could push the benefit a bit higher.
We estimate that approximately $150 million of these annual benefits were in the fourth quarter run rate and that the remainder should be realized by the first quarter of 2008. We completed the sale of 15 First Horizon branches in the fourth quarter resulting in the transfer of approximately $230 million in deposits and loans both of which were classified in held of sale categories at the end of the third quarter.
We expect the sale of the remaining locations to occur in the first quarter of 2008. In aggregate we expected investors to provide approximately $30 million in annual pre-tax improvements by the second quarter of 2008.
As we’ve done in the past we continue to pursue opportunities to reduce our Mortgage and National Specialty Lending businesses. Since the middle of the third quarter we have eliminated the bottom 50% of our retail sales force, reduced wholesale account executives, construction relationship managers, management and support staff, closed more than 60 offices and cut other back office costs such as IT.
We ended the fourth quarter with 4,000 employees in these businesses 600 less than the end of the third quarter and down more than 1,300 from a year ago. We anticipate that these reductions will provide $40 million in annual pre-tax savings beginning in the first quarter.
Given the continued challenges and outlook for these businesses we will look for ways to reduce costs even further. As a result of all of our efficiency and restructuring efforts total full time equivalent employees declined 10% from the end of the third quarter and are down approximately 18% from a year ago.
We expect headcount to decline further in 2008 as we become more efficient. Total expenses in the fourth quarter excluding the $167 million of charges from significant items were approximately $390 million.
While exhibiting normal seasonal patterns and impacted by variable commissions we expect expenses to climb further in 2008. We have again provided a detailed schedule on page five in the financial supplement to explain all of these charges and benefits.
Now I’ll discuss the highlights from each of our business lines beginning with Mortgage. Clearly this was another disappointing quarter by Mortgage business as we recorded a pre-tax loss of $263 million.
As I’ve already mentioned this loss was mainly driven by two larger items; first we recorded a goodwill impairment charge of $71 million writing off all of the goodwill in this business based upon market valuation. Second, we recognized a $135 million reduction in the carrying value of retained servicing assets this quarter.
Each quarter we assessed the model value of our servicing assets by comparing them to those of other mortgage companies, observable trade of servicing in the market and third party broker valuations. Given the ongoing disruptions in the mortgage market we adjusted our carrying value this quarter to be more in line with third party broker values.
In addition to these larger unusual items there are also some persistent operational challenges in the business. On the origination side, deliveries declined seasonally as expected to $5.5 billion in the fourth quarter.
Pricing remained below historical levels. Gain on sale margins were five basis points in the fourth quarter, again adversely impacted by significant spread widening on ARM and non-agency eligible production.
Although the impact was smaller than the third quarter as we had substantially reduced volumes in these products. Margins were also negatively impacted by the aforementioned low com adjustments.
On the servicing side of the business run off expenses decreased to $41 million in the fourth quarter versus $49 million in the third quarter. Net hedging performance was a loss of $18 million in the fourth quarter significantly below last quarters positive $22 million.
This quarter’s loss was primarily driven by significant rate volatility in December and weaker market liquidity and certain hedging. In part this increased transaction costs to maintain our targeted hedging profile.
Despite these challenges servicing portfolio metrics continue to reflect our operational expertise and focus on prime and forming customers. Servicing costs loans remain at best in class levels and delinquencies though increasing somewhat are well below industry norms.
As of the end of the fourth quarter 148 basis points in this portfolio was 90 days delinquent up from 118 basis points last quarter. Lastly, we completed two bulk servicing sales in December totaling $7.3 billion in unpaid principle balances.
This reduced servicing assets by approximately $120 million driving reduced utilization of capital by the business. Going forward we expect the Mortgage business will remain challenging in the near term given current credit market conditions.
We believe the actions we have undertaken in recent quarters and our ongoing focus on discipline pricing management and cost control should position this business as well as possible for the current environment. That being said we also recognize that our work is not done here and we will continue to explore ways to further reduce our mortgage exposure.
Capital markets was a bright spot for us in the fourth quarter as our focus on maintaining a balanced business model was evident. Pre-tax income increased sequentially from an $8 million loss in the third quarter to a $21 million profit in the fourth quarter.
Fixed income sales improved sharply as the Fed reduced rates and the [inaudible] producing $77 million in revenues compared to $46 million in the third quarter. Other product revenues improved from $16 million in the third quarter to $24 million in the fourth quarter, although still well below the levels seen in prior quarters.
We completed a small through preferred trust issue this quarter of approximately $370 million and profitability was minimal. Despite ongoing strong demand from our financial institution client base to raise capital through trust preferred issuances demand for high quality CDO products remains ado.
We have temporarily adjusted this business accordingly and have managed our warehouse down to less than $400 million at year end. Going forward we expect our Capital Markets business to benefit from continued increased levels of fixed income activity.
Additionally while we believe credit market illiquidity may continue to restrict our pool trust preferred business over the near term we believe this business will recover in time. We continue to be pleased with the performance of our First Tennessee Bank franchise.
Customer and account trends remain strong as a result of our efforts to open new financial centers, increase marketing spending and intensify sales, particularly in light of ongoing bank consolidations in our trade areas. As a result of these efforts, fee income at our regional banking business increased 3% sequentially and deposits grew as well.
We expect profitability to grow in the quarters ahead as we reap the benefits of continued investment in this business. Turning to the total retail commercial banking segment, we recorded a pre-tax loss of $52 million in the fourth quarter driven mainly by the aforementioned increased provision expense associated with our national construction portfolios.
Deposits were flat and loans declined 2% sequentially over the third quarter, primarily driven by First Horizon branch sales completed during the quarter. Our Real Estate Construction Loan portfolios mainly OTC and Home Builder declined by a combined $227 million from the end of the third quarter to the end of the fourth quarter.
We expect a faster rate of contraction over the next few quarters. The Retail Commercial Bank net interest margin declined 17 basis points to 3.71% in the fourth quarter driven by additional non-accrual construction loans in our national market and the impact of Fed rate cuts on deposit rates.
The Corporate segment incurred net charges of $93 million this quarter associated with our various restructuring, repositioning and efficiency initiatives, the Visa litigation accrual and equity security laws. Turning to our consolidated results, the tax provision this quarter was a credit of $146 million reflecting our normal statutory Federal and State rates, permanent fixed credits of $6 million and approximately $40 million of non-deductible goodwill impairment in the Mortgage business.
Consolidated net interest margin declined from 2.87% last quarter to 2.77% in the fourth quarter. The decrease largely resulted from increased wholesale funding costs tied to Libor, although we were able to leverage alternative short terms funding sources to mitigate some of this negative impact.
In general every 30 basis points sustained higher Libor rates relative to Fed funds cost us roughly $5 million pre-tax per quarter as more liabilities than assets are tied to Libor. Going forward, we expect the margin to show some improvement given the prospects of a safer yield curve and our overall liability sensitivity.
In addition, the reduction of lower margin business from the balance sheet including the First Horizon Bank and National Consumer Lending business should provide benefit as well. While we have seen improvement in Libor rates in recent days these benefits could be eroded by resumption of the Libor illiquidity premium experienced in the fourth quarter.
As Jerry indicated capital ratios declined in the fourth quarter driven by reported losses. All ratios continue to be above well capitalized standards based on our estimates for the end of the fourth quarter, 6.0% for tangible equity to risk related assets, 8.0% for tier one and 12.5% for total capital.
While these ratios are at or above our more conservative internal targets we also recognize the need to build capital into 2008 to facilitate ongoing investments in our bank and provide cushion given our market uncertainties. A number of the actions we’ve outlined today will do just that.
Reduction of our quarter dividend saves roughly $130 million annually relative to our prior run rate, contraction of $2 billion from more and National Real Estate loans freeze up roughly another $160 million of tier one capital. The divesture of remaining of First Horizon bank should create another $40 million at tier one improvements.
In total these three initiatives alone should improve our tier one capital position by roughly $330 million over the next year. Combined with our strategic initiative to improve core earnings we expect capital ratios to improve during 2008.
With that I’ll turn it back over to Jerry for some closing thoughts.
Jerry Baker
This has been a challenging year for our company reflecting back on 2007 we have made major strategic changes while addressing complex market conditions. We’ve taken significant charges and made difficult decisions despite the challenges.
Our core business assets are strong, the First Tennessee franchise continues to perform well, we are building new financial centers focusing on growing deposits and wealth management services, refining our targeted value propositions and adding top talent to grow the bottom line of this business that has great potential. Our Capital Markets division continues to be an important complementary business and its balanced model should continue to drive profitability and improvement despite current CDO market pressures.
We will continue to make further significant adjustments to our Mortgage and related vending businesses including pursuing strategic alternatives to further reduce our exposure to these areas. In short, the earnings power and potential of the Tennessee bank and Capital Markets businesses are strong and improving.
By focusing on our fundamental strength, our regional banking business we are positioning the company for an improved 2008 result and better long term returns on capital. I’m sure no CEO wants to cut their company’s dividend, at the same time I believe that in these extraordinary times we need to build capital, improve liquidity and provide the flexibility for continued investment in our banking business.
We believe that we are making the right strategic adjustments and we believe these changes will reward shareholders in the long term. Now we will take your questions.
Operator
[Operator Instructions] We’ll go first to Steven [Alexopoulis], JP Morgan.
Steven [Alexopoulis] – JP Morgan
You commented that with the dividend cut the payout ratio should be in the 40% to 50% range, what time frame are you thinking there? Is that in ’08 assumption or next quarter?
Jerry Baker
That’s our assumption for ’08, we believe that we should progress and be at that level as we move through the year.
Steven [Alexopoulis] – JP Morgan
Could you touch on how you are thinking about the Mortgage banking segment here? You’ve had headcount reductions and a lot of moving pieces.
When do you expect that segment to actually become profitable again?
Bryan Jordan
That’s a good question; the disruptions in the market seem to continue to persist. You see improvement for a couple of months and then the spreads widen out like they did towards the end of the year especially in December.
We expect as we sit here today to continue to see a difficult operating environment for the Mortgage business for the foreseeable future, we don’t expect significant recovery over 2008 and probably will persist into 2009. Our hope is that we can reduce the, if you pulled out a number of the one time items in the business and look just at the operating results you probably would have had in the neighborhood of $40 million pre-tax operating loss in the business.
That pulls out the goodwill, the MSR valuations [inaudible]. We’re trying to drive that much closer to break even over the next couple of quarters.
As Jerry said in his comments and as I’ve said a couple different ways in my comments that that’s a business we are going to continue to address as aggressively as we can to reduce exposure to the volatility of the business and to reduce the cost structure and the capital allocated in a way that we drive greater profitability of the business.
Operator
We’ll go next to Paul Miller, FBR Capital Markets.
Paul Miller – FBR Capital Markets
You talked about having provision of roughly $200 million on a $50 million run rate if I’m correct throughout the year. You had $50 million roughly charge off in the fourth quarter alone.
Are you planning, going forward, to provision what you expect to charge off? In saying that do you expect charge offs to be roughed in that $200 million range?
Bryan Jordan
Let me put into context the fourth quarter. We went through as we said a very detailed bottoms up analysis of our reserving methodology.
We reviewed 70% of our Commercial Real Estate portfolio loan by loan, we looked at all of the loans in high risk markets and our Construction portfolio and clearly we were trying to make sure that as we looked at these assets that we got then charged down to expected realizable values making as good estimates as we can. As we look into 2008 and as we sit here today we expected the credit quality will continue to deteriorate.
We expect that our loan portfolios will come down some as we reduce our exposure to our Construction portfolio. In an absolute sense, just by covering charge offs, reserve levels will build as a percentage of loans.
I’m not prepared today to say that we are going to limit our provisioning to whatever charge offs are. Our expectation is that we will cover charge offs and we will continue to evaluate the adequacy of the loss reserve in 2008 as events unfold again against the backdrop we think credit quality and the total environment will continue to deteriorate and we’ll see how our portfolio performs in that context.
Paul Miller – FBR Capital Markets
You talked about taking out $170 million of expenses. What time frame would that take and then what’s a good run rate?
What’s a good solid core run rate for the expenses for the company?
Bryan Jordan
In the $175 million of expense commitments that we have already committed to we’ve got about $150 million or so of that in our fourth quarter run rate. Given the nature of our business, particularly Capital Markets and to some extent the Mortgage business it causes compensation expenses to fluctuate from period to period.
It makes it a little harder to get to a run rate. Additionally the first quarter is probably not a good benchmark because you’ve got a seasonal impact of taxes and things like that flowing back in.
Our general expectation is once we complete the realization of the $175 million commitment we realize the cost reductions associated with the First Horizon branch divestures and we realize the savings that we expect out of the mortgage initiatives that we have in place. The 2008 expenses will be significantly below 2007 expenses so I would sort of benchmark a 390 kind of run rate for the fourth quarter and I would expect that it would decline from there going into 2008 given you’ve got to factor in some effective capital markets and seasonality and things of that nature.
Operator
We’ll go next to Christopher Marinac, FIG Partners.
Christopher Marinac – FIG Partners
Why tier one capital when you mentioned the $40 million divestitures does that include the M&T sale that already happened or just the pending Atlanta sale?
Bryan Jordan
That just includes the pending Atlanta and Texas sales plus whatever premium we get there plus the benefit of freed up balance sheet relief of about $240 to $250 million of assets.
Christopher Marinac – FIG Partners
My next question had to do with the loss rate going forward on home equity lines. Is this rate a sort of sustainable pace for the next quarter or two?
Bryan Jordan
We think that the pick up and loss rate is likely to be sustained for a period of time. I talked a little bit about some of the, we had a clean up of the fraud loans and one of the divestures counted for maybe $700,000 or so a charge off, three or four basis points on an annualized basis.
We are seeing a picked up and loss rates particularly in the higher risk markets, California, Florida, places like that. We are seeing a slight pick up in our roll rates in delinquencies, i.e.
from 30 to 60, 60 to 90 days in the 20% range, higher probability of roll rates. Our expectations today are that we’re probably likely to be in more of a 55 to 65 basis point range for the near term.
Christopher Marinac – FIG Partners
That’s just on home equity correct?
Bryan Jordan
Yes.
Christopher Marinac – FIG Partners
For other areas such as the home building losses, and CNI, etcetera, any other general thoughts on where this might be headed in near term?
Bryan Jordan
We’ve taken fairly significant losses, a big piece of the losses that we took in the current quarter were clearly driven by that, in the supplement you can see the loss rates that we incurred. We’ve built substantial reserves around those portfolios, we expect some continued deterioration in terms of the real estate markets and that will probably drive further delinquencies and probably pick up in non-performing assets.
Loss rates we don’t think should go up significantly from where we are today.
Operator
We’ll go next to Heather Wolf, Merrill Lynch.
Heather Wolf – Merrill Lynch
One question on reserves, I know you’re building reserves as a percentage of your loans but reserves is a percentage of non-performers is actually deteriorating a little bit and I think you said your non-performers going forward. Can you talk about how you’re managing for that ratio?
Bryan Jordan
When we look at the reserve to non-performing assets we’re not really trying to build a ratio there, what we’re doing is we are looking at the content of loss in our non-performing loans. We have gone through very detailed review of our home builder, commercial real estate portfolios our one time close portfolios and if you step back from it we’ve got about 6% of the construction portfolios from a non-accrual basis at the end of the year.
We’ve taken a pretty aggressive step in trying to identify the problem assets that take charge offs and evaluate the content in those. When we look at the reserve to loan ratio, we are really not trying to assume a loan is a non-performing asset, we are not trying to drive a specific ratio.
One of the reasons that we expect it to build is not a significant additional surge in non-performing assets, but the very fact that non-performing asset inflows will continue while resolution will take a period of time until the housing market recovers. So it is the fact that we are seeing a slowdown in the ability to resolve problem assets in the current environment.
Heather Wolf – Merrill Lynch
Gerry, as you said, these are extraordinary times and I know that in recent days we had seen one of your competitors in the mortgage industry look for some help through M&A. Can you just address your view on First Horizon and whether or not you would seek a partner to help you through these times?
Gerald L. Baker
Absolutely, Heather. As I think we have tried to state in my comments for sure, we are looking at all kinds of alternatives which include a partner in one form or another, including the sale of mortgage servicing assets.
We are mindful of the need to be profitable in that business in the short run, reducing our costs; but we are certainly evaluating what would be appropriate options to deal with what I see as an issue in housing in the mortgage business through this year and certainly into next.
Heather Wolf – Merrill Lynch
Would you consider a full sale at this point?
Gerald L. Baker
It would certainly be something to look at based on whatever options or whatever offers that might be there, but I think that is putting the cart before the horse. We are clearly looking at what our options are from a very strong franchise.
Operator
Your next question comes from Robert Patten – Morgan Keegan.
Robert Patten – Morgan Keegan
Good morning. To follow up on Heather’s question, reserve to NPA, Bryan.
Can you give us an idea of how aggressive you guys were in writing down credit when they go into NPA so we can get a feel there?
Bryan Jordan
Take OTC as an example. When we put an OTC loan in the non-accrual, we take a charge-off to appraised value.
Then try to take into account the estimated holding and selling costs around that asset. We are trying on the front end to take an adequate charge to get these loans to what we believe is a most likely outcome in sales.
We are not trying to do it through a reserving methodology, we are trying to make sure we get proactive at taking charge-offs.
Robert Patten – Morgan Keegan
I guess the question was, 6% are construction lending. The question is, have we done enough and where do we go from here?
You’ve taken that big chunk of your portfolio which is the high stress market, and you have written them down to what we believe are current costs. The question is, as the market gets worse it will go down more.
We are trying to figure out where you are.
Bryan Jordan
One way to put it in perspective there, is there is a chart that I think Dave put in the supplement. I think the broad point that might help dimension the construction portfolios, in broad terms in homebuilder and one-time close, somewhere between 20% and 25% of our exposure in those portfolios are in the higher risk market, like Florida or California.
Today, 50% of our non-performing assets are within those markets. Said another way, the problems tend to be more concentrated in some of those higher risk markets, and we have been fairly aggressive in identifying problems in those markets, we think, because we have spent a lot of time focused on them.
So the flip side of that is, is that performance in other markets continues to be very good. You are not saying the same kind of depreciation in real estate values that you are seeing in some concentrated markets.
What is driving some of the problems today is more concentrated in real estate in some of higher risk markets. We are mindful of keeping an eye on it and focused on it and we expect that it is not a problem that is going to turn around in the next couple of quarters, that real estate prices will remain soft across the country.
But most of the problem right now is concentrated in the higher risk markets.
Gerald L. Baker
I would just add, Bob, that in those higher risk markets, as we went through the end of the year we essentially reviewed every loan and reserved and took actions as appropriate.
Robert Patten – Morgan Keegan
What can we expect in contribution from the Tennessee banking operations? Are you going to break those out in terms of reporting going forward?
Bryan Jordan
Bob, our intent is to break the Tennessee franchise out in the first quarter. It really requires going back – not that you care about the mechanics – but it requires going back and restating all of our reporting.
Clearly we want to separate the Tennessee banking franchise from the real estate commercial bank which includes the national real estate portfolios and home equity portfolios. The Tennessee banking franchise continues to be very strong on an operating contribution basis.
We are very pleased with the progress that we’ve made there. We are continuing to invest in that franchise through advertising.
We have got new branches that we have started that we are opening in 2008. We intend to break that out and isolate it in 2008.
Dave Miller
Bob, one thing to add. We have also in the supplement, in the retail commercial banking section, added some information on deposits and loans and net interest margins in our regional banking franchise, which is mainly First Tennessee, so that should give you some incremental information while we are also making those changes.
It gives you a sense of what the net interest margin, it is close to 500 basis points, and so forth.
Robert Patten – Morgan Keegan
What was the contribution from the Tennessee banking operations for the fourth quarter?
Bryan Jordan
It was in the $60 million to $65 million operating contribution range.
Robert Patten – Morgan Keegan
Regulators, was there any regulatory pressure on the dividend cut?
Bryan Jordan
No.
Operator
Your next question comes from Fred Cannon – KBW.
Fred Cannon – KBW
Good morning. I wonder if you could walk us through a bit more on the one-time flows product, in particular.
Essentially what went wrong on that product, in terms of the structure of it and the loss content you are seeing? If I remember correctly, historically you have implied that you thought that was a fairly safe product and would perform like first mortgages; that isn’t occurring.
Now it sounds like it is performing more in line with the national homebuilder portfolio. Also, was there any kind of breakdown in your risk management regarding that product?
Bryan Jordan
The one-time close is a product, just to restate, is an individual construction loan for an individual borrower to build a home. It is often made in a scenario where the homebuilder is – it also includes a take-out into a permanent structure.
The average loan size is about $435,000 or so. The issues that we are seeing in the portfolio are largely driven by a couple of major factors.
In a lot of cases, the portfolio had an Alt-A structure or an Alt-A take-out. A lot of the problems that we are seeing today are in the products that we significantly curtailed in 2006 and into 2007.
For example, stated income product and other expanded approval products. We are seeing the greatest deterioration in those products.
You have got the overall slowdown in the real estate markets driving the ability of buyers to sell the home they are in, move into this one; a number of different factors from the economy affecting it. The biggest drivers in general have been the difficulties in the real estate market and the unavailability of financing and the ability to sell some of those products.
Fred Cannon – KBW
So just on that note, so essentially the risk characteristic that created this issue were alt-A stated income issues? Secondly, you said that essentially you would make this loan to an individual while you still had another mortgage on another property, and then therefore it was essentially a second home loan to individuals and that was another risk characteristic?
Bryan Jordan
It wasn’t always a second home loan. It was intended to be a first and that was part of the approval where you would sell the existing home, you would move the equity over.
But clearly a [stepped] product is more susceptible to misrepresentation and fraud.
Dave Miller
Fred, those expanded guideline type of products also tended to be more for some of the higher-risk markets. So with the slowdown in some of those areas that sort of exacerbated the issue.
Fred Cannon – KBW
You are talking about my home state of California, I bet.
Gerald L. Baker
That would be one, Fred.
Fred Cannon – KBW
To follow on that note, you guys are basically getting out of this business, it sounds like. I was wondering if you have evaluated actually just selling that portfolio?
We were wondering if you could give us an idea of what discount you would have to sell that for today if you were going to get out of it that way?
Bryan Jordan
We have not pursued selling those portfolios. We tend to believe that with the dislocation of the real estate markets that our ability to collect is in realized value through the aggressive administration process that we have put in place, we tend to create more value than trying to liquidate it in the sale.
We really have not pursued that.
Gerald L. Baker
We manage it ourselves and pay attention to the details.
Operator
Your next question comes from Alex Lopez – Tallis Partners
Alex Lopez – Tallis Partners
Good morning. First question with respect to your MSR valuations, to what extent does your prepayment speed of assumption take into consideration the home price, depreciation and the credit crunch pressures faced by the borrower?
Bryan Jordan
It is factored in. We factored in our prepayment speed estimate a percent of the structural impediments to refinance in the current environment.
Given the falling rate environment that we’ve seen and the expectation for a falling rate environment, our prepay speed has been lessened a little bit by the fact that there are structural barriers that make it more difficult to refinance.
Alex Lopez – Tallis Partners
My second question has to do with the consumer real estate portfolio. What is the geographic make-up of your consumer real estate portfolio that has LTV greater than 80%?
Dave Miller
You have got in the analyst packet, the materials, Bryan referenced that we have breakouts of the consumer real estate portfolio by state. The LTV mix, and given your LTV and FICO grids, but generally speaking you have got a third of the portfolio that is going to be in the State of Tennessee; what is outside of Tennessee is going to broadly diverse across the remainder of states, and I don’t think the LTV mix would be [inaudible] in that regard.
So average LTV in that portfolio is going to be in the mid to high 70s; the average FICO is 730 plus on a refresh basis. So despite some of the challenges in the geographies that we have talked about, that portfolio seems to be performing relatively well, but we expect incremental pressure.
Operator
Your next question comes from Kevin Fitzsimmons – Sandler O’Neill.
Kevin Fitzsimmons – Sandler O’Neill
Good morning, everyone. Gerry and Bryan, I was wondering if you could address generally, you have touched on it a few times here this morning, but the commitment level going forward with the capital markets and the mortgage business separately.
On mortgage, I heard what you are saying about the servicing side, that you would be open to looking for alternatives, maybe selling some more of your servicing assets. Can you talk more about the other side of mortgage?
If really we are looking at a continued, very difficult environment going into 2009 and this business might continue to be operating at a loss in the near term, while I realize it may be difficult to sell that business, is there an option on the table to close part or all of it down? On the capital markets, Bryan, you always spoke about the capital markets as being a good source to securitize assets and get them off the balance sheet.
With the liquidity crunch that we have now, has your view on that changed? I know in the near-term we are having a nice balance of fixed income activity, but just generally to get an update on your thoughts there.
Thanks.
Gerald L. Baker
A couple of different comments I will make, and Bryan can add his views as well. I think in terms of the capital markets business, we have a good, balanced operation there.
We have been – I think we have tried to diversify that well. The trust preferred business is certainly not something that we see coming back any time soon, but I think we are optimistic that it will come back and we are pleased with these results and see continued results from capital markets throughout the rest of this year.
So capital markets, I think we feel good about and I will let Bryan make some comments when I am done talking about mortgage. Mortgage is a business in which we invest for the future in terms of spreads, volumes and so forth.
It is difficult, I think making adjustments in our own SRs that give us perhaps a better opportunity as we think about selling some portion of our servicing portfolio; it was a good move. We sold some servicing in the fourth quarter and we will continue to look for opportunities to do that.
You asked about our origination. We have a strong origination franchise.
We think we can make that business profitable, but at the same time I am mindful of the need to make sure that we continue to reduce our exposure to that business. So there may be options, as you suggest; I don’t have anything that I can specifically discuss, but we will certainly evaluate any and all options because I think we have a valuable franchise.
Bryan Jordan
I will add to Gerry’s comments on the capital markets business. I think we’ve got a very good business, it is well-balanced.
In terms of the capital we have allocated to this business we continue to produce very good returns in the business. It is going through a period of market volatility.
The capital markets business, by their very nature, have their ups and downs in what products are in favor and what products are out of favor, but with the balance of the business we are pleased with the mix and we think that it’s a business we can continue to grow in the near term and do it very profitably.
Operator
Your next question comes from Gary Tenner – Suntrust Robinson Humphrey.
Gary Tenner – Suntrust Robinson Humphrey
Good morning. Of the $2 billion expected shrinkage of the homebuilder portfolios in 2008, how much of that is homebuilder versus one-time closing?
I can’t recall what that number was, how that breakout worked.
Bryan Jordan
The $2 billion really includes decline in home equity lending as well. The numbers are about evenly split between homebuilder and one-time close that total about $1.5 billion in total, that is about $700 million to $800 million in each of the portfolios.
It is about $500 million or so in our home equity portfolios. Clearly those are projections that we have talked about for a couple of quarters.
Given the continued disruption in the markets, given our continued desire to reduce exposure to those products, we are going to continue to aggressively look for opportunities to reduce them further. I would expect that those numbers can go up from there over the next couple of quarters as we continue to restrict product and continue to move aggressively to restrict the markets that we are in to just those with very low risk.
Gary Tenner – Suntrust Robinson Humphrey
On that topic, to the extent that you have slowed down exposure in the homebuilder portfolio, maybe you can remind us what that amount is? I am just curious how the construction of credit availability nationally would impact your ability to run off some more of those loans?
Bryan Jordan
I missed the first part – exposure and what in the homebuilder?
Gary Tenner – Suntrust Robinson Humphrey
The level of land exposure in the homebuilder portfolio? That was an impact –
Bryan Jordan
Now I am with you. The homebuilder portfolio in total is a little over $2 billion.
About 25% or less of that is in the land, so we call it less than $500 million, $600 million.
Gerald L. Baker
And the majority of that developed land as well, we have consistently worked down the amount of land that we’ve had over the last year, really mitigating the exposure to the raw land, which is going to be in the low single-digits.
Operator
That concludes our question and answer session for today. I will turn the conference back over to Mr.
Gerry Baker for additional or closing remarks.
Gerald L. Baker
Let me just end by thanking you for joining us. I am not certainly delighted about some aspects of the marketplace, I am pleased with the progress we are making; our ability to reposition our company, and particularly invest and grow in our Tennessee banking operation.
We look forward to the opportunity to speak with you next quarter and share with you our progress as we move through this year. Thank you very much and have a good rest of the day.