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MB Financial, Inc. (NASDAQ:MBFI)

Q3 2008 Earnings Call

October 31, 2008 11:00 am ET

Executives

Mitchell Feiger - President and Chief Executive Officer

Jill York - Chief Financial Officer

Thomas Panos - President, Chief Financial Banking Officer

Thomas Prothero - Chief Operating Officer, Commercial Banking

Thomas Watts - Chief Credit Officer

Analysts

John Pancari - JP Morgan

Ben Crabtree - Stifel Nicolaus

Mac Hudson - SunTrust Robinson Humphry

Brad Milsaps - Sandler O’Neill

Jeff Davis - Wolf River Capital

Peyton Green - FTN Midwest Securities

David Konrad - KBW

Daniel Cardenas - Howe Barnes

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2008 MB Financial Earnings Conference Call. My name is Melelia (Ph) 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] As a reminder, this conference is being recorded for replay purposes.

In today’s call, we have Mitchell Feiger, President and Chief Executive Officer; Jill York, Chief Financial Officer of MB Financial Inc.; and Thomas Panos, President, Chief Financial Banking Officer; Thomas Prothero, Chief Operating Officer - Commercial Banking; and Thomas Watts, Chief Credit Officer.

Before we begin, I need to remind you that during the course of this call the Company may make forward-looking statements about future events and future financial performance. You should not place undue reliance on any forward-looking statements, which speak only as of the date made. These statements are subject to numerous factors that could cause actual results to differ materially from those anticipated or projected. For a list of some of these factors, please see MB Financial’s forward-looking statement disclosure in their 2008 third quarter earnings release.

I would now like to turn the presentation over to your host for today’s conference, Mitchell Feiger, President and Chief Executive Officer. Please proceed, sir.

Mitchell Feiger - President and Chief Executive Officer

Good morning. This is Mitch Feiger. Thank you for joining us this morning. Earlier today, we issued our regular quarterly earnings press release. As usual, we have tried to tweak the release to make it as useful as possible for you. This quarter’s release has additional detail on credit quality, which should be of interest to all of our shareholders.

This quarter’s report is again a relatively clean one. We earned $13.2 million in the quarter which equates to $0.38 per share. The only significant non-core item is a relatively small state tax reserve adjustment. Now we had something similar to this in the second quarter, which I admit may seem odd. We and at least one other public bank in Illinois have had state tax reserve adjustments, because Illinois tax law recently changed and we’re getting better clarity about what those changes mean. So, as we have gained confidence in our tax position, we’ve had to reduce our tax valuation reserves. I think it’s a bit messy, but this seems to be what GAAP requires.

Jill is going to review the numbers with you, so I’ll confine my comments to more macro issues. And we also have with us this morning Tom Panos, Tom Watts, and Tom Prothero should you have any questions about credit.

Now given the operating environment I guess which can only be described as rotten, I am pleased with our performance in the quarter. We very much believe that this is a time for a strong balance sheet and we took significant steps in the quarter to make ours stronger. And this reduced earnings in the quarter, but we think it was an appropriate thing to do and will pay dividends in the future.

In the quarter, we increased our capital ratios and will probably increase them further. We significantly improved our liquidity by lengthening liabilities. Now also to that end, we had core deposit growth, over $200 million in the quarter that allowed us to materially reduce our short-term wholesale funding. I believe that our liquidity position is better than it’s been in years.

For our investment portfolio, our treasury staff has done an excellent job keeping it downright boring, and boring is good. Unrecognized gains in the portfolio were over $5 million at quarter-end.

With regard to credit quality, obviously the environment is unfavorable. As I’ve said earlier, we’ve expanded our press release to provide more information about credit. Now, Jill is going to review credit quality numbers with you in a minute and we have our top three credit people on the call should you have any credit related questions. My concern on credit is that, while we all know about home and residential construction loan problems, I think – I don’t think anybody knows yet the effect of the broader economic downturn that’s clearly here. Jill is going to tell you that part of the increase in our provision for loan losses this quarter is based on our belief that the economy is going to get worse and maybe very bad in the next two quarters and we want to be prepared.

Now back to strengthening our balance sheet for a minute, we are carefully considering our participation in the Treasury Department’s capital purchase program. At this point, we’re inclined to participate at the maximum amount permitted. For us, that’s around $195 million. While I’m unhappy about the program, because it leveled the competitive playing field and I think we would have been a significant winner on the old less level playing field, I think we’re also very well positioned to take advantage of the added capital. Obvious uses for the capital are more rapid organic growth, loan growth in particular where I think we’re well positioned, and also for acquisitions where I think we’re well positioned also. I suppose the money can also be used to cover operating losses, but I’d rather not use it that way and we have no intention of using it that way should we take it.

Lastly on the TARP, at this point we haven’t been able to review the security purchase or operating agreements and we will not make a final decision until we can review those documents.

All right, let me turn it over to Jill. Go ahead, Jill.

Jill York - Chief Financial Officer

Good morning, everyone. As Mitch discussed in his opening remarks, net income for the third quarter was 13.2 million or $0.38 per share. I would categorize this quarter as one where we fortified our already strong balance sheet by increasing our capital ratios, increasing our allowance for loan losses ratio, substantially improving our liquidity position and continuing to improve our asset liability position to minimize the negative impact of a changing rate environment on our net interest margin.

Commercial related loan growth was strong year-over-year 15%, while on a linked quarter basis loan growth showed evidence of slowing a bit and increased at a 6% annualized pace, as we extracted significantly better credit spreads on both new and renewing relationships. Spreads have increased by 50 to 100 basis points, and in some areas like lease lending credit spreads have improved even more.

Deposit growth was robust as customer deposits in the quarter grew by $233 million or 20% on an annualized linked quarter basis. Seeing this amount of customer deposit growth was especially gratifying, given the uncertain economic environment in the quarter.

We also took the opportunity to increase and lengthen our new and renewing brokered CDs and substantially paid short-term borrowings. Brokered CDs increased by 140 million while short-term borrowings declined by 379 million during the quarter, and excluding customer repos totaled only $125 million at quarter-end.

Our securities portfolio continues to perform very well with unrealized gains over 5 million, we have not incurred impairment losses on any investment securities during 2008 and avoided the problem securities causing many financial institutions incur large losses.

Net interest income grew by 4.4% on a linked quarter basis at solid balance sheet growth which partially offset by 7 basis point decline in our margin. The margin compression experience was primarily due to the liquidity positioning moves we took to pay down lower cost short-term borrowings and increase more expensive long-term customer brokerage funding.

As I mentioned earlier, credit spreads have materially widened which I believe in the long run will have positive impact on the net interest margin. Unfortunately in short run deposits continue to be very expensive and are offsetting the margin benefits derived on the loan side.

As mentioned earlier we continue to improve our asset liability position to minimize the negative impact of a changing rate environment. Today at our end we have approximately 1.5 billion of loan rates floors. This is slightly under half of our floating rate loans. Out of the 1.5 billion floors well over 1 billion are currently in the money. We have also avoided putting problem securities or problem borrowings on the balance sheet where we do not control the coaction. However all these things said with a fed funds rate reduction of 100 basis points in October I do believe the margin will be under a bit of pressure in the fourth quarter as our variable rate loans of that floors may reprice faster than we can reprice the deposit side of our balance sheet.

Moving on to credit quality; as Mitch mentioned, our provision for loan losses was 18.4 million while our net charge-offs were 12.1 million. Six million of the charge-offs related to one of the three problem credits that was identified and fully reserved for in the first quarter. Thus we provided 12.4 million more than our adjusted charge-offs for the quarter. Of this total approximately 4 million related to money set aside because of worsening economic trends. By the way we have approximately 19 million of our allowance assigned to macroeconomic and precision factors. And the balance of the provision related to loan growth and loan migration within the portfolio. Our allowance for loan losses ratio increased from 1.3% loans to 1.46%. And our non-performing loans increased by 24 million while our potential problem loans declined slightly.

Now let’s talk about fee income and operating expenses. Similar to the last few quarters we’ve include schedules which divide our fee income and operating expenses between core and non-core sources. I view this as a pretty clean quarter with very little of our fee income or operating expenses considered non-core. Core fee income continues to be quite strong and grew by 16% compared to the third quarter of 2007.

Our Cedar Hill acquisition in the second quarter positively impacted our asset management fees, while loan service fees and deposit fees have increased substantially compared to a year ago. This was primarily, or this is primarily due to the low rate environment which has positively impacted treasury management deposit fees and prepayments fees on loans.

Core expenses (inaudible) manageable, if you exclude our investment in new bankers hired over the past four quarters and the impact on the third quarter was about 1.3 million and the impact of Cedar Hill on expenses about 1.1 million and the impact of lower brokerage expense this year versus last year related to the sale of our third-party brokerage business in 2007, our expenses increased about 4% compared to a year ago.

As Mitch noted, during the quarter we did benefit from a $1.5 million adjustment to our state tax contingency reserves. We believe that our effective tax rate will be in the neighborhood of 10 to 15% for the fourth quarter depending on pre-tax income and the effective rate will slightly increase in 2009 due to higher state income taxes and of course depending on our level of pre-tax income.

Regarding capital, we continue to maintain a strong capital position. We maintain capital ratio substantially above the well capitalized threshold. And our capital ratio has improved slightly compared to last quarter. I’m also pleased to report that last week our Board approved our normal quarterly dividend of $0.18 per share.

Okay, now at this point I would like to turn over the call over to Mitch for final comments.

Mitchell Feiger - President and Chief Executive Officer

Okay, thanks Jill. I really don’t have any more comments than that. Operator, let’s open it up to questions.

Question-and-Answer Session

Operator: [Operator Instructions]. Your first question comes from the line of John Pancari with JP Morgan.

John Pancari

Good morning.

Mitchell Feiger

Hey, John.

Jill York

Good morning John.

John Pancari

Can you talk a little bit about the inflow of non-performers that came from outside of the troubles, the potential problem loan portfolio; looks like half of your inflows in the non-performers came from outside of that bucket. So from your normal portfolio of loans should have not been identified as being problematic. So if you can talk about that a little bit.

Jill York

Sure. We put some extra detail in our release to answer those sorts of migration questions. But basically we had one larger construction loan that deteriorated rapidly in the quarter that when – they got downgraded to non-performing status in the quarter. We also had two commercial real estate loans that were smaller but also deteriorated and went right to non-performing status.

John Pancari

Okay. And can you talk a little bit about the rate of deterioration in the next quarter and as to why they were not credits that were on potential problem loan status?

Jill York

Well, the construction loans (inaudible) construction loans that we are talking about was performing well at the end of the second quarter paying. And – that before loan just start paying.

Mitchell Feiger

I think in that case we think it’s a good project.

John Pancari

Right.

Mitchell Feiger

But the sponsor of the project had problems. So for us it’s almost better. I think if it goes to non-performing because we can workout the credit.

Thomas Watts

We’ve got a number of construction credits where our – our loan seems to be pretty good, our project seem to be pretty good. But the sponsor has run into problems on other projects. So they all get wrapped up together and go down together. And so we have a good project that looks all for good and then sponsor get some trouble and just stops paying.

John Pancari

Okay, all right. And then I guess more broadly, can you talk a little bit about the rate of deterioration and credit that we are seeing at your banks, obviously a lot of the other banks are seeing pressure here and the lot of it’s around real estate and, you know, but looking at your year-over-year increase in your non-performers, I mean, it’s up almost five fold year from the year ago period, and obviously another 30% jump, 27% jump in non-performers this quarter on a link quarter basis. So can you just talk about that rate of deterioration that we are seeing? It seems like the rate of deterioration is little bit greater than some of your peer banks.

Mitchell Feiger

Yeah, let me comment first and I’ll open up on to anybody else in the room here who has -- want to add any qualitative comments there. Keep in mind that year ago and before the – several years before that, I think at least a several years, we were saying that the level of non-performers back in was unsustainably low. We said that each quarter. So I don’t know that – the comparison to the base, I don’t think is – I just – I wouldn’t encourage that. I don’t know – anybody having thoughts about more current migration, the piece of migration? (inaudible) thoughts.

Thomas Watts

I think it’s little bit in the third quarter relative to second quarter. I also think if you compare our credit quality to other banks in Chicago we would compare pretty favorably.

John Pancari

Yeah, and I was just looking at your third quarter MPA ratio of 45 basis point or 46 basis points of related assets. It was certainly lower, but that was through this those sums were around where some of your peer banks were?

Mitchell Feiger

Yeah, John I think your question is a good one, it’s one that we think about here all the time is; what is the pace of migration, is it normal, has it accelerating, it is changing and it’s a hard thing to put your finger on exactly. And that’s why we’ve included in the release additional information about that to give you at least some insight into that. I don’t know that we could be more helpful than that.

John Pancari

Okay. And then you mentioned that you are, in terms of what you are considering in your reserve, you are increasing your reserve for the outlook for the much more challenging economic outlook forth coming in, can you give us idea of the size of our unallocated reserves in that light?

Mitchell Feiger

Right. I think I touched on that in my prepared comments. We did increase our macroeconomic piece by an additional $4 million. And we have roughly 19 million in our allowance had set a side for macroeconomic and precision factors.

John Pancari

Okay. So that will be your total unallocated bucket?

Mitchell Feiger

We do not treat it as unallocated. We try to allocate all of our reserve. But the portion allocated to those two factors is $19 million.

Jill York

I think the way to think about it is the top portion of the reserve is caused by those factors that then is allocated by loan type, is the 19 million.

Mitchell Feiger

Correct.

John Pancari

Okay, all right. And then lastly, I know you indicated that you are evaluating TARP and you would apply for the maximum. But also on the capital front you reaffirmed your dividend. And your payout ratio is going to be nearing, looks like 50% if not higher as we go through ’09. And that’s much higher than your traditional trajectory. So I just want to get an idea of how you are thinking about the dividend here?

Mitchell Feiger

What I’m thinking about right now is we are going to keep paying it. And I don’t see any issue in paying that dividend.

Jill York

Yeah, in fact our capital ratios are increasing.

Mitchell Feiger

Yeah, capital ratios are going up even with that. So I don’t – I guess we don’t see an issue of increasing or keeping the dividend and growing our capital ratios. And that’s without the chart money or any other substance.

John Pancari

Okay, all right. Thank you.

Operator

Your next question comes from the line of Ben Crabtree with Stifel Nicolaus.

Ben Crabtree

Yes, good morning.

Mitchell Feiger

Good morning Ben.

Ben Crabtree

Couple of questions. And this one’s probably kind of a foolish questions in today’s environment. But I’m trying to figure out why now you need so much more liquidity than you needed a quarter or two ago?

Mitchell Feiger

Well, I think we started – I think improving liquidity in the second quarter and load into the third. I mean, things have been changing rapidly. But, I think if you take back to the third quarter, I mean liquidity for everybody was an issue, we felt it was just prudent in managing this company to increase our liquidity. I am not sure that the liquidity issues are over in the marketplace.

Ben Crabtree

So, have you had -- I mean you obviously have been able to attract deposits?

Mitchell Feiger

Yeah.

Ben Crabtree

So that is -- has not been the issue. I don’t know, I am just -- if I look at it from your standpoint and your capital ratios are better but there is still a little skinny and your earnings retention rate is awfully low here when you get right down to it. So, I am just wondering if you are in a situation of looking at a lot more loan demand than you can effectively satisfy?

Mitchell Feiger

There is more loan demand than we can satisfy, that’s always been true here. So, what we’re trying to do is pick through the ones that are good and take those. And ones that are priced right, we’re going into our own commercial -- into out own client base and we’re trying to rationalize that as well, as we’ve got weak credits that should be served by another company. We’re trying to encourage that for the credits we’ve that are not market priced anymore. We’re trying to adjust rates there and we’ve a high degree of confidence in doing that because, the external on-demand is there. And that’s why Joe mentioned, that we’re seeing credit spreads widening, it’s going to take a while for all that to roll through, but it looks like 50 to a 100 basis points.

Ben Crabtree

And the -- you said in your release that you hired 32 new bankers is that so far this year?

Mitchell Feiger

That would be since the -- actually over the last 12 months.

Ben Crabtree

Okay.

Mitchell Feiger

We started process in the fourth quarter of 2007.

Jill York

Yeah, but more not net plus 32.

Ben Crabtree

Right.

Jill York

Sales bankers, I mean we’ve had people leave as well.

Ben Crabtree

And can I infer from the changing loan mix that that has somewhat driven given by the character of the bankers you’ve hired or would you do much more CNI oriented?

Jill York

Yeah, the bankers we’ve hired are mostly of CNI lenders. Correct.

Ben Crabtree

Okay. And Mitch you said something, just want to make sure I understood here. I think, I am note sure whether it was you or Jill but you talked about the time required to get -- I just have a question about would you have a loan going bed especially say a construction loan. How long does it take you to actually get control, you said you would like to see the loan go non-performing because then you can kind of get control of it. What’s the timeline on getting control of that loan and being able to move it off your books?

Mitchell Feiger

Well, it can vary but, the legal process at times and our status is slow. So, we will jump on it write away to get -- we get the legal process going right away and then at times it’s up to the court.

Jill York

But it takes a while.

Mitchell Feiger

It takes a while.

Jill York

It takes too long it’s really unfortunate but it takes too long.

Ben Crabtree

So unless you can get them to refinance some place else you are going to be dealing with it for close to a year finally?

Jill York

Oh yeah I think I leased it.

Ben Crabtree

Okay and I guess the last question is the given what you have done duration and the liabilities and Jill, I think you indicated that you are getting close to being well balanced. Are you pretty comfortable that you are at a basically a well-balanced asset liability risk exposure?

Jill York

Well, absolutely I mean I think we’re well balanced at the end of last quarter but, what we’ve really tried to do is through the additional floors and avoiding actions that we don’t control we want to be in the position where rates dramatically change either up or down we don’t get hurt too much on our net interest margins. So given the every rapid decline in the FED Funds Rate in October could we have a little bit of margin compression sure. But I think our margin is pretty well protected.

Ben Crabtree

Okay great. Thank you.

Operator

Your next question comes from the line of Mac Hudson with SunTrust Robinson Humphry.

Mac Hudson

Hey good morning.

Mitchell Feiger

Good morning Mac.

Mac Hudson

Mitch, I had a question on capital and I know you have touched on this a little bit in your prepared remarks you talked about probably increasing capital further and was that meant to imply through retained earnings in the top or also just rationale it down growth a little bit or other means?

Mitchell Feiger

Yeah, that’s a good question. I probably should have been more clear about that no I mean. No, what we are thinking about just retained earnings in managing our balance sheet growth in a way that it allows our capital ratios to improve. If the top money comes along I guess, we will have rethink that a little bit what that would mean we haven’t thought that all the way through yet.

Mac Hudson

Is it that the loan growth was a little slower than I thought and would you envision actually dig that extra capital from the top speeding things up a little bit?

Mitchell Feiger

Yeah, this is one company that if you took the top money you could probably use it the way as intended.

Mac Hudson

Okay. Joe, I had a question on the margin. Yeah, obviously I understand the pressure this quarter was driven a lot by deposit efforts you talk about the rate for is a $1.5 billion and the rate for over a 1 billion in the money and I know you talked about before in prior conference calls is there way for us to understand the benefit they are providing, what the margin would have been without the floors because I know that you said that there going to be more pressure probably in the fourth quarter is there a way to quantify that or is that I got that wrong?

Jill York

I think the pressure I am referring would is the force that actually help alleviate some because we’ve many more, mores that are being floored out especially with prime going down to 100 basis points. We have not computed that the total amount of benefit but it is very, very substantial we have many floors at 6%, 5.5%, 5% and I think of the floors that are in the money the average rate is in the 5.30 to 5.4% range.

Mac Hudson

Okay.

Jill York

Of the ones in the money. So, that’s well, well above prime.

Mitchell Feiger

Okay. Mac, it’s a little difficult I thought about this question and it’s a little difficult to figure out because if we didn’t have the floor it’s entirely possible in some of the loan rates would change, the underlying rates. So I am not sure we can home in on an exact number.

Mac Hudson

Okay, thanks. And Jill I guess moving beyond the fourth quarter I know its impossible to look really further to three months out front, but do you envision that the margin bottom here in the fourth quarter then it has back up where do you think for each day down where they are that its going to kind of plug around the slow 3% range for a while?

Jill York

I think, it really depends on deposit pricing, and if deposit pricing normalizes I can end with better credit spreads holding I think then you will see the margins of course dripped up. I think much of that depended on deposit pricing.

Mac Hudson

Okay. Great, thanks.

Operator

Your next question comes from the line of Brad Milsaps with Sandler O’Neill.

Brad Milsaps

Hey, good morning.

Mitchell Feiger

Good morning, Brad.

Jill York

Good morning.

Brad Milsaps

Mitch, I was going to see if you could maybe talk a little bit about urban versus suburban real estate, maybe you could subdivide your construction portfolio a bit. And, I am just curios of the majority of the weakness you are still seeing in kind of that suburban -- the suburban exposure that you do have?

Mitchell Feiger

Yeah. Brad, I am going to let Tom Prothero, who is the Chief Operating Officer of our Commercial Banking, answer that question, he is got the facts for you.

Thomas Prothero

The suburban projects continue to be the most problematic and those encompass roughly 60% of our wholesale housing exposure. Let me give you an example in terms of appraisals we’re seeing a decline in value of anywhere from 30 to 50% depending on how far out from the city we go.

Jill York

I think Tom, you had further stratified I think if you look at condos for example that’s much more urban versus suburban in terms of the breakdown. I think two-thirds or so of our condos are downtown. Those are on average doing much better. Suburban -- on single-family goes the other way though we are 75% would be suburban versus Chicago.

Brad Milsaps

Okay. So I think you disclosed in the release there was bout $450 million of residential construction. You were saying Tom that that 60% of that would be suburban?

Thomas Prothero

Yeah.

Brad Milsaps

Okay. Okay. And then the you mentioned the $6 million charge-off during the quarter related to I guess it’s that group of loans that you identified in the first quarter, is that correct that from that Loan Division? I am just curious how -- I'm trying to follow in your schedules here but it looks like I guess there is still a couple in that potential problem loan category I am curious if you could just give us some more color there if you think those are going to migrate to an non-performing status and if you have to come at the same sort of lost content just trying to follow those kind of through the process here?

Thomas Prothero

There are two lots and one is performing fairly well and the other one is struggling. Now, we will see how that goes over the next quarter or two.

Mitchell Feiger

Well, we’ve quite a bit in payoffs on those, I think since the first got identified.

Tom Watts

I would say one of -- this is Tom Watts, one of them is actually performing fairly well and we are in the process of negotiating and restructuring that loan with significant reductions on our exposure and a committed repayment program and the other one is not doing as well revenues are off. We’ve got better values there is some volatility in what could happen there but management were supportive of putting some money in the company we are going to restructure the loan.

Mitchell Feiger

So one good, one not so good.

Brad Milsaps

Okay, okay. And then another question in the construction book Mitch I was just curious you guys were able to reduce those balances maybe more than some of your peers. I’m kind of curious how you were successfully able to do that, did some of those projects going to another category or is that simply just you guys just working hard to get that work done further?

Mitchell Feiger

Yeah we are finding to work down as much as we can (indiscernible) fairly successful projects that have paid off, we are paying down in the residential side.

Brad Milsaps

Okay and then Jill final question on margin. It looked like I think in that category of money market in our accounts those are up about 14 basis points on a link quarter basis, you guys running some type of special day or it seem to me that that would be a category that you could partially begin to manage lower to some degree, just kind of curious if you have any thoughts there.

Mitchell Feiger

That’s a great question. We did run a money market special throughout or part of the second quarter and throughout the third quarter and it was quite successful. And overtime, we have been successful in reducing the rates on those types of accounts. So, given the recent reduction the fed funds rates we have moved down some of our money market rates.

Brad Milsaps

Right. And you still like the -- the broker CD money in terms of giving you what you want in terms of rate and duration?

Mitchell Feiger

What we like about the broker CDs are the liquidity characteristics which I admit may seem odd, but we tend to add broker CDs that are long in duration, so they are around two to five years. And what’s nice about our broker CD is the only way they can be cashed in early is if the holder passes away, whereas on the retail side, a customer can come in and ask to have their CD redeemed and that would do that. So view them as probably a better liquidity stores spend, some types of customer deposits.

Brad Milsaps

So the bulk of the CDs -- the broker CDs would be two years or longer in duration?

Mitchell Feiger

What we -- certainly what we added in the third quarter was pretty much all two years now?

Brad Milsaps

Okay, all right. Thank you very much.

Mitchell Feiger

You’re welcome.

Operator

[Operator Instructions]. Your next question comes from the line of Jeff Davis with Wolf River Capital.

Jeff Davis

Good morning. Question Mitch for the group in terms of, maybe thinking all over the next couple years in terms of commercial real estate whether -- whether or not so much for MB Financial, but maybe generally in terms of cap rates on office, retail, and maybe industrial what you are seeing happened over the last six months and how that may play out over the next year or two? And with the CNBS market shut down, how that might impact losses whether for the company or for the industry?

Mitchell Feiger

Well, this is Mitch. I am -- I don’t think anybody in the room here is a real expert on cap rates. I think to the degree that you think about commercial real estate values, my personal feeling is values are going down. I think that vacancies had an upward in most types of properties. So revenues are going to go down those properties, financing costs are up, because cap rates move, I mean cap rates move a bit with interest rates. So, I’m not sure if they are going to be down or up, but my thinking is commercial real estate value has had a downward, in fact, yes.

Jeff Davis

Yeah. And then, let me ask a little bit different, Mitch, is the loss rate – the loss rates go up dramatically for the other -- and this is a bit of a loaded question, but do loss rate go up dramatically for the industry within the overall category or to look at the sub group like retail where -- there is a lot of bearishness or does the situation look more manageable, say vis-à-vis for construction 18 months ago, where we figure residential construction within badly?

Mitchell Feiger

I think loss rates get more volatile, when you think about a retail center. When a retail center goes half vacant or three quarters vacant, value drops pretty considerably. So, I think – could average loss rates go up? I think they may.

Jeff Davis

Okay. But, right now your thinking is commercial real estates not next residential CNB here to drop?

Mitchell Feiger

And I can only think about this from our portfolio’s perspective, I think that if the commercial real estate – rest of commercial real estate -- the United States feels stress, we will feel some stress in that portfolio as well, but I like the way our commercial real estate is diversified and positioned and the kinds of borrowers that we have. So, I think -- I am hopeful that, if there is stress there, we would see less stress than others and do quite well.

Jeff Davis

Thank you.

Operator

Your next question is a follow-up question from the line of John Pancari with JP Morgan.

John Pancari

Thanks. Can you talk a little bit about your holiness to consider bulk sales of non-performers in this environment?

Mitchell Feiger

You got a fire?

John Pancari

I guess, no.

Mitchell Feiger

We have sold assets in the past. And we will continue to look at selling assets, mostly on a one-off basis. We’ve done it a number of times over the years.

Thomas Watts

I think, I’d absolutely consider bulk sale or one-off sale. We are working out the loans and keeping them on our balance sheet which ever produces the highest, the best economics. We totally make that analysis, make that judgment on economics.

John Pancari

Okay. All right and then, just separately, can you just give us any information if you have the amount of shared national credits you may have on your portfolio, is there any – in the book?

Thomas Watts

Anybody want to guess? [Multiple speakers].

Mitchell Feiger

We have some. We have some.

Jill York

Many of those that we have our plug transactions with local banks here in Chicago.

Mitchell Feiger

Yeah. Let’s talk about just a little bit, John, you bring up an interesting question that we talk about maybe a year ago, it was a more frequent topic or conversation because when we acquired First Oak Brook in August 2006 they had a share national credit loan book that was about -- can you remember the size?

Jill York

125 million.

Mitchell Feiger

125 million. And this -- the vast majority of those were true – SNIC (Ph) credits, they really didn’t have much of relationship with the bank and some of those remain still, because they have longer terms and they didn’t return, so they are still here. I think, to the degree we’ve added to that or have some other size was added to that, but we have some others -- they are mostly club deals that involve three or more banks, so they end up falling in a SNIC category. But we have – they are either our customer or we have a relationship with a customer that’s deeper than just the long – there are general counts generally. And so, there is something else that’s there. We don’t like doing just shared national credits to put out more loan money. It’s not something that we do.

John Pancari

Okay. And, are any of the First Oak Brook’s mix or these other club deals under your watch list right now or seeing some pressure?

Mitchell Feiger

Some of the shared national credits, a very small handful, some of which were originated at First Oak Brook are on the watch list, with one exception they are all real estate related.

John Pancari

Is that performance much different from the rest?

Mitchell Feiger

No.

John Pancari

No. I mean, it looks the like the rest of our portfolio – I guess, I think in performance.

Mitchell Feiger

I don’t think there is much to worry about. And I don’t think -- it’s pretty -- it’s a very small percentage of our portfolio, I believe, it was less than two, less than 3% maybe 4%, three I don’t know, I am guessing.

Jill York

I guess, John it would less -- 3% or less.

John Pancari

Okay. All right, thanks.

Operator

Your next question comes from the line of Peyton Green with FTN Midwest Securities.

Peyton Green

Hi, good morning. I was wondering if you could comment a little bit Mitch about the opportunity over the next two or three years to approximately see some significant consolidation in the Chicago marketplace?

Mitchell Feiger

Yeah. Well, it has to happen. It just has to happen. We still have way too many banks in Chicago -- too many banks in United States. We got far too in many in Chicago. It has to happen. I think it should happen. I think it will happen. I just have no idea how.

Peyton Green

Do you think the participation if it’s fairly broad into the TARP stalls it or accelerates it?

Mitchell Feiger

Stalls it. And I think in this market, the TARP money is going to reduce consolidation. Those consolidations would have happened much more rapidly without the TARP money. This is my opinion, because I think there are banks in this market that was strong enough to make acquisition without TARP money.

Peyton Green

Okay, great. And then, on the deposit side, I mean, how are you all seeing things through -- and I know it’s early. But through the fourth quarter, have you seen any material change or improvement on your ability to gather deposit, you certainly had a very strong third quarter. But, what about the pricing, I mean, when do you think the pricing really comes down to a level that this is more in line with what the fed has done?

Mitchell Feiger

I mean, let me make a comment and then, I will see if anybody else in the room has can add to this. Just remember that the fourth quarter is traditionally our best deposit growth quarter. And often times that comes in non-interest bearing demand. The other thing I think we may begin to see here is, if you remember back into 2002-2003 timeframe when interest rates got really, really -- that was the timeframe right – it’s got really, really low. And we saw a fairly significant migration of deposits. The whole industry gets into non-bearing accounts. And, because the interest bearing accounts been pay much more and it wasn’t worth people effort to have them. And then, when rates -- obviously we saw people shift back. And I don’t think anyone of us really understood how much money had shifted into the non-bearing interest bucket until all that it shifted out. And I wonder, I think a lot of you -- if we may see some of that again now if that funds rate back at 1% and perhaps even go low. Anybody really have thoughts on that on fourth quarter flows?

Jill York

We have customers that are certainly migrating out of interest bearings back to non-interest bearing, so that they can cover their deposit service charges. We are seeing them now.

Peyton Green

Okay. And then, a question about the TARP, I mean, conceptually, I mean it just seems to be that there is ultimately going to be a push towards the higher tangible equity ratio for the banking industry, I mean to get to the kind of bottom line basis. But -- and this -- I mean, this doesn’t necessarily help one get there, I mean, if you all consider just bracing hard common equity and not having to rely on the government?

Mitchell Feiger

The answer is -- the MB is not thinking about capital these days, a little selling of course. We are thinking about this all the time. I think we are very comfortable with where our capital ratios are right now. I think, I agree with you. I think the industry’s capital ratios are going to drift up and it’s not clear to me how – yet how the investment community is going to view the TARP capital. We’ve heard some information from the rating agencies, how they think about it. But I think it’s in flux. And so I think if it made sense to – are we willing to add common, are we thinking about adding common right now? No, we are not; we’ll take it as it comes. If an acquisition came along let’s say that it made sense to raise common, would we consider it, sure. Sure, we’d consider it. One other thing that’s at least (indiscernible) from my mind is the tangible common ratio as opposed to the tangible capital ratio and what that means. And I think we’re in pretty good shape on a tangible common ratio. And adding the TARP money doesn’t help that. I mean it does a little bit for the warrants, but I don’t think that means that much to most. And I think the people that I worry about are folks that are running with very low tangible common ratios and I’m not sure because ultimate – really it’s the common that absorbs any losses. I mean that’s the real backstop against losses.

Peyton Green

No. I guess my only point is, is it just seems like another form of hybrid capital.

Mitchell Feiger

Yeah, I agree with that, and that’s going to need to be repaid.

Peyton Green

Right, okay.

Mitchell Feiger

And I think that’s part of the thing we’re thinking about is okay if we take the money, how long would we have it and how would we repay it.

Peyton Green

Okay, good enough. Thank you.

Mitchell Feiger

Okay.

Operator

Your next question comes from the line of David Konrad with KBW.

David Konrad

Hey, good morning.

Mitchell Feiger

Good morning, David.

David Konrad

My question was actually already asked and answered regarding TARP and consolidation, so thanks.

Mitchell Feiger

Okay. Thanks.

Operator

Your next question comes from the line of Daniel Cardenas with Howe Barnes.

Daniel Cardenas

Good morning.

Mitchell Feiger

Good morning, Dan.

Daniel Cardenas

How are you?

Mitchell Feiger

Good.

Daniel Cardenas

Just quick question, could you give us a quick update on the health of your indirect portfolios?

Mitchell Feiger

Indirect, anybody?

Jill York

We have slowed the origination of the indirect automobiles and we have seen increased delinquencies on the motorcycle side of indirects.

Mitchell Feiger

Was it meaningful?

Thomas Prothero

But not meaningful.

Jill York

And that’s a very low percentage of our overall loan book.

Thomas Prothero

Right.

Daniel Cardenas

Yeah. The average credit score in that portfolio is north of 740 I think, is that right?

Jill York

Yeah, it’s quite high.

Thomas Prothero

Yeah.

Mitchell Feiger

Does that answer your question.

Daniel Cardenas

It does, it does. And then just one quick question going back to acquisitions, I mean if you do restart the acquisition machine or can you talk a little bit as to whether -- what your focus is going to be, is it going to be assisted transaction or your traditional acquisitions?

Mitchell Feiger

Dan, can you speak up a little bit, we’re having a hard time hearing you?

Daniel Cardenas

Sure, no problem. Just referring back to acquisitions, if you restart the acquisition machine, is it going to be more assisted types of transactions or your traditional acquisitions, and if you go to the traditional route, is there going to be any change in terms of your internal rate of return benchmarks?

Mitchell Feiger

Yeah, good question. I think given the economic outlook that I spoke about, if we made another acquisition that was unassisted, we would view a loan book with the – in that way believing that the economy is really soft and probably going to get worse. And that adds risk to the transaction, and so the IRRs we would expect would probably increase, in fact they would increase. Now in an assisted transaction, obviously if it consists of deposits only, there’s not a lot of risk in that and I’d be probably looking for more traditional IRRs. If they are whole bank transactions through the FDIC, we’d probably look at it the way we do at regular acquisition.

Daniel Cardenas

Okay. Thank you.

Operator

And I’m showing at this moment you have no further questions, I would like to turn the call back to Mitchell Feiger for closing remarks.

Mitchell Feiger

Okay. Well, thank you everyone for listening this morning. We very much appreciate your time and have a good day.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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Source: MB Financial, Inc. Q3 2008 Earnings Call Transcript
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