Apr 20, 2010
Executives
James Abbott – Director, Investor Relations Harris Simmons – Chairman, Chief Executive Officer Doyle Arnold – Chief Financial Officer
Analysts
David Rochester - FBR Capital Markets Craig Siegenthaler - Credit Suisse Steven Alexopoulos - J.P. Morgan Brian Foran - Goldman Sachs Ken Zerbe - Morgan Stanley Jennifer Demba - Suntrust Robinson Humphrey Erika Penala - UBS John Hecht - JMP Securities Kenneth Usdin - BofA Merrill Lynch Jason Goldberg - Barclays Capital
Operator
Good day ladies and gentlemen, and thank you for standing by and welcome to the Zions Bancorporation Q1 2010 earnings conference call. (Operator Instructions) And now I’d like to turn the program over to our speaker, Mr.
James Abbott. Sir, please go ahead.
James Abbott
Thank you and good afternoon. We welcome you to this conference call to discuss our first quarter 2010 earnings.
I would like to remind you during this call we will be making forward-looking statements and actual results may differ materially. We encourage you to review the disclaimer in the press release dealing with forward-looking information which applies equally to statements made in this call.
We will be referring to several schedules in the press release during this call. If you do not yet have a copy of the press release, it is available as an Adobe Acrobat file at zionsbancorporation.com and can easily be downloaded and printed.
We will limit the length of this call to one hour, which will include the time for you to ask questions. During the Q&A section we will ask you to limit your questions to one primary and one follow up question to enable other participants to ask questions.
With that, I will turn the time over to Harris Simmons, Chairman and Chief Executive Officer. Harris?
Harris Simmons
Thanks very much, James, and to all of you for joining us and welcome to the call. The situation that we’ve seen in the first quarter is continuing to underscore the fact that credit conditions in our franchise, and I think you see it generally across the industry, are improving.
We are very pleased with the strong margin that we’ve shown and the underlying strong core earnings picture. It came despite an awfully sluggish loan demand.
We’ve seen shrinkage as so many have. But the results this quarter have strengthened our view that we should return to profitability on a pretax basis later this year, and we are encouraged that the debt and the equity markets seem to be coming to a similar view.
As we turn to our results, we reported a significant improvement in our quarterly results, although we reported a loss of $0.57 per share available to common shareholders in the first quarter. That’s obviously a strong improvement compared to the net loss of $1.26 per share in the fourth quarter.
Additionally as noted in the release there were two items related to capital and tax strategies that were unusual in nature and which netted to adversely impact earnings by about $0.17 per share. We also boosted the allowance for credit losses by a net of about 20 basis points on total loans which adversely impacted earnings by an additional $0.32 a share.
Given the trends in losses and problem credits, we don’t expect further material additions to the allowance in the near term. Doyle will speak more to that as we get into the detail.
We’re encouraged by the significant improvement in gross charge-offs, which were down 30% compared to the prior quarter, $248 million as compared to $356 million in the fourth quarter of 2009. In previous investor conference calls and presentations we have noted that the loss severity of substandard and non-accrual loans was likely to decline and indeed that forecast is playing out.
Our allowance looks particularly strong when you compare our annualized first quarter net charge-offs, which had about 1.8 times coverage to our peer group, which is at about 1.1 times coverage. If you look at the total provision for both loan losses and unfunded commitments relative to net charge-offs, the excess provisioning peaked in the second quarter 2009 at 122% of net charge-offs, in terms of excess provision; 58% in the third quarter; 40% in the fourth quarter and 8% this quarter, so its been kind of trajectory that we have been suggesting was likely to occur for the last few quarters.
Non-accrual loan growth continued to slow, rising 3% compared to the fourth quarter. As a result of the slowing as well as our frequent reviews of our largest problem credits, we believe the credit trends will continue to improve and that credit costs will continue to trend lower, although the rate of improvement we would expect would be more moderate than we saw in the first quarter.
We’re also very pleased with the continued improvement in both our GAAP and regulatory capital ratios, as well as for the strengthening of the allowance for credit loss ratio. We look back at what we have accomplished during the past year, our tangible common equity ratio has increased a full percentage point from 5.3% a year ago to 6.3% currently, despite absorbing $1.25 billion of net charge-offs, providing $780 million for loan losses in excess of net charge-offs.
Taking roughly $465 million of securities impairments, including what has come through both OCI and OTTI, and $125 million of real estate owned expense. So to be able to build capital without viewing more dilutive damage than has [inaudible] so far, we think given what’s happened in the last year has been an achievement.
Initially the allowance for credit loss ratios improved by 2.3 percentage points during that period, and our Tier One capital plus reserves now equals 19% of total loans compared to a regional bank peer group average of about 16.5%. That places us in about the 75th percentile.
We remain very pleased with the performance of our core deposit franchise, average DDA growth and our balances remain strong, rose an additional 13% from the prior quarter, partly attributable I’m sure to the absolute level of interest rates, which remains very low, as well as the FDIC guarantees on these deposits. Nevertheless we are encouraged that our growth rate has significantly exceeded that of the industry and helped to produce a very strong margin performance this quarter.
With that overview, I’m going to ask Doyle to go through the detail of our performance. Doyle?
Doyle Arnold
Thanks, Harris. Good afternoon, good evening everyone.
As noted in the release and by Harris we posted a net loss applicable to common shareholders of $86.5 million or $0.57 a diluted share, which included a special tax item related to the cancellation of some BOLI policies as well as a modest gain on the exchange of subordinated debt for common stock that we did during the quarter. I’m going to talk about three key areas this call, revenue, credit and capital, and then we’ll turn it over for Q&A.
First the revenue drivers. GAAP net interest margin expanded 22 basis points to 4.03% from 3.81 the prior quarter.
The adverse impact of subordinated debt amortization on the modified sub-debt was 23 basis points this quarter, about 5 basis points less than in the fourth quarter. Additionally, the NIM is pressured by more than 30 basis points by our calculation due to the level of non-accrual assets and interest reversals, as well as move into non-accrual status.
The primary driver of the NIM improvement was decline in both the rate paid and the balance of higher cost deposits, which accounted for about three-fifths of the NIM expansion. The other key component of revenue is the earning asset base.
The picture here isn’t quite as bright. Period end loans declined $1.2 billion from end of year to end of first quarter.
Average loans declined about $1 billion. We just continue to see very weak loan demand.
The biggest piece of the decline was in construction loans, which declined by about $550 million, which was a roughly similar amount to the runoff in the prior quarter. And this does include owner and builder homes.
We would expect that we’ll continue to see runoff in construction as projects are completed and sell throughs continue while there is limited demand for new construction and development loans. C&I loan shrinkage drove about a third of the total portfolio contraction, although we had seen some tentative hints that C&I was stabilizing in the last couple of months of 2009.
Line usage rates for commercial loans declined during the quarter from 39.3% to 37.8%, on average. We note that others have been experiencing similar declines at C&I lending.
In fact, our results are, we think, somewhat better than we have seen nationally. The components of non-interest income and non-interest expense contained significantly less noise than in the fourth quarter.
Fair value of non-hedged derivative income declined significantly to $2 million from $31 million in the fourth quarter. We would expect it to remain at a moderately positive level in the near term.
This income is related to interest rate swaps, some pools of loans, floating rape pools swapped for received fixed. And over time the invented gain has declined such that when a loan matures or is renewed, the swap gain is relatively small at this point.
These gains are already recognized in accumulated OCI and thus gains on the P&L are not impacting GAAP equity. On expenses, the primary thing to note is that salary expense declined during the quarter, although the amount of decline was masked a bit due to the seasonal expenses related to payroll taxes, which are always higher in the first quarter.
Provision for unfunded lending commitments was a negative $20.1 million. This is due essentially to shrinking unfunded loan commitments that are outstanding, particularly for construction loans, but also C&I as well as lower loss severity factors or reserve severity factors on these loan types.
While we did release $20 million of reserves from the unfunded commitment reserve, we actually built the overall allowance for credit losses by $30 million, we over provided about $50 million in the A Triple F. Also of note is that the other than temporary impairment of the CDOs was significantly better than the prior quarter’s levels.
This is due to two drivers. The vast majority of the banks that failed during the quarter had previously been modeled as of December 31 at a very high probability of default.
In fact, going back to the prior quarter end, when we last computed OTTI, the average default probability assigned then to banks that failed in our pool this quarter was 89%. Also, the dollar amount of defaults for the quarter were about a tenth of the amount experienced in prior quarters, as mostly we are seeing much smaller bank failures now and we generally have had less exposure.
In fact, year-to-date we have had exposure to 30% of bank failures nationally which compared to about 44% exposure rate in 2009. So far this year the bank failures have been smaller, we’ve been exposed to fewer of them and our modeling has modeled those that did fail at a very high default probability which leads to lower OTTI.
Now moving to loan credit quality, as Harris mentioned we are encouraged by the lower level of loan losses. The overall net charge-offs to loan ratio fell to 2.4% from 3% in the prior quarter.
And on Page 15, which I won’t go through here in detail, but you can see net charge-offs by loan type. Construction and land development loan losses fell nearly 40% sequentially and accounted for less than 40% of total net charge-offs.
That was down from about 60% of charge-offs six months ago. The annualized net charge-off rate for this particular loan category was about 6.5% in the first quarter compared to 9.6% fourth quarter, and a peak of 13.5% in the third quarter of last year.
As many of you know we track losses given classified status a bit more comprehensive than a loss given default ratio. For residential construction lending, that rate during the first quarter was roughly similar to the fourth quarter, although there were fewer loans in that category, leading to lower overall charge-offs.
For commercial construction, the severity fell nearly 40% compared to the fourth quarter. Owner occupied loans account for 22% of total loans, 22% of non-accrual loans, but about 16% of quarterly charge-offs.
The loss rate continues to increase at a modest but steady pace and may continue to rise in the near future. However, we are encouraged by the fact that we’ve seen a flattening in the non-accrual ratio for this particular loan category.
Term commercial real estate loans, which account for 19% of all loans, experienced a decline in the net charge-off ratio to approximately 1.25% compared to the prior two quarters and the 1.5 to 1.6% range, if you exclude two casino credits that had C&I characteristics as much as they had CRE characteristics. So we are not seeing at this point a rise in the charge-off ratio in term CRE lending.
The C&I portfolio accounts for 24% of total loans. It experienced a net charge-off rate near 2%, down from a normalized rate near 3% in the prior quarter.
And then finally consumer net charge-offs were stable compared to the prior quarter. Also note that there’s non-accrual loan information on Page 15.
We are encouraged by the continued slowing rate of increase for non-accrual loans, which rose only 5% sequentially for the fourth consecutive quarter in which that has slowed. Owner occupied non-accrual loans declined about $14 million, a reversal from the previous trend.
One quarter is no guarantee that we will continue to experience declines but it’s encouraging that the upper trajectory did not continue in the first quarter. Term CRE loans increased $95 million, which was largely attributable SBA 504 loans or similar type loans which have lower loss content.
Note that the net charge-off ratio on that portfolio declined to a 1.25% annualized rate, which is better than the industry’s rate of 1.5% in the fourth quarter of ’09. We’ll now talk about migration trends, something that I know some of you are interested in within the non-accrual loan and OREO categories.
Within non-accrual loans we experienced total, new non-accrual loans of about $600 million during the quarter, and that is down significantly from about $860 million in the prior quarter. We experienced about $270 million of favorable resolutions, which would include pay downs, payoffs and upgrades, compared to $310 million last quarter, so favorable resolutions down a bit.
But unfavorable resolutions which include charge-offs and charge downs, OREO transfers, etc., dropped to approximately $267 million this quarter from nearly $400 million in the prior quarter. So fewer net new non-accruals and again an improving ratio of favorable resolutions to unfavorable resolutions.
Although other real estate owned increased, it did so at a significantly slower rate than the prior quarter. It was up about 9% sequentially.
We will briefly discuss capital. During the quarter we raised more than $200 million of common equity, both in the common equity distribution program and the exchange of sub-debt for common stock.
As noted in the release, our tangible common equity ratio increased to 6.30% from 6.12% in the fourth quarter. Not included in the release, if cash had remained at a similar proportion to last quarter’s loans, the TCE ratio would have improved to 6.5%.
The higher concentration of cash is the primary reason that the regulatory ratios improved at a faster rate or more than the TCE ratio. Our Tier One ratio improved about 50 basis points from 11% to 10.5%.
Net of commissions we raised about $150 million of common stock during the quarter. That includes the close-out of a previous dribble program and issuance of about half of the currently authorized dribble program.
We also exchanged about $55 million of subordinated debt for common stock. Both added to the common equity ratio.
Summary of guidance for the next few quarters. Regarding the balance sheet, we expect loan balances to decline in the second quarter.
Again, there is very little data to suggest otherwise at this point. We would expect NIM stability in the near term as pressure from excess cash balances will likely offset much of the effect from further rate declines in interest bearing deposits.
Long-term, we remain well positioned for rising rates, as our cash to tangible asset ratio of 9% is approximately twice that of our peers. Organic loan production, including renewals, continues to be done at very accretive spreads, but cash is now a significant component of earning assets.
Such assets have a negative spread. As a general statement, the balance sheet remains asset sensitive.
We do continue to try to shrink the overall size of the balance sheet. We have identified about $1 billion of non-core funding that we believe we can reduce or eliminate in the second quarter, but we are also still experiencing very strong growth in DVA and other balances.
And it is basically deposits that are driving the total size of our balance sheet at this point. So whether or not we can actually shrink the balance sheet or not or just sort of hold our own is something we really can’t forecast at this point.
Our trend to credit quality, we expect the trend in gross charge-offs and net charge-offs to continue to decline although at a more moderate pace than in the first quarter compared to the fourth. We would expect provisions to approximately match net charge-offs in the near term.
Probably just a bit too early to start forecasting reserve releases. Securities portfolio, although our model was more accurate in predicting failures in the first quarter, we expect that we may continue to experience some OTTI charges for the next several quarters, as previous failures have depleted the over-collateralization of many of our regional A and Triple B rated bank CDOs.
However, we believe that most of the impact on tangible common equity has already been reflected in other comprehensive income, through fair value marks, and indeed that was the case this quarter. Finally a comment on capital.
As credit fundamentals continue to show improvement, and pretax profitability some time in the next couple of quarters looks a bit more certain, the need to raise equity just to maintain and incrementally grow our capital ratios is becoming a lesser issue. We’ve begun to turn our thoughts toward the eventual goal of repaying TARP and what our normalized capital ratio should be in a post crisis, post TARP environment.
We don’t have any specific plans for imminent TARP repayment, but we are considering various strategies that would eventually facilitate such repayment including actions that would affect both the numerator and the denominator of our regulatory capital ratios. And whatever we do, the higher stock price we have today certainly makes any additional capital raises less diluted to earnings and to TCE per share than they would have been even just a few months ago.
With that, I think we will conclude our opening remarks and operator, if you would open the lines for questions please.
Operator
(Operator Instructions) Your first question comes from David Rochester - FBR Capital Markets.
David Rochester - FBR Capital Markets
Could you just quickly talk about the driver of the reduction and the severities? I know you mentioned you didn’t have the hotel credits you had to worry about, but is there anything else going on?
Better pricing, anything like that? And then what kind of steps you’re taking in terms of modifications that will help keep that solid in the future.
Doyle Arnold
If I could ask for a clarify – I didn’t get the connection or maybe there wasn’t one between pricing and severity. I’m sorry.
Did anybody else?
David Rochester - FBR Capital Markets
In terms of basically where you’re marking these things. Where you’re marking the collateral.
Doyle Arnold
For real estate?
David Rochester - FBR Capital Markets
Yes, for your charge-offs, for real estate credits whether its construction, CRE.
Harris Simmons
Let me offer an observation and that is as you, which I really believe applies across the industry, as you get further into this recession or this cycle you had a lot of charge downs. I mean since the end of 2008 we’ve charged off and charged down $1.4 billion.
And a lot of the loans which had been subject to charge downs are still on the books as classified loans, but I mean you’ve kind of run the loss out of them. And so almost by definition as you get further into a cycle, you’re going to see less severity as you’ve taken some of those early hits, particularly given the fact that a lot of these markets are in fact stabilizing.
You’ve seen some stabilization in both residential and commercial values. And so the combination of what we’ve done here for and what the markets are doing is a lot of that.
I think in terms of where we have them marked, we continue to get new appraisals as the loan remains classified. We update those appraisals every 90 to 120 days.
I mean they’re frequently updated. And we mark them at a discount to the appraisals.
So all of that is starting to bear fruit.
James Abbott
David, this is James. One thing I might chime in is we’ve heard a little bit anecdotally recently of some of the other participants on the buy side, property REITs, etc., coming in to buy properties and we’re hearing that cap rates are falling a little bit as a result of that cash sitting in the marketplace as we talk to the lending officers.
David Rochester - FBR Capital Markets
I would imagine the parent company at liquidity is in a better position now even than it was last quarter. Can you update us on that and then talk about how much capital you actually had to push down into sales this quarter?
Harris Simmons
Yes. Total parent cash was $600 million and change at quarter end, and I believe that’s similar to or up a bit from year end.
So I would agree with your statement. We’ve basically pushed about $100 million down to M&G Bank this quarter and currently don’t anticipate pushing much if any capital to the banks from here on out.
Operator
Your next question comes from Craig Siegenthaler - Credit Suisse.
Craig Siegenthaler - Credit Suisse
First question, and I just wanted to see if you could clarify your comments a little bit around these higher cash balances. I’m just wondering, have you started to deploy some of this excess cash into higher yielding assets just yet in the second quarter or should we think about higher cash for longer?
Potentially is this cash set aside for TARP repayment? And will that also continue to benefit your capital ratios?
Harris Simmons
Well, the answer is no, we’ve not deployed it into any higher yielding assets. We are very loathe to buy longer day of securities given the prospect of rising interest rates.
So what we’re basically trying to do is continue to run off higher costs of deposits to keep that excess cash balance from building as opposed to trying to deploy it in any particular way. We continue to revisit that.
At this stage, most of that cash, I mean there’s $600 million of it that is at the parent. The other $3 billion or so is at the bank level and would not immediately be available to repay TARP.
That’s not kind of the way we’re thinking of it at this point.
Craig Siegenthaler - Credit Suisse
Just a follow up question on the commercial real estate portfolio. Your charge-offs has really improved a lot here, you know, both in the term portfolio and in the construction portfolio.
And when you think about the drivers here, maybe you could identify some of them. Is this new run rate sustainable?
And you did say term you expect to get better from here, but construction? I’m guessing you also expect to see improvement there.
And do you also think restructuring activity has been one of the drivers? And we don’t actually have the mix of restructuring in the commercial real estate, but if you have that number, that would be pretty helpful.
Harris Simmons
Well, first of all thank you for noticing that the severity did decline. Second, you cheated.
That was one question and four follow ups, and we weren’t taking notes. I mean I guess his underlying question is do we think the general trend and severity of construction is sustainable and whether or not we see indication that term severities going to uptick.
Is that a fair?
Craig Siegenthaler - Credit Suisse
That’s fair.
Doyle Arnold
Well, I think as we said during the early part of the call, I think we would expect to continue to see improvement as we go along but not at the same pace as we saw in the first quarter. And I think that was a significant improvement from the fourth quarter.
We think it probably gets better from here. It looks to me, personally, as though we’re getting some kind of positive feedback where it’s going in the economy, consumers are starting to spend, etc., etc., and that that will help over time.
And that’s how these cycles run. And that that will lead to continuing improvements in severity, but it may not be totally linear.
I think we’ve seen the worst of it.
Harris Simmons
And I’d say, to repeat something we’ve said before was that by far our biggest severity issues were with land and development loans in Arizona and Nevada, and those are now charged down or paid down to such a relatively low level of total balances that the continuing charge-offs coming out of there will be much more modest. And the charge-offs coming out of even the same categories in other geographies are just not as severe as they were in those markets.
Operator
Your next question comes from Steven Alexopoulos - J.P. Morgan.
Steven Alexopoulos - J.P. Morgan
It seems that most of the prepared comments focused on profitability on a pretax basis. I just wanted to confirm, are you guiding to expect profitability later in the year inclusive of the TARP dividend?
Doyle Arnold
You’re getting us back into earnings guidance, aren’t you?
Steven Alexopoulos - J.P. Morgan
Well, I just want to make sure there’s not a difference between after tax expectations and pretax expectations.
Harris Simmons
I don’t want to refine that to that degree. The preferred dividends are running about $25 million, and I think we wouldn’t slice it that thin yet.
Steven Alexopoulos - J.P. Morgan
I’m sorry, I didn’t get that, Harris.
Harris Simmons
I’m just saying I think that we’re reasonably comfortable in saying that we probably think that pretax we’re probably going to get to profitable. I don’t know if we really have developed a view on how the dividend affects it.
I would hope to get there, but I don’t know.
Doyle Arnold
I think it’s fair to say, Steve, that even we are a bit pleasantly surprised by this quarter turning out a bit better than we would have expected, even a month or two ago. And trying to figure out what and we are confident that the fundamental trends that drove that are real, but exactly when the lines cross and how strongly they cross, we’re not yet.
Harris Simmons
I mean, among other things for example, and I know we talked a lot about these CDOs and depending on which banks fail, etc., that could affect earnings, though not capital, very severely. And that could make all the difference in the answer to the question that you’re asking.
Steven Alexopoulos - J.P. Morgan
Given the drop we saw in the severity of losses on the C&D, how much loss content do you think is roughly left on that $5 billion book? I mean, is it $500 million?
You’re at $86 million in charge-offs this quarter. Just wondering how much is left there.
Doyle Arnold
I don’t think we’re prepared to try to forecast that yet.
Harris Simmons
The annualized net charge-off rate in the quarter was about 6.2%, I think, 6.5% and that’s going to remain elevated here for another two or three quarters. But the size of the portfolio is certainly coming down, but there’s still problems in there.
Operator
Your next question comes from Brian Foran - Goldman Sachs.
Brian Foran - Goldman Sachs
I guess from your comments it’s clear that we’re seeing core improvement, but is there any kind of gauging you can give us of seasonality this quarter? You know historically we’ve seen lower charge-offs in the first quarter versus the fourth.
You know, especially in the construction book how much of it is seasonal improvement? And is that factoring into kind of some of your comments around the second quarter also being better, but maybe not better as quickly as the first?
Harris Simmons
I don’t think we would agree that there was any seasonality to those numbers to speak of. I think it’s all driven by the economy and fundamentals.
And no, I mean I think our first versus second quarter guidance is maybe just a note of caution. We’ve had a pretty steep decline in gross charge-offs from $392 to $350 to, you know, it’s just been coming down pretty precipitously.
Until the economy really starts to generate jobs and so forth, it’s hard for us to believe that that pace of decline can continue. We’re confident that the trends are stable to improving, but that pace, particularly first quarter compared to fourth strikes us as unsustainable.
We’d have zero charge-offs in two more quarters if it did.
Brian Foran - Goldman Sachs
And if I could ask one follow up on loan pricing. At your analyst day you had a helpful Slide showing that spreads on new loan originations month by month for the past two years or so.
How does that look now, I guess, if we updated that chart for March?
Harris Simmons
I haven’t actually seen the March numbers yet but it was pretty stable through February. Anecdotally we’re hearing about a little more price competition out there, because everybody has got the same issue that we have, to a more less degree.
That issue being lots of liquidity and very limited loan demands, so everybody’s chasing the good customers now. Our overall spread, that chart would be relatively flattish through at least most of the quarter compared to what you saw.
Operator
Your next question comes from Ken Zerbe - Morgan Stanley.
Ken Zerbe - Morgan Stanley
Doyle, you made a comment about TARP repayment saying that you wanted to do something or you would consider doing something that affected both the numerator and denominator. Numerator I get, but in terms of the denominator, can you elaborate on that comment?
Doyle Arnold
Not now. Stay tuned.
I mean it’s one of those things. There’s more than one way to skin a cat is all and for those who are trying to project, you know, $1 billion of capital raises to repay TARP, be careful as a ratio has two numbers in it and we’re going to work on both.
And I’ve said this before, it’s too early to say for sure but some of the strategies that we’ve been working on, whether or not they will come to fruition, but nothing that we’ve been working on has fallen off the wagon yet. And we’re growing increasingly confident that we might be able to take a whack at some things.
The only thing I’ll say is we’re trying to address risk weightings of certain assets, not the fact that we have certain assets on our books. That’s the only hint I’ll give you.
Ken Zerbe - Morgan Stanley
Just in terms of broader capital position, obviously the Tier One comment and TCE over the last several quarters, you mentioned that the equity issuance that you’re doing is becoming lesser of an issue I think your words were. Are you guys targeting any informal capital levels?
You know, what’s driving you to increase it say, 20 basis points versus 40 basis points in any given quarter?
Harris Simmons
Well, I wish we could hit the bullseye as accurately as you maybe try and give us credit for there, but our general thought is that we didn’t want to see them drop. We wanted to see them increase.
If you look at our risk based capital ratio particular compared to a number of banks that have repaid TARP, ours are still light by some measures against some of those people. So we think there’s probably some additional capital build that needs to occur.
But quite frankly I don’t know what and when yet. There’s no particular number that I can give you, in part because the regulators to my knowledge have not given anybody a particular ratio or target that is the magic bullseye.
Doyle Arnold
I think it’s also really affected by again, what happens with transient charge-offs. We’ve indicated we think we’re probably reasonably close, at least to the peak in terms of the coverage we’re likely to need in reserves.
The other question is, what happens to the absolute levels of charge-offs as they come down and that starts actually to replenish capital? That’s going to help because like I say over the course of the last year, January 1 of 2009 we’ve built our reserves by $940 million.
If you don’t have that kind of drag and you see charge-offs coming down, then the picture really could change a lot. And particularly in an environment where you have reasonably weak loan demand.
Harris Simmons
I don’t want anybody on the call to sort of get ahead of us here. I think it’s a fair observation that most of the banks that have repaid TARP have either lower problem credit ratios than Zions and/or declining ones, and they also have either been profitable or within striking distance of being profitable.
While we’re very encouraged by what happened this quarter, its probably going to take another quarter or two of moving toward striking distance of profitable and seeing the credit metrics, particularly classifieds and non-accruals, things like that, not just stabilize but begin to actually come down before we’ll have a clearer picture. And that may be a quarter or two away, and maybe second half of this year is probably when we get more serious about what does it take to repay TARP.
Operator
Your next question comes from Jennifer Demba - Suntrust Robinson Humphrey.
Jennifer Demba - Suntrust Robinson Humphrey
Two questions. One, with loan demand being as weak as it is, where do you see the loan portfolio troughing?
And two, Doyle you typically give us some more color about what’s going on credit quality wise and economically in the various markets. Can you give us an idea there?
Doyle Arnold
Well, I’ll take the second one first. We’ve probably seen a, I guess in almost all geographies and loan types we’ve seen a meaningful decline in special mention loans and in earlier stage delinquencies.
We have seen a flattening or decline in classified loans and non-accrual loans and a lot of markets, but probably the most notable exception would be in Zions Bank where classified loans continue to trend upward. A lot of that is being driven again out of the owner occupied real estate portfolio and we continue to see significant increase in non-accruals although not graded or classified in substandard, special mention loans in [amage].
We saw probably if you look at non-accruals, which were more or less flattish for the quarter, up a little bit, if you kind of go around the geographies the biggest increase by some margin was at amage, the biggest decline was in Arizona and all of the other banks were ups and downs a little bit. But the general plateauing or improvement was fairly widespread.
I guess in terms of geography in terms of categories, the improvement in construction of both types was pretty widespread. Where we’ve seen some continued deterioration, increasing classifieds, etc.
at a modest rate is in term CRE and in C&I. That’s a broad characterization.
Harris Simmons
I’d just add to that. I think with respect to amage, though we had an increase in non-accruals they also probably, as we go through deals and look at what’s on the calendar for resolution in the second quarter that probably looks like where we’re going to see probably the biggest pace of problem resolution.
And we’ve seen actually some good reduction in sort of the special mention categories, sort of the front end of the pipeline, and we have a lot of things being resolved at amage, so as not to read too much into that [situation].
Unidentified Executive
As for where does loan demand bottom, that’s really hard to forecast at this point. We all have our gut feels about it.
If the economy continues to recover, let me just say I’d be very surprised to see this rate of runoff that we’ve had in the last couple of quarters continue for more than another quarter or so. I think it’s tough to believe that by mid-year we’ll start to see that attenuate, but that is just my gut feel.
I can’t point to much evidence to support that right now.
Operator
Your next question comes from Erika Penala – UBS.
Erika Penala – UBS
My first question has to do with the OTTI run rate on the [tropic] portfolio. So I guess if the bank failure rate in both number and size accelerates later in the year, do we expect the OTTI to increase from this quarter’s run rate?
Or has that acceleration already been recaptured in the dividend deferment part of your model?
Doyle Arnold
Well, our model has embedded in it an expectation of the number of failures that we will experience not only this year but for the remaining life of the securities. We’ve got one year, two year, five year and LIFO, life of the security default probabilities modeled in.
I’m trying to think, David, do we have a? I don’t know what we’ve got.
I haven’t tried to mentally adjust for kind of what’s the rate first quarter, but we had built into our OTTI last quarter and this a significantly higher rate of failures than occurred last year. Now I haven’t tried to extrapolate from first quarter.
Well, there’s 50 year-to-date nationwide of which we had exposure to 15. So that would imply almost 200 for the year.
Is that right? I think that’s roughly where we’re modeled.
Unidentified Executive
If it increases, it will have an effect on OTTI. It’s just that it will be less severe in terms of impact on capital, because probabilistically we do have a lot of that modeled into our GAAP capital.
Doyle Arnold
It affects regulatory but not GAAP as much. I’m sorry.
If you want to go, one of the things if you haven’t seen it, Erika, I believe we’ve disclosed some stress testing scenarios of that portfolio to give you. You can sort of pick your own poison as to how much more severe default probabilities get and deferral, lack of recoveries get, and we show you.
And if you look at our presentation at the Citi conference about a month ago.
Unidentified Executive
Erika, just looking at Slide 25 from the Citigroup presentation, it would be a run rate of about 220 bank failures this year. That assumes a 45% exposure ratio and our exposure ratio as we mentioned on the call earlier is about 30%.
So it would be a closer number to maybe 300, perhaps 275 would be the annual number that our OTTI implies right now.
Unidentified Executive
Or what’s more important than the number of banks is the amount of exposure that we have to them, and what probability of default that we’ve already taken the loss. And as they continue to close, smaller banks, it’s important to remember we have less exposures as a percentage to smaller banks.
And if we do have exposure, the amount of exposure tends to be a smaller amount which will lead to lower OTTI.
Doyle Arnold
I guess final comment would be, if there’s a large bank out there that we have somehow missed and modeled at a low default probability, that would have an impact. But the last time that occurred was UCBH which committed accounting fraud by allegation at least, and that’s hard for us to work around.
But short of somebody else out there doing that, we think the modeling is increasingly honing in on reality here for us. Sorry, that’s probably too long an answer.
Erika Penala – UBS
My follow up question was on strategies for TARP repayment. I hear you loud and clear that it’s not necessarily something that you’re looking to do over the next few quarters, but have you actually had in depth conversations with your regulators in terms of I guess different past inning strategies?
Because it seems like the folks that have already gone and paid haven’t necessarily gotten full credit for asset disposals or denominator reworking.
Harris Simmons
I think it’s fair to say we’ve had discussions. Whether I’d characterize them as in depth, I don’t know.
I would characterize them as certainly unclear at this point, and including all the points you’ve raised. How much credit do we get for the well over $1 billion of capital we’ve already raised, whether or not we get credit for denominator reduction, how much?
But there does come a point when the ratios, if they’re built strong enough, they sort of speak for themselves. We have not engaged, and it’s premature to really totally engage on that point, so I just can’t.
But we’ve started having discussions.
Operator
Your next question comes from John Hecht - JMP Securities.
John Hecht - JMP Securities
Doyle, you did touch a little bit on the classified assets in various parts of the discussion, but I guess just to summarize the classified asset trends, is it fair to say that migration trends in classified assets was similar to the migration trends in the non-accrual category?
Doyle Arnold
Well, yes, I think it probably is fair to say. What I don’t know is how it compared to last quarter, but you know overall classified assets were up only about 2% and that’s by far the smallest increase that we’ve had.
We’ve just had pretty good upgrade and payoff activity compared to, and certainly charge-offs were a lot lower this quarter. So while I haven’t really tried to tie that all out, I don’t know of any reason to think that the pattern isn’t similar to the non-accrual.
John Hecht - JMP Securities
And then a follow up question. Harris, both you and Doyle talked about that you would probably keep a provision level that mirrored your charge-off levels for the foreseeable future.
The question is, what would set the stage for you guys to be able to begin to pull back on your allowance level? And what level, if you look through the cycles, is a good level to think where it would normalize out to as you pull it back?
Harris Simmons
Well, first of all there’s a methodology in place that you must cue to. And so there’s a limited amount of discretion that you have around sort of the qualitative adjustments you make to a quantitative approach to this.
I think the reason that we have said what we’ve said is because the loss severity is decreasing, the loss factors as we look back over time, you know, we think we’ve seen the peak of those loss factors in classified, criticized, problem assets are also reasonably stable. And so that would lead one to believe that probably the pressure on the reserve starts to come down.
And I do think that going forward probably most outside the industry and most inside the industry are interested in not running reserves way down. We really need to get, I think, from the loss incurred to more of a forward-looking approach to reserving.
And I think regulators are reasonably intent on that. And so there are question marks, I think, around how this will play out and what kind of guidance the industry will see from regulators.
But I think we would hope that we will all see methodologies employed that will not introduce the kind of cyclicality to this process that became so ruinous during this cycle.
James Abbott
We have time for maybe a couple more questions and maybe just one question each. And then we’re going to have to cut it off.
But I will get back to anyone who is on the line who doesn’t get addressed afterwards.
Operator
Your next question comes from Kenneth Usdin - BofA Merrill Lynch.
Kenneth Usdin - BofA Merrill Lynch
My question is really to net interest margin. Doyle, I think I got your context that kind of pluses or minuses pretty much wash out near term with a couple of the moving parts.
But I was wondering if you can just kind of give us some thoughts around future direction of the margin and how much lift do you think you can get in the margin once rates actually do go up? Maybe in the context of where it needs to sit, at the last peak was $470 or so.
I don’t know if you think that’s attainable, but any comments you could help us understand that magnitude and potential would be appreciated.
Doyle Arnold
Hi Ken. Good question.
Well, there’s a couple of things. One is, if rates tighten, yes we do think we have margin expansion.
A second comment would be a rate tightening scenario is probably also consistent with a non-accruals coming down scenario, which also helps the margin. In other words, the Fed is not likely to tighten unless there’s real strength in the economy which would imply low credit quality continues to improve.
So I have not tried to quantify it, but I think you get lift from both of those things. In our present capital structure I’ll leave it to you to decide whether you want to model and if so how you want to model.
The third thing that could happen in that scenario which is that current holders of sub-debt can be exchanged for preferred might choose to do that, and as we’ve discussed many, many times if and as that happens that’s a one time hit to the margin at the time it happens. But the fundamental margin probably has many tens of basis points of potential lift in it and the scenario you were describing.
Kenneth Usdin - BofA Merrill Lynch
One little clarification. The 23 basis points of drag from the sub-debt now, does that run rate from here or does that alleviator get worse from here?
Can you just describe that? The 13 and the 10 that were in this quarter’s numbers?
Doyle Arnold
Ken, it will probably accelerate somewhat. The accelerated amortization will be relatively volatile.
That’s what we can’t predict. And in the second quarter there are two issues that can convert, so that actually exacerbates it in the second quarter or in the fourth quarters as well.
In the other, what we call normal amortization that actually can accelerate or increase a little bit over time because it’s done on the effective yield method. And I can go over that with you offline, but it’ll slowly creep up over time because of that methodology.
Kenneth Usdin - BofA Merrill Lynch
So directionally they both could creep up in terms of basis points impact in the second?
Doyle Arnold
That’s correct.
Operator
Your last question comes from Jason Goldberg - Barclays Capital.
Jason Goldberg - Barclays Capital
Looking at the loan numbers, it looked like I think construction came down about $500 million but term went up about $300 million in the quarter. Were there any kind of I guess financing some of the construction products were overturned, given they don’t have access to the permanent market and maybe just talk about that.
And then secondly, unrelated but your security deals went up like 50 bits lean quarter and your healthy maturities are up over 200 bits. Can you talk about what’s going on there as well as any impact from purchase accounting adjustments tied to prior acquisitions?
Doyle Arnold
I’ll address the second question real quick. The security deal we had a contra interest expense last quarter that pushed the, you’ll notice it most in the P&L.
You’ll see that there was a negative interest income line item last quarter. That was a true up of about $4.5 million.
That went away and so we’re kind of back to a normal. So it was the fourth quarter that was the aberration not first quarter.
And Jerry, do you want to talk about the other?
Unidentified Executive
The increase in the term commercial real estate loans is only partially a result of the decrease in the construction loans. We do have some construction loans that are moving to term loan because the properties are leasing up and they are qualifying.
We have fairly strict standards for moving a loan from construction to term. They basically need to qualify as though they were being originally underwritten as a term loan before we move them into that category.
Doyle Arnold
And just Jason, in general some people have asked what does that mean? And it’s generally a 1.25 debt service coverage and a very solid loan to value ratio.
James Abbott
Okay. Thanks everyone.
That will do it for today’s Q&A session and there are a handful of people, we’ve taken down your names and so I will give you a call back as soon as I can tonight. And thank you again for your time.
If you have any follow up questions feel free to email me and we’ll talk to you next quarter if not before. Thank you.
Operator
Thank you sir. Well, ladies and gentlemen this does conclude today’s program.
Thank you for your participation and have a wonderful day. Attendees, you may now disconnect.