Jan 21, 2009
Executives
Judy Murphy - Senior Vice President, Investor Relations Richard Davis - Chairman, President and Chief Executive Officer Andrew Cecere - Vice Chairman and Chief Financial Officer Bill Parker - Chief Credit Officer
Analysts
Matt O’Connor - UBS David Rochester – FBR Capital Markets Mike Mayo - Deutsche Bank Chris Mutascio - Stifel Nicolaus Bryan Duran – Goldman Sachs Todd Hagerman – Credit Suisse Eric Wasserstrom – Galleon
Operator
Welcome to U.S. Bancorp’s fourth quarter 2008 earnings conference call.
Following a review of the results by Richard Davis, Chairman, President and Chief Executive Officer and Andy Cecere, U.S. Bancorp’s Vice Chairman and Chief Financial Officer, there will be a formal question-and-answer session.
(Operator Instructions) I will now turn the conference call over to Judy Murphy, Director of Investor Relations for U.S. Bancorp.
Judy Murphy
Thank you and good morning to everyone who has joined us on the call today. Richard Davis, Andy Cecere and Bill Parker are here with me to review U.S.
Bancorp’s fourth quarter 2008 results and to answer your questions. If you have not received a copy of our earnings release and supplemental schedules, they are available on our website at www.usbank.com.
I would like to remind you that any forward-looking statements made during today’s call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are detailed in our press release and in our Form 10-K and subsequent reports on file with the SEC.
I will now turn the call over to Richard.
Richard Davis
Thank you Judy. Good morning and thank you for joining us.
Andy and I would like to start the call today with a short review of our fourth quarter results. As we complete our brief formal remarks we will open the line up to questions from the audience.
Our company reported net income of $330 million for the fourth quarter of 2008. Reported earnings per diluted common share of $0.15 were $0.38 lower than the earnings per diluted common share in the same period of 2007 and $0.17 lower than the prior quarter.
Although the company’s operating business continues to do well, the decline in reported earnings from a year ago and the prior quarter was primarily the result of higher credit costs including the cost of building a reserve for credit losses and additional impairment charges on securities, a consequence of current market conditions. Significant items impacting the company’s fourth quarter earnings included $253 million of securities impairments and a $635 million incremental provision expense.
In total, significant items reduced earnings per diluted common share by approximately $0.34. Our performance metrics were negatively impacted by these significant items as return on average assets in the current quarter fell to 0.51% or 1.63% in the fourth quarter of 2007.
Return on average common equity dropped to 5.3% from 18.3% in the fourth quarter of last year. Without the securities impairments and reserve build, return on average assets and return on average common equity would have been approximately 1.46% and 17.5% respectively.
As I stated in the beginning our operating businesses continued to do very well this quarter and results were highlighted by the following: Growth in total average loans, excluding the acquisitions of Mellon 1st Business Bank, PFF Bank and Trust and Downey Financial, was $19.2 billion or 12.7% year-over-year with solid growth in all major categories. On a linked quarter basis, total average loans excluding acquisitions increased by $5.2 billion or 12.4% on an annualized basis.
As many of you have heard me say in the past, U.S. Bank is open for business.
Our growth in average loans this quarter demonstrated that fact and our fourth quarter new business statistics further illustrate just how successful our business lines were in attracting new loan customers and servicing the lending needs of our current customers. During the fourth quarter, U.S.
Bank originated over $16 billion in new loans to businesses and consumers including over $3 billion of consumer loans, over $8 billion of residential mortgages, over $1 billion of loans to small businesses and well over $3 billion of commercial and commercial real estate loans. Be assured that we have not strayed from our high quality standards to attract and establish all of these new and expanded customer relationships.
We also experienced exceptional growth in average total deposits this quarter. Average total deposits excluding acquisitions increased by $12 billion, 9.6% over the same quarter of last year and $5.8 billion or 17.2% annualized on a linked quarter basis.
Our company continues to benefit from the uncertainty in the financial markets and the flight to quality by customers seeking our stability. Net interest income in the fourth quarter increased by 22.6% year-over-year and 9.9% on an annualized linked quarter.
This increase was the result of an improvement in the net interest margin which was 3.81% in the fourth quarter, 16 basis points higher than the previous quarter and 30 basis points higher than the same quarter of last year in addition to the quarter’s strong growth in average earnings assets. Moving onto fee income, seasonality, a slowing economy and unfavorable equity markets led to the decline in a number of fee-based categories this quarter including payments, trust investment management fees and deposit service charges.
Payments related fees, which include credit and debit card revenue, corporate payment products and merchant processing services were lower on both a year-over-year and linked quarter basis as a result in the decline in transaction volumes. Trust and investment management fees were also lower year-over-year and linked quarter as adverse equity market conditions reduced the value of assets under management and consequently related management fees.
Deposit service charges decreased for both of the comparable time periods due to a change in consumer spending patterns in this challenging economic environment. Mortgage banking revenue also declined year-over-year and linked quarter primarily reflecting a change in the fair value of mortgage servicing rights, none of the economic hedging activity.
Mortgage production of $8.1 billion was higher than both the same quarter of 2007 and the prior quarter the majority of which was packaged and sold in to the secondary market. As many of you are aware, mortgage originations are up substantially in 2009 with the drop in interest rates and we expect our mortgage originations to continue to accommodate the increased demand from both new and existing customers.
Treasury management fees and commercial product revenue were higher than the fourth quarter of 2007 by 9.4% and 8.3% respectively reflecting the wholesale group’s ongoing revenue initiatives. On a linked quarter basis, Treasury management fees were seasonally flat while lower syndication fees offset increases in other lines within the commercial product revenue category.
Finally, within non-interest income other income was lower year-over-year primarily due to the higher end of term residual losses and impairment on consumer auto leases offset somewhat by the impact of a Visa gain of $59 million as the litigation escrow account maintained by Visa, Inc. was funded in the quarter in connection with their recent settlement with Discover.
On a linked quarter basis the Visa gain made up the majority of the positive variance with end of term losses on retail auto leases slightly favorable as well. Total non-interest expense in the current quarter was essentially flat to the fourth quarter of last year but $137 million higher than the previous quarter.
The variance or lack of a significant variance year-over-year was largely the result of the $215 million Visa litigation charge which was taken in the fourth quarter of last year. Offsetting this favorable year-over-year variance was approximately $70 million of operating and integration expenses relating to recent acquisitions as well as higher expenses associated with the ongoing investment in our business lines, financial marketing campaigns, loan work out expense and tax credit investments.
Our efficiency ratio as reported for the fourth quarter 2008 was 50.6%, lower than the 55.1% we posted in the fourth quarter of 2007 and slightly higher than the previous quarter. We continue to be one of the most efficient financial institutions in the industry with a full-year efficiency ratio of 47.4%.
We have always operated with a disciplined approach to expense control and our ability to manage our costs is particularly important in this environment. As many of you know, in addition to our standard profit plan each of our managers submits a contingency budget that includes a 5% reduction in expenses relative to their approved plan.
This year’s process was no exception and we recently have begun to ask managers in certain business lines to implement their expense reduction scenario. Be assured this company will implement cost saving strategies in a very thoughtful and deliberate manner so as not to hamper the momentum of the business lines and their future success.
Now moving on to credit. As expected, credit costs trended higher again this quarter.
Net charge offs of $632 million were 26.9% higher than the third quarter of 2008, an increase similar to what we experienced last quarter and in the middle of the range that we projected in December. The increase in net charge offs reflected the continued stress in the residential home and mortgage related industries, declining home prices and the impact of the worsening economy on both our commercial and retail customers.
Total net charge offs to average loans outstanding were 1.42% in the fourth quarter compared to 1.19% in the third quarter. Also, as expected non-performing assets increased this quarter.
The change reflects an increase in the banks core loan portfolio and the effect of the nonperforming assets in the recent acquisitions of Downey Savings and PFF Bank and Trust. At December 31, total nonperforming assets were $2.624 billion.
Included in nonperforming assets was $643 million of loans and other real estate covered by a loss share agreement with the FDIC in connection with our acquisition of PFF Bank and Trust and Downey Financial. In other words, there is a minimal amount of potential loss given the terms of the agreement with the FDIC.
Excluding these covered assets, nonperforming assets increased by $489 million or 32.8%. This is also in line with our expectations as previously communicated to investors.
The majority of the increase in the core bank portfolio was related to residential construction, residential mortgages and related industries. However, the economic slow down also had an impact on some of our commercial and retail customers.
The ratio of nonperforming assets to loans plus other real estate owned, excluding covered loans, was 114 basis points at December 31, still well below the ratios posted by our peer banks to date. Restructured loans that continued to accrue interest rose by 22.9% this quarter as the company continues to work with customers who are current or will become current on their payments to renegotiate loan terms enabling them to keep their homes and retain the value of that relationship for our shareholders.
As I have said in the past, we intend to protect the quality and strength of the balance sheet and given the upward trends in both net charge offs and nonperforming assets. In addition to the current economic slowdown we increased the allowance for loan loss this quarter by recording an incremental provision for loan losses of $635 million or an amount equal to 100% of net charge offs.
With this addition to the allowance for credit losses, the company’s allowance for credit losses to period end loans excluding covered assets was 2.09% compared with 1.71% at September 30 and the ratio of allowance to nonperforming loans, excluding covered assets, was 206%. Going forward we will also continue to assess the adequacy of our reserve to loan losses and provide for credit losses to reflect changes in the credit risk of the loan portfolio and economic conditions.
Again, we entered this credit cycle with a strong balance sheet and we will continue to protect that position going forward. Finally and importantly, our capital position remains strong.
On November 3 we announced our participation in the Treasury’s capital purchase plan and subsequently issued $6.6 billion of preferred stock and related warrants to the U.S. Treasury.
Our tier-1 and total capital ratios were 10.6% and 14.3% respectively at December 31, both well above our target levels. I will now turn the call over to Andy who will make a few more comments about the quarter.
Andrew Cecere
Thanks Richard. I would like to begin with a quick summary of the significant items that have impacted the comparison of our fourth quarter results to prior periods.
At an investor conference in December we disclosed a few significant items that were expected to impact our company’s fourth quarter results. The actual impact was as predicted.
Included in our December presentation were the following: First, we expected an impairment charge on our SIV exposure of $200-300 million. The actual impairment was $253 million.
Second, we predicted net charge offs to be in the range of $610-650 million and that we were expected to build the company’s loan loss reserve by an amount equal to 90-110% of net charge offs for the quarter at a rate higher than previous quarters. Net charge offs in the fourth quarter equaled $632 million and the actual reserve built was $635 million.
Significant items totaling $888 million were very close to the expectations and reduced earnings per diluted common share by approximately $0.34. For comparison purposes, during the third quarter 2008 the company recorded $411 million of security losses, the result of impairment charges on restructured investment securities, other preferred securities and non-agency mortgage backed securities.
Other income in the third quarter included $39 million of losses related to the bankruptcy of an investment banking firm. In addition, third quarter results included incremental provision expense of $250 million.
Together, these significant items reduced third quarter earnings per diluted common share by approximately $0.28. Finally, as you may recall, the fourth quarter of 2007 included two significant items including $107 million charge to other income related to the original purchase of the structured investment vehicles for an affiliate and a $215 million charge related to Visa, Inc.’
s litigation settlement. Now just a few comments about operating earnings.
Net interest income in the fourth quarter was higher on a year-over-year and linked quarter basis due to both earning asset growth and strong net interest margin. The improvement in margin on both a year-over-year and linked quarter basis was the result of growth in higher spread assets, the benefit of being liability sensitive in a declining rate environment and net free funds.
In addition we were also able to maintain very favorable short-term funding rates as market volatility continued throughout the quarter. Going forward, assuming the current rate environment and yield curve, we expect net interest margin to moderate to a level comparable to the average for 2008 or in the low to mid 360’s.
This expectation accounts for the impact of the recent acquisitions of PFF and Downey Financial, the dollar re-price in certain consumer loan products and the normalization of funding and liquidity in the wholesale funding markets. As Richard mentioned, the growth in non-interest income was affected in the fourth quarter by losses on auto lease residuals.
Specifically, $71 million of the decrease in other income year-over-year was attributed to residual losses. On a linked quarter basis we saw $3 million improvement in the total amount of losses from retail auto leases.
We continue to carefully manage the residual risk on this portfolio. Given the current market for used cars we expect adverse market pressure on auto lease residual values to continue in 2009 but overall losses will be manageable as the number of vehicles coming off lease declines.
On November 21, U.S. Bancorp acquired substantially all the assets, assumed all deposits and most of the liabilities of Downey Savings and Loan and PFF Bank and Trust from the FDIC.
We did not acquire the legal entities of either of these institutions and I would like to clarify a few points regarding the impact that these acquisitions had on our results and financial reporting. First, the company purchased net assets of approximately $1.6 billion between these two acquisitions for a nominal amount of consideration.
Second, as part of these transactions U.S. Bancorp entered into a loss sharing agreement with the FDIC which provided for specific credit loss and asset yield protection for a significant portion of the loans and foreclosed real estate.
These assets encompassed by the loss sharing agreement with the FDIC are referred to as “covered assets” in our financial reporting and are segregated from all other assets for transparency. Table eight in our fourth quarter earnings release includes a summary of these covered assets.
As of December 31 we have estimated that these covered assets with a contract value of $13.8 billion will incur cumulative credit losses of approximately $4.7 billion or 34%. Of the $4.7 billion, $2.4 billion represents the company’s estimate of the losses to be offset by the loss share agreement with the FDIC.
The remaining $2.3 billion represents U.S. Bancorp’s first loss position of $1.6 billion, essentially equal to the net assets received at close plus an additional $700 million of losses which represents the company’s remaining share of expected losses.
Finally, because the majority of the assets acquired in the Downey and PFF transactions were experiencing credit deterioration they were recorded in the financial statements as their estimated fair market value to reflect expected credit losses and the estimated impact of loss sharing agreements. Accordingly, we will not record additional provision or charge offs related to covered assets unless further credit deterioration occurs going forward.
You will note we have provided credit statistics with and without these covered loans for comparison purposes. I will now turn the call back to Richard.
Richard Davis
Thank you Andy. In conclusion, overall I was disappointed with the relative size of our earnings this quarter and our inability to increase earnings on either a linked quarter or year-over-year basis.
However, I am very proud of the fact that our company continues to profitably navigate through this difficult economic environment while continuing to build momentum for our future. Our fundamental businesses remain strong.
We are, however, a bank and therefore not immune to the challenges facing our industry. As the results of the fourth quarter and full-year 2008 demonstrate we are actively lending to credit-worthy borrowers.
We are judiciously investing in and growing our banking franchise and businesses. We are serving our communities through business partnerships and employee volunteerism and we are creating value for our shareholders by maintaining our prudent approach to risk, preserving the quality of our balance sheet and the strength of our capital and positioning U.S.
Bank to meet both the challenges of today and the opportunities of tomorrow. That concludes our formal remarks.
Andy, Bill and I would now be happy to answer questions from our audience.
Operator
(Operator Instructions) The first question comes from the line of Matt O’Connor – UBS.
Matt O’Connor - UBS
I was hoping you could give us a little more color in terms of how you calculate the tangible common equity ratio. You are showing 4.5 and I get 3.8 when I X goodwill and exclude other intangibles I get closer to 3.3.
I’m just trying to reconcile how you are calculating it to get to 4.5.
Andrew Cecere
It is a calculation we have actually used for over a decade and it has been consistently applied. I believe the fundamental difference between the way you are calculating, and we are, is some components of OCI and the inclusion of those.
We start with core capital and probably the biggest difference is the exclusion of the unrealized gain loss in securities in our calculation. We believe that starting with the core capital number is more appropriate.
Matt O’Connor - UBS
Obviously you are excluding goodwill but what about the intangibles?
Andrew Cecere
Yes we are.
Matt O’Connor - UBS
So all intangibles other than the MSR I would assume?
Andrew Cecere
That is correct. All goodwill, all intangibles and then adding back or not excluding the MSR.
Correct.
Matt O’Connor - UBS
Separately, Richard you have been one of the more responsible banks out there and one of the stronger banks out there but the outlook for the industry overall seems rather dire and I know this might be a little bit of an unfair question but how do you think about what the government can do to fix the industry overall? You have been dragged down by it and I think everybody is kind of looking around for some solutions.
I’m wondering if you have any thoughts in how you think this all plays out.
Richard Davis
First of all I am actually quite optimistic with the new administration and the new team that we will have some new solutions and I think perhaps a more collaborative view of asking a lot of us in the banking community in how we think different solutions might be best suited. I am looking forward to being part of it.
I will also tell you that as difficult as things look I am looking forward to the time when banks will start to trade again on their core earnings and I know that is quite a ways into the future when the fear and the unknown finally is extracted from the formula. Our company is pretty simple, as you know, and we are doing exactly what we did a few years ago in exactly the same way.
All the same businesses and despite the economy bringing us slower with some revenue based on the payments and trust businesses which is an interim solution that will eventually recover and the fact that loan losses are a reality and we are taking our fair share of those but still earning well above those. I am kind of encouraged that at least in the simple form of things as this is a cycle it is longer than we thought it would be.
It might be a deeper and more protracted than we thought it would be in more places but I am actually looking forward to getting to the other side because our core fundamentals haven’t been affected. We are still operating kind of the old fashioned way of a balance sheet bank growing the business with fees and spending money to insure there is a future.
In terms of the actions of the government hopefully to take I think we all agree that part of this is just confidence. That might be the biggest part and that is very intangible but to the extent we can get things moving again I think it is going to be instructive for people to believe there is a market out there that is willing to help them either grow their companies or grow their personal assets.
You look at the headline that banks aren’t lending and obviously we don’t participate in that headline because as I said we loaned over $16 billion in new loans last quarter. I specifically celebrate the fact that we are having a flight to quality that many of our peers are not but in this circumstance we are no longer celebrating that distinction.
We are wishful that everybody will get back onto the game and we will have a more robust banking environment where people start coming back to banks for lending. So I am looking for a solution that will help all of us equally and I think getting the housing situation fixed will be the first remedy.
Getting the foreclosures behind us and turning the market where the valuations start to improve instead of degrade is going to be helpful and I think that confidence is the other piece that kicks in because after real estate and real estate related issues, which are many, we are just going to have people needing to turn the corner and believing that an investment in themselves, their homes and their companies is going to be a well placed investment that will eventually yield a return. What I am happy to report, in my long answer to your question, is that banks are the place again where they are going to go.
Despite all of this turmoil and discord in the last couple of years I don’t know if anybody noticed but banking is back again. It is a really good business and it is a place where consumers and businesses are going to go to grow their company and grow their lives.
The risk premium is back. The yield curve is back.
The confidence isn’t but it will be and eventually when you look at the alternatives and the interlopers that came in with international funding, foreign investors and private equity, most of that has been there, visited and left. On the long view if we can get past this difficult time the structure of core banking is sound and I’m kind of looking forward to getting there first.
Matt O’Connor - UBS
In your terms, specific to USB, would you be interested in additional capital from the government or some sort of loss sharing arrangement or do you feel like your capital structure is adequate where it is?
Richard Davis
I feel our capital structure is very adequate as is and while you never know if plans may come along we don’t have any projected view of needing any additional capital or needing any government assistance in virtually any combination of outcomes.
Operator
The next question comes from David Rochester – FBR Capital Markets.
David Rochester – FBR Capital Markets
A quick question regarding your dividend. I just want to get your updated thoughts on that in the context of the deepening recession and with the tangible common equity reduction you took this quarter if you get to the point where you are internally looking at under-earning a dividend for more than just a couple of quarters whether it is due to securities impairments or continued reserve building are you thinking in that kind of a scenario you would take a closer look at that payout ratio?
Richard Davis
Thanks for asking it that way, that is exactly the right way to ask it and the answer is yes. Let me just remind our investors every 90 days our Board evaluates the dividend and seriously every 90 days.
There has never been any rubber stamp about it. As you know, we just declared our dividend in the late, middle of last month, just paid it out a couple of weeks ago and are scheduled to look at it again in the middle of March at which time we will.
To the extent that we have a dividend out there should reflect to you we think we can more than cover our dividend with earnings and that is how we identify the level at which we should pay out. To the extent that the world becomes more impaired or becomes scenarios that aren’t currently contemplated even by us at this point in time then we will use that information to evaluate in March and again in June and again in September.
We will make the right call. We are not going to preserve the dividend to be ridiculous about being dead right if it is not going to be appropriately covered by earnings but we are also not going to reduce the dividend until which time we feel it is appropriate and necessary given number one the constraint on being able to raise it again and number two on the fact we recognize that is a value to our investors and our shareholders as part of the strength of this company.
David Rochester – FBR Capital Markets
In terms of the restructured loans and the increased linked quarter can you talk about what drove that increase? Where you saw most of this and was any part due to the inclusion of Downey and PFF?
Bill Parker
The restructured loan increase is just a continuation of something we began more than two years ago primarily in two areas. One was residential mortgages where either we know people have rate resets coming up and will be proactive and get a hold of them and if they are current we will say you will not have to increase your payment, just keep making the same payment.
That is about half of the residential restructuring loan increases. The other piece is where people have fallen behind.
We have a variety of programs to help them. We verify their income and hopefully can create a program where they can continue making reasonable payments.
If it is something where they can’t make a payment that at least have some kind of market rate then it will be an un-performing loan even if they do stay in the home. On the credit card side where the other increase comes from we have a variety of either hardship or work out programs and again for what we consider fair rates or something less than what they have been paying to allow them to get back on their feet.
Andrew Cecere
I would also add that with the Downey acquisition we agreed to participate in the FDIC’s restructuring program and we are actually having good success with that.
Bill Parker
The restructured loans you see in our table do not include the Downey. Most of the single family homes came out of Downey.
$10-11 billion. We are offering a specific program that was put forth by the FDIC.
It all goes through verified income. You can extend the loan term up to 40 years; reduce the interest rate down to 3%.
All those are covered assets and to the extent that we reduce our rates below something which is market that is part of what the FDIC has offered up as their loss sharing, not just credit loss sharing it is also a value loss sharing.
David Rochester – FBR Capital Markets
The increase in terms of the net charge offs and CNI, can you talk about that and what industries you saw increased stress that contributed to that?
Bill Parker
We did have a couple of larger CNI charge offs in the fourth quarter. One of them was related to the oil and gas energy industry with a pipeline and storage company.
Another credit we had a larger loss on was in the gaming industry. Both are industries we have active roles in financing but there were issues in both of those credits.
Operator
The next question comes from Mike Mayo - Deutsche Bank.
Mike Mayo - Deutsche Bank
Can you just comment on your outlook for credit and nonperforming assets and what you are seeing and to follow-up to that last question what other industry groups are you monitoring more closely? Also as related to the covered assets is there any scenario where you can lose money on those covered assets?
I’m just trying to figure out if I look at a reserve to NPA ratio should I permanently exclude those covered assets or is there a chance you can have losses down the road?
Andrew Cecere
On the covered asset question first of all I would highlight our current expectation is very, very consistent with the expectation we had a month and a half ago or two months ago. For the most part we are at the point of the loss sharing agreement on those covered assets that it is a 95% FDIC loss and 5% U.S.
Bank loss. So to the extent that we are wrong for the most part we are at that level of sharing.
Richard Davis
In regards to kind of our view looking at credit loss, both charge offs and nonperforming I am happy to report that as basic and predictable as we have been in the last four quarters you can just go forward so far on the same trajectory. We are seeing the same kind of linked quarter 20-30% increase in nonperforming and charge offs and I don’t see that changing in the near term.
I have always been a pundant of saying if you can see 90 days out after that it gets a bit blurry. In the 90 days out we are seeing nothing remarkable but nothing improving.
We are just seeing a continuation of what we have seen heretofore and that is why we thought we’d wait to the end of the year basically double down on our reserves to continue to be at the high end of a [inaudible] balance sheet and that may or may not need to continue because we may not see that as necessary if we just continue the same kind of trajectory. We are looking forward to that moment when all of a sudden loan losses appear to start flattening out and eventually settling and going down.
Somewhere around that time reserve build starts to slow and goes down to equal to earning offset growth and when those days happen those are going to be great days for at least those of us that are just operating standard above the line in core growth and then it will definitely shine through. In the meantime I think we are going to predict the rest of this year is probably more of that traditional increase in losses first, reserve build along the way and we haven’t seen a place yet for that turning the corner is evident.
Mike Mayo - Deutsche Bank
So FDIC covers 95% of the covered assets. So you are exposed 5% of what number would it be?
Would it be of the $5 billion that is currently covered or an original amount?
Andrew Cecere
It is of the original amount. So we expect a certain amount of loss.
We wrote down our assets to that loss level. There was a 20/80 loss sharing agreement.
20% to U.S. Bank and 80% to the FDIC.
To some level we are just about to that level. There is a little bit left to go.
After that it would be 95% FDIC, 5%.
Mike Mayo - Deutsche Bank
So 5% of the $14 billion?
Andrew Cecere
5% of whatever losses occur on that loan portfolio.
Mike Mayo - Deutsche Bank
Of the $14 billion. So it can’t hurt too much at this point?
Andrew Cecere
That’s correct. You are right on the $14 billion.
Mike Mayo - Deutsche Bank
One separate question, the processing business how much of the decline is seasonal and how much is more permanent through this cycle with consumer spending going down the way it has? Can you just elaborate on that?
Richard Davis
Processing business will decline. My answer will include merchant processing and we will take our corporate spend so the less traditional businesses that a lot of our peers don’t have.
I would say the decreases you have seen a majority of those are recession related. They are not seasonal.
Seasonality would typically take us to a fairly flat quarter run over or quarter four over quarter three because the government is higher in quarter three and comes down in four but the retail goes up in quarter four from quarter three. Instead they are both down and they are both down linked quarter and down year-over-year and that is almost entirely recessionary or slowing.
We saw, as you all did, on the merchant side you can see either our big portfolio of airlines, hotels and resorts or retailing is 1/3, 1/3 and 1/3. They all showed a certain level of significant drop year-over-year in the month of December and the government spending went to almost nothing in the last half of the last month in the quarter based on what appears to be a lot of cost cutting and budget controls.
We are seeing in January we expect it to be slower. It is slower.
It is not exceeding our expectations so it is actually firmed up a bit over perhaps the delta year-over-year that December had. But make no mistake about it, consumers and businesses are spending less, traveling less and they are watching their nickels and dimes.
We will be affected by that in the near term. What I like best about this business though is the pipeline if you will is built and it is done.
So just as this is flowing through it when the market recovers we should start putting more through it and it is very scalable. We don’t have any structural loss here and we have no loss of customers.
We are still building our base of new business. We simply have less per customer incident for the next 6 months or so.
Mike Mayo - Deutsche Bank
If this is scalable and revenues aren’t quite as strong why not do another acquisition in the processing area?
Richard Davis
Absolutely could. That would be brilliant and to the extent that we are able to find one you could expect that to be on the shortest list of things we would do.
Operator
The next question comes from Chris Mutascio - Stifel Nicolaus.
Chris Mutascio - Stifel Nicolaus
I wanted to follow-up on Matt’s original question. If I calculate the table common ratio like I do for most banks instead of being a range I get 3.2%.
You have banks that are below 3 of course and they got hit hard because of that. Can you give me your thoughts on your comfort level with the TCE ratio calculated like I do for other banks in the low 3’s?
Andrew Cecere
First of all, as you know that ratio is calculated differently along different banks who calculate it differently. Some of the rating agencies calculate it differently.
We have been using this consistent calculation and again we start with the core capital number. As we have talked about we think the way we calculate it we like to stay above the 4% ratio as sort of an internal target we set for ourselves.
Perhaps the way you are calculating it is above 3%. So it is something we are cognizant of.
However, we have a very strong earnings power. We have great businesses.
We are very comfortable with the ratio as it is and as Richard mentioned we don’t see any need to capital raise or anything around that for that ratio. We are comfortable where it is.
Chris Mutascio - Stifel Nicolaus
If I could follow up on a different question, you gave some margin guidance and I think some of this is already answered. If you look, and I missed the first part of the call so forgive me, but of the 16 or so basis points of margin expansion in the quarter was any of that tied to the acquisitions made in the quarter or not?
Andrew Cecere
No. None of it was tied to the acquisitions.
First, we benefited from rates coming down on the fourth quarter and liabilities so that helped us. That will level in the first quarter and the rest of 2009.
Second, as you know particularly in the month of November there was a very volatile market particularly in LIBOR and we are wide in LIBOR on that side of the equation so that helped us out a little bit. The acquisitions actually are a bit negative to our net interest margin and once we have the full impact of the quarter in there that is why we said we would be in the low 360’s.
Richard Davis
I want to go back and just confirm what we just said. Basically the way we define tangible common and you can define it however you want, we are not going to debate that, but based on our measurements we have indicated and would indicate here if we were to do another deal or transaction we set a limit for ourselves at 4%.
So that’s the way we define it. There is no magic about that.
We thought it would be constructive for our investors to know we do think there is a minimum level that is appropriate to have no matter what your preferred or tier-1 capital is and we would make sure we would go out and raise the difference to protect those levels.
Operator
The next question comes from Bryan Duran – Goldman Sachs.
Bryan Duran – Goldman Sachs
I’m sorry if I missed this but do you have any re-default metric you can give us on the restructuring book so we can think about how much of that ultimately fell to performing versus nonperforming?
Andrew Cecere
Everything in restructured loans gets reported as either current loan, delinquent loan or if it does re-default goes into non-accrual. Two comments on that.
One, we have been doing this for over a couple of years. One of the ways we measure that is looking at on residential mortgages anybody that eventually does go into for the first time into foreclosure by that measurement it is about 13%.
I will say, though, that has a blend of older loans which tend to have a higher rate and that can get up to 20-30% along with the newer ones which we have just restructured which are obviously at least in the short-term doing fine. On a blended rate basis up through our data on the fourth quarter was 13% rate going into foreclosure.
Richard Davis
I would say although the layman view, we do have some comps against some of our OCC and we were slightly more successful than our peers have been. I don’t exactly know the approaches they are all taking or the time at which we grab the customer and do what we can to restructure but that is favorable.
I would say we would do this again and again and again. This is good business in times like this.
We have long given up the need to be underwriting and hold onto the terms and conditions of a loan and put a customer out of their car, out of their home or out of their credit card. We have found it for years to be smart to restructure but it is never to our benefit to let the numbers lie or confuse any of you.
So for us it is not 100% guarantee it is going to stave off an eventual loss but it is well worth the effort and in many cases it has proven to be successful.
Bryan Duran – Goldman Sachs
Not to beat a dead horse on the tangible common but is there any piece of the securities portfolio you would highlight? 4.5% basically assume that a lot of this stuff will convert to par.
Is there any piece of the securities portfolio that you would highlight as potentially actually being at risk of defaulting at some point in the future that we should kind of think about in 2009?
Andrew Cecere
If you think about our portfolio of about $40 billion, about 60% of it is agency backed, mortgage backed securities, high quality. About 20% is municipal or treasury related securities, all high quality.
Then we have about $3 billion of jumbo. About $1 billion of alt-A and then some other debt securities in trust preferred.
I would say that we have appropriately priced all of those and the stresses that occurred in this quarter relate to spread widening on some of those securities that I talked about. We reflected the losses through the other than temporary impairment and I am very comfortable with the accounting there.
Overall, it is a high quality portfolio. There may be additional stress.
Also in there is the SIV portfolio which is down to $1.225 billion now. It is a high quality portfolio reflective of prices and the OTTI and the permanent impairment.
Richard Davis
On SIV, let’s go back and reflect we are down to $1.2 billion. We have it marked at…
Andrew Cecere
It is now marked at $0.54 on the dollar.
Richard Davis
So we are not here to say it is over and we won’t have any other further impairments. Based on the starting point of a year ago of $3.1 billion and both the pay downs and write downs and current position we don’t feel any longer that is a material surprise activity for any of us to forecast and while there may be some additional losses in the tens of millions of dollars over the next few quarters it is just that.
So now we are down to just being a simple bank with earnings above the line and loan losses and reserve build below it.
Operator
The next question comes from Todd Hagerman – Credit Suisse.
Todd Hagerman – Credit Suisse
I was just wondering in terms of your outlook on the credit side and expectations for the higher loss levels going forward and NPA’s and so forth what kind of unemployment scenario are you factoring in and as you have talked in the past kind of about your recession plan and so forth can you give us a little more color in terms of the general economic backdrop you kind of are factoring in whether it is lease residuals or the car portfolio and so forth?
Richard Davis
We are looking at a 7-8% scenario moving through to 8% and maybe even a little higher by year’s end. So, we are not the Armageddon 9.5-10.5% kind of levels but we are still reflecting what we see in the current world.
One thing I will say is as you know because our portfolios are wholly prime based on the credit card side a majority of that on the consumer side and all of that in the mortgage side we probably haven’t felt all of the effects yet of unemployment trickling into the customer’s inability to pay. In other words at 6.5% or 6.7% unemployment you would probably agree with me that even most of us on this telephone call don’t know a lot of people unemployed and those aren’t the people we have been making loans to or doing business with on the lending side but if all of a sudden you get to 7.5%, 8% or 8.5% we are all going to start knowing people that have liable positions that have lost their job and they have assets that they owe banks to and all those things.
So we are expecting to see something less than linear. Perhaps something more than linear that losses will start to move up as unemployment goes higher.
So my point is we have accounted for it that way. I do think you will see our loan losses to be very predictable and pretty steady based on the quality of our portfolio but where you have seen losses in credit cards, retail lending or homeowner’s products we will just continue to see those move up over the course of many days in a very steady way.
The charge offs that come from commercial real estate or from commercial lending, CNI lending, that is a little lumpier and while 2008 has been our look back on taking care of some fairly big losses in our California housing and developer portfolio those are done and paid for. Now I think in 2009 we will have a fairly steady amount of losses in commercial real estate attributed to just more traditional commercial real estate across our national footprint.
On the CNI side I don’t expect that to change a great deal. I just think we will continue to have new names replace prior names with a slight increase over the course of time.
So for us I think the cycle is done while it has continued to enjoy a meaningful spread below the loss of most of our peers but we are going to see a meaningful increase from where we ended last year by the end of 2009 just because the world is going to get worse before it gets better.
Todd Hagerman – Credit Suisse
More specifically with the card portfolio again essentially a prime based portfolio but as you mentioned before potentially with the unemployment level perhaps exceeding 8% in the near term, your loss rate is over 5% now. Conceptually, and again a big part of your loss coming through in the card portfolio can that conceptually go over 6%?
Richard Davis
I got you. I know the sound bite you want now.
In quarter four you see we are at 5.18% on credit cards. We are going to forecast that to be slightly over 6-6.5% at the end of this year or a year from today as we are talking back on quarter four.
We are not talking 7-8 but we aren’t talking in the 5’s. We see it continuing to atrophy to something more like 100-125 basis points from where it is.
Operator
The next question comes from Eric Wasserstrom – Galleon.
Eric Wasserstrom – Galleon
I just want to make sure I understood how the incremental $700 million of losses from the acquired portfolio is going to be treated. That does or does not flow through the provision?
Andrew Cecere
Most of those losses do not flow through the provision. Most of the loans that we acquired are accounted for at a fair value level and those have been marked down.
So to the extent there are further mark downs against it over and above our expectations that would flow through. But to the extent they are at fair value that is already being marked down and will not flow through charge offs.
Eric Wasserstrom – Galleon
So the $1.6 billion taken at closing, the incremental loss above that you are saying was actually captured in the basis adjustment?
Andrew Cecere
Think of it this way. We purchased an entity that was $1.6 billion long in assets.
Our total loss expectation for the portfolio is just over $4.5 billion of which about half is covered by the FDIC covered guarantee. The remainder, let’s call it $2.3 billion, you really net against the long asset position of the $1.6 billion and that represents the $700 million that we really think economically will be a loss to U.S.
Bancorp as reflected in our numbers.
Eric Wasserstrom – Galleon
That is the basis adjustment portion?
Andrew Cecere
Yes.
Richard Davis
So we have marked those down.
Andrew Cecere
Those assets we have marked down to 34% consistent with what we talked about in both the presentation and our call here. Those have been marked down and our expectation loss is 34% and that is how going through the math I described we get to the $700 million net number for ourselves.
Richard Davis
We will undoubtedly have something flow through provision I’m sure but it won’t be very much to the extent we have already marked it down to 66% of original value and because we have accounted for so much of the stuff that has happened in those portfolios at this point in time. I will say, though, how grateful we are that we have that loss sharing agreement as a back stop that protects us given what could be a more dire scenario for some of those primarily California assets.
Eric Wasserstrom – Galleon
I didn’t understand from the press release what happened with your tax rate in the period. Can you explain that to me?
Andrew Cecere
Simply stated, we have a number of items that are tax benefited income items and to the extent that our revenues and net income was lower those tax benefited revenue items were a better component of the overall income number and therefore our tax rate went down. We would expect it to go back up to more normal levels in 2009.
Operator
There are no further questions at this time. I would now like to turn the call back over to Richard for closing remarks.
Richard Davis
I just wanted to say one last thing in terms of our closing comments. I am greatly, as I said, disappointed about our top line earnings but I can tell you I am very proud of the momentum we are building in this company and at the end of the day we will be traded eventually on our core earnings with reasonable loan losses and with reserves and I think you will see that we will be one of those banks to come through this even stronger than when we started.
I also draw your attention to the rating agencies that have recently made a number of changes since the first of December and at least as we speak to you today both with S&P and Moody’s we now are alone as the most highly rated bank of our large bank peer group with a AA rating and a stable outlook with S&P with an AA2 and stable outlook with Moody’s. We are quite proud of that and to the extent you would agree that that is some reflection of the quality of both our balance sheet and our earnings ability.
We close with that as one of our points of pride and certainly the employees here and I are using that to our benefit to continue to grab the opportunity that has been created in this environment where we are taking market share. We are growing deposits and loans and we are able to continue to invest in some of the business you would expect us to be investing in so we are distinctly different and diversified in earnings and prepared for a better day when I think things start to improve.
That is all we have. We thank you for your attention and interest in our company.
Judy I will turn it to you for the final legal comments.
Judy Murphy
Thanks Richard. Thanks all of you for listening to our review of the fourth quarter 2008 results.
If you have any follow-up questions or need copies of the supplemental schedule or press release feel free to contact me at (612) 303-0783. Thank you.
Operator
That concludes today’s conference. You may now disconnect.