Citizens Republic Bancorp, Inc. Q3 2008 Earnings Call Transcript

Oct.17.08 | About: Citizens Republic (CRBC)

Citizens Republic Bancorp, Inc. (NASDAQ:PMCS)

Q3 2008 Earnings Call

October 17, 2008 10:00 am ET

Executives

Kristine D. Brenner – Director, Investor Relations

William R. Hartman – Chairman, President and Chief Executive Officer

Charles D. Christy – Chief Financial Officer

John D. Schwab – Chief Credit Officer

Martin E. Grunst - Treasurer

Analysts

John Pancari – J.P. Morgan

Terry Mcevoy – Oppenheimer Funds

Greg Keechon - Citigroup

Jason O’Donnell – Boenning & Scattergood

Eileen Rooney – KBW Inc.

Operator

Welcome to the Citizens Bancorp quarterly earnings call. (Operator Instructions) I would now like to turn the call over to Kristine Brenner, Director of Investor Relations.

Kristine D. Brenner

This call is being recorded and a telephone replay will be available through October 24. This call is also being simulcast live on our website, www.citizensbanking.com where it will be archived for 90 days.

With me today is Bill Hartman, Chairman, President and CEO; Charlie Christy, Chief Financial Officer; John Schwab, Chief Credit Officer and Marty Grunst, Treasurer. After management concludes their prepared remarks, we will open the line up for questions from research analysts.

Before we begin, I would like to point out that during today’s conference call statements will be made that are not historical fact. These forward-looking statements involve risks and uncertainties which include but are not limited to those discussed in the company’s filings with the SEC. Forward-looking statements are not guarantees of future performance and actual results could differ materially from those contained in the forward-looking information. These forward-looking statements reflect management’s judgment as of today and we expressly disclaim any obligation to update and/or revise information contained in these statements in the future.

Now I’d like to turn the call over to our CEO, Bill Hartman. Bill.

William R. Hartman

Thank you Kristine and good morning and thank all of you for joining our call today. This morning John and Charlie are going to review the credit and financial trends, so I’d like to focus my comments on why we believe we have the people, processes, capital, the liquidity, the strategies and the commitment to manage through this environment successfully.

We’re very focused on implementing the strategies and action plans necessary to win and not just survive. And we’re positioning ourselves to be a strong, regional financial services company that can take advantage of the opportunities that will be available the highly capitalized winners like ourselves.

Clearly, we are in unprecedented times within our industry. Record setting changes occurred during the quarter and volatility is now also at record levels. Much of the news seems to be more related to the large banks and investment banks. But it’s clear that the Midwest economy, specifically Michigan, has its own level of stress and ongoing challenges. As that relates to our third quarter earnings, we saw more economic decline during the quarter than we had anticipated last quarter as the recessionary environment in our markets continues to worsen.

The decline affected our portfolio in general and in particular, two large commercial real estate loans that were performing past credits last quarter deteriorated to the point where we’ve pushed them to non-performing status at quarter end and took adequate levels of specific reserves against them, consistent with our conservative methodology. This resulted in a loss of

$7.2 million. We do expect the economic impact on our portfolio next quarter to be at least similar to what we saw this quarter.

We are definitely in an economic downturn that we can’t control. Our short term earnings will be impacted by credit costs until the economic environment in our markets improves, which will be evidenced when charge alls decline and stabilize at more normalized levels. Fortunately, we are very well positioned and well prepared for this environment and I would like to spend a few minutes this morning covering our balance sheet position and our strategies for success.

First, I’d like to start with our strong balance sheet, capital liquidity and fundamental earnings power. While we can’t control our economic environment, we did anticipate it and issued

$200 million of new capital in June to insure that we would have more than adequate capital to get through the downturn and to be well positioned for profitable, long term growth. Our tier one capital position of 10.85% is one of the highest when compared to peers. And we remain well capitalized, even if we experience industry peak cumulative losses under a worse case scenario.

We further strengthened our balance sheet by increasing our loan loss reserve to 2.32% of portfolio loans through providing $36 million in excess of our charge-offs. We will continue to recognize deteriorating credit and maintain a strong reserve position to insure balance sheet strength and integrity. We do believe that our balance sheet is more conservatively stated than many of our peers, as we’ve earlier this year moved $128 million to held for sale status after being written down to fair value, isolating our riskiest assets.

Our liquidity position is also extremely strong, as we had $220.3 million dollars of parent company cash as of October 7, even after paying off $50 million of senior debt, giving us more than adequate long term liquidity. We enhanced our earnings this quarter in a number of ways, but first we did it to show investors our pre-tax, pre-provision earnings, which totaled over

$41 million for the third quarter.

This pre-tax, pre-provision profitability, which has been consistent over the past several quarters, represents strong fundamental earnings power that in conjunction with our strong capital, reserves, and liquidity positions gives us more than adequate resources to navigate this downturn.

In addition to our strong balance sheet, we have four primary strategies, all supported by tactical action plans that will enable us to optimize performance and improve our pre-tax, pre-provision earnings which is something we recognize we need to do.

Number one, of course, is credit quality. We have the people, the culture and the processes to manage credit quality well, and have added significant resources to our special loans division which now totals 28 people and also to our newly formed commercial real estate portfolio team, which now totals 22 people. That’s 50 people dedicated to these units that report directly to Chief Credit Officer John Schwab.

These units are focused on addressing credit quality where it has deteriorated or is most likely to deteriorate, isolating our riskiest assets, which also allows the rest of our company to focus on the execution of our four primary strategies. We are identifying problems and recognizing losses quickly, writing down assets to fair market value, and engaging in numerous initiatives to litigate losses which John will cover.

Our second primary strategy is to improve the profitability of our revenue. While we’ve always had a disciplined credit approval process, we’ve significantly increased the rigor and discipline around our loan pricing process. Our lending businesses target full relationships with deposit balances and other banking services. While we remain strongly committed to lending and to supporting our clients, we are focused on targets that meet our profitability objectives and return on capital objectives through deposit relationships and not just loan pricing.

We measure and reward our bankers through incentive plans, based on shareholder value added and their contributions to profitability. We’re also increasing the emphasis on fee income in all of our businesses.

Our third strategy is deposit generation. Our sales management models have improved the generation of checking and savings accounts and improved the accounts cross sold as we open new accounts. While we support our efforts through advertising, it’s primarily a sales and service oriented approach, based on retaining and expanding relationships. It’s resulted in four consecutive quarters of core deposit growth.

We think our deposit strength is not just a function of our sales and service efforts, but also a function of the faith that customers have in our company based on our strong capital and liquidity positions and our outstanding employees throughout the company. Market research and focus groups we’ve done show that our employees are viewed as giving better service than our competitors and we think this gives us a competitive advantage.

Our fourth primary strategy is cost management. Last quarter we announced a $15 million cost reduction initiative. We have implemented the action plans necessary to take a minimum of

$15 million out of 2009’s expense run rate. You can clearly see the results of our cost cutting efforts as our third quarter non-interest expenses, which included $2 million in severance expense, represented the lowest expense level in over five quarters.

Future expense reductions will be somewhat offset by OREO write downs based on real estate value declines and SDIC insurance costs based on the pricing increases and the new programs. At this point we don’t have a specific dollar estimate for those cost increases. We continue to build a culture of productivity, a culture of process improvement, and a culture of efficiency.

I’d now like to turn it over to John to review our credit quality results, trends and plans, and then Charlie will review the financials.

John D. Schwab

As we talk about the credit trend for Citizens, I will highlight those areas where we continue to see stress in our portfolios, as well as those areas that continue to perform well despite a challenging environment.

The distressed economic environment in our markets continues to stress our loan portfolios, particularly those collateralized by real estate. With the extended duration of the declining real estate values, severity dynamics accelerate. We have, therefore, continued to raise the level and broadened the spectrum of our credit risk management practices in order that we: A, be proactive in mitigating increasing risk and B, insure that the values of our real estate collateral and financial reporting of borrowers and guarantors are current.

While I believe our quarterly earnings release appropriately discloses credit quality trends, by loan type and areas of ongoing concern, I suggest we spend some of our time this morning adding some perspective and context to complement your analysis of the numbers.

Let’s start with commercial. Second quarter charge-offs were materially impacted by the mark down related to commercial and residential real estate assets moved into held for sale at discounted values. Third quarter commercial charge-offs of $15.2 million were again heavily concentrated in real estate, with $14.8 or 99% of the $15.2 million being commercial real estate. Nearly $10 million of the commercial real estate charge-offs are attributed to five loans.

The other $4.8 million in commercial real estate charge-offs were spread across over 20 borrowers, illustrating how broadly commercial real estate performance and collateral values have been impacted in our market. CNI charge-offs remain consistently low, reflecting, we believe, the conservative underwriting practices applied to this portfolio over the past five years. Net CNI charge-offs for the quarter were $417,000, an annualized charge-off rate of 56 basis points.

Another view of real estate as the heart of our credit quality challenge can be seen from the non-performing asset table under three in our release. Non-performing loans grew $92.1 million quarter over quarter with $85.4 million or 93% attributable to real estate, $57.6 million commercial real estate and $27.8 million residential. Of the $57.6 increase in commercial real estate non-performing loans, $38.2 million is related to two loans which in turn drove

$16 million of provision expense in the quarter to cover specific reserves established for these loans.

Parenthetically, I note that the larger of these two loans, a $28.3 million relationship exposure in Michigan would not have passed the 90 past due clock until early October but again, consistent with our pro-active risk recognition and disclosure philosophy and policy, we pushed the loan into non-performing in advance of the September 30 date recognizing the inevitable early.

While still on commercial and commercial real estate I believe there is lingering confusion among some about our disclosed watch list numbers, what they mean and what if anything they foretell. Commercial watch list loans at September 30 increased $74.2 million over the June quarter, all attributed to commercial real estate. Over the last six quarters commercial real estate watch dollars have remained relatively level, in the $550 million range.

Over the same previous six quarters, commercial real estate related charge-offs excluding the June 30, ’08 mark and held for sale exercise were an annual charge-off rate of 1.94%. This was an acquired portfolio, underwritten in prior periods to different underwriting standards and credit risk management practices from Citizens. I will come back to that thought in a few minutes when we discuss the commercial real estate portfolio management group with you.

Now back to watch. This time CNI. Underwritten over five years to Citizens underwriting guidelines and credit risk management practices, over those same six prior quarters CNI watch credits have averaged $380 million reaching $407 million at September 30, ’08. CNI charge-offs over those same six quarters beginning back in March of ’07 aggregated $4.9 million. That’s over six quarters for an annualized charge-off rate of 20 basis points.

One final observation on watch line oversight [inaudible]. Of the $343 million in CNI watch loans outstanding 18 months ago, at 3/31/07, $7 million or 2% has been charged-off, 10% or

$35 million is now non-performing, and $165 million or almost 50% has been paid or upgraded to pass status. And $135 million or approximately 40% remains on accruing watch.

Over a similar period of time from 2007, commercial real estate watch loans have performed differently; 15% were charged-off or written to held for sale, 7% is now non-performing, 37% has been paid or upgraded and 40% still on accruing watch. There are several important points here. The percent of watch remaining on the watch list over six quarters is fairly consistent. 40% of charge-offs and repayment patterns vary significantly by product type. Watch list loans do not have a strong correlation to future charge-offs and performance will vary by line of business and strength of original underwriting.

As we have said previously, watch is simply our credit risk management practice which steps up the level of scrutiny, consistency, and early. Noise on the commercial real estate portfolio is being handled similarly and it’s challenges in our economic environment and the related impact on real estate collateral values.

A stronger leading indicator of future loan challenges, non-performings and potential charges is delinquency patterns over time. Coupled with an understanding of the credit risk management practices and organization utilizes to work delinquencies. Review of those rates over the past five quarters as disclosed in our release underline the appropriate focus on commercial real estate.

Earlier in my remarks today, I made reference to raising the bar and broadening the spectrum of credit risk management practices as real estate values in our markets are under stress. We note that all new business underwriting and credit approval activity post acquisition has been in compliance with Citizens more conservative underwriting practices. However, the acquired commercial real estate portfolio had been a model of hunters and skinners with both roles reporting into the commercial real estate markets rather than into credit.

By mid-2007, we implemented a quarterly review of pass. That means non-rated commercial real estate credits. By using a template of information, populated by market sales FTE and their support staff of portfolio managers based on information available to them from the client base, these initial deep dive efforts were frustrated by material turnover in both the hunter and skinner FTE base, not surprising in a post-merger environment.

We continued this process into early 2008 at which time we concluded it would be more consistent and appropriate as we suggested last quarter to put in place a more regimented commercial real estate management function, staffed by experienced commercial real estate bankers reporting to the Chief Credit Officer through one of our highly qualified and trusted Senior Credit Officers with deep experience in commercial real estate lending. This group, now comprised of 22 FTE is managing the commercial real estate portfolio pro-actively and consistently.

As a result, I am quite frankly becoming significantly more confident in the timeliness and accuracy of the information flowing to us on this portfolio. It is significant to note that material increases in the third quarter moves to commercial real estate watch and transfers to our special loans work out group have been driven by this portfolio management group. I emphasize our intent here.

The commercial real estate market in Michigan and Ohio is challenged by the economic environment which we cannot control. What we can control is the early recognition of deteriorating situations and implementation of pro-active risk mitigation practices, and this is what we have been doing and will continue to do so.

Our small business portfolio is a sub-grouping within CNI and includes aggregate credit exposures up to $750,000 and excludes any non-vanilla commercial loans and any commercial real estate loans in excess of $150,000. Approval is on a Fair Isaac scoring platform. Pricing varies according to score tier. And any collection activity is managed by our small business consumer collection unit in Saginaw.

Charge-offs on this portfolio are 50 basis points year-to-date versus 35 basis points for all of 2007 and non-performers at 1.77% versus 1.12% a year ago. Limited market decision and pricing in override authority were eliminated earlier this year. We consider this business without material issues.

Now we’ve spent a significant time going through the portfolios, however we fell it is important for you to understand both where we are and what we’re doing about it, particularly in commercial real estate.

The other portion of the real estate portfolio experiencing stress is residential mortgage. In the quarter, non-performers increased 27.8 million quarter over quarter. Taken in the context, however, of the lower reported NPL number in the second quarter reflected the impact of mark downs on the held for sale transfer. Nearly $5 million of the increase is comprised of a few large, adjustable rate mortgages which are being aggressively managed.

Also relevant are the changes in collection practices as a result of transitioning our servicing to PHH Mortgage. Conversion to that platform drove a near term increase in our reported residential non-performing loans. As PHH works through this portfolio, we believe we will see a more consistent trend after November, due to their enhanced collection practices. We are pleased with the enhanced drill down reporting platform PHH provides us and we are confident this partnership will have a positive impact in the longer term on early collection efforts and risk mitigation.

Residential portfolio lending has been structurally tightened, leading to the $165 million portfolio reduction year-to-date. We do no sub-prime and our average refreshed FICO score is 692, in line with the national average.

In the direct consumer portfolio, which is largely home equity loans and lines, the delinquency rates have remained stable, representing 1.32% in the 30 to 89 day bucket at September 30. FICO scores for newly booked home equity loans and lines remain firm at 745, while refreshed scores on the entire home equity portfolio have slipped slightly, 14 basis points to 725 since the third quarter a year ago.

Charge-offs in this portfolio have remained relatively constant year-to-date, averaging $3 million or 80 basis points per quarter. As we mentioned in the release, underwriting has been tightened as well.

The indirect portfolio, mainly marine and RV paper, has historically carried delinquency levels slightly higher than direct, as remains seasonably stable at 1.61% at quarter end. Charge-off levels and non-performings remain fairly constant, indicating stability despite the challenge the economic environment presents. Indirect auto paper is less than 1.5% of indirect outstanding. In light of the tightened credit controls and pricing we expect to see runoff in the overall $843 million indirect portfolio.

In closing, Citizens credit quality challenges continue to be focused in the real estate collateralized portfolio, commercial and residential. We believe the shift to PHH servicing platform and implementation of a credit driven commercial real estate monitoring function have upgraded our credit risk managed practices commensurate with continued pressure the external economic environment bears on these portfolios. Our capital raise affords us the flexibility to deal with this challenging market, and we are committed to maintaining sound reserve levels.

From a credit risk management perspective, everything we do here is being pro-active and much out front as possible in this challenging environment.

Charles D. Christy

John has done a great job, particularly in key factors underlining our credit issues and portions of our loan portfolio that continues to show stress and the portions that continue to perform very well in challenging economic period. What I want to do today is focus on the top line portion of our financials that continue to show strength and consistency.

Moving on to the key financial highlights for the quarter, our net loss for the quarter was

$7.2 million which equates to an EPS loss of $0.07 per diluted share and a negative ROA of 0.22% and a negative ROE of 1.84%, all which were driven by continued credit issues and hyper-vision expenses. Our pre-tax, pre-provision results continue to remain very solid and consistent.

From balance sheet perspective, and on an end-of-period basis, total loans were down by

$71 million from the second quarter but were up $159 million in the third quarter a year ago. The majority of the decrease in the second quarter was driven by real estate portfolios, as commercial real estate was down $31 million and residential real estate was down $29 million.

CNI loans remain relatively flat as compared to the second quarter while these loans are up

$468 million or 21% from the third quarter of 2007. Consumer loans continued to show a lack of demand except for the seasonal increase in direct.

We still continue to see good customer demand across all of our markets for CNI loans and very select commercial real estate loans. As we have noted before, we stopped lending in the residential real estate development space back in January, 2007. Any new commercial real estate is specifically an income producing and an owner occupied CRE. We are also seeing more rational pricing in commercial loans in all of our markets, as other banks are now recognizing the need to increase spread.

Total deposits were up $345 million from the second quarter primarily driven by an increase of 337 in time deposits and an increase in core deposits of 8 million. Increases in deposits were accomplished by action plans that focused on driving household retention and expansion, stealing market share and gaining deeper share of wallets through an increased focus on cross sales and targeted marketing campaigns in the retail delivery channels.

And most importantly we have trained and will continue to train all of our branches to be experts in FDIC insurance programs available to all of our clients. We even test our branches by mystery shopping them on the details.

We added a new section in our earnings release that highlights our capital liquidity. Our intent is to highlight the strategies we began to implement early in 2008 and to show their results and impact on our capital position and liquidity. These strategies have clearly put us in the solid position to withstand these turbulent times and volatile markets.

To highlight a few strategies, Bill noted the new incentive plans in the June capital raise. Additionally we suspended our dividends, which was a tough choice at the time, but it saves

$88 million a year. And we’ve created a bank-wide process that focuses on pricing that helps us reserve capital, which enhances returns on list adjusted capital, emphasizes full relationship banking, and is reducing capital intensive credit only business.

As a result, our tier one capitals were the highest amongst our peers at 1085, and is $492 million above well capitalized minimums. Our total capital at the end of the quarter was 13.1% while our tangible common equity was 7.33%.

From a funding base perspective, we recognized early in the year that reliance on the secondary market may become troublesome as has happened before back in the 1980’s. In addition to the deposit strategies that I just mentioned, we began to take action in order to strengthen our balance sheet and to reduce our reliance on short-term funding.

We added a number of brokered CD’s with terms between one to four years put the necessary actions and increased our available collateral for FHLV funding and as I noted before we created a bank-wide process on pricing and funding that aligns the changes in loan outstandings with funding liquidity and profitability objectives.

As a result of these initiatives, we have a solid core deposit base, currently maintain high levels of untapped liquidity, paid down the majority of our short-term funding and are now in a Fed fund sell position. As for our parent company cash resources, we have $220 million of cash resources and no maturing debt in three years. The parent company’s annual fixed expenses are approximately $20 million per year. Do the math. Our parent company clearly has adequate long-term liquidity.

Another section earnings release that highlights pre-tax, pre-provision operating earnings, our intent is to provide investors with the ability to better understand Citizens underlying core operating trends separate from the direct effects of the credit issues. The table included our earnings release displays a consistent operating earnings trend before the impact of credit and taxes. It should be noted that the table reconciles pre-tax, pre-provision operating earnings that consolidate a net income or loss, presented in accordance with GAAP.

During third quarter 2008, our pre-tax, pre-provision operating earnings was $41 million, up

$2.2 million from the second quarter. For the past four quarters our pre-tax pre-provision operating earnings were over $165 million. In comparison our provision for loan losses for the four quarters was equal to $169 million.

Many investors ask us the question whether or not we raised enough capital back in June. When you look at the past four quarters and compare our pre-tax, pre-provision operating earnings against the amount of provision for loan loss, it clearly shows that we generate enough solid top line earnings at a level that has handled the credit issues we have seen for the past four quarters.

If the economy continues to drive more credit issues over the next three years, equal to or even above peak industry cumulative loss levels, the amount of capital raised in June added to our beginning tier one capital level where the ratio was at 9.04% at the time, along with our pre-tax, pre-provision operating earnings, more than offsets the potential losses to the point where we still have capital significantly above regulatory minimums for well capitalized banks at the end of those three years.

Net interest income was relatively flat from the second quarter. Our net interest margin was slightly down by 2 basis points to 3.09%. We saw a benefit from wider loan spreads and improved low cost deposit trends. Deposit price competition within our markets continues to be fierce, with a couple outliers pricing CD’s in excess of broker levels. We continue to be competitive in our deposit pricing but do not chase the outliers.

Other components that impacted our top line revenue was the transition of loans to non-performing status and the cost of terming down our short-term funding. Looking forward to the fourth quarter we anticipate net interest income will be slightly lower than the third quarter due to potential lower earning asset levels and continued migration of certain loans to non-performing status.

As noted by John, total charge-offs were $22.4 million while our provision for loan loss was

$58.4 million. Consumer net charge-offs, which include residential mortgage, home equity, direct consumer and indirect consumer loans continued to show consistency in the range of $7 to $8 million per quarter, not including the credit write down in the second quarter.

CNI net charge-offs also continued to show consistency of less than $1 million per quarter. Commercial real estate charge-offs is where we see the majority and volatility of our credit issues, ranging from $10 to $40 million per quarter.

Provision for loan loss at $58.4 million was $36 million more than net charge-offs. The key drivers for the additional provision included $16 million in separate reserves related to two CRE loans, $11 million in specific reserves as a result of the $107 million in downgrades from the commercial real estate portfolio management team, approximately $4 million from historical loss migration models and increases in the qualitative portion of our loan loss reserve.

As we noted in our earnings release, it has become very difficult to give a narrow range of qualitative guidance for net charge-offs and resulting provision expense due to the uncertainties in the Midwest economy, continued downturn in real estate markets and the volatility we now see in borrower capacities. For the fourth quarter we anticipate the net charge-offs provision for loan losses will be equal to or higher than the third quarter. All this of course depends on the level of migration to non-performing status of our loan portfolio and the continued challenges from the economic trends of our markets.

Net interest income for the quarter was $28 million, an increase of $0.09 million or 3.5% from the second quarter. Service charges, trust fees, and mortgage fees remained relatively consistent to the second quarter while brokerage was down due to lower demand. All other fees remained relatively consistent with the previous quarters.

For the fourth quarter we anticipate total amount interest income will be lower than the third quarter of 2008 due to lower trust and brokerage fees as a result of the volatile investment market conditions and lower origination fees for mortgage. Non-interest expense for the quarter was

$74.3 million or $3.8 million less than the second quarter, a total of $261 million adjusted for two items taken in the second quarter, $178 million good will impairment charge and the

$5 million net loss taken as part of the credit write-down on REO properties.

Salaries and employee benefits included $2 million in severance costs which were related to the initiatives to drive an additional $15 million in savings announced last quarter. We do not expect to have as high a severance amount in the fourth quarter.

Professional fees were down $1.3 million. Other expenses were down $1.8 and other loan expenses were down $1.7. All other expenses remained relatively flat as compared to previous quarters.

For the fourth quarter we anticipate that our NIE will be consistent with the third quarter as increases in FDIC premiums are expected to offset current cost savings initiatives. Back to you Bill.

William R. Hartman

Thanks Charlie for a thorough report. One of the challenges that we’re facing in the current economic climate is the uncertainty around the length and depth of the recession we’re in. Uncertainty calls for a stronger capital position which we are fortunate and pleased to have. We’re also pleased with the strong steps that our government is taking by implementing programs to stabilize the economy, improve liquidity, and provide relief to the financial services industry. We’re evaluating those programs closely and we’ll determine if it is beneficial to our shareholders to participate in them.

At this juncture the criteria and procedures to participate in these programs have not yet been defined by the governing agencies. So we’re unable to speculate on what our participation might be or what the impact our participation might have would be.

Regardless of whether or how we may participate, based on our strong capital position, our strong reserves, our strong liquidity and pre-tax, pre-provision earnings in addition to the effective implementation of the four primary strategies I commented on, we believe that we will successfully emerge from the downturn position to ultimately grow profitably and to increase shareholder value. We believe we’ve got a very good understanding of our challenges. We’ve been addressing them aggressively and we’re fully prepared to take whatever further actions are necessary.

Those are our comments that we have today. At this point we would like to open it up to the analysts for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Pancari – J.P. Morgan.

John Pancari – J.P. Morgan

Just one question on your funding. I know you indicated you took some out of liquidity steps in efforts to shore up funding and also you will probably need to participate in the non-interest bearing, you know the list of limitations on insurance for non-interest bearing deposits but can you talk about any movement you’ve seen in your CD’s or your public funds and what type of efforts you’re doing around that side of the deposit base?

Martin E. Grunst

I think we talked about some of the marketing programs that we’ve had going for quite a while. We’re consistently in the paper with CD specials that are right in line with the rest of the market and if you look at each of the consumer business and public funds arenas, we’ve been pretty consistent in all of those areas over the last several months that it’s been interesting to monitor.

John Pancari – J.P. Morgan

So you haven’t seen much movement in terms of your public funds deposits?

Martin E. Grunst

Yes.

John Pancari – J.P. Morgan

Have you been evaluating bulk sales of MPA’s? John if you could just talk about that a little bit in terms of if you see the opportunity to and if so have you seen any public costs in terms of some of the write downs taken on the sales?

John D. Schwab

We are not pursuing, John, any bulk sales in the near term here. In testing where the market may be, there are some what I would call true bottom feeders that are out there, but we do not think it is in the best interests of our shareholders to move precipitously in a bulk sale right now.

Charles D. Christy

Bulk sales, if you think about it, create that auction you’ve got a middle person who trades all kinds of additional fees and so on. We have found that we do better by dealing one on one, finding buyers that are looking for that property for its intended use or some other use. And we don’t have a whole lot of movement. We are having movement there, but the auction would be really passing on to two other different parties lots of discounts which we don’t feel is appropriate.

Martin E. Grunst

I think John that I’ll add here the strategy that we are attempting to pursue here is to attempt to work with some of the original investors and principals and guarantors behind some of these projects. They liked the real estate at the outset, and at some price they like the real estate longer term. It’s just a question of how much more equity they may be able to put into the project to make it work, to hold it. And that’s the avenue that we are pursuing.

John Pancari – J.P. Morgan

I guess what I’m a little worried about, in certain markets let’s say in Florida or California where population growth is still pretty active and they can expect an ultimate resumption of that economic activity to support the value of real estate, but in Michigan clearly where you’re seeing a structural change in auto and out migration of population certain markets, I’m concerned just around the how quickly you can see a resumption in activity and demand for those properties, and that’s why I’m asking is make more sense, to get more decisive in terms of a measured move to get these things off the balance sheet.

John D. Schwab

This is going to take some time, and we have decided we are not going to be precipitous, which I don’t think is in the best interest of our shareholders. Yes we live in a very difficult economic environment, but appropriately marked and held for sale and discounted and maintaining our appraisals current, I think we are just going to slug through this a month at a time.

Operator

Your next question comes from Terry Mcevoy – Oppenheimer Funds.

Terry Mcevoy – Oppenheimer Funds

Hey John when do you think CNI is really going to be an issue? It just seems like Michigan has been a challenge for a while in terms of the economy, the CNI portfolio has been very stable. I guess what needs to happen in order for charge-offs to increase and for that to be an area of concern? Because it clearly hasn’t.

John D. Schwab

Well I think the longer we stay in the dumper here, Terry, there will undoubtedly be some impact in the CNI portfolio. If you look at the tables in the release and see the movements in the delinquencies and the non-performings in CNI, that may be an early indication.

Now if we go back a few years, understanding that this CNI portfolio has been underwritten to our underwriting standards and we’ve got receivables, inventory and collateral that we can liquidate through fairly quickly, we’re not going to see even if and when a significant increase in CNI problem credits occurs, we’re not going to see the level of losses that we have in the real estate portfolio.

And in fact I’d be happy to share a copy of our underwriting guidelines with you, Terry. They were basically written and guidance being as we underwrite new CNI loans as if we were in a recession to begin with.

Will there be an increase in CNIs? Depends.

Terry Mcevoy – Oppenheimer Funds

And Bill I think the First Bank in Michigan failed last week or the week before and the consensus is more will follow. Any interest in acquiring a failed institution in terms of the deposits? Does that make sense?

William R. Hartman

Yes. Good question, Terry, and I think under the right circumstances it definitely would. Number one, we’ve got the infrastructure, the systems, the processes, the people, the capacity to take one on. I think what we would be looking for is pricing and economics. In other words, we would want to make sure that the deposit composition, and the deposit pricing, and the price at which we would have to pay would result in it being a strongly accretive to our shareholders. But if we found that kind of an opportunity, which we think it is very possible, we are very open to that.

Charles D. Christy

I’ll add one more thing to that. I spent some time in Texas back in the early ‘90s and I went through the RTC process back then. And one thing I learned back then is the troubled organizations end up having a lot of hot money and a lot of high rate deposits that basically run very fast. You could have basically run off as much as 80% of your deposits back in the old RTC days.

And so as these come up and as we give, actually been asked to look at these ahead of time, if it’s very hot money you’re just buying infrastructure and people and you’re not going to get a whole lot. So you’ve got to be very selective and you’ve got to be patient and make sure it’s prudent for the shareholder.

Terry Mcevoy – Oppenheimer Funds

One of the rationale or reasons behind the Republic acquisition was to accelerate the move into southeast Michigan, Oakland County, etc. Could you just comment about just balance sheet trends in that market in the third quarter?

Charles D. Christy

Yes. Basically we had good growth in that market from before we purchased and then we went from 16 branches to 37 branches within that marketplace. And we’re seeing good deposit growth and we’re seeing very good loan growth, and from strong borrowers. The key that John always says is he’s not a collateral lender, he is a borrower lender. And he looks at the capacity of the borrowers and he looks at the equity in cash not just at the collateral. It’s a piece of it but it’s not all of it.

So we’re finding that that market is still very strong in a lot of different sectors and we’re finding that the balance sheet there is probably our best growing balance sheet. But we have that a little bit in check right now as we’re being prudent as to how we fund, reserve capital and maintain liquidity.

William R. Hartman

I’m pleased with some of the progress we’re making in deposit generation in southeast Michigan. Republic had some very good branch locations in southeast Michigan which complement our locations very nicely. And what we’ve done, as we’re applying our sales management and sales operating model techniques to those branches, we are seeing some lift. In the last quarter in particular we saw some good deposit generation there. So I think that that’s definitely going to pay off as an improved deposit funding source.

Operator

Your next question comes from Greg [Keechon] – Citigroup.

Greg Keechon – Citigroup

Just a couple of questions, one regarding TARP and I know you had discussed very early in analyzing the program. There’s still details that our coming out. But maybe just to get some color on how you might think about it. Your capital ratios are already pretty strong, but based on a couple conversations in earnings calls of banks over the last couple of days, it’s ranged anywhere from they’re still setting it to we definitely are going to participate in it.

Is there any color you can provide along those lines in terms of how you would think about it? Whether your capital ratios would, in your view, be sufficient enough where you may not want to participate in it? Or whether there’s any eligibility issues?

William R. Hartman

I think that obviously as I said earlier we’re very pleased that the government has come out with these programs and I do definitely think that it will be helpful to the economy and helpful to the industry. At this point I’ll answer your question just like Charlie and I answered Jerry’s question about whether we would take on a failed institution. And that is it’s all going to be based on the shareholder value that it would add to us. So what we’re planning to do is as the agencies further define the criteria and procedures, we’re going to do economic modeling.

And we’re going to look at what would be the return on capital we could get, how could we deploy the capital in TARP, what’s going to be the impact of that? And if we can use these programs in a way that is very shareholder friendly and would accelerate our earnings and return on capital, then we’re going to be very interested in looking at how we do it.

But as you correctly indicated in your comments earlier, we’re in the very fortunate and luxurious position of having a very strong and capital liquidity position right now. So it’s not something we need to rush out and do simply because we need more capital. We really don’t.

Greg Keechon – Citigroup

And on the asset side of TARP have you heard anything? I mean what we heard yesterday in one of the earnings calls was a request that had been sent in to the bank where they listed assets they would like to see eligible in that program and it was commercial real estate, maybe some CNI, definitely residential. Have you had any correspondence along those lines you can discuss at this point?

William R. Hartman

Just to clarify is this on where we’re selling the assets to them?

Greg Keechon – Citigroup

Yes this would be the asset side of TARP, right.

William R. Hartman

So this would be the phase two which is because the first tranch is obviously the recap piece. You know there really hasn’t been a whole lot of definition. We are talking to the right people today and they’re still working through it. That one I think is going to take a lot more work define and that’s probably why it’s in the second tranch.

Greg Keechon – Citigroup

Do you think there’s a chance they take construction loans through that program?

William R. Hartman

I don’t know. We’ll have to see. I think they intend to deal with real estate first and it might trickle to CNI. But I think there’s some flexibility in Mr. Paulson’s ability to make some changes to that.

Greg Keechon – Citigroup

Just a question regarding holding company liquidity. You had noted it’s very strong. Was that on a stand alone basis or can you comment on the bank dividend upstreaming to the holding company? Because I know with the goodwill impairment certainly not all of that hit the bank, more of that hit the holding company in the last quarter. But with this quarter’s losses is there any concern about the ability to continue to upstream in that dividend?

Martin E. Grunst

Yes. The upstream capability will be a fairly small number for the next couple quarters which is why it’s important to see that we’ve got nine years worth of fixed charge coverage in the cash that’s already sitting in the holding company.

Greg Keechon – Citigroup

Okay. So it’s nine years coverage?

Martin E. Grunst

Yes.

Greg Keechon – Citigroup

Ex the dividend?

Martin E. Grunst

Right.

Operator

Your next question comes from Jason [O’Donnell] – Boenning & Scattergood.

Jason O’Donnell – Boenning & Scattergood

Can you just give us a better sense of the size of your largest commercial non-performers at quarter end? I assume the $28.3 million piece that John referenced, the CRE is the largest piece there?

John D. Schwab

It is. I can say that that was the largest one in there. We have – looking back at what has come into that portfolio non-performing since the end of June, the next largest is the second asset on which we took the specific reserve, which just happens to be a family of mobile home parks in Indiana. The issue there is they’re not fully occupied. And then it drops down into the $5, $3, $2, $1 million range. Granularity kind of increases fairly quickly.

Jason O’Donnell – Boenning & Scattergood

On the 30 to 89 day delinquencies you referenced that over, this is in the release that over 40% of the increase in delinquencies presumably relative to the prior quarter is due to administrative and renewal issues. Is that typical?

John D. Schwab

That’s an excellent question, Jason. It really gets back to the culture of the organization. And we as an organization have been, we’re a lot better in terms of staying on top of our customers and getting maturity issues fixed. And that has been very high on my radar screen.

So those things, once they get on the delinquency page, we are attacking that with a vengeance so that we don’t have something slip into a non-performing status simply because we haven’t gotten out and gotten a note signed. So those are what I just call administrative. A large, large majority of them do not have embedded credit issues.

Jason O’Donnell – Boenning & Scattergood

And then finally just on the expense page, just looking out here accounting for the cost reduction program and you’ve got increases in FDIC insurance expense, is the current level a good run rate in terms of looking out over the next couple of quarters?

Charles D. Christy

I would say that there’s going to be a little range up and down because of timing of different things in different quarters. And you can kind of see how that’s done. Like normally our first quarter of the year is usually our highest expense year and then it trends down a little bit as you go through that. And you can kind of look back and see how that’s kind of worked. But yes it is. Again and granted we’re still waiting to see how all the FDIC programs will impact us.

But the $15 million that we put in place, the cost savings is going to be spread out over between really this past quarter and into probably middle of next year. And we would anticipate though that we would continue to have some growth in ORE expenses and probably some increased advertising and continue to try to chase and steal market share for deposits. And then the third piece that would offset that $15 million would be the FDIC. So we hope to at least maintain flat or down. We’re going to continue to find ways to do that. And we’ve done that, really, for the last couple years.

Operator

Your next question comes from Eileen Rooney – KBW Inc.

Eileen Rooney – KBW Inc.

I apologize if you already went over this, but the two large commercial real estate credits that went on to non-performing. Were they the ones that we talked about last quarter? The Traverse City hotel and another building in Cleveland?

Martin E. Grunst

No.

Eileen Rooney – KBW Inc.

And what are the status of those two?

Martin E. Grunst

We are in under forbearance on both of them and working through. We have fresh appraisals and we believe that reserves are adequate. The two that we pushed this quarter, one is a large, actually it’s two student housing apartment buildings in East Lansing. The principal has a couple of other retail strips there which we pushed into non-performing together with those two notes. And we’ve set a very aggressive reserve based on appraisals on file and a discount to those.

The mobile home properties in Indiana are, well there are three of them, and they are not fully occupied, cash flow is negative. That one came a little bit, annoyed me, because he’d been normally paying about 60 days past due and then just the third week in September said I’m headed back to the Middle East, here are the deeds-of-lieu. We’ve reserved specific lay on both of them, again consistent with our philosophy and policy.

Eileen Rooney – KBW Inc.

And then jumping over to the margin, I was just wondering with the borrowings you paid down last quarter and doing more of the long term CD funding, I was just wondering what that did to your interest rate sensitivity?

William R. Hartman

Eileen, we basically hedged all the re-pricing frequency stuff so it’s back to what it was at the end of June basically. So it didn’t have a material impact.

Eileen Rooney – KBW Inc.

And what impact do you anticipate from the most recent Fed move?

William R. Hartman

You know there’s two things that are driving what will occur in the margin in the fourth quarter. Number one, we’re a net receiver of Libor, got a lot more receive Libor than pay Libor, so the Libor dislocation can be a positive for us. And the loan pricing environment should be a small positive.

And then with the rate cut, kind of depends on how quickly the Fed rate cut flows into the deposit, the non-maturity deposit pricing. I anticipate that that will be a little bit slower than it normally would be and I think that all nets out to a very small amount of pressure on the margin for the fourth quarter.

Eileen Rooney – KBW Inc.

With your focus on maintaining capital and liquidity, just wanted to get your thoughts on the preferred dividend?

Charles D. Christy

The one that we did the $150 million, 7 ½ coupon? That one?

Martin E. Grunst

Yes.

Charles D. Christy

That would be, we have no plans at this time to defer that at all. We have more than enough capital in cash.

Martin E. Grunst

The holding company cash position has nine years worth of interest expense sitting there today, so that’s simply not an issue.

Operator

And those are all the questions that we have in queue today.

William R. Hartman

Okay. Well I’d like to thank you all very much for joining the call and as always feel free to call us at any time with any questions or anything we can do to help you understand our company. Thanks very much. I hope you all have a great weekend.

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