Provident Bankshares Corporation Q3 2008 (Qtr End 9/30/08) Earnings Call Transcript

Provident Bankshares Corporation (PBKS)

Q3 2009 Earnings Call

October 27, 2008 2:00 pm ET

Executives

Gary N. Geisel - Chairman of the Board, Chief Executive Officer

Dennis A. Starliper - Chief Financial Officer, Executive Vice President

Kevin G. Byrnes - President, Chief Operating Officer, Director

Kenneth J. Waldych - Executive Vice President - Credit Administration of Provident Bank

[Larry Byer] - Managing Director and Treasurer

Analysts

John Pancari – JP Morgan

Jennifer Demba – Suntrust Robinson Humphrey

Presentation

Operator

Welcome to the Q3 2008 Provident Bankshares Corporation earnings conference call. My name is Sandy and I’ll be your coordinator for today. At this time all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of today’s conference. (Operator Instructions) Thank you for joining Provident Bankshares third quarter earnings teleconference.

With respect to any statements made today that are not historical facts are forward-looking statements. Please review the language at the end of the press release regarding forward-looking statements as the same information applies to the comments made on today’s teleconference. In the event that any non-GAAP financial information as described in this afternoon’s teleconference is disclosed, please review the press release and supplemental financial statements published on Provident’s website for the GAAP reconciliation for this information.

With us today is Chairman and Chief Executive Officer Gary Geisel, President and Chief Operating Officer Kevin Byrnes, Chief Financial Officer Dennis Starliper, Chief Credit Officer Ken Waldych, and Managing Director and Treasurer [Larry Byer]. At this time I’d like to turn the call over to Chairman Geisel.

Gary N. Geisel

On today’s call we will provide you the details around the results for the third quarter. But before I turn the call over to Dennis for his analysis of our financial performance, I will discuss the major highlights of the quarter.

We recorded a net loss of $5.4 million or $0.21 per diluted share in the third quarter. That loss was attributable to a $24.6 million pretax noncash charge for other than temporary impairment of certain investment securities. Dennis will provide more details on the particular securities later in the call.

Clearly we are disappointed that the negative trends in the securities portfolio continue to significantly affect our bottom line. While for the most part the cash flows from these securities continue to perform according to expectations, accounting rules require that we reduce their carrying value. This underscores the importance of the proactive efforts that we took earlier in the year to raise capital when conditions were more favorable so that we could absorb additional losses without having a material impact on the health of the bank. This is precisely the position we are in.

Despite the $24 million write-down this quarter we continue to be well above the well-capitalized guidelines. In fact our current capital position provides a cushion of $117 million beyond well-capitalized guidelines.

Now aside from the securities portfolio the core banking operations have remained steady despite the turmoil in the financial market. We worked hard to proactively communicate with our customers so that they understand that Provident continues to be a well-capitalized bank that they can rely upon to serve all their financial needs. Our participation in the CDARS program has been particularly helpful in allowing us to work with larger CD depositors to increase their FDIC insurance coverage without seeing the deposit balances leave our balance sheet.

We have not experienced any meaningful impact on our deposit base from the turmoil in the financial markets and our overall core deposit balances are tracking very close to our plans.

While the regional markets continue to be on a relative basis healthy, the prevailing economic headwinds are clearly resulting in a lower level of profitability for the core bank operations. The weaker economic conditions are affecting net interest margin, loan demand and credit costs. In the current environment our highest priority is to maintain a strong balance sheet and from that perspective we are pleased with our capital ratios and liquidity positions that they continue to be very healthy.

Nonperforming loans increased moderately during the quarter. This was related to two residential construction loans that had been on our watch list for a number of quarters. Specific measures have been established to fully cover any collateral shortfall identified with these loans and all of our nonperforming loans are based upon current appraised values. This increase to nonperforming loans was in line with our expectations. As the environment remains very unsettled, we will continue to closely monitor our reserve requirements.

Now let me turn to the regional economy. The Mid-Atlantic region continues to perform better than the national averages. During August the unemployment rate was 4.8% in Baltimore, 5% in Richmond and 4.1% for the Washington/Arlington/Alexandria area. These levels were well below the national unemployment rate of 6.1%; however they do represent increases from last quarter so there is some degree of weakening in our regional economy.

With respect to housing I think we are seeing some positive signs particularly in the Northern Virginia market. According to September data year-over-year home sales were up 78% in Northern Virginia while overall listings were down 19%. This resulted in the month of supply of listings dropping to eight months.

In Maryland, listings were up 1% year-over-year but sales were higher by 7%. This is actually the first time since the slowdown began that year-over-year sales were positive in Maryland. As a result the supply of listings that have been increasing remained essentially flat at 12 months. While it’s far too early to make any assertions about the future, this is certainly a positive trend for the Maryland market.

I think we are clearly seeing the effects of the weaker economy in our loan demand. We have strong capital and liquidity positions that afford us the ability to fund good lending opportunities but we are seeing a higher degree of caution among businesses and consumers that is resulting in decreased loan demands.

We’ve made some strategic shifts in focusing our business development officers a bit more on deposit gatherings in this current environment based upon this decreasing loan demand. Once borrowers begin to gain more confidence we expect loan demand will rebound and we believe we’ll be in a good position to finance those lending opportunities.

Before I conclude I would like to briefly update you on national developments and thus discuss their likely implications to Provident Bank. Our thoughts on this subject are very preliminary at this stage but there are specifically two sections of TARP, the Treasury Asset Relief Program, that might ultimately benefit Provident Bank.

The first is the capital purchase plan that is part of TARP. We were recently notified by the Treasury of our preliminary approval to participate in this capital plan. We are investigating our participation and while our evaluation is not complete, there seems to be every reason to proceed. The implication to us at the 3% capital level of participation is approximately $150 million.

The other portion of the Treasury plan that may interest us is the Treasury’s purchase of mortgage loans and mortgage securities. As of this date there are still lots of questions surrounding this plan and not a lot of answers.

We think the most important outcome for us from TARP may actually be the increased valuation in our bank trust preferred securities within the investment portfolio. That could be the indirect but most important benefit of TARP to the bank.

Another important recent development was the FDIC’s recent announceme4nt to provide FDIC coverage on all non-interest-bearing checking deposits. We believe this will reduce customer anxiety across the industry especially among small and medium business customers.

Now I’ll turn the call over to Dennis for his remarks about the quarter.

Dennis A. Starliper

I’m going to begin really by discussing the investment portfolio. If you notice, we added some new and rather comprehensive disclosure regarding the investment portfolio to the press release tables. This table presents the content of the investment portfolio by product, credit rating and the cumulative fair value adjustments recorded either through other comprehensive income, OCI, or via other than temporary impairment, OTTI.

From the schedule you can see the capital implications presented by the weakness in the CDO and the non-agency MBS elements of this portfolio. At the bottom of the schedule is presented the cumulative pretax amounts of negative marks through OCI of $174 million and through OTTI of $135 million for a combined total of $309 million or about $185 million of capital reduction after taxes.

As I’m sure you’re already aware, over the quarter there was little to no transaction activity in the market for pooled bank trust preferred CDOs. Because of this it was necessary for us as well as several other banks to change our valuation methodology for this portfolio from a level three matrix methodology to a weighted combination of level three income valuation approach and matrix methodology. That sounds like a lot of gobbledy gook but I’ll be glad to provide you with any details on this methodology if you’d like to give me a call.

In summary though, this process has involved establishing default probabilities on each of the 1,138 underlying issuer banks and having this corroborated by a reputable and independent third party. Each CDO is then tested for impairment using our in-house [in-tech] software. We then apply a discount rate constructed on the basis of liquidity and credit to the resulting cash flows in order to determine fair value; a very comprehensive process and we do that in-house.

The OTTI for the third quarter was $24.6 million and included number one, $619,000 associated with the REIT trust preferred portfolio leaving an amortized cost basis of $23 million versus a PAR amount of $106 million. Number two, $20 million of impairment associated with the non-agency MBS portfolio leaving an amortized cost basis of $77 million versus a PAR of $126 million.

Number three, $4 million of impairment associated with the pooled bank and insurance trust preferred portfolio leaving an amortized cost basis of $404 million versus a PAR of $483 million. That’s the analysis behind the quarter’s impairment right now.

Let me go on now and summarize where we stand with respect to all of the challenged segments of our investment portfolio after giving consideration to the cumulative OTTI write-downs and the fair value adjustments recognized in OCI.

The pooled trust REIT portfolio with a PAR amount of $106 million has been reduced to a carrying value of $0.14 on the dollar, the pooled trust bank and insurance portfolio held in the AFS portfolio that has a PAR value of $137 million has been reduced to a carrying value of $0.53 on the dollar, and the non-agency MBS portfolio with a PAR amount of $126 million has been reduced to a carrying value of $0.54 on the dollar.

I’d like to also point out that within the pooled trust REIT and the non-agency portfolios the noninvestment grade elements as you can see have been written down significantly to very low levels.

With respect to the total bank and insurance portfolio of $483 million, all but $1 million is paying on schedule while $8 million is contained in the held to maturity portfolio that we project will fall short of contractual cash flow. This is without consideration to the TARP capital purchase plan which we would expect to produce a more positive than negative outlook for this entire portfolio. Write-downs in future quarters do remain a possibility if among other things a rise in default rates occurs or the duration of current priced declines extends.

Moving on to the operations of the bank, leaving the investment portfolio behind here. I’ll begin by discussing our net interest margin. The margin was 3.09% for the third quarter, a drop of 19 basis points from the prior quarter. This decrease was primarily related to actions taken on the funding side of the balance sheet. As you may recall we took action in the second quarter to strengthen our capital by raising $115 million in common and preferred stock and subordinated debt.

During the third quarter we took additional actions to strengthen our liquidity through the development and implementation of a plan to: One, reduce the need to raise liabilities in this challenging environment, and two, increase our available facility for secured funding. We did this by locking in longer-term funding sources thereby reducing our reliance on short-term borrowings which we believe may become less predictable in this current environment.

During the quarter we added $710 million in brokered CDs with an average duration of 27 months replacing approximately $620 million of borrowings with an original maturity of eight months. This action also had the effect of increasing our secured funding capacity by about $210 million. Interest rate swaps were added as an element of this program to maintain acceptable interest rate risk exposure after this liability extension program.

While this will reduce our net interest margin, we believe it’s better to ensure our liquidity in the current environment even if that has negative near-term consequences on earnings. Going forward we’ll be focused on efforts to restore our margin to the extent that there’s no negative impact on our higher capital and liquidity priorities.

Now on to non-interest income and operating expenses. Our non-interest income was $28.2 million in the quarter down from $35.3 million in the same period the prior year. Last year you might recall we had about a $5 million gain from the sale of the deposits and facilities of six branches which accounts for the majority of the difference between this year and last.

Our deposit fees though were a little lower than we expected for the third quarter of ’08. We saw lower transaction based consumer deposit fees than anticipated and we believe the reason is that the Federal stimulus checks as well as rebate checks sent out by a local utility helped to keep low balance accounts from incurring the level of NSFEs that are typically generated.

Operating expenses were up less than 1% on a year-over-year basis. On a linked quarter basis expenses were up about $2.8 million. $1 million of this increase was due to accruals associated with a legal action and for professional fees associated with our change in auditors. Compensation costs were up $400,000 due to seasonal staffing through the summer. Other seasonality in the quarter is found in the level of advertising expense which was up $350,000 and normal professional fees which were higher by $600,000 and were related primarily to the annual Sarbanes-Oxley work.

We’re seeing higher levels of expenses in the area of troubled asset management. It was up about $400,000 during the quarter and expect that this will continue as we aggressively manage our portfolios. While we intend to continue being aggressive with our advertising during this period as we see good opportunities to attract new customers that are reconsidering their banking relationships, we are placing tighter controls around our discretionary spending with the goal of reducing overall expense levels. Once again operating expenses were up 1% compared to the third quarter of last year.

Turning to the balance sheet, our average total deposits were up 16% annualized from the prior quarter. Again this is due to the brokered CDs that we added. Core deposits actually declined $60 million during the quarter primarily in the demand and money market accounts which is pretty typical and seasonal for Provident. If you look back over the last three years, our core deposits have declined from the second quarter to the third quarter.

Consumer deposits declined by $53 million and commercial deposits declined by $7 million. The decline in consumer deposits was a little higher in the Washington area while the decline in commercial deposits was primarily in Baltimore.

Turning now to loans, average total loans increased $22 million in the linked quarter or 4% on an annualized basis.

Commercial mortgages saw growth of $26 million reflecting our success in capturing permanent financing on commercial construction loans that previously were off at a loss to the conduit market. Average commercial business loans including small ticket leasing and business banking loans grew $26 million reflecting our continued emphasis in the small to mid market commercial customer segment.

Average home equity loans growth of $28 million is largely the result of increased line utilization which grew to 46.8% from 45.4% and the lower level of payoffs due to the constrained refinance market. Over the past year while we’ve continued to make home equity loans, we have tightened our standards to reflect the current economic environment. This growth offset $61 million in declines in construction and residential mortgages both originated and acquired.

Now we’ll leave that part of the balance sheet and move on to a review of asset quality. You have a page in the press release that covers this. As Gary mentioned, we did see an increase in nonperforming loans during the quarter which was consistent with our expectations. Nonperforming loans increased to 95 basis points from 59 basis points last quarter. Within the other portfolios we saw slight increases in nonperforming loans in the commercial business and home equity portfolios while there were declines in residential mortgages, other consumer and commercial mortgages.

Ninety-day loan delinquencies were 27 basis points of total loans in the third quarter. That’s up from 17 basis points last quarter. This was driven primarily by increases in residential mortgages and other consumer loans while we saw declines in home equity and commercial business loans. Delinquencies in the 30 to 89 day range actually declined a bit during the quarter to 76 basis points from 78 basis points. Our total delinquencies, meaning everything over 30 days, have remained extremely stable this whole year long. Total delinquencies were 96 basis points in Q1, 95 basis points in Q2 and 99 basis points in Q3.

Net charge-offs were 48 basis points of average loans in the third quarter, an increase from 33 basis points last quarter. The increase is primarily attributable to higher charge-offs in the home equity and commercial business portfolios. We recorded a provision of $6.6 million which reflects the increase in net charge-offs and nonperforming loans given the weakening economic conditions.

Our allowance to total loans was at 1.40% up slightly from June 30 and our allowance to nonperforming loans is a very strong 148% at September 30. The linked quarter decline in this ratio reflects the strong collateral underlying the loans that we placed on nonperforming status in this quarter.

If we simply look at the trends within our portfolio, the credit picture’s incomplete. We also have to take into account the macro economic conditions and trends being experienced by other banks. For this reason we have continued to move in a more conservative direction in terms of our loan loss methodology. We know that the in the current environment we can’t place too much reliance on our historical loss rates for the purpose of calculating our reserves.

Going forward we don’t expect to see dramatic changes in credit quality but as long as the economy remains under stress we do expect to see higher levels of delinquencies, nonperforming loans and net charge-offs. However, we do not believe that the current economic environment is bringing a wider range of possible credit scenarios in to play. With unemployment and housing data most likely to have the largest impact on these scenarios.

We intend to continue to be very conservative in our reserve methodology so that we can be adequately prepared for any scenario that materializes. With that, I’ll turn the call back to Gary.

Gary N. Geisel

Let me just close with a few comments about our outlook. For the next few quarters we expect continued modest loan growth, stable non-interest income, a further decline in our net interest margin and a downward trend in expense levels. We also believe that the continued economic weakness will likely result in elevated credit costs.

Given our strong capital ratios and stable deposit base, we believe we are well positioned from a capital and liquidity standpoint to effectively manage through this challenging period. With that, I will turn it back to the operator to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Pancari – JP Morgan.

John Pancari – JP Morgan

Can you talk to us a little bit more about your margin outlook and the impact of the swap that you expect and how much of that impacted the margin this quarter or when you put it on? Then, just some more details around the swap, the size of it, etc.

Dennis A. Starliper

Margin outlook and swaps we put on a create deal of brokered CDs. We didn’t finish all of the program we wanted to finish but we did get put on about $150 million of interest rate swaps and we’ll continue to monitor the sensitivity of the overall balance sheet going forward here. But, to give you color on the margin, over the quarter essentially had the effects of fall in prime, fall in one month LIBOR having an impact on our earning asset yields and a decline in deposits that were replaced partially by the brokered CDs and then the brokered CD program itself not permitting our funding cost to fall in unison with our earning asset yield.

That’s why you saw earning asset yields declined a lot more than our funding cost. You should have seen that in the press release.

John Pancari – JP Morgan

Yes, I’m just trying to interpret what that means for your outlook then in terms of how much of a margin compression we could see.

Dennis A. Starliper

Outlook wise I would expect our margin to be down slightly in the fourth quarter. I would expect our margin to come in somewhere plus or minus 10 basis points around 3%.

John Pancari – JP Morgan

I know you indicated the deposits were generally seasonally low in terms of your core deposit balances in the third quarter but looking at your low cost core deposits so if I exclude all time I’m still seeing a decline here on a year-over-year basis. So, there seems to be a little bit more just outside of seasonality here so if you could talk a little bit about the pressure you’re seeing on that low cost base.

Gary N. Geisel

I think we’re seeing pretty typical for what other banks are seeing. The seasonality I think is the [inaudible] question if we look at our total deposits plan and budget for the year we’re tracking very much aligned to that budget and very much aligned to that plan. Certainly customers are asking questions and certainly we’re seeing the use of [Cedars] is important to them.

But, if you look at, by example, our customer generation that was up in September, our balances we think are more seasonal. Kevin do you want to add to that?

Kevin G. Byrnes

Well, if you want to break it down John, I don’t know if I agree with you. DDA is down year-over-year but again, that has to do with what I think everybody’s experiencing with demand deposits. Money market accounts is actually up 3% year-over-year and savings which is a real [bell weather] for us is up slightly 1% year-over-year. Then CDs are down, but then again, that’s kind of managed on our part because it was the way we did pricing and migrated in to the broker CD to extend our maturities.

John Pancari – JP Morgan

I was just looking at your average balances here. You’re excluding all time looking at low costs is down 3% year-over-year.

Kevin G. Byrnes

I am too.

John Pancari – JP Morgan

Then lastly if I can ask a question here on TARP, in terms of your uses for the TARP capital I know you indicated Gary that you’re comfortable with your capital levels as they stand now. Assuming you take advantage of the TARP capital if you can talk a little bit about the uses of that capital that you would consider.

Gary N. Geisel

We’re still sorting through it. I mean I think one is we’re sorting through the level of participation that we want to be a part of and then two, to your point John I think what we would do with that capital and how we would apply it. The first and most easy answer to it would just be to reduce our borrowing base but beyond that it would be premature for me to try to answer your question.

Operator

Our next question comes from Jennifer Demba – Suntrust Robinson Humphrey.

Jennifer Demba – Suntrust Robinson Humphrey

Two questions, first Dennis you said that you guys are being more conservative with your loan loss methodology right now. How big is your unallocated reserve right now?

Dennis A. Starliper

It’s about 5% or 6% of the total reserve.

Jennifer Demba – Suntrust Robinson Humphrey

And how would that compare to maybe the end of ’07?

Gary N. Geisel

It’s probably a little higher at this point. We generally keep it in a range below 10% as a target but we’re staying more towards the top end of that range than the bottom end these days. I think it’s actually at around 6.5% Jennifer.

Dennis A. Starliper

I might add that I have a bit of fight Jennifer if it gets much higher the level of documentation that Ken and all of us need to put together to support our auditors it gets to be pretty cantankerous confrontation anything higher.

Dennis A. Starliper

I think when we talk about conservative methodology that’s an all-inclusive description not any one section of the reserve.

Jennifer Demba – Suntrust Robinson Humphrey

You also mentioned that you felt like rebate checks had affected your NSF fees. Can you give us some more color on that.

Gary N. Geisel

Locally here the political utility issued rebate checks right in the middle of the quarter and we’re speculating that that provided a little bit more spending power for some of the consumers and that could have had an impact on NSF revenue. Kevin, do you have more color on NSFs?

Kevin G. Byrnes

It’s just when you combine the two with the rebate, we just saw a level of activity of recurrences on NSFs across the board and just people had some more money than they originally thought.

Operator

I’m not showing any further questions at this time so I would turn the conference back over to Chairman and Chief Executive Officer Mr. Gary Geisel.

Gary N. Geisel

I want to thank everybody for joining us for the third quarter teleconference. We will see everybody at the end of the fourth quarter. Thank you.

Operator

This concludes the presentation. You may now disconnect. Have a great day.

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