Independent Bank Corporation (IBCP) Q1 2008 Earnings Report, Transcript and Summary

Hello and welcome to Independent Bank Corporation first quarter 2008 earnings conference call. (Operator Instructions) Now I would like to turn the conference over to Mr. Mike Magee. Mr. Magee?

Thank you. Good afternoon and welcome to our first quarter 2008 earnings conference call. I am Mike Magee, President and CEO of Independent Bank. Joining me on the call today are Rob Shuster, our Chief Financial Officer and Stefanie Kimball, our Chief Lending Officer. Following my introductory comments, Rob will provide a detailed review of our financial performance during the first quarter. Following Rob’s comments, Stefanie will provide a progress report on our lending initiatives and risk management. We will conclude the call with a brief question-and-answer session. Also please note that an accompanying PowerPoint presentation will be referenced throughout today’s call. To access this presentation, please go to the Investor Relations section of our website at www.ibcp.com. Please also note that this presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to our Safe Harbor provision on slide three of the presentation for additional information on forward-looking statements. I will begin today’s discussion with a review of our first quarter financial results which are summarized on slide four of the accompanying slide presentation. With the first quarter ended March 31, 2008, we reported income from continuing operations of $341,000 or $0.01 per fully diluted share compared to $3.9 million or $0.17 per fully diluted share in the first quarter of 2007. They year-over-year decline in the operating profitability is primarily attributed to a $3.2 million increase in provision for loan losses and the higher loan and collection expenses as a result of several commercial real estate loans moving from the watch list to nonperforming status during the quarter. These delinquencies are primarily the result of real estate developers experiencing cash flow difficulties as they confront a significant decline in real estate values throughout various regions in Michigan. While we…

Thank you Mike good morning everyone. I am starting at page nine of our PowerPoint presentation. I will focus my comments on net interest income in our margin, certain components of non-interest income and non-interest expense, asset quality and conclude by making a few comments about our current cash dividend. As outlined on page 10 there were several unusual items impacting first quarter 2008 results. Our fair value election on preferred stocks and impairment charge on capitalized mortgage loan servicing rights, the reversal of previously accrued and uncollected interest on loans based on non-accrual, severance costs in an elevated loan loss provision all negatively impacted the quarter. Conversely the VISA IPO fair value election on loans helped for sale SAB 109 implementation for commitments to originate mortgage loans and the released of a previously established income tax reserve favorably impacted the quarter. We outline our implementation of FAS 159 and SAB 109 in greater detail on page 11. Effective January 1, 2008 we elected fair value accounting for several preferred stocks that we own. These preferred stocks were purchased long before the disclosure of any of the sub-prime mortgage problems that have impacted some of these issuers. The market values of these preferred stocks have declined sharply due in large part to the general aversion to risk and liquidity challenges in the current marketplace. Because these are perpetual securities assessing these preferred stocks for other than temporary impairment is very difficult because there is no maturity date and thus forecasting when the market value might recover is difficult. Further, OTI accounting is one way. Once you write down a security for other than temporary impairment, you establish a new carrying value or cost basis for accounting purposes and cannot subsequently recover the impairment unless you sell the security. As a…

Thanks Rob. As I make my comments regarding credit quality, I will be referencing the handout starting on page 24 and I will start with the commercial lending business. As a brief overview, there are several encouraging signs as we look at the details behind our first quarter results. The first is that the speed of the inflow and the growth in the level of the watch credit has slowed. Secondly, as Mike noted, the new loans that we are adding to the portfolio are of a higher quality and they are also related to our strategy to develop relationship focused new clients which will be in the best long-term profitability interest of the Bank. Third, we have recently rolled out a new risk based and relationship focused pricing model which is helping us redirect our commercial lending team to our target customer base. Like the rest of the industry, we continue to be faced with challenges which include rising delinquency and non-accrual rates. Charge-off and collection expenses that are elevated as Rob highlighted. Both of these have required significant investments in our time and our resources to address each client’s individual situation. With that as a backdrop, I will now turn to some of the details of the commercial loan portfolio starting with page 25. Overall, commercial loan outstanding have declined slightly as we have been replacing our run-off but also looking as well at some strategic exits. For example, during the first quarter, we did choose not to match the extended credit terms offered to one of our clients for a $10 million real estate loan which we did not consider to be prudent. That customer paid us off which accounted for most of the decline in the outstanding during the quarter. As we turn to page 26,…

Thank you Stef, thank you Rob. With over a century of community banking experience and as one of the oldest and most established banking firms in Michigan we have whether to a variety of market cycles and business trends over the years. Of all the current credit cycle remains a challenging one. We have taken the appropriate measures to enhance our portfolio and risk management functions within the bank. We are confident that these measures and our continued commitment to the fundamentals of Community Bank our trusted relationships, reputation for excellence and local knowledge in expertise position us for improved performance in the future. That concludes our prepared comments. At this time we will open the line for questions.

(Operator Instructions) Our first question comes from Terry Mcevoy at Oppenheimer.

Good morning.

Good morning Terry.

Good morning.

Good morning.

Stef you have mentioned that the improved watch credit slowed in the level of internal watch and substandard loans declined, could you may be break out the commercial portfolio and make that same statement for the vacant land development and constructions as opposed to the income producing owner occupied in C&I and did that happen in both portfolio’s or was just may be some $0.06 on those three stress portfolio that’s may be over shadowing some of the increase in the other three?

As Rob highlighted in his comments there is some additional detail in our financial statements that has been provided in those portfolios and I will let Rob highlight those specific balances.

Okay Terry just to give you some mix we were down a fair amount in total watch credits in the categories of land and land development. We were flat in construction and owner occupied. Owner occupied was actually down a bit where we did see some rise was an income producing, so that’s the mix of the change. Although I will say within the income producing and owner occupied, I don’t think we have seen anything way out of the ordinary in terms of sort of the -- some of the historical issues and one of the I guess question is, is this the soft economy beginning to gravitate in the other areas. Certainly we have not seen that yet in the owner occupied and we have seen a bit of an increase in the income producing but I don’t think at a level that would be way out of the ordinary from what we may have seen in other historical time frames.

The other thing I would add in terms of the income producing in the movement in is if that was primarily driven by one large credit that’s in the process of redoing some of the properties and does have some significant other sources of income. So, it’s not a trend that we have seen yet in the portfolio. Terry Mcevoy – Oppenheime: Rob you had mentioned $50 million of NPL, there is no reserve set….

Well, there is little reserves. To give you an idea for example when we charged down a commercial credit based on that criteria I outlined we will leave at the minimized allowance to cover holding and liquidation costs so as you incur those expenses during the liquidation process you have essentially approved for some of them. So there is very little reserve related or allowance related to $50 million of the total of the $102 million. So I know that ratio gives us enormous amount of attention and that 49% compared to historical levels it looks very low, but I think the key there is -- and you are seeing this trend in a lot of financial institutions. We have been actively charging down credits as they cycle in from a statutory basis under the bank regulations we’re subjected to your required to take a statutory charge down on real estate secured collateral at 180 days past due or we will do it before then if we’re -- if its reasonably certain that we are going to incur a loss. So, those level of charge downs that you are seeing over the last four quarters or so is that active process of charging down credits to net realizable value. So my -- I guess my synopsis would be on $50 million of the $102 million unless we are either wrong in our estimate of the net realizable value and our estimate takes into account current conditions very distressed conditions and estimated liquidation and holding costs or unless we see a continued down turn in prices $50 million of the $102 million really ought to not create any additional losses for us. It’s going to take some time to liquidate it as Stefanie said, but the point is that in mind when looking at that ratio you kind of carve that out. Then you’re looking at $50 million of remaining non performers against $45 million, $46 million of allowance that you’re around that 100% coverage rate and even within that remaining portfolio most of or a big chunk of that is secured with collateral and we have evaluated it or its in categories like rating categories where we have done relatively recent estimates of probability of default and the loss rate given the default in the computed reserves based on that up dated analysis.

The other thing I would add to Rob comments is that the -- although its relatively early in our workout stage the credits that we have began to see move out of the portfolio or resolve a credit that we have taken the charge down. Our process appears to be coming in right at those levels, so we take some comfort in the methodology from that. Terry Mcevoy – Oppenheime: This is also the last question and the next question what are you writing your one to four family residential real estate values down to?

Currently of our one to four family residential portfolio that are 90 days passed due or on a non-accrual status we currently have written those down to a net book value of 60% of the original appraised values, so I feel we have been aggressive and conservative in what we have written down the one to four family on the pro properties act. Also very optimistic about the future I think, especially in the one to four families commercial seems to take a little longer to work through the litigation process, because several of the one to four family mortgages that has been on non accrual for a while are starting to come out of the legal process to the redemption period. We are starting to obtain titles on those properties and our in a position to actually start selling them we are holding our first auctions here in a few weeks on some mortgages -- one to four family as one of the strategies were used or initiatives to liquidate and start moving out some of these none performing assets. Up to this point unfortunately we have been only adding to the non-performing asset category in starting the litigation process but in several cases we have been -- now for several months we have been -- for closing that property and it’s just getting to the point now where the redemption periods are expiring and we can obtain title to the property and start moving it out of the non-performing asset category. Terry Mcevoy – Oppenheime: Okay, and Rob will you continue to bring down brokerage CD balances and will that provide some further support for the margin like we saw in the first quarter?

Yes. We still expect see that going down probably not because there is only $248 million but I think we could -- over the next quarter that might come down again about 50% so about an half because of what we project as calls on the portfolio so that will provide support in terms of migration out of a higher costing broker CDs and into lower costing borrowings which we are predominantly doing with the Federal Home Loan Bank and the Federal Reserve Bank because borrowing rates there are at for sub LIBOR whereas brokers CD rates remain at elevated levels, we are still looking it about 3.5% for a short term broker CD and moving higher has you extend out of that. Terry Mcevoy – Oppenheime: Thanks a lot.

Our next question comes from Brad Milsaps of Sandler O'Neill. Brad Milsaps – Sandler O’Neill: Two questions; Stefanie I think you said that your watched -- the inflow into the watched list credit has declined, but I am looking at the table I guess it’s on page 29 that shows commercial loans 30 days plus the delinquent on accrued, that is -- that number has gone up. So I am wondering if you could just kind of reconcile those two statements and then also on the month before as you indicated you wrote them down to 60% of original appraised value. I am wondering what those write downs represent relative to the current appraised value.

Okay, well first of all I’ll start with on page 29 in the delinquent account. We do see a number of those on the delinquent account and the majority of them are in the watch category but what we have been seeing is some of the non watch credits also are in to the delinquent status as we try to renegotiate terms and so that’s really the difference between what was in the inflow. Generally we don’t find commercial delinquency to be too predictive of movement into the watched category. It seems to be more of a lagging than a leading indicator and with regard to the residential real estate and our practices of writing down. The 60% of the original appraisal would be writing the properties down to their current distressed values less all of our liquidation and holding cost.

And we would often discount depending on different attributes we could discount that current distressed value a bit as well. So we would look at it and depending on the what market it might be in or the type of property it might be we might write that down even a little bit more. Brad Milsaps – Sandler O’Neill: Okay, so essentially they are written down to realize at more value at this point so this means they are not likely to be recovered?

Well, unless there is a recovery in the market, I mean -- it’s spotted you’ll get a few that sell at north of where we’re valuing them. We have seen as Stefanie had indicated, we have had some liquidations of some larger commercial properties and we have been pretty much spot on what we value in that. We have had a few modest recoveries there where we have done a little bit better than what we anticipated, but I -- in this market given the competition of more than just a few financial institutions probably starting to liquidate collateral it’s probably not the type of market that’s going to provide for a lot of recoveries but we have been finding that. Our valuations have been done very accurate relative to where we have been able to dispose of these things at. Brad Milsaps – Sandler O’Neill: Okay thank you.

Next question comes from David Scharf, at FTN Midwest Securities

Hey, thanks for taking my call. I wanted to go over the exhibit that you put in the press released the one that talks about the total commercial loans. If we could talk about: one, are there anymore lending going towards these portfolios and have they made it a land development loan in the last year?

In terms of the land development, no we are not making new loans in those categories. We have seen some of the existing commitments in those businesses that have been drown upon so what shows up in the information that you are referencing is more of the balances as those loans have been drawn.

When did you start making or extending credits to these sort of projects?

That was in July of last year.

Okay, and how old or how much would you say these portfolios are?

I would say probably the vintage would be somewhere in the 2004 to 2006 range. I would say by the end of 2006 it really started to taper off.

Okay, and when did they come up for renewal if you will?

Well I mean most -- a lot of them that are non-performing probably they have come up for renewal or are not going to be renewed because of the circumstances with the power. I think Stefanie touched on it earlier that one of the things that is been popping up like a 30 day deliquesce bit is on some credits that do come up for renewal we are demanding additional collateral or other type of terms to better protect themselves.

But in some cases we have also been able to take additional collateral if somebody has an investment that doesn’t appear to be able to be moved in the short run, if there is some additional collateral that will sure up -- the loan will look at that as well as looking for pay down.

And what were the (inaudible) the other non-performance that you have right now?

I would say generally the write downs have been about 35% to 40%.

I am hearing that people are coming in and making offers at like $0.60 -- about $0.40 on a dollar, so that kind of implies that there is more downside than fair value?

Although we have been able to liquidate more than just a couple of development loans at levels that we had written them down to. So I do think there is some element probably of -- if you were doing it in mass we might have to look at those kind of valuations but I think in a more orderly scenario you are still able to get a little bit better execution than that.

And when I referenced that 35% to 40% I am referencing the charge down that we would take in the loan. Obviously you wouldn’t have a 100% loan when you made it, so your -- what you would advance from originally let’s say it was 80%, for us to take a 40% write down is probably close to the numbers that you are referencing in the market.

I guess what I am looking at it to is I mean unemployment is the highest in the nation. You still have all these properties coming on. There is no immigration of people and business. You look at this and then balance that against the reserve and I understand the reserve methodology is that current appraisals but I mean you do have to look a year to two years out and speculate and I don’t see how you don’t incur another 20% write down possibly on all of these, is that -- do you not agree with that?

Well one of the things that the appraisals and the current appraisals look at is exactly that issue and that is the absorption period, so very deep discounts are applied to the values to account for a very slow absorption.

So I don’t necessarily disagree with your promise. I think though that the valuations are taking that into account.

Okay, what do you…

I would say that there was a study recently done on the risk of further declines in residential real estate values based on the 50 largest metropolitan areas and this was looking at the percentage risk of further declines moving out towards the end of ’08 and into ‘09 and actually in Michigan it was reasonably -- well it was in the 14% to 16% chance of risk. That’s not the percent of decline but the percent of risk of further declines. You had states such as Florida, California, Arizona and Nevada that were north of 80% and then Texas was the lowest state at 1%. So if that study at least would suggest based on how much decline we have already seen here that the risk is not that -- not up there with some of these other states.

Do you agree with the 14% down side to stay?

Well it’s not -- it’s yeah. What they are suggesting is there is 14% to 16 % risk of further declines, that’s not the percent of decline that’s just of further decline. So they are suggesting that its relatively on -- your study was done by PMI as the name of the company but they were suggesting that Michigan’s risk of further price declines -- and this was mostly in south eastern Michigan is relatively low. Now weather you agree with that or not that’s the study that I have seen most recent.

What would -- could you give us some color on the level of inventory that is kind of focusing on South East, the South East as far as homes, as far as months -- the 50 months of inventory.

It varies so dramatically by price point. The higher price points here in a well over a year, multiple years of absorption if you are getting a north of say $1.5 million. If you are down below $300,000 the absorption periods are a lot more modest, so it just varies all over the map depending on price point. I would say that our average loan balance in our portfolio is about $130,000, so we don’t have a lot of that real high end type of inventory and at least average suggests that your outlook for absorption period relative to the size of our loans is certainly better than if you had a portfolio that was heavily in the jumbo or super jumbo loans and the smallest representation of our portfolio, total portfolio is from south east Michigan in one to four family residential.

Yeah, but you have a lot of land and land development loans and constructions on there.

A lot -- I mean we have remaining in South East Michigan in land and land development we have about $38 million of which about $30 million is already in the watch credit, so it strikes to me that that’s not relative to our size and enormous exposure even in that category in South East Michigan.

What are you seeing in your own mortgage business? I mean you mentioned that resize were a large driver of your mortgage volume, what are you under writing now?

Well, we are actually seeing. I mean just the volumes are relatively flat. Now we did in the first quarters as I pointed out it was more heavily skewed to refinance volume and the overall market is a little lower. The other thing you are contending with on refinances is in some instances the appraised value of the property is lower, so the customer is even eligible to refinance the loan, but offsetting that is we have seen an enormous amount of people exit the market. When the market was stronger you always have because it’s a low barrier entry industry you had a huge number of mortgage brokers and bankers entering the market. Well many of those have gone away, even some more substantive mortgage bankers in this market have gone away and what that’s done is even thought the market is smaller institutions that have been enable to remain and place the mortgage banking like ourselves are gathering a better market share, so you are still seeing reasonable activity there. I don’t think it’s going to be anything substantive but I still think it will be steady.

Are you under writing any loans where the LTV is less than or greater than 80%?

Well, you are still doing loans above 80 and if that meets Fanny and Freddie’s criteria and you could get PMI insurance I could tell you just about every week the PMI companies are coming out with changes in their underwriting matrices and in addition to that you also have changes on a pretty continuous basis from Fanny and Freddie on the risk based pricing. The other thing that we have at our mortgage banking arm is FAJ lending which is continuing to do well and again those loans are sold so we are not retaining that exposure and then finally in the instances where we may do a portfolio loan above 80 we would get PMI insurance and then some instances we have a lap insurance policy that we have that our disposal to also insure the exposure down well below 80% outside of PMI, so if it happens we are -- we put in place a wide verity of scenarios to ensure the risk well below that level and I add it’s based on current evaluations which are distressed.

That’s all I wanted to touch on but I just add that it appears that really clearly that real estate, residential real estate is going to continue to fall and the reserves like you had mentioned obviously it does effect your borrowing. Now it encourage you to increase that to a higher percentage to cover the problem assets, but….

I will respect it, but we disagree.

Okay, fair enough. Thank you then.

Our next question comes from Kurt Harvardson [ph] from NTF.

Yeah, just a quick question on the preferred as if they are variable or fixed and what the original rationale was?

They are variable; all of them I think are variable and the original rational is these are preferred where we get the dividend received deduction of 70% and they had relatively high ROEs across the board and obviously the market values have come down quite a bit but we were comfortable with the names at the time. Fanny and Freddy are holding that we’ve had for a fairly lengthy period of time on the preferred and the Merrill Lynch we had it long before the sub-prime problems that hadn’t at the time and both Merrill and Goldman were very highly rated and Goldman continues to be very highly rated and so we felt comfortable with those investments.

Okay and one another comment on just board of directors showing confidence in your stock would be a nice thing.

Okay thanks.

Thank you.

Your next question goes from Jason Werner of Howe Barnes.

Good morning guys.

Good morning.

Good morning Jason.

My first question is kind of a verification and one of Terry’s questions on the broker CDs I just want to confirm that you do have room to continue borrowing from the Federal Home Bank and -- or do you need to some point increase your securities for collateral and that sort of thing.

We have more modest capacity of the Federal Home Loan Bank but we still have a fairly large capacity at the Federal Reserve Bank probably in excess of $400 million there, so we have quite a bit of remaining capacity.

The rate different between those two sources, is there much of a difference?

Well the Federal Reserve right now -- we had been doing the term auctions which the fed is doing twice a month. We’ve not done those lately because the cover did on the term options set them about to discount rate or primary borrowing rate so we’ve been borrowing at the discount window which is at 2.5%, so it’s just a little bit north of where the fed funds rate is. Federal Home Loan Bank advances would be generally a little bit below LIBOR rates, sometimes it could be a little bit above depending on the type of advance that you are doing and so they are probably a little bit higher than the discount window rates. You can go longer term with the Federal Home Loan Bank advance rates or advances so you could get longer term funding there were as the discount window you could do I think the max is a 90 day borrowing which is a variable rate borrowing, so you do have to turn those reserved window borrowings over in a regularly frequent basis but we still have lots of capacity there if you will be able to observe the further declines in the broker CDs which is down to $248 million.

How long are you going out with the Federal Home Loan Banking in this?

We will go out probably as far as three, four years. One thing we’ve also done is we’ve done three years where we have a call rate at the end of one year. We have to pay up a little bit more for that but it gives us a little bit more flexibility in the funding that we have in case rates come down even more. Jason a similar example to that would be our strategy with the callable brokerage CDs and then we hedge those with swaps. I mean that structure host us a little bit more but it gave us the ability when we first did it -- but it gave us the ability to do what we are doing right now which is to call them as rates have come down and not be saddled with a lot of term -- longer term funding. So we’ve always paid up probably a little more to give ourselves more flexibility in the structure of our liability base and that served us well in responding to changes in interest rates.

Okay. Giving that maybe able to continue to bring those brokerage CDs down I mean are you looking for more margin expansion in the second quarter?

I would say we are still -- our modeling would still suggest that we will benefit from lower short term interest rates, so that we would expect depending on what the fed does to still have some upside potential in the margin. The sort of the offset to that is the drag of the non-performers that I pointed out although that’s already in the margin, so as long as they don’t role a lot we still should see some benefit there. The other thing is depending on how much in loans are migrating. The non-approval if that slows or stays down, we won’t get that reversal of interest like we saw in this first quarter which would help the margin as well.

Okay and another question on the quarter quality; looking at that table in the press release that has the commercial loans broken out, when I combined in land, land development destruction and compare that to the previous quarter I notice it was down about $9.2 million. Obviously you didn’t had that much in charge offs in the quarter. I was just kind of curious to gives us some color as to what explain that the rest of that -- you did mention that you were able to get rid of a few things. Is that just keeping stock open?

Yeah, there was a couple of things in the first quarter; first of all we were able to sell one loan that was secured by land development and then also we were able to negotiate up here on another land development loan that was partially secured by mark over securities as well.

Okay.

So a couple of those things moving out did help us contribute to the decline.

Okay and I also noticed and this is just kind of ancillary, but I noticed that I also calculated the portion of those three categories that were non-watched still performing and the land category actually went up about $4 million and obviously the balance of outstanding loans didn’t change but what was performing went up and I was wondering if something moved from to watch list back to the performing non-watch.

Yes we did have one of the credits that additional collateral was provided and it moved back into the performing part of the portfolio.

Okay and my last question is, guess I was just hoping to get a little bit of color about the tax issue that was up in the benefit in the quarter. What would have -- why was that accrual reversed?

Oh you saw the same thing on Citizens Republic and my guess is it was the same item but it relates to a caps case that was held and or decided and whatever rates to -- there is something called a taper adjustment were you allocate some -- there is a calculation you have to do with allocating interest expense to tax exempt securities, and that renders that interest expense, not tax deductible and the case related to whether you do that constitution on a consolidated basis or an entity level basis and because what occurred there and the facts involved, it allowed us to release the reserve that we had previously established on that issue.

Okay, thank you.

At this time, as there are no further questions, would you like to make any closing remarks?

Thank you. With that this concludes our conference call today. Thank you for your interest in Independent Bank Corporation and we look forward to speaking with you again next quarter. For an archived webcast of today’s call, you can go to our website at www.ibcp.com under Investor Relations. This webcast will be archived on our website for approximately 90 days from the date of today’s call. Again, thank you and have a great day.