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Executives

Benjamin A. Smith III – Chairman & CEO

Jon Swets – SVP & CFO

Ronald L. Haan – EVP & Head of Lending

Philip J. Koning – President & CEO

Analysts

Eileen Rooney – Keefe, Bruyette & Woods

Jason Werner – Howe Barnes Investments

Stephen Geyen – Stifel Nicolaus and Company

Macatawa Bank Corporation, (MCBC) Q3 2008 Earnings Call Transcript October 21, 2008 10:00 AM ET

Operator

Good morning. My name is Josh and I'll be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Mr. Smith, you may begin your conference.

Ben Smith

Thank you, Josh. Good morning. My name is Ben Smith. I am Chairman and CEO of Macatawa Bank Corp. Thanks very much for joining us this morning for our third -- let's see our second quarter conference call. This is third quarter conference call. This morning, we have with us Phil Koning, who is President and CEO; Jon Swets, the CFO; and Ron Haan, who is Executive Vice President.

So this morning what we'll start with is Jon reviewing the actual numbers for the third quarter, and after that Phil will follow with some comments. After that, we'll open it up for questions and answers. Jon?

Jon Swets

Thank you, Ben. All right. I am going to touch on just a few topics regarding our third quarter earnings results. I know you are going to want to get to questions early, but there are just a few things I wanted to highlight.

First of all with the provision for loan losses. For the third quarter we had only $1.5 million in net charge-offs for the quarter. We did record a provision of $2.4 million. Our internal allowance for loan losses computation showed the need to do a little reserve building over and above the charge-offs, and so that's why the provision was slightly above the charge-off level.

Net interest margin, just wanted to touch on that, 2.98% for the quarter. On a linked quarter basis, it was down 8 basis points. Just to give a little more color on that, our yield on the total portfolio loans for the quarter was down 13 basis points. Our cost of funds in total was also down that same amount, 13 basis points, but our total yield on assets, not just the loan portfolio, but yield on assets was down 18 basis points. And really the difference between the yield on total assets and the yield on the portfolio loans was really due to adding more short-term marketable investments to the asset side of our balance sheet. And that's really what caused that additional decline in yield. We had some seasonal deposit in-flows that gave us some excess cash that we invested and kept short. And that offered certainly some benefits in terms of our liquidity ratios and thought it was prudent to stay short in those added investments given the seasonal nature of those deposit in-flows.

In previous quarters, we have also had a fair amount of influence by the non-performing asset portfolio on our net interest margin. This quarter there was very little influence on the margin by the non-performing asset activity. So we continue to have a stable underlying net interest margin despite, I guess, the excess liquidity that we had in the third quarter and also despite some pricing pressure we do experience on the funding side in both retail CDs and brokered CDs right now.

Just a couple comments about non-interest income. Total non-interest income was $4.1 million versus flat $4 million in the third quarter a year ago. Revenues from deposit services and debit card interchange income moved up for us. Deposit service fee revenues were up 6% on an annualized basis compared to the third quarter of the prior year. We are getting better penetration in our cash management services primarily to our business customers, and so that is having a positive impact on our deposit service revenues. Plus we do continue to grow numbers of deposit accounts, which I know Phil will touch on a little bit more later.

Our interchange income from debit card activities was up 20% compared to the third quarter of the prior year, and we continue to get better penetration with our existing deposit customers in their debit card usage. So these positive activities serve to offset decreases in the trust services revenue and gains on mortgage loan sales as discussed in the press release.

Non-interest expense, just wanted to point out a couple of things there. The press release talks about how the total was up $1.3 million versus the third quarter of the prior year. Salaries and benefits were up only 1% when you compare third quarter of last year to this year's third quarter. Most of the increase in non-interest expense was in other non-interest expense items which in total was up $1.1 million, all of which, and then some is tied to cost of administration and disposition of problem assets.

For the third quarter, we had ORE write-downs and losses on sales at $515,000, which was up $428,000 from the prior year third quarter. And then other administration and disposition costs amounted to $1.1 million, including $635,000 that related to one project. This was a one-time expense. We don't anticipate this expense to recur.

In prior quarters, I have also talked about our FDIC insurance levels. FDIC insurance was up $61,000 in this quarter compared to third quarter of the prior year, and again that relates mostly to just higher levels of non-performing loans.

Just a couple of brief comments on the loan portfolio and the change during the quarter in the loan portfolio. Total loans were up about $12 million for the quarter. Our commercial portfolio was about flat, finished and ended the quarter at about the same level. So our growth in loans came in the consumer area. Our consumer loans, HELOCs were up about $5 million for the quarter. And then residential retail mortgages were up about $7 million. Much of that growth was in jumbo mortgages which have proven to be a very healthy cross section of retail mortgages for us. Deposits, I touched on briefly in talking about margin. I know Phil will have some more comments on that. So I will turn that over to Phil.

Phil Koning

Thank you Jon. Given all of the concerns about the banking system these last few months, you can see we have taken some additional actions which we feel are prudent in this environment. We have used our increase in deposits to reduce our reliance on other borrowings, paying down Fed funds lines and the Federal home loan bank advances, preserving these sources of liquidity. And in addition, we have increased our liquid assets.

We have been pleased with the stability of our deposit base over the last few weeks and months. While we have been fielding questions about the bank, FDIC insurance and what's going on in the banking industry and on Wall Street, we have seen little attrition and actually have experienced net growth in both retail and business customers. So we are very happy about that.

Ben, I will turn it back to you.

Ben Smith

All right, at this time what we would like to do is throw it open for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) And at this time there are no questions in queue.

Ben Smith

Al right, is that --

Operator

Actually I do apologize; we did have some come in. The first one comes from Eileen Rooney, your line is open.

Eileen Rooney

Good morning, guys.

Ben Smith

Good morning.

Jon Swets

Good morning.

Eileen Rooney

I was wondering if you could just talk a little bit about the restatement that you had in second quarter? What changed since your last conference call?

Jon Swets

Well as far as the need for the restatement is concerned, we are continuously evaluating and re-evaluating valuations on our non-performing loans, the underlying collateral, and the most recent, very involved, very detailed valuation had indicated that we'd had more deterioration in values to the tune of, well as we announced, $15 million, actually $17 million in charge-offs we took. And in the process of identifying that number, the timeframe within which we identified that was too close to the end of the second quarter to suggest that those conditions didn't really truly exist at June 30. So we had to -- we really had to, as painful as it is, go back and restate those second quarter results.

And the hard part with this is valuations is a million dollar or $15 million question, however you want to state it. It is the underlying values in how you assess what value should be on this collateral changes rapidly. And based upon market conditions, what had happened during kind of the prime selling season throughout the summer, we are responding to what we are seeing, and felt the need to take the additional charge and to move it back into that second quarter.

Eileen Rooney

Okay, and have you reviewed the rest of the loan portfolio? Any of the performing construction related credits?

Jon Swets

Yes we have. Yes, very, very thoroughly. And that's a part of that valuation process every time.

Eileen Rooney

Okay and have you done reappraisals on those loans?

Jon Swets

On many of them, yes if not all of them. That's absolutely a very important part of the process, but you can imagine there too, I mean an appraisal that we received two and three months ago might be very different if we got it -- a new one today. And that's kind of the challenge that I am speaking to. The uncertainty about valuations is so immense, and the appraisals continue on a downward trend. And so, getting up-to-date valuation information is very, very challenging.

Eileen Rooney

Okay and where is your unallocated reserve stand now?

Jon Swets

We -- in our allowance computation we allocate all of it. There is no unallocated. We allocate -- we have got specific reserves on specific credits but then every other dollar of the allowance for loan losses is allocated either to the commercial portfolio that's not specifically reserved for in the mortgage and consumer portfolio.

Eileen Rooney

Okay, I guess yes and my question is what are your specific reserves?

Jon Swets

Okay. Our specific reserves as of June 30 or I am sorry September 30 were $12.2 million.

Eileen Rooney

Okay. And I am sorry this is my last question then, if you could talk a little bit about the watch list trends and 30 to 89 day past dues?

Ron Haan

Yes Eileen, its Ron Haan. Delinquencies really are holding pretty steady. We have not seen any real significant deterioration in delinquencies. Again, as we have talked about I think for the last several quarters, our problem is pretty well -- well it's clearly identified, okay and it's pretty well contained to those residential land developments. So, other than that, you know if you look our delinquencies -- consumer mortgage delinquencies continue to perform or the delinquencies are fine and the portfolio’s perform at levels that are acceptable to us. And the commercial side really -- actually commercial loan delinquencies went down just slightly during the quarter.

Eileen Rooney

Okay. Thank you, guys.

Operator

Our next question comes from Jason Werner. Your line is open.

Jason Werner

Good morning, Jason.

Ben Smith

Good morning, Jason.

Jon Swets

Good morning. I have also the question about the restatement. Obviously in your amended 10-K, you updated the non-accrual loans, non-performing assets and even though you did increase your charge-offs by $17 million, I think it was up to $20 million down number for the quarter, your NPAs only went down a couple of million. So obviously you moved a lot of things over also with this restatement. I just wanted to get some color, I mean looking at the breakdown of non-performing loans that you have in your press release, it looks like it's still mostly in the C&D portfolio. But can you just give us color as to what exactly moved over and also what was being charged off? Was it mostly C&D being charged off also?

Jon Swets

Yes, it was mostly loans to residential developers that were being charged off. And yes in the course of the restatement, as I described the process we went through earlier and we identified additional valuation shortfalls, that certainly also causes the need to move loans in the grading process as well. And move loans into that non-performing status if valuations are suggesting that that's what to do. So certainly, that non-performing loan number was also revised as more primarily residential developer loans moved into that category.

Jason Werner

Okay. Obviously you didn't restate your interest income for the quarter. So obviously, you didn't go back and reverse any interest as you move these things over, which suggest these things were still current during the second quarter. I am just curious, are these performing non-performers at this point or did they stop performing also?

Jon Swets

They were very -- well it's going, it depends case by case, but the assessment was made that they are truly non-performing, whether they were paying or not. The amount of interest reversals that took place on those balances were nominal. And so, yes that would suggest that at least they were relatively current at the time, but frankly based upon the valuations, that's irrelevant.

Jason Werner

Could you give us a broad look at your pool of NPAs? How much of those are actually still current? Is there any of those that are still current or since then have these things all gone delinquent?

Jon Swets

Of the total $87 million in non-performing loans at September 30, $20 million of it is less than 30 days past due; about $8 million of it is 30 to 89; and the remaining $59 million is 90 plus.

Jason Werner

Okay. Now looking at the change from the amended numbers for June and the press release, the amount of residential development loans that were non-performing only went up a little bit and is now a smaller piece of the non-performing -- it's still obviously the bulk of it, but a smaller piece. So it sounds like there is some other stuff that's kind of going to non-accrual. Can you kind of talk about that a little bit?

Jon Swets

Well the table in the press release does identify the stuff that's in non-performing. And yes, like commercial and industrial is a little higher now than it was in prior quarters, not a lot higher but a little higher. Our residential mortgage loans, our retail residential mortgage loans and consumer loans in the non-performing totals still remain quite low, slightly elevated level in residential mortgages as you compare it to year end last year. But, still relative level quite low. So I mean we did see a little creep in commercial and industrial, not much. And then we did see a little creep in the commercial real estate portfolio that doesn't relate to residential developers. That number amounted to approximately -- well it's $11.9 million in loans that are not residential developer-related in that commercial real estate number of $77.9 million.

Jason Werner

At this point -- I am sorry. I guess there's a little echo. At this point, is it too early to tell? Is there a trend forming here on that type of lending? Do you see that stuff continuing to get worse given Michigan's economy or is it just sort of a tail of it with that stuff?

Phil Koning

No I think we have -- again we are really not seeing any deterioration. I would characterize it more as we just kind of continue to work through it. The sales, lot sales during the summer months, we had hoped for a better sales environment, but that isn't to say that we aren't selling through them. Every month we do see sales, albeit a lot slower than what we would like to see. But again, I continue to feel like we have a pretty good handle on where our problems are and it is just a matter of continuing to work through these. I mean every month we are seeing some sales.

On the last quarter we did add really two larger loans, I guess to that non-performing list. But again, we weren't surprised by them. We knew they were out there. We just simply made the decision to move them to non-performing.

Jason Werner

Okay. Moving off the credit quality for a second here, I was kind of curious what you guys thought the impact of the Fed rate cuts would have on margins kind of going forward?

Jon Swets

We remained well balanced in our interest rate risk profile. The impact in the early quarters would be a short-term decrease, but then over the course of a full 12 months, we would expect to see that even out. We still anticipate that this last 50 basis point reduction won't have a material impact on margin over the next 12 months.

Jason Werner

How much room do you have on deposits there to kind of bring costs down?

Jon Swets

Well, yes, I mean that's a good question. There are definitely deposit categories where there's not as much room anymore, but there are still portions of the fixed rate portfolios that can re-price downward that will continue to benefit us.

Phil Koning

As well as some money market accounts and things of that nature. We'll try and balance those risks.

Jason Werner

What can you tell us about the levels of competition right now given what's happening both on loan side and deposit side?

Phil Koning

I will go first on the deposit side. You know everyone is trying to increase deposits. So it is still a competitive environment out there. CD rates are still fairly high. They have come down recently just a little bit with the Fed reduction. And we are trying to help lead those rates down, but it's still very competitive.

Ron Haan

On the lending side Jason, I guess I would characterize --we're open for business. We are supporting our customers that have credit needs. We are being very careful as we should be in this environment. And as Jon pointed out, we are really not seeing any growth but we are not seeing significant run off in that portfolio either.

As far as the competition, it really varies from between competitors. I think most are lending even though that's a difficult assessment to make. Some particularly with their exposure to real estate, okay, are interested in reducing that exposure.

Jason Werner

Are you seeing the ability to price better because --?

Ron Haan

No question about that. Yes, no question about that.

Jason Werner

Okay. I will step off and see if anybody else has any questions.

Operator

Our next question comes from Stephen Geyen. Your line is open sir.

Stephen Geyen – Stifel Nicolaus and Company

This is Stephen Geyen with Stifel Nicolaus. Good morning.

Ben Smith

Good morning, Steve.

Jon Swets

Good morning, Steve.

Stephen Geyen – Stifel Nicolaus and Company

Excuse me. Just a quick question on the -- Jon you mentioned that the yield on assets was down 18 basis points. And just wondering if you can walk me through the thought process of the deposit building and putting in lower yielding securities? Was that a market-driven decision, a desire to maintain liquidity, or was it more a decision to protect market share, deposit market share or what went into that thinking?

Jon Swets

Yes it was -- I would say that it was primarily driven by a sense for the importance of having strong liquidity in this, especially over the last month, month and a half as the media has created a tremendous amount of frenzy amongst the general public and depositors felt like it was very important for us to make sure we had appropriate levels of liquidity on our balance sheet. So that was, I think, probably the main driving force behind that decision.

Stephen Geyen – Stifel Nicolaus and Company

Okay. And non-performing loans, you were up about $10 million quarter to quarter or maybe you didn't -- even if you can kind of look back to Q2, were any of those loans that were moved over to non-performing, were they -- kind of what was the average size or what was the largest loan that was moved over?

Ron Haan

The largest loan was $10 million.

Stephen Geyen – Stifel Nicolaus and Company

Okay. And can you give a little more detail was that a -- that was a C&D I imagine, residential C&D?

Ron Haan

Yes.

Stephen Geyen – Stifel Nicolaus and Company

And can you give a little bit more detail about that loan? Was it primarily in the western part of Michigan or did you have some parts of that loan outside of Michigan?

Ron Haan

That particular loan there is a small part that's outside of Michigan.

Stephen Geyen – Stifel Nicolaus and Company

Okay. Thank you.

Operator

And at this time, there are no further questions in queue.

Ben Smith

All right, with that I would like to thank everyone for joining us today. It's a very difficult market out there not only in Michigan but in the world as it's an unusual time. A lot of our customers don't understand what's going on. They are asking us, is the whole system going to melt down? And I am not sure we are in much better position to answer it than they are themselves. But one thing we are focused on is we know that Macatawa's problems are focused in the loan situations, primarily the residential loan situations that we have. We are committed to resolving those issues. We are firm that we can. We actually believe we are seeing a little bit of light at the end of the tunnel. And that we are hopeful that at the next meeting we will be further along in that and can look forward to a quick return to profitability and a resumption of our dividends to our shareholders. Thank you again for joining us.

Operator

And at this time this concludes this morning's conference call. You may now disconnect.

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Source: Macatawa Bank Corporation. Q3 2008 Earnings Call Transcript
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