KeyCorp (KEY) Q3 2007 Earnings Report, Transcript and Summary

Welcome to the KeyCorp third quarter 2007 earnings resultsconference call. This call is being recorded. At this time, I would like toturn the conference over to your host, Chairman and Chief Executive Officer HenryMeyer. Mr. Meyer, please go ahead. Henry Meyer: Thank you, operator. Good morning and welcome to KeyCorp'sthird quarter earnings conference call. We appreciate you taking the time to bea part of our discussion today. Joining me for today's presentation is our CFO,Jeff Weeden. Also joining us for the Q&A portion of our call are our Vice Chairs,Tom Bunn and Beth Mooney. Chuck Hyle, our Chief Risk Officer, is unavailable toparticipate today due to a family emergency that called him out of town. I would now like to turn your attention to Slide 2, which isour forward-looking disclosure statement. As you know, it covers ourpresentation and the Q&A portion that will follow. Before Jeff reviews our third quarter financial results, Iwant to make a few comments with respect to the points noted on Slide 3. Duringthe third quarter, the fixed income markets experienced one of the mostvolatile periods in a long, long time. As an industry, we saw credit spreadswiden rapidly and financial markets come to a near halt for a number of weeksas markets repriced for risk. This repricing of the financial assets in thethird quarter resulted in writedowns in our commercial real estate held for saleportfolio, our loan trading book, and other investments impacted by thechanging market conditions. While the fixed income markets continue to remain under somepressure as we head into the fourth quarter, they certainly feel better to ustoday than they did just a few short weeks ago; as a result, we believe most ofthe financial impact of our held for sale portfolios is behind us and we expectto see improved results from these portfolios over the remainder of the year. Business activity outside of the fixed income marketsremained fairly good during the quarter. We experienced better growth in bothloans and core deposits than we had for several quarters, and we also sawgrowth in our institutional asset management business. Given the revenue challenges related to the fixed incomemarkets and increased credit costs, we have focused on controlling our expensesand will continue to manage our expenses closely while still making investmentsin our franchise for the future. As you saw in our earnings release, we experienced anincrease in our non-performing assets during the third quarter resulting fromseveral projects in the residential property segment of our real estate capitalline of business moving to non-accrual. The two geographic areas of the countrythat we have been watching for some time and have taken action to reduce ourexposure in are Florida and Southern California. These are the two parts of the country where weexperienced an increase in non-performing assets. As you may recall, we started reducing our condo exposure inFlorida over two years ago, bynot making any new commitments. There are a number of projects we financed inFlorida that are coming to completion in the next two quarters which willfurther reduce our exposure to this market. During the third quarter, we continued to pursueopportunities to grow our franchise through targeted acquisitions. In lateJuly, we announced our plans to acquire USB Holding Company, the holdingcompany for Union State Bank, headquartered in Orangeburg, New York. We remain on track with thisacquisition and expect to close the transaction in early 2008, subject toapproval by the USB Holding Company shareholders and banking regulators. Theaddition of Union State Bank to our community bank operations in the lower Hudson Valley will double our presence inthis market to 64 branches. Another addition to our operations that we announced in thethird quarter and just recently closed on earlier this month was theacquisition of Tuition Management Systems, one of the leading providers ofeducation-related financial services. With this addition to Key, we now operateone of the largest educational payment plan providers in the nation. As we have said in the past, we will continue to look atopportunities to build our community bank as well as to add strength to our nationalbanking businesses to further leverage our capabilities. Now I'll turn the call over to Jeff for a review of ourfinancial results. Jeff Weeden: Thank you, Henry. I'll begin with the financial summaryshown on slide 4. My comments today will be with respect to Key's results fromcontinuing operations; however, before I begin, I will comment on the $0.03loss from discontinued operations. This amount relates to the writedown of thelease on the former Champion Mortgage Headquarters building in the thirdquarter. Now, from third quarter continuing operations, we earned$0.57 per share compared to $0.74 per share for the same period one year agoand $0.85 in the second quarter of 2007. Our ROE in the third quarter of 2007was 11.50%, down from 15.52% in the third quarter of 2006. The disruptions inthe fixed income markets and higher credit costs had an impact on ouryear-over-year quarterly comparison. I'll comment further on our third quarter results and ourfourth quarter outlook as we review the remaining slides in our presentation. Turning to slide 5, the company’s taxable equivalent netinterest income for the third quarter increased $6 million from the secondquarter and decreased $14 million from the same period one year ago. For thethird quarter of 2007, our net interest margin remained under pressure,declining 6 basis points to 3.40% from the second quarter level and down 21basis points from the same period one year ago. We did experience good growthin our core deposits during the third quarter compared to the second quarter;however, the cost of these deposits continued to rise. With the rate cut by the Fed in September, we havesubsequently made adjustments in a number of our deposit rates; however, due tocompetitive pressures, the full amount of the adjustment has yet to be made inthe rates paid for these funds. This normal lag effect on consumer depositrates and increase in the line utilization on the part of commercial customersand higher levels of non-performing assets will continue to place pressure onthe net interest margin until wider credit spreads can work their way throughthe balance sheet. On the other hand, higher earning asset levels should offsetthe margin pressure impact on net interest income. Our outlook for the netinterest margin in the fourth quarter is to be in the low to mid 3.30% range. Slide 6 highlights the changes in our non-interest incomebetween the third quarter of 2007, the second quarter of 2007 and the thirdquarter of 2006. As we stated in our earnings release and in our earliercomments, the volatility of the fixed income markets had a significant impacton our third quarter non-interest income. For the quarter, our non-interestincome was down $211 million from the very strong second quarter of this year,and down $105 million from the same period one year ago. During the third quarter, we recognized $77 million in netlosses in our held for sale loan portfolio, trading assets and otherinvestments primarily related to commercial real estate. This total reflectsboth realized and unrealized losses as we mark these portfolios to market atthe end of September. Another area of non-interest income that was down in thethird quarter was principal investing. In this case, we had comparison to verystrong prior quarter results. We did experience growth in several other non-interestincome categories during the quarter, including deposit service charge incomewhich grew from both the second quarter and prior year level as we continue toadd more transaction deposit accounts in our community banking operations. In addition, income from trusted investment services showedgrowth over the second quarter and the prior year results, adjusting for thesale of McDonald Investments Branch Network. In the third quarter of 2006, wehad brokerage income of $33 million from the McDonald Investments Branchoperations recorded in this category. Also in the third quarter, we realized a $27 million gainrelated to the sale of MasterCard shares compared to $40 million in the secondquarter. With this third quarter sale, we have no additional MasterCard sharesremaining. Turning to slide 7, we have prepared a similar comparison ofthe increase/decrease in non-interest expense between the third quarter of 2007,the second quarter of this year and the third quarter of last year. Overall, wemaintained control of our expenses and reduced incentive accruals to reflectthe decline in revenue we experienced in the third quarter. Turning to Slide 8, our average loans from continuingoperations increased $1.4 billion, or 2.1% unannualized from the second quarterof 2007 and were up $2.5 billion or 3.8% compared to the same period one yearago. Average commercial loan balances were up 4.5% in the current quarterversus one year ago, and up 1.9% unannualized from the second quarter of 2007.Average consumer loans were up 2.1% from the same period one year ago and up2.4% unannualized from the second quarter level. Our outlook for commercial loans is an annualized growthrate in the mid to upper single-digit range for the balance of 2007 and forconsumer loans, an annualized growth rate in the low to mid single-digit rangeon a linked quarter basis. Turning to slide 9, I'll speak to the growth we experiencedin our average core deposits in the third quarter versus the second quarter.Comparisons to the first quarter and prior quarter shown are impacted by thesale of the McDonald Investment Branch network. Comparisons to the secondquarter are not impacted by this sale. The dotted line on this chart representsthe adjusted year-over-year percentage growth comparisons, excluding the impactof the McDonald deposits sold. We experienced good growth in average core deposits duringthe third quarter compared to the second quarter of this year, as we priced ourNOW and money market deposit accounts more competitively in the markets inwhich we compete. Our NOW and money-market deposit accounts were up $1.2billion, or 5.4% unannualized. In addition, our DDA balances increased $497million or 3.6% unannualized compared to the second quarter. The growth we experienced in our DDA balances came from ourcommercial mortgage servicing area. As of the end of the third quarter, ourcommercial mortgage servicing portfolio had grown to over $134 billion and had $4.5billion of escrow balances associated with this business. Our CD balances were down $0.5 billion compared to thesecond quarter of this year as consumers continued to move money back into theNOW and money market deposit accounts. Our expectation for the fourth quarter2007 is to see an annualized core deposit growth rate in the low to midsingle-digit range on a linked quarter basis. Slide 10 shows our asset quality summary. Net charge-offs inthe quarter were $59 million, or 35 basis points, compared to $53 million or 32basis points in the second quarter and $43 million, or 26 basis points, in thesame period one year ago. While not shown on this slide, our provision for loanlosses was $69 million in the third quarter compared to $53 million in thesecond quarter and $35 million in the third quarter of 2006. Non-performing assets at September 30, 2007, totaled $570 million and represented83 basis points of total loans, other real estate owned and othernon-performing assets. This compares with $378 million, or 57 basis points inthe second quarter, and $329 million or 50 basis points one year ago. As we stated in our earnings release, the increase innon-performing assets was primarily related to the residential property segmentof our commercial real estate construction portfolio. The majority of thisincrease in this segment came from loans outstanding in Floridaand California. We have includedin the appendix of the slides today a breakdown by property type and geographiclocation of our entire commercial real estate book. In addition, we have includedadditional information with respect to the residential construction portfolio. Outside of the residential real estate constructionportfolio, we experienced only modest increases in non- performing loans duringthe current quarter. The loan loss reserve at September 30, 2007 represented 1.38% of total loans andour coverage ratio of our allowance to non-performing loans stood at 192%. Ouroutlook for net charge-offs for the fourth quarter is in the 35 to 45 basispoint range. Looking at Slide 11, the company's tangible capital totangible asset ratio was 6.78% and our tier 1 capital ratio was 7.92% at September 30, 2007. During the thirdquarter, we repurchased 2 million of our common shares and reissued 1.3 millionshares under employee benefit plans. At September 30, 2007 we had 14 million shares remaining under our current boardrepurchase authorization. Again, our capital levels allow for future growthopportunities both organically and through acquisitions; in addition, we willuse share repurchase activities in the overall management of our capitallevels. Slide 12 summarizes my comments on our outlook for thefourth quarter of 2007. Included on this slide is our fourth quarter earningsoutlook of $0.68 to $0.74 per share. That concludes our remarks and now I'll turn the call backover to the operator to provide instructions for the Q&A segment of ourcall.

Your first question comes from Brent Erensel - PortalesPartners.

On your preannouncement in August you talked about capital marketdislocations. What surprised me was the $200 million jump in the real estate, residentialconstruction portfolio non-performers. I was hoping you could address that,given that KeyCorp traditionally has been broad with a diversified product andgeographic category, very conservative underwriting, national skills in local markets;and now, we're seeing a reflection of national “ills”. Can you comment on this and give us some guidance in termsof what's in the pipeline and how far and how long you think this thing will goon?

I'll comment with respect to the portfolio and Tom Bunn mayalso add some additional comments in a few minutes. I think with respect to thehomebuilder segment, specifically within this residential real estate segment,we saw the deterioration really happened in August and September, so it wasafter we had already filed our second quarter 10-Q. We were seeing it more in the latter part of September, thedisruptions caused by some of the financing activities related to theresidential mortgage activities. So as those particular financing activitiesstarted to tighten up and the jumbo market became dislocated at that time, anumber of these projects, some of which are still current, we just have taken theproactive activity of placing those particular loans on non-accrual and puttingthem under additional scrutiny. Our expectation, I think, as we look at migration throughthe credit cycle here, some of it is going to depend on how quickly theresidential mortgage market comes back in some of these particular markets.There weren't a large number of credits that related to that particularincrease. There were only a handful of credits but they were concentrated intwo markets, those being Southern California and also inFlorida.

Brent, the only thing I would add to that is we have notadded a new client to our homebuilder segment in the last 12 months and so asyou probably see in these numbers, our homebuilder exposure has declined.Additionally, we feel the loan to value on these specific loans is good andwe're working through them.

I don't want to seem too morbid here, but you saw that DR Hortontoday just got slaughtered with cancellations, 48%. I'm just wondering how youguys can protect yourselves going forward? Henry Meyer: I think in terms of cancellations that are out there, theycertainly have an impact on the homebuilder segment of the marketplace. As Tomwas talking about, when we originally underwrote these particular transactions,they were generally done at 65% to 75% loan to value. We've had somedegradation in values in the marketplace. We believe that we still have someprotection out there, but we can't guarantee that there won't be additionalwritedowns in the market values that are out there associated with theunderlying properties. So we'll continue to monitor appraisals and the ultimatesale of those particular properties that we are financing.

Your next question comes from Matthew O'Connor - UBS. Matthew O’Connor - UBS: If you could just elaborate a little bit on how you guysdecide when to writedown loans as they move into non- performing? It justjumped out; you had a big increase in non-performers. The charge-offs wererelatively stable. Is it that you have a loss content or are you taking aninitial stab at estimating charge-offs and there's probably more to comerelated to those loans? Jeff Weeden: As we go through and we place a loan on non-performing,we'll take the charge-off at that particular point in time. We also have to, ofcourse, to continue to monitor the asset values over time and we'll continue toadjust if necessary and put charge-offs through at subsequent time periods. Matthew O’Connor - UBS: So you're pretty confident that the increase in NPAs thisquarter, you've written them down to values that you'll recover? Jeff Weeden: As of the end of September, Matt. I don't think any of uscan have a crystal ball to look out into the future on that.

Matt, the one thing I would add to that is that an exampleis we have a piece of property where we have a conservative loan to value andwe have an offer on the table for our loan value for that piece of property. Wewill obviously execute that contract. I think going back to Jeff's comment iswe feel like the carry value of these properties is currently written to wherewe think we can get them. Matthew O’Connor - UBS: Will that sale occur in the fourth quarter, meaningnon-performers will decline?

We don't have a crystal ball on that. We would expect someof this to occur, but we're not sure. Henry Meyer: Matt, I think it's a dynamic portfolio so while thisparticular transaction that Tom referred to may close and have a positiveimpact on non-performers, I don't think of us can clearly say that there won'tbe additional migration of credit over time as we go through the credit cycle. Matthew O’Connor - UBS: Just separately, your core deposit growth -- and I'm just looking at deposits ex-CDs -- wasvery good this quarter but the rates rose a lot. You talked about somemigration from CD's to the money market. Was that an active campaign that youhad going on? I am just trying to reconcile the increase in rates with obviouslythe lower rates in the market overall.

Third quarter is typically a historically strong quarter forthe acquisition of new clients and we did position two new products into themarketplace that were in our NOW and money market accounts. Both wererelationship-based, required a core checking account along with it, and acrossour geography carried relatively premium rates. We were successful ingenerating, as you can see, some strong account as well as deposit growth aspart of that, and really repopulated some of our CD book into what we considermore core accounts. We feel like those were cost effective deposits in thiscurrent rate environment and if you think about we're going into a period ofdeclining rates, that is a managed rate book and we feel like those not onlywere attractive client segments and new deposits, but also something we'll beable to cost effectively manage over the cycle.

Your next question comes from John McDonald - Banc ofAmerica Securities. John McDonald - Banc of America Securities: Could you give a little color, Jeff, on what kind of capitalmarkets fee revenue assumptions are embedded in your fourth quarter EPSoutlook? Jeff Weeden: John, what we had basically in the third quarter, wereported losses of $77 million between all of the various capital markets-relatedactivities, net losses. We would expect that we would have obviously a reboundin the fourth quarter, I think what we are looking at now, a number of themarks that we took in the fourth quarter we've been able to clear some of thatproduct through the market. In addition, some of the credit spreads havetightened up somewhat here as we've gone into October, so I think that bodesbetter for profitability. So it bounced back from where we were, but not necessarilygoing back to what we experienced in the second quarter; but certainly, a morenormal related activity for us. John McDonald - Banc of America Securities: How about just interms of private equity activity and then maybe if you can comment on studentsecuritization? Jeff Weeden: With respect to the private equity activity, we had $9million in gains in the third quarter and we were coming off some pretty strongcomps. Obviously I think as we go into the fourth quarter private equity gainsare difficult to forecast but we would expect that we would be at least at thethird quarter level in the fourth quarter, and may do better than that. As far as the student loan securitization, those particularmarkets are still fairly tight at this point in time, and we are not currentlyplanning on a securitization in the fourth quarter. That will probablycarryover into the first quarter of next year.

Your next question comes from Terry McEvoy - Oppenheimer.

Looking at the community banking line of business, theprovision had been running at about $20 million a quarter. I was surprised tosee it dip down to $1 million, just given the size of that portfolio, about $27billion. Could you just talk about that line of business and the provision inthe third quarter? Jeff Weeden: Yes. As far as theprovision goes, we had an overall provision of $69 million compared to netcharge-offs of $59 million, and we went through our book of business and wereallocated some of our reserves over to the commercial side. You saw commercialreal estate’s provision for loan losses was much increased this quarter as wesaw migration of credit. The community bank book of business, the creditquality has held up very well there so we moved some of our reserves over intosome of the other lines of business.

The indirect marine portfolio was up about 19% from lastyear, about 5% of the loan portfolio. Could you just talk about the quality ofthe borrower and maybe a geographic breakdown of the portfolio?

We have kept a close eye on the quality of that borrower.We've increased expected credit scores there. The credit quality of thatportfolio has remained good. It is predominantly a water-related portfolio,obviously, so you have exposures in Floridaand California, but the creditqualities remain very good and the credit scores, we've pushed credit scores upand we're working to improve spreads.

Your next question comes from Tony Davis - Stifel Nicolaus.

Jeff, do you actually have an aggregate loan to value forthe entire CRE portfolio today, and could you also identify the remainingexposure to Florida condos? Jeff Weeden: I do not have, Tony, an overall loan to value for the entirecommercial real estate book of business with me today. With respect to the Floridacondo exposure, around $360 million is what's remaining.

I wondered about the size, Tom, of the real estate capital markets,the private equity investment pools you have there. I guess your basis forconfidence is you will revert back to gains this quarter.

Well, we're talkingabout two different portfolios. There's a real estate private equity portfolio,and Jeff answered a question regarding our broader KeyCorp private equity.

Yes, I understand.

Our portfolio is $238 million total in the private equityside for real estate. That consists of $134 million which is mezzanine, so it'snot equity debt, and $104 million in equity, and a large majority of that is incommercial real estate rather than in residential real estate.

One final questionhere is the trend you're seeing in risk classification migrations outside ofcommercial real estate. I gather, Jeff, that they're reasonably stable? Jeff Weeden: They are reasonably stable. I mean, we continue to watch themigration but it's been very stable. Henry Meyer: If I might add one other comment here, even within the real estateportfolio, outside the homebuilder sector, the commercial real estate has hadsolid credit performance with very low migration.

We'll take our next question with Paul Delaney - MorganStanley. Paul Delaney - Morgan Stanley: I had a question on the allowance in non-performers; it has comedown very significantly, in about the last three quarters. Is that really justa function of the loss content that you see in those constructionnon-performers being pretty low? I am just trying to reconcile that ratio goingdown while all of the other credit ratios are going up. Jeff Weeden: I think any time, Paul, that you look over a credit cycle thereare going to be times when you see the allowance in non-performing loans getdown to a lower percentage. With your non-performing loans, you are notindicating that there is massive loss content in those particular credits. Justlike when you look at non-performing drop and you have a very high percentagecoverage, you are really reserving for the entire portfolio, includingnon-performing loans. As we go through our non-performing assets, we'll take thecharge-offs when we place them into non- performing and we'll continue tomonitor those credits, obviously, for any further degradation or finalliquidation and there may be additional charges that go through subsequent tothat particular placement on non-accrual. Paul Delaney - Morgan Stanley: Can you just tell us a little bit more about how you aredoing the appraisals on the construction book? Is that a rolling process orwill we have to wait until the spring selling season next year to get a betterunderstanding of how those appraisals will shake out?

We are very actively monitoring this portfolio. We areactively reappraising and relooking at every loan, specifically the homebuildercondo portfolio. So no, we are not waiting around for the spring sellingseason.

Your next question comes from Ed Najarian - Merrill Lynch. Ed Najarian - Merrill Lynch: To come back to residential real estate, could you provideany color on how the jump in non-accrual status might impact net interestincome in terms of not generating interest revenue on those loans, orpotentially having to reverse out prior interest revenue? Then could you alsopotentially provide some color on how this increase in NPA's might affect yourfuture CMBS securitization revenue? Thanks. Jeff Weeden: Ed, with respect to the net interest income and net interestmargin, it did have an impact on the third quarter; it probably reduced ourmargin by 1 basis point. So as we look at the fourth quarter, our guidance thatwe provided of low to mid 3.30% range incorporates in the higher level ofnon-performing assets that we have on our books. Ed Najarian - Merrill Lynch: Are there anyreversals of interest income happening because of this? Jeff Weeden: For the most part, the loans we put on non-accrual, theywere relatively current so there was very little in the reversal of netinterest income. Those reversals happened in the third quarter. So if there arenew loans placed on non-accrual in the fourth quarter, there may be somereversals of income, but that's very difficult to project at this point. Ed Najarian - Merrill Lynch: Secondarily, could you make some comments about the CMBSsecuritization revenue going forward?

We think the adjustment that occurred in the third quarterwas an extraordinary adjustment. We have seen spreads tighten, as we've talkedabout earlier, which has improved the outlook for the CMBS book. The CMBSorigination has slowed; not surprisingly, given the overall cost of thatbusiness now. We are optimistic that it's going to return to normalprofitability of the business as early as the fourth quarter and we're veryoptimistic about the business going into ‘08. It's a very core business to ouroriginate/distribute model and it's a business that has been profitable for aslong as we've been in it and we expect that to continue. Jeff Weeden: Ed, I'll make oneadditional comment on that. With respect to about 25% of what we have in ourwarehouse currently, it's locked in with a total return hedge, so we're verycomfortable with that. We've hedged the rest of the portfolio with respect tointerest rate risks, and we'll have to see how credit spreads continue throughthe process. I think as we look into 2008, activity for origination hascertainly slowed down so we'll probably have less activity in 2008 associatedwith this particular business, just because those loans are not beingoriginated at the present time. Ed Najarian - Merrill Lynch: So we should look atthat business going forward as a somewhat slower business from an originationstandpoint versus where it was prior to Q3? As well as a business that shouldhave potentially -- or could have potentially -- tighter spreads onsecuritization for you as the bank?

Correct.

We'll take our next question from Gerard Cassidy - RBCCapital Markets. Gerard Cassidy - RBC Capital Markets: A couple of questions coming back to the commercial real estateloans. I think you indicated you had $360 million of condominium loans still inFlorida. Could you tell us what thenon-performing asset number is attached to that portfolio? Jeff Weeden: Yes. I think I've gotthat here with me, I just have to look to the schedule. On the non-performingassets associated with condos, there are no non-performers in the condo portfolioin Florida as of the end ofSeptember. Gerard Cassidy - RBC Capital Markets: In the commercial real estate detail you gave us about $2billion of retail properties. Could you tell us what dollar amount orpercentage is in strip malls versus large malls or other types of retailproperties?

Strip center total is about $390 million. Gerard Cassidy - RBC Capital Markets: Finally, in the past credit cycles that we've had, theregulators tend to become a little more focused on credit and in fact they'veeven used specific, targeted commercial real estate exams. Have you guys heardanything from the OCC about that maybe starting or have you experienced thatalready? Henry Meyer: We have not been notified by either of our regulators, theOCC and the Fed. Although we hear talk of that, we can't confirm anything. Gerard Cassidy - RBC Capital Markets: Finally since you're there, Henry, in terms of acquisitionsobviously you guys are always looking to enhance the franchise. Are you sensingthat smaller regional/community banks are more interested in coming togetherand possibly selling to you guys or to others because of some of the challengeson the horizon? Henry Meyer: I hope that starts but no, I can't tell you that we've beeneither better received or had regional banks calling us, community banks inparticular. I think that this environment is not unique to Key in terms of whatspreads are doing and what's happening. I think that as all of us in thisindustry are in some stage of our process for 2008 planning, I think 2008 willbe a more difficult year. Bernanke was saying yesterday that this marketdisruption isn't going to work its way through until maybe late in 2008. One hopes, at least from my perspective, that there will besome banks and boards that come to the conclusion that maybe the capabilitiesof a company like Key would benefit them and their clients and their markets;but no, I haven't seen it yet.

Your next question comes from Gaurav Patankar – SuNovaCapital.

In terms of allowance to total loans, you said that goingthrough a cycle 192% might not be that much. I was wondering, what kind ofcomfort level is there operating at those levels versus providing a little moreinto the coming quarters? Can you giveus some color on how the management team has been thinking about that? Henry Meyer: Certainly. I think as we go through and look at our build upof our loan loss reserve, it's something that we have to go through and documenteach and every quarter. As non-performers increase, as you see just normalmigration credit, I think there's the normal expectation that as charge-offs goup in this time of the cycle that provision will also end up going up and thenjust like it did in the third quarter, we've ended up providing more than whatwe've charged off. So that particular pattern could exist in future periods aswe continue to go through the cycle.

A question on the $77 million in losses that you guys took; Ithink this is both a combination of a gain on sale losses as well as some markdowns.With the market, as you alluded to, with the market coming back toward the endof the third quarter and the beginning of the fourth quarter, would you expectsome write backs in the fourth quarter? Henry Meyer: Well, we would have to see what is actually realized onthose particular portfolios that we're just taking marks on. So as thoseparticular loans are securitized through the CMBS structures and they're placedinto the marketplace, we'll have to judge what we receive versus what the marksare on those particular bonds. We feel comfortable with our marks as of the endof the third quarter, but it's very difficult to project out what creditspreads are going to do for the balance of the year.

We'll take our next question with John Boland - MapleCapital Management.

We've had a lot of questions about the loan loss provisions,but it just seems to me you should have been a lot more aggressive this quarter.I'm just wondering, what might I be missing? Are you seeing some trendsmoderating that have given you the comfort to not take bigger charges thisquarter? Jeff Weeden: When we look at the charge-offs, we have to look at theactual loss content in the specific loans and we were able to either sellparticular loans or we wrote them down to net realizable values. It is notsomething that you can just go through and start charging off.

I'm sorry, I meantprovision. Excuse me, I may have misspoken. Jeff Weeden: Well provision again,we go through a very elaborate build-up process and it's going to bespecifically related to the credit grade. I believe there was an earlierquestion that asked about what are we seeing outside of the residential propertyportfolio and those particular portfolios seem to be performing fine, evenwithin commercial real estate as well as other portfolios. We are seeing normal migration of credit, but we've factoredthat in when we do our reserve analysis. I think if you compare our reservelevels we maintain as a company, they would compare favorably to some of ourother peers.

Given the trends out there that seem to be developing oncredit and given the fact that you seem to be somewhat under reserved right nowat 192, do you have any comment or can you give us any guidance on what mightbe happening to the balance of your $14 million share repurchase program? Canwe assume that's on hold? Henry Meyer: First of all, I take a little bit of exception with yourunder-reserved at 192. You are focusing on one number, which is reserved tonon- performers. We talked about a little bit of a jump in the non-performersin the commercial real estate area, some of which we indicated -- maybe youdidn't hear it -- but that they are current. It has to do with, what's thequality and what's the loss content on those non-accruals? That's one ratio. Our reserve to total loans is one of the strongest in theindustry and we've added more than we charged off, and we've talked about therest of the portfolio being stable. You can focus on anything you want. I wouldtell you that is one ratio, but it's only one of a number of ratios that youreally need to look at. On the stock buyback, we have been very consistent intalking about how we use stock repurchase as a capital management tool andwe'll continue to do that. There is no question that we will use a little bitof our capital when we close the Union State Bank deal in the first quarter of2008, so we want to build to that point where after that deal is completed westill have the flexibility on our balance sheet that we strive to retain.

So we can assume that buybacks will moderate a little bit inthe next quarter or two, until the deal closes? Jeff Weeden: I think you can lookat share repurchase activity to be comparable to what we experienced in thethird quarter which was just nominal activity to offset primarily what wasreissued under employee benefit plans.

Your next question comes from Gary Townsend - FBR CapitalMarkets.

On another subject, deposit growth seemed to be very good inthe quarter. Can you discuss what was helping with that success and are youdoing anything different? What are your competitors doing?

As I've stated earlier, we did have some very targeted andfocused marketing and new client acquisitions in the third quarter, centeredboth around core transactional DDA accounts as well as money market and NOWaccounts. Those were programmatic in the third quarter. They were successful.We increased the average number of accounts in both money market and coretransactional, as well as our balances, as you saw grew nicely in the money marketand NOW. Competitive price on the interest bearing book, but as Isaid in a declining interest rate environment, that will serve us well versus continuedCDs which a lot of our competitors put in the market. We had a solidacquisition of new accounts and new deposit dollars in the third quarter.

Oftentimes, these new accounts don't stick. How do youassess that issue?

One, they wererelationship accounts, they were paired to a core transactional or DDA account.You are right, there are always some ebbs and flows but we monitor that, and thequality of the average balances and the profile of the client look strong. Partof what we do in the fourth quarter is a very robust on-boarding where wecontact and follow back up with those new households for additional productsand services.

Geographically, any particular areas of special strength?

The western markets were the strongest. That rateenvironment seems to be the most rational from a competitive point of view sowe saw, probably on a percentage basis, the strongest growth and the weakestwould be in the Great Lakes where you have the mostcompetitive rates in the market.

Your next question comes from David Pringle - SalespointResearch.

How much of your loan growth this quarter came from slower capitalmarkets activity in the C&I book and the commercial real estate book?

I don't think we canexactly quantify it dollar for dollar, but it is clear to us the institutionalside of both real estate and corporate we saw some clients who normally wouldhave capital market access use their lines either because they didn't have theaccess or didn't like the pricing of that access. We don't expect that tocontinue. In Jeff's estimates for loan growth for the fourth quarter weexpected that activity to be flat to down, so we think it's an aberration ofthe market and those clients will go back to the capital market, and havealready, in some cases.

In the commercial real estate book, you're up about $600million in the third quarter. How much of that, if the markets had been open,would have been securitized? Jeff Weeden: Well, the securitization side of the equation would be inthe held for sale portfolio, so not in what you're seeing in the other book.Those are going to be just new construction loans and mortgage loans that arebeing made by the company.

You had a pretty substantial reduction in expenses in thethird quarter. Can you do that in the fourth quarter again? Jeff Weeden: David, if you recall, the third quarter versus the secondquarter, the most substantial portion of the reduction, there were two areas:one related to the incentive compensation accruals coming down and the secondarea was the litigation reserve that we had in the second quarter, which didnot repeat in the third quarter. I would not anticipate that type of reductionas we go into the fourth quarter and we may see some expenses that are tieddirectly to revenue go back up slightly in the fourth quarter.

How many people do you have in loan work out at this point,and how does that compare to say six months ago? Jeff Weeden: I don't have theexact number of FTE's that we have specifically in the loan work out area butclearly we continue to look at, do we ship additional resources into that group?We have less need on some of the line side of the equation moving resourcesaround in the organization, so that's how we're going to try to manage some ofthose costs, is the redistribution of some of the resources to collectingversus the origination.

This does conclude our question-and-answer session. I'd liketo turn it back over to Mr. Henry Meyer for any additional or closing remarks. Henry Meyer: Thank you, operator. Again, we thank all of you for takingtime out of your busy schedule to participate in our call today. If you haveany follow-up questions on the items we discussed, please call Vern Pattersonin our Investor Relation's Department at 216.689.0520. That concludes our remarks. I hope everyone has a great dayand we are adjourned.