Jul 17, 2009
Executives
Bryan Jordan - Chief Executive Officer Greg Olivier - Chief Credit Officer BJ Losche - Chief Financial Officer Dave Miller - Investor Relations
Analysts
Craig Siegenthaler - Credit Suisse Bob Patten - Morgan Keegan Tony Davis - Stifel Nicolaus Kevin Fitzsimmons - Sandler O’Neill Steve Alexopoulos - JP Morgan Kevin Reynolds - Wunderlich Securities Matt O’Connor - Deutsche Bank Gary Tenner - Soleil Securities Christopher Marinac - FIG Partners Al Savastano - Fox-Pitt Kelton Joe Stieven - Stieven Capital Jessica Halenda - FBR Capital Markets Jon Arfstrom - RBC Capital Markets
Operator
Welcome to First Horizon National Corporation’s second quarter earnings conference call. Today’s call is being recorded.
In addition, you can listen simultaneously at www.fhnc.com at the Investor Relations link. At this time all participants have been placed in a listen-only mode, but the floor will be opened for your questions.
Mr. Miller you may begin.
Dave Miller
Thank you, operator. Good morning.
Please note that our press release and financial supplement, as well as the slide presentation we’ll use this morning, are posted on the Investor Relations section of our website at www.fhnc.com. Before we begin, we need to inform you that this conference call contains forward-looking statements which may include guidance involving significant risk 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 is noted in this conference call.
A reconciliation of that non-GAAP information, to comparable GAAP information is provided in the appendix of the slide presentation available on our website. Listeners are encouraged to review the reconciliations after this call.
Also, please remember that this webcast on our website is the only authorized record of this call. This morning’s speakers include our CEO, Bryan Jordan; our Chief Credit Officer, Greg Olivier; and our CFO, B.J.
Losche. With that, I’ll turn it over to Bryan.
Bryan Jordan
Thank you, Dave. Good morning everyone and welcome to our call.
Second quarter results were noisy, but our core businesses and credit were inline with expectations. Despite a challenging environment, First Horizon’s team made significant progress on key initiatives to further strengthen our company and improve our profit potential as summarized on slide three.
The flattening trend in our problem loans continued as NPAs declined 2% linked quarter and charge-offs met expectations. This is the first drop in NPAs since the third quarter, 2007.
We continue to believe we are ahead of the curve on credit, having proactively attacked our problematic national construction portfolios, and applied the same rigorous practices to our input print portfolios. Unless the economy significantly worsens from here, we think our NPAs, charge-offs and reserves will peak over the next few quarters, a critical step in returning to profitability.
We continue to shrink our balance sheet and improve liquidity through a combination of winding down our high risk national loan portfolios and strengthening our customer deposit base. Our net interest margins multi-quarter down trend was reversed, with the margin up 16 basis points to 3.05%.
We expect further margin improvement in the second half of 2009 as we continue our emphasis on loan and deposit pricing discipline, building customer deposits and winding down our national businesses. Our core businesses performed well, regional bankings pre-tax, pre-provision earnings increased 24% linked-quarter, while capital markets achieved another very strong quarter; it’s pre-tax, pre-provision earnings up 13%.
Finally, we maintained capital ratios; they are among the strongest in the industry, with tier 1 improving to 15.4%, tier 1 common to 9.5% and tangible common equity to tangible assets to 7.3%. Let me spend a moment on capital.
Slide four shows an updated internal stress test analysis using assumptions similar to those applied in May’s public supervisory capital assessment program. We have applied the median two year loan loss rates under the more adverse scenario as reported for the 19 SCAP bank.
Additionally, we made some simplifying assumptions that include broker pre-provision earnings estimates, shrinking balance sheet and loan loss reserves of 2% at year-end 2010. As you can see, even in an adverse economic environment where we experienced higher than anticipated losses, our capital ratios would be significantly above well capitalized standards, with tier 1 common at 8.5% and tier 1 at 14.5%.
Given the strength you maybe wondering about First Horizon’s ongoing participation in the capital purchase program. While we believe our NPAs, charge-offs and reserve will peak over the next few quarter, economic conditions are soft.
So, we’d like improved clarity around the economic outlook. Also CPP funds are a relatively inexpensive source of capital.
We are therefore not in a rushed repay it off, but intend to work with our regulators to repay the funds at a prudent time as the economy stabilizes and credit trends improve. Turning back the second quarter result, Slide five provides the financial highlights.
We reported a loss of $0.58 per share for the quarter as BJ will detail in a few minutes, there are a number of moving pieces. This includes a dividend on the CPP preferred as well as a modest loan loss reserve an increase of $20 million.
Pre-tax, pre-provision income on a consolidated basis was $79 million; a stronger performance from our core regional banking and capital markets businesses was mitigated by negative impacts from winding down our national specialty business, lower hedging results in mortgage banks, actions taken to further de-risk our balance sheet and the FDIC special assessment. Clearly performance in our wind-down national businesses his been volatile in the past few quarters.
We expect they’ll continue to be somewhat unpredictable going forward as they are liquidated and we are working aggressively to dampen those effects. As we see some light at the end of the tunnel on credit quality and our balance sheet remains one of the strongest in the industry, we are increasingly turning our attention to drive in long term earnings power.
With that in mind, we focused on making our core businesses more efficient and productive. In our regional bank, we streamline processes by shortening loan approval times, streamlining infrastructure to better serve our customers.
Loan and deposit pricing has also been an emphasis. In capital markets we’ve made targeted sales force additions and reduced fixed costs, so that this business can generate solid returns even when the economic environment changes.
We have also been doing a fair bit of work around key financial and performance drivers. We have highlighted several of our key metrics here and BJ will cover those in more detail later in the call.
With the analysis we have done and the core businesses we have, I think that our new, more focused First Horizon can generate 15% to 20% ROE’s in a normalized environment assuming tangible common equity to tangible assets of 6% to 7%. We know however, that we’ve got a lot of work to do to get there.
Now, I will turn it over to Greg to discuss asset quality trends and I will be back to help take your questions. Greg.
Greg Olivier
Thanks, Brian. I’ll begin my comments on slide seven with an overview of the quarter.
As a general statement results continue to be as expected. We still feel we are approaching peak levels of charge-offs and loan loss reserve, and in fact expect lower charge-off and lower aggregate reserve levels in the back half of this year.
Keep in mind, however that these comments are based on our expectation of a continued incremental economic deterioration. If an unexpected significant acceleration in the rate of economy deterioration should occur, our results maybe materially different.
Charge-offs was inline with expectations at $239 million or an annualized 4.77% of loans, increasing modestly over last quarter. NPAs continue their flattening trend, negative commercial grade migration slowed and the problematic wind-down portfolios continued to shrink all of which led to a decrease in provision expense of $40 million to $260 million.
We had a small reserve build of $20 million as we expect incremental deterioration in our C&I and income CRE portfolios and the permanent mortgage portfolio continues to deteriorate. Lastly, I would note that 90 day plus delinquent loans declined $68 million over the last quarter as we had anticipated.
As you may recall we have burdened ourselves with an unusual level of administrative delinquencies last quarter and those issues have been resolved. Slide eight gives more detail on NPAs which were down for the first time since first quarter 2007.
The decline was a modest 2%, but we feel it is an important milestone on the way to normalizing the performance of our portfolio and serve as an evidence of the proactive approach to managing credit quality. NPOs decreased is 1% as inflow slowed while the rate of disposition improved somewhat.
Inflows from the commercial portfolio tended to be real estate related including both res CRE and Income CRE exposures. ORE management has been a focus over the past several quarters over which time we have consolidated the management of the majority of ORE under a single team.
We continue to have success disposing of individual asset at/or around carrying values. We also executed a handful of bulk sales at a loss in Q2.
This allowed us to manage the age of our ORE inventory and was in recognition of the impact decreasing appraised values are having on our regimented valuation adjustment process. Valuation adjustments, the process of regularly marketing our ORE inventory to market accounted for over half of the foreclosure expense in the second quarter.
Our strong capital position enables us to appropriately manage our NPAs and we will continue to selectively and prudently pursue ways to accelerate improved assets quality metrics. It is also worth noting that the down word migration of commercial loans continues its slowing trend this quarter, which translate into a smaller increase in required reserves.
Now I’ll cover the key trends in each portfolio starting with C&I on slide nine. Charge-offs in our C&I portfolio were $27 million down incrementally from the $30 million in first quarter.
Losses in general were small, as approximately 60% of our C&I charge-offs were less than $1 million. While charge-offs were not concentrated in any particular portfolio sub-segment, industry that are seeing elevated levels of stress, include construction related businesses, retail trade and banking.
As a reminder our trust preferred and other bank loans are housed in C&I portfolio and totaled about $800 million. Trust preferred borrows include banks and insurance companies, they have solid capital levels and several of them have received tarp.
This quarter we had one additional bank elected for interest on a trust preferred loan that we hold, bringing the number of trust preferred loans on interest deferrals to three. These three loans totaled $22.5 million.
Due to continued stress on the trust preferred loan portfolio we have increased reserves accordingly. Delinquencies and NPO rates in the C&I portfolio remain manageable owing to good borrower relationship and are predominately Tennessee footprint.
Economic conditions are softening here as they are everywhere and thus we expect performance trends in this book to deteriorate incrementally over the balance of the year. With that said, we’ve been aggressive in reviewing credits in this portfolio with regular on going reviews to insure accurate loan grading.
We have also increased reserves to 3.4% of loans. Turning to Income CRE on slide 10, outstanding balances stood at $1.9 billion at quarter end, the majority of which is managed by our regional bank.
Charge-offs were $31 million in second quarter, up from $17 million in the last quarter. In contrast, C&I losses, 68% of the charge-offs in this portfolio exceeded $1 million and were driven by a hand full of relationships.
Both the geography and the collateral types land, retail and mixed use projects varied. We expect continued deterioration in the Income CRE portfolio as vacancy rates increase, cap rates increase and the permanent market financing remains illusive.
Our reserves in this portfolio stood at 5.77% at quarter end. As we said before, loans in this book were underwritten to our balance sheet standards and in contrast to CMBS debt, our relationship loans that almost always includes personal guarantees and debt right sizing provisions.
Maturities due tend to be shorter than CMBS debt however, so we are proactively working with our borrowers to improve the banks tradition on upcoming renewals. Moving to slide 11, our home equity portfolio has a balance of $7.34 billion with declining $4.7 billion international markets in $2.7 billion in our core Tennessee Market.
30 day delinquencies increased 11 days its points to 2.12% from last quarter mainly driven by national markets. Rising unemployment seems to be most meaningful driver although we’ve been pleasantly surprised by the modest degree of up tick.
You’ll also note that our performance continues to runs much better than the industry due to our strong borrowers and underwriting. 85% of these loans were retail originated and have an average refreshed FICO of 730.
As you can see from the graph on the lower left hand corner of slide 11, borrowers are able to refinance out of our portfolio. Prepay speeds in the wind-down national book continue to be higher than a few quarters ago.
A final point on home equity, the majority of our current charge-offs are coming from the vintage years 2005 through 2007. In analyzing our loss curve, losses tend to peak between 24 months and 48 months suggesting that the underlying natural charge-off emergence period for the largest origination vintages should be nearing their peaks, notwithstanding further deterioration in economic conditions.
We still expect that consumer economy to remain stressed, however the given the offsetting impact of vintage dynamics we expect the charge-offs will remain near the current run rate in the second half of 2009, compared to a prior view that they would tend to increase. Our cumulative loss views from this portfolio remain consistent with prior expectations.
Slide 12 is an update on our national construction in our Perm mortgage portfolio which continued to drive disproportionate percentage of our problem loans. The res CRE wind-down remains on track as balances dropped another $100 million in the quarter to $579 million.
Charge-offs in this quarter were $34 million, down to $1million from first quarter. Reserves remained relatively flat.
The national res CRE commitments are now down 70% since the wind-down began in January 2008. One-time close balances ended second quarter of $558 million down $215 million linked-quarter.
OTC commitments are now down 79% since the wind-down began. Charge-offs totaled $51 million, up from $47 million in the first quarter as expected.
We expect that OTC charge-offs will decrease in the second half of the year as this portfolio wanes. Likewise, since we hold reserves for [Inaudible] loss in this portfolio, reserve levels should continue to decrease from this book.
Note that we did increase our estimate of remaining inherent losses quarter and adjusted reserves accordingly. Between the national specialty and mortgage segments, our permanent mortgage totals $1.1 billion.
It is heterogeneous pool of loans that contain a mix of high quality permanent mortgages from our core bank, prime performing mortgages from warehouse, OTC loans that where taken to the balance sheet, scratch dent loans from the warehouse and some loans repurchased from investors, as a result performance varies dramatically within this portfolio. Permanent mortgage charge-offs were $22 million in the second quarter driven by performance deterioration, increased loss severities and the depletion of available low come marks on a portion of this book.
We have increased reserved to 8.9%. I will wrap up on Slide 13.
Here is a look at our updated charge with directional trend arrows which we have shown you in the past two quarters. We have adjusted the format somewhat in an attempt to make our expectations for the balance of the year clearer.
To summarize our performance relative to expectations in the first half of the year, charge-off trend were generally as expected across all portfolios and somewhat lower than expected in res CRE. Our expectations regarding the required level of reserve were low however, as C&I and Income CRE reserve levels were increased and not held constant as anticipated.
Our expectation for the second half of the year is above charge-off and reserve levels are expected to decline in the aggregate relative to second quarter results. We have a slightly more favorable view on the home equity portfolio than we did at the outset of the year, but more negative view on C&I as we expect to incrementally build reserve and on Income CRE as we expect both higher reserves on higher charge-offs.
The thesis for these expectations is that we expect the economic environment to remain challenging well into 2010 with unemployment rising and on prices falling further. With that I will turn it over to BJ who will discuss financial results.
BJ Losche
Thanks, Greg and if everybody will flip to Slide 15, we’ll start with an overview of this quarters consolidated income statement and as Brian mentioned we reported a loss of $0.58 per common share, while provision expense declined $40 million linked-quarter and NII with stable, significantly lower mortgage results drove lower pre-tax pre-provision income of $79 million. This matches some really encouraging signs that we see in our core businesses and in fact, the next slide, slide 16 shows in our core business segments which are regional baking, capital markets and corporate, pre-tax pre-provision earnings improved to $131 million up $23 million from 1Q ‘09.
I will touch on some of the highlights of the core businesses in a few minutes. The wind-down businesses however posted a pre-tax pre-provision loss of $52 million compared to first quarter's positive $79 million.
If you look at the column on the right on this slide, it shows some of the significant revenue and expense impacts by each segment. So, I will touch on some of the more meaningful ones which will include a number of actions that we took to dispose the problem assets and mitigate future exposures in those wind-down businesses.
First, you can see at the bottom the accrual for the special FDIC assessment totaled $13 million across all of our segments. Next, as we have done on loan loss reserve, we also proactively addressed credit related aspects of our wind-down businesses this quarter that impact revenue and expense lines, repurchase expenses were $29 million in our mortgage business as we increased those reserves to address repurchase activity as industry delinquency rise.
We also recorded a $12 million reduction to income associated with home equity repurchases, and in the repurchase area we’ve assembled a strong cross functional team of experienced professionals to address and resolve requests from legacy originations going forward, and we had about $8 million in reinsurance reserve adjustment for our legacy mortgage reinsurance business based on higher loss projections although we’ve not yet actually paid any losses to date. Third, we incurred $22 million of foreclosure costs this quarter, that Greg mentioned up from $10 million in 1Q ‘09, including some losses associated with more aggressive dispositions.
While most of our foreclosure sales continue to incur inline with those carrying values, this quarter we did execute a bulk sale transaction that resulted in the disposition of about 100 properties at an incremental loss to book of about $5 million. Finally, mortgage hedge revenue results while still positive were much lower than the out size results in 1Q due to a more volatile rate environment and a smaller MSR book.
I would also note that in 2Q ‘09 we reviewed cost allocation and funds transfer pricing methodology views to determine segment performance, and as a result of this review some of those methodologies were revised. So for comparability, segment history has been revised as with well to reflect those changes and although the review impacted across segments the consolidated representation of financials was not affected.
So, if you turn to page 17, to review some of our key financial drivers beginning with the balance sheet. We are pleased again with the progress in managing down our national assets, growing core deposits and improving the loan-to-core deposit ratio that will ultimately improve and continue to improve our funding mix.
Our assets were reduced by about $2.5 billion in the second quarter as we sold mortgage servicing and continued to liquidate those national loan books. On the funding side, core deposits were positive up 2% from last quarter, even as we transferred approximately $300 million in escrow balance with the sale of that $13 million of national mortgage servicing.
What offset this decline from the escrow balance is was solid customer trends and early success to expanding share of wallet and our private banking and wealth management client business and that drove a meaningful increase in deposits in our regional bank. Combined with balance sheet production, good core deposit trends allowed us to retire $700 million in debt at maturity, reduce our cap utilization by $1.1 billion and maintain no utilization of our federal home loan bank borrowing capability.
As a result of asset reductions and good deposit trends, our loan-to-core deposit ratio dropped from 149% to 140 linked-quarter and is down 27 points from a year ago. Going forward, we expect another $0.5 billion to $1 billion of balance sheet reduction throughout the rest of ‘09, with continued core deposit growth and a declining loan-to-deposit ratio into the mid-to-low 130s, leading to a company that is ultimately smaller, but more profitable.
Flipping to Slide 18, our net interest margin was a real bright spot this quarter, improving 16 basis points to 3.05%. We benefited from reduced deposit funding costs as promotional money market savings balances reprised at materially lower rates.
We also experienced improved spreads on new and renewed loans although lack of significant loan demand here muted that benefit so far. Lastly, we’ve experienced continued slowing in the drag from non-accruals as our national businesses wind down.
As we’ve talked about before, going forward pricing is a major focus for us. Our margin is likely to expand modestly throughout 2009 as pricing improves and we wind down our lower margin national businesses.
Although, volatility and LIBOR makes the magnitude of impact tough to size with much precision. Long term, we think the net interest margin for our business is 350 to 375 and that’s achievable for the core franchise.
Of course to get all the way there, we need credit head winds to abate and interest rates to rise from the current low levels. Moving on to the next key driver, fee income to total revenue on slide 19; the fee income as a percentage of total revenue was 60% in the second quarter, down a bit from last quarter, but still very strong.
Our Capital Markets businesses continues to be the main driver of our fee income and our distribution base firm remains well positioned to take advantage of the continued favorable fixed income market conditions. While fixed income fees softened modestly in the second quarter after a previous quarter’s record, they remained very strong by historical standards.
Fees in our banking business rebounded seasonally, but remained relatively soft as weak consumer confidence drives lower overdrafts, debit card purchases and wealth management fees. Our national businesses drove significantly lower fees as previous quarters out sized mortgage hedge gains were not repeated in Q2 as rates rose.
Increased volatility caused repositioning of the hedge book and we had a 25% smaller servicing portfolio via the sale of $13 billion of MSR. Although, the hedging profile remains predisposed to modest gains, given the steepness of the current yield curve, volatile rates will continue to make results difficult to predict.
Also remind you, that fees were impacted this quarter by the addition to the home equity repurchase reserve of about $12 million which is contra revenue. As our net interest margin improves and Capital Markets production normalizes.
Our fee income mix will comedown from the 60%, which should remain strong relative to the industry at roughly 40% to 50%. Turning to page 20, expenses declined 1% linked-quarter to $412 million as we saw increased costs in our national businesses that we previously discussed and the FDIC assessment, while maintaining focus on reducing expenses across all of our businesses.
Capital Markets expense decreased primarily due to reduced rate of incentive provisioning and decreased production levels. As I’ve talked about earlier, much of the increased cost in our wind down national businesses is cyclical in nature as we move to address repurchases in these businesses as well as ORE.
Total headcount declined in the second quarter as we focused on efficiency initiatives across the enterprise. We’re in the process of implementing a number of initiatives to get at what we call here bad costs, things that don’t significantly impact customers or revenue.
For example, we’re closing a number of teller only branches, since our full service branches have more convenient hours and services. We’ve also been able to restructure our consumer lending processes as Bryan talked about, streamlining infrastructure, but also dramatically cutting loan origination time for the customer.
We are beginning to experience the first opportunities to reduce resources assigned to liquidating our national portfolios. Driven by some of the significant expense items and lower mortgage revenue, our consolidated efficiency ratio remained elevated in the second quarter at 84%.
Going forward, we expect our revenue improvement and cost reduction efforts to push this down into the lower 60s over the long term. Now I’ll just spend a few minutes on highlights from our core business segments and remember we did adjust some allocation methodologies this quarter that impacted segment numbers, but we’ve revised that history to reflect those changes.
So, if you turn to regional banking on slide 21, pre-tax pre-provision earnings here were up 24% linked-quarter to $38 million. Provision costs in this business also declined significantly linked-quarter, as delinquency trends in the consumer portfolio stabilized and grade migration continued to moderate in the commercial books.
Underlying customer trends in this business remain solid and very encouraging. The net interest margin improved 21 basis points, as deposit promo rates from the fall rolled-off, and we maintained a significant number of those balances at much lower rates.
You’ll note that we did a nice job retaining these balances through the re-pricing of the portfolio. Deposits were up 1% linked-quarter, as downward seasonal impacts from tax season were offset by solid growth, primarily in our private banking and wealth business.
Average loans on the other hand were down 3% linked-quarter, as we proactively managed watchlist credits and there were soft demand for new loans. New commercial loan demand in particular, is as subdued as we’ve seen in quite some period of time.
Revenues increased $8 million linked-quarter on the strength of improved NII and a seasonal rebound in fees, although those deposit fees remained soft. Lastly, expenses were flat in the bank as improvements in the run rate were muted by elevated environmental costs, particularly related to credit and the portion of the FDIC assessment that was allocated to the bank.
If you flip to slide 22, a bit on our Capital Markets business, which had another strong quarter with $100 million in pre-tax, pre-provision earnings, up from the $89 million that we saw in the first quarter. It continued to perform very well in the favorable environment, and we benefit from our strong distribution capabilities.
Our average daily fixed income revenue remained well above normal at about $2.7 million a day; again, driven by our product capabilities across agencies, mortgages, treasuries and corporates. Total return clients continue to drive over about half of our sales, consistent with our experience over the last few quarters.
Our balance sheet usage remains flat from last quarter and well below prior year levels, with trading inventory just under a billion dollars. Given the fairly modest use of the balance sheet and the lower risk profile, you can see why we like this business; it drives good returns from relatively little use of capital.
Capital Market expenses were positively impacted in the second quarter by relatively lower production and by a reduced rate of incentive provisioning that resulted in improved operating leverage. Going forward, we expect the fixed income business to remain strong, particularly if economic conditions remain poor and liquidity is tight.
As always, however the magnitude and duration of continued benefit from unusual market conditions is difficult to predict in this business. So let me wrap up a little bit on slide 23 and summarize.
As we refocus on our Regional Banking and Capital Markets businesses, there’s increasing evidence of strength and opportunities going forward in these businesses. With each passing quarter, we’ve also increased clarity around our credit quality issues as NPA’s flatten and higher risk portfolio shrink and given our strong capital position and headway in dealing with problematic credits, we’re increasingly turning our attention to the future, although we surely know the challenges aren’t over.
If you turn to page 24, we believe that driving long term returns and profitability is our key focus for us going forward and we believe that our strategic actions over the past year to refocus our company and leverage the competitive advantages in our core businesses will lead to good, long term earnings power when this credit cycle ends. When this occurs, we believe that 15% to 20% returns to shareholders are achievable and we’ve also defined the key financial drivers that will lead us there, and we’re rigorously managing execution around those.
We’re working on integrating all of our executive reporting, our scorecards down through the organization and our incentive plans to align with these key metrics that will drive them. Of the net interest margin, we think substantial improvement can be made over current levels, as our national wholesale funded businesses are reduced, credit headwinds abate, core deposit growth continues, and wider lending spreads persist leading to better risk adjusted margins.
With our Capital Markets franchise and solid deposit in wealth management businesses, we should be able to maintain a mix of fee income that is well above average. So clearly below current levels if market conditions return to normal and our efficiency ratio is elevated today, in part due to cyclical costs related to asset quality.
Overtime, we should be able to eliminate the remaining infrastructure costs associated with the wind down mortgage in national lending businesses which are meaningful today, but we also know we have some structural work to do. Through a focused internal effort involving all parts of our company, we’ve identified significant costs we can eliminate the next 18 months, driving down our overall efficiency ratio.
Over the past several quarters and again this quarter, our management team and employees have delivered on our commitments. Whether that’s been shrinking our balance sheet, tacking problem credits, improving liquidity or providing top rank customer service, we’ve done what we said we’d do.
We’re equally committed to returning this company not only to profitability, but to the kind of returns that will meaningfully reward shareholders over the long term. Thanks!
And with that we’ll be happy to take your questions.
Operator
(Operator Instructions) Your first question comes from Craig Siegenthaler - Credit Suisse.
Craig Siegenthaler - Credit Suisse
Question for Bryan. Maybe you can help me on some of the high level of trends.
I’m just looking at the decline in nonperforming assets and nonperforming loans this quarter and in your view was the first quarter actually the cyclical peak in both NPAs and NPLs or is there potential for double peak in the second half?
Bryan Jordan
Craig Siegenthaler - Credit Suisse
Maybe I can kind of ask this question a different way to kind of get at what I’m looking for. In your guidance slide on 13, basically First Horizon still expects, it looks like reserves to decline and net charge-offs to decline in the second half of this year, but your guidance actually changed on the commercial side, where now you’re expected to build reserves.
Is First Horizon’s overall forecast for declining net charge-offs and reserves; is it more modest now in terms of magnitude than it was in the first quarter or should we just not really read into that?
Bryan Jordan
It maybe slightly more modest, but it’s not a significant change in our outlook and I think the pieces are going move from time-to-time, but I don’t think they’ve changed significantly. Our outlook is very similar to the way it was 30 days ago, the way it was 90 days ago.
We feel very confident that our asset quality trends are on track and as we discussed a minute ago, I think you can infer from the charge-offs and allowance that NPAs would follow a similar path.
Craig Siegenthaler - Credit Suisse
I just had one question on your OTC one-time closed loan portfolio. It looks like delinquencies picked up again to about 8%, pretty high level and I’m just thinking with 64% of this portfolio now NPL, how much more potential is there for this portfolio to move into NPL?
Greg Olivier
Craig, this is Greg. I think we’ve had an awful lot of the portfolio in nonperforming.
Now, the ratio analysis on any portfolio and wind down starts to get distorted when there’s very little accruing loans left. So I think what you’re seeing in the volatility around delinquency is exactly that.
Actually intra-quarter it was at one point down, so it’s pretty volatile right now, because there’s few accruing assets left and some are of a large size, so it bounces around a bit.
Operator
Your next question comes from Bob Patten - Morgan Keegan.
Bob Patten - Morgan Keegan
A couple of comments; Bryan if you could just make a quick comment on the loan sale market and how you’re looking at the rest of the year in terms of dispositions. Second question, really hits slide 16 which I think is probably one of the more important slides here.
BJ outlined a number of one-timers, but there’s also going to be some ongoing stuffs, and the wind down in the mortgage, so could you just give a little more color on what he considers more a one-time expense and maybe ongoing numbers that we’ll see over the next couple of quarters, and maybe comment about the wind down of mortgage; when does that volatility go away. Last but not least, if BJ you can just fill in all the numbers in slide 24, it’ll make our life a lot easier.
Bryan Jordan
I will start with the easy stuff first then Bob. This is Brian.
On the loan sale market, BJ and Greg mentioned we sold a small portfolio of ORE. The loan sale market seems to be slightly more active, where we keep an eye on it and we continue to look at opportunities to sell.
We’ve not gotten to a point; at this point where we feel that the market has improved so significantly that our strategy is changed. We’ll keep an eye on it over the quarter and the rest of the year.
My guess is, if the economy improves, that market improves and if we do see the turn, we’ll see opportunities to further reduce NPAs over the next several quarters through sales. BJ you want to pick up the other two.
BJ Losche
I think a couple of things; one, I just want to reiterate that we seen some really encouraging trends in our core businesses. So while over the long term, we don’t know how long the capital markets business will remain as strong as it is, we do think that it will remain strong.
So could it come down 10%, 15%? It definitely could, but we also see encouraging trends in the regional bank that would offset that.
So we like what we’re seeing in the core businesses and would expect those positive upwards trends to continue. In the mortgage business, really is where we saw most of the volatility.
To be honest, first quarter was not nearly as good as it looked and second quarter was not nearly as bad as it looked and so, you can see as we outlined the hedge gains. In the first quarter we’re $85 million, and even though we did have modest positive hedge in effectiveness, we only had hedge gains of $7 million in the second.
What we would assume is that we’d have much closer to those types of hedge gains that we saw in the second quarter versus those in the first. On the expense side, we do continue to see as delinquencies rise on consumer loan portfolios and mortgage portfolio.
We do see repurchase activity continuing, but it’s probably, is it at the $29 million level? Probably not; it might be modestly lower than that, but we’ve also got a really good program approach and team together to actively minimize and mitigate our expenses there going forward.
We also had some things that were a little bit more one-time in nature as it relates to foreclosures and valuation adjustments that we saw. So we’re not actually just giving you actual numbers for guidance, I think you can see that there were certain things on the expense side and mortgage that won’t be repeatable, and that our hedge gains should be much lower and look more like second quarter than they would have looked in the first.
Bryan Jordan
Hey Bob, let me add to BJ. The slide on page 24 was somewhat affectionately named the bone fish slide.
It’s a framework or a lens that we look at our decision and our financial metric. We try to fill in a few of the pieces on this call and the difficulty in putting the right numbers in the boxes, a lot of combinations work, but if you start with 6% to 7% tangible common equity, a margin that runs probably 3.5% to 4% fee income in the 50% range, which is slightly lower than where it is today and getting expenses in the low 60s, a lot of combinations will work, but we think with that we can drive 15% to 20% ROEs and we use this as a framework for evaluating business decisions and strategies.
So we’ve laid it out, not say that there’s a precise answer for each one of these boxes, but this is the way we’re looking at the business.
Operator
Your next question comes from Tony Davis - Stifel Nicolaus.
Tony Davis - Stifel Nicolaus
I guess for Greg, the deterioration in the mortgage book, how much of the one-to-four family is out of footprint right now and what have you really seen I guess in terms of modification impacts or other changes and asset quality drivers there?
Greg Olivier
Tony, just to be specific, you’re talking about the $1.1 billion in permanent mortgages. That book is primarily a legacy book from the national business, so the properties are nationwide.
I think in terms of impact from mortgage modifications, it’s tough to break that out as an individual impact. I think what we’re seeing is increased stress in that portfolio, just due to economic conditions, unemployment and then the most serious driver or increase in losses has been the severities we’ve been experiencing; the severities have seen an increase over the past six months.
Tony Davis - Stifel Nicolaus
Can you talk maybe a bit more Greg about the potential repurchase risk by loan type or maybe business segment? Just any color you can give us on that as you look at it today?
Greg Olivier
Sure. The repurchase risk exists in any portfolio where obviously we sold loans, which is primarily the first mortgage book from the legacy mortgage business and then secondarily, our home equity business.
The volume of repurchases, I guess industry wide probably picked up in the fourth quarter as the agencies put more of an emphasis on putting back problems on the originators, so the majority of the volume is coming right now from Fannie. We in response have built that team as BJ said and have actually improved our recession rate over the past six months on the claims.
A lot of the claims of the increased volumes have been a little less realistic or based on factors that would typically drive a repurchase or our recession rate has increased, but it’s primarily Fannie and it’s picked up because of their attempts to minimize their loss.
Tony Davis - Stifel Nicolaus
BJ, the final question for you I guess is sort of the timing on your resizing initiative. You’ve got several things going on there.
Obviously there is still a fair amount of the embedded costs from the legacy national businesses in the book. Any color you can give us there I guess in terms of where you are and complete some of these new initiatives you’ve got going?
BJ Losche
You are probably talking about more on the expense side. Yes, so we showed in here, first of all that we probably think we have $60 million, $70 million, $80 million in the second quarter of what we call environmental costs, which is higher credit related expenses, FDIC assessments, all of those kinds of things and so overtime, we certainly think those will abate.
That’s stuff that we can’t 100% control. So what we’ve been working on is internally trying to drive costs out of the organization that we can control and what we’ve identified so far is about $50 million to $75 million of core expense that we expect to get out of the organization over the next 12 to 18 months.
So we’ve definitely seen that showing up in our core numbers, but it’s been masked if you look at our numbers here, by some of the more one-timer environmental costs. So, we talked about the consumer lending transformation that we’ve done, that has saved us several million dollars, and that is every month accreting back to us through our expense line.
Closing teller only facilities; we’re just in the process of doing that, and overtime that will save us a significant amount of money. We’ve reduced corporate support and infrastructure expenses that again accrete to us over time.
So, we need a couple of more quarters to be able to moderate these environmental costs and really show continued improvement in our core run rate, but I’m pretty pleased with the progress that I’ve seen so far.
Operator
Your next question comes from Kevin Fitzsimmons - Sandler O’Neill.
Kevin Fitzsimmons - Sandler O’Neill
I just wanted to drill down a little more on home equity and get a little clearer on the outlook. On one hand, the net charge-offs definitely shot up this quarter and I think that’s consistent with what you said last quarter, that you thought they were going to go up.
I think you indicated that home equity, you feel a little more positive on it for the second half of the year and that net charge-offs were going be roughly stable with this run rate. Is that more that it is stable with a rate that was higher than you thought this quarter?
In other words, did it shoot up more than you thought and now you’re base lining it off of a higher loss rate in the second half? Then just additionally, if you can give us a little color specifically on how you’re feeling about California?
I know California is a big chunk of that national portfolio and why you’re running off home equity? It’s tough to run that off as aggressively as you did in construction.
So, just kind of how you feel and kind of reconcile how you’re feeling that things are going to be stable in the second half of the year.
Bryan Jordan
Sure Kevin. I’ll start with the caveat.
I think all of us have put on our best attempts to give you a view of what we expect to happen in the next six months. This further economic deterioration beyond our expectations can throw all of our views off.
I think I’ll start with that. Secondly, you’re right; the view on home equity is what we had talked about in the first quarter.
We saw those delinquency buckets fill up in the fourth quarter and early first quarter and then that stabilization and the delinquency occurred. So what we experienced in terms of charge-offs in the second quarter as a result of those buckets filling up, it takes a while for those charge-offs to flow through.
Delinquency at this point has been fairly stable through the quarter, so that’s allowed us to look out six months and say we think the level of charge-offs we’ve taken in the second quarter will be fairly consistent with what we’ll see in the near term and third and fourth quarters. So we have, I think a fairly solid view of what to expect for the balance of the year.
That answers all of your questions Kevin?
Kevin Fitzsimmons - Sandler O’Neill
The California…
Bryan Jordan
California. Yes, our success in getting in people to refinance out is absolutely contingent upon their ability to refinance the first and end markets like California, Florida and Arizona, that remains more difficult with the lack of availability to jump up financing.
So, I think if you saw prepayment speeds via markets, you’d see a difference in California.
Operator
Your next question comes from Steve Alexopoulos – JP Morgan.
Steve Alexopoulos – JP Morgan
Brian, I’m curious; in your conversations with the regulators, do you have a sense that they would require you to raise more comments, before you could actually repay the TARP?
Bryan Jordan
We haven’t gotten that far in the discussion. As I indicated earlier, we are still looking for signs of economic improvement, a real downturn or improvement in credit trends and economic environment.
We’ve had of course discussions about the strength of our capital and the CPP, but we’ve not gotten to that point in the discussion that we would have any sense as to whether that’s an expectation of our regulators.
Steve Alexopoulos – JP Morgan
Can you touch on the drivers of your outlook for margin expansion the rest of the year, and where do you really think fed funds would need to go to, to get even to the low end of your long term range of 350 number.
BJ Losche
This is BJ. I think the drivers of our margin expansion, throughout the rest of 2009 and what I’d say is we expect it to expand modestly, so you can interpret what that means, but we think that the loan pricing work that we’ve got, we have soft demand, but we are seeing probably 80 basis points of expansion on newly funded loans from a year ago on that demand.
So eventually that’s going to roll through our portfolios, but it just takes a little bit of time and we’ll see incrementally better results from that. We also in one of the slides here today showed you the drag that we have on NPAs, both interest reversals when we put credits into NPA, as well as the ongoing headwind of non-earning assets.
That continues to decline and so not that we’re saying necessarily it’ll be a huge change, that we think we needed to peak on NPAs. The additions to NPAs and the interest reversals we believe will get incrementally less than they’ve been in the past, therefore expanding our margin.
Thirdly, continuing to wind down, there’s national business which are lower margin, are going to incrementally help us going forward and fourth, we’ve just seen the early signs of our reprising on our deposit from our balances that we’re very encouraged by. So we continue to look for ways to put more and more signs around our deposit pricing; to be able to keep those as optimized as possible to be able to expand the margin.
So again, we think it’s a modest improvement throughout the rest of ‘09, but then, going forward we think those will have a material impact over time. As it relates to fed funds, I think the steepness of the yield curve is actually fairly good right now, but that we need a parallel shift in rates and this is an estimate, but we’d probably need 200 basis point parallel shifts or so and rates upwards to be able to get to our long term rates of 350 to 375.
So until that happens, we will have a tough time getting all the way home to our long term goals, but we’re doing everything we can to improve the stuff that we can control.
Operator
Your next question comes from Kevin Reynolds - Wunderlich Securities.
Kevin Reynolds - Wunderlich Securities
Most of my questions have been answered, but I had I guess a couple, and maybe this is the first one specifically. You’ve probably answered it in one form or another, but I’m just trying to get a better feel across the industry this quarter.
How do you feel about the economy today, not just specific asset quality on a quarterly basis, but do you really feel better about the local conditions, not so much the macro economy and the big picture? Do you feel better about the local conditions or do you feel worse this quarter versus last?
Then, I guess kind of a follow-up to that is, can you comment on the competitive environment, big banks and small banks since you seem to be kind of right in the middle from a size perspective in your markets? Then a final piece, I’ve heard you say that over the long run your capital could be deployed in some acquisitions, but you’re in no rush to do it; how is that environment shaping up right now and do you think there’s going to be more potential sooner rather than later or is that still the same?
Bryan Jordan
Kevin, this is Bryan, thank you. Maybe the first question and the last one in some sense go hand in glove.
The economy, we’re not seeing big signs or any significant signs of improvement today. Our loan demand continues to be very low.
We’re maybe incrementally a little less optimistic on the economy at this point than we were 90 days ago, simply because we’re not seeing the signs of traction, parallel maybe a better way to describe it. We just don’t see it getting a lot better right now.
There’s clearly a lot of talk about encouraging signs. We’re optimistic that we’ll see some of those later in the year, but to-date we haven’t seen those.
From a competitive standpoint, we feel very, very good about our competitive standpoint and our footprint. We’ve seen very good traction across all of our markets, very good opportunities with our existing customer base to deepen the level of service that we have with them, to grow new relationships, deposit trends; we’ve been very encouraged by it.
We’ve seen very good growth in the underlying customer relationships through our deposit base. So we feel very, very good about our competitive position.
Competitive environment is I think probably no worse than it was 90 days ago; in fact maybe in some ways its better. Deposit competition may have lessened a little bit in the last few weeks of the quarter.
So we think that the competitive environment is probably a pretty decent one. With respect to deploying capital and acquisition, that’s not an end objective, that’s a way to deploy capital.
We think there are likely to be some opportunities when the economy turned, but again I’ll go back to the slide 24, the filter for looking at them. Our goal is to drive returns and drive profitability in the business.
We look at acquisition as a way to deploy capital, and we feel like we can do it and drive those 15% to 20% range returns throughout the cycle. That’s probably an attractive way to do it, but it’s going to take a lot more clarity about the economy I think, before you’d see significant interest from us and pursuing acquisition.
Operator
Your next question comes from Matt O’Connor - Deutsche Bank.
Matt O’Connor - Deutsche Bank
All of my questions have been answered. Thanks, guys.
Operator
Your next question comes from Gary Tenner - Soleil Securities.
Gary Tenner - Soleil Securities
Just a couple of questions, Bryan. I wonder, you talked about the long term ROE expectation or goal of 15% to 20%, can you talk about that in the context of sort of re-regulation of the industry and what that might do potentially or profitability for you guys over the long term?
I know things aren’t certain on that side of the things, but give us a sense of what your thoughts are on it?
Bryan Jordan
You’re right, it’s not certain. Our expectation would be really on two fronts; one, that capital levels are likely to be higher for the industry and so embedded in the 6% to 7% tangible common assumption, is that we operate at a higher tangible level and inherently we’ve got a higher Tier 1 ratio we think as a result of that.
So, we think the industry will face higher capitalization. Probably, directionally speaking, I think costs of complying with increased regulation of the industry is likely.
I think it’s likely to have an impact on fees structures as we go forward and that will offset some of the impact of improved relationship pricing. So we think, in some sense returns will come down for the industry as a result of the fundamental trends, but until you get a lot more clarity about what those changes in regulation, what that means to us, it’s hard to pin it down to a natural cost.
Operator
Your next question comes from Christopher Marinac - FIG Partners.
Christopher Marinac - FIG Partners
Just to follow-up on Kevin’s question about acquisitions before, to what extent do FDIC failed banks change the dynamic to how you answered the previous statement?
Bryan Jordan
It can’t change it, but in some sense the lens that I’m approaching it through is, those will be opportunities. There haven’t been a lot in our footprint today and I’m not sure when or if that ever changes.
Our focus today is on winding down these national businesses and keeping our focus on that ball is real important to us and we want to do that, because we think that minimizes the impact to shareholders, minimize losses and preserves our capital base. I think, clearly something could come up with an FDIC assisted transaction that would make sense, but right now our emphasis is covering as much ground as we possibly can on nonperforming assets and repositioning our business model, make it more efficient and more effective.
Operator
Your next question comes from Al Savastano - Fox-Pitt Kelton.
Al Savastano - Fox-Pitt Kelton
Can you talk to us about the dividend policy and what would have to happen for you to change it?
Bryan Jordan
Well, we’ve got the stock dividend policy in place and I guess there are a couple of ways of answering that. One would be, what’s the impact of the stock dividend and should we continue to do that and two, when will we flip back into a cash dividend.
Clearly, it’s our desire to get back into paying the dividend and cash. We’ve got to see the turn in problem assets and the turn in profitability before we do that.
The mechanics of the stock dividend, we understand are somewhat more difficult from a modeling perspective; somewhat maybe an understatement, they are more difficult. The value originally was to our retail shareholder base, that they appreciated the cash like yield that afforded the ability to sell the additional shares.
So I don’t know what our policy will be, it’s something we discussed with the Board, but I think the key driver is the return to profitability and the focus on paying the cash dividend when we get to that point.
Operator
Your next question comes from Joe Stieven - Stieven Capital
Joe Stieven - Stieven Capital
Listen, all my questions have been answered. My last one was just on an assisted deal.
Thank you. Good quarter.
Operator
Your next question comes from Jessica Halenda - FBR Capital Markets.
Jessica Halenda - FBR Capital Markets
I just had a couple of questions on the fixed income and mortgage banking. In terms of the mortgage warehouse valuation adjustment you discussed briefly in the release, is that tied to not hedging the mortgage pipe line?
Bryan Jordan
No. The mortgage valuation adjustment is really made up of two factors.
One is, we had a slightly smaller UPB in the mortgage warehouse; and number two, as we look at that and we have to fair value market, we also look at the underlying credit quality of it as well and run it through our valuation models, relative to what is out there in the industry. So the combination of smaller UPB plus incremental deterioration in underlying credit quality is what caused the valuation adjustment.
BJ Losche
Keep in mind that this warehouse that we’re valuing is mortgages that were originated into the warehouse in the early part of 2008 that haven’t been sold. We elected fair value accounting for them, and even in the permanent portfolio, they carry fair value accounting.
So we still account for them on a fair value basis, so these are somewhat older.
Dave Miller
Jessica, its Dave Miller. Warehouse valuation also is impacted by the level of rates.
So as mortgage rafts rose during the quarter, that actually causes the warehouse and the DCF to be worthless and the opposite effect a little bit in the first quarter. So, there’s a number of dynamics.
Operator
Your next question comes from Jon Arfstrom - RBC Capital Markets.
Jon Arfstrom – RBC Capital Markets
How did the Capital Markets revenue trend during the quarter? Was it something that was fairly stable by month or did it generally get weaker as the quarter moved on?
Bryan Jordan
This is Bryan, John, thank you. In the summer months it always slows down, so you see the seasonal effect.
So it slowed down some as you got into late May and early June and we’d expect the summer months to be a little bit softer. It’s still been very healthy, but we’re seeing the summer effect, where vacations and the slow time summer takes over.
Operator
With no more questions in the queue, I would like to turn the call back over to our presenters for any additional or closing remarks.
Bryan Jordan
Thank you, operator. This is Brian Jordan.
We appreciate you joining us on this call. We appreciate your following the company.
We think we’ve made a tremendous amount of progress on the strategic initiatives that we have pursue. We are optimistic about our positioning for the future.
Thank you to the First Horizon, First Tennessee employees across the franchise for what you are doing. If you have any further questions, please don’t hesitate to contact Dave or any of us.
We appreciate your time and interest. Have a great weekend.
Operator
This does conclude today’s conference. We thank you for your participation.