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Independent Bank Corporation (NASDAQ:IBCP)

Q3 2008 Earnings Call Transcript

October 28, 2008, 10:00 am ET

Executives

Mike Magee – President and CEO

Rob Shuster – EVP and CFO

Stefanie Kimball – EVP and Chief Lending Officer

Analysts

Terry McEvoy – Oppenheimer & Company

Brad Millsaps – Sandler O’Neill

Jason Werner – Howe Barnes

Operator

Hello and welcome to the Independent Bank Corporation third quarter 2008 earnings conference call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today’s presentation.

(Operator instructions) Now, I would like to turn the conference over to Mr. Michael Magee, President and CEO. Sir, you may begin.

Mike Magee

Thank you. Good morning and welcome to our third quarter 2008 earnings conference call. I am Mike Magee, President and CEO of Independent Bank. Joining me on the call today are Rob Shuster, our Chief Financial Officer, and Stefanie Kimball, our Chief Lending Officer.

Following my introductory comments, Rob will provide a detailed review of our financial performance during the third quarter. Following Rob’s comments, Stefanie will provide an update on our commercial and retail loan portfolios. We will conclude the call with a brief question-and-answer question.

Also, please note that in the company PowerPoint presentation will be referenced throughout the day’s call. To access this presentation, please go to the investor relation section of our website at www.ibcp.com. Please also note that this presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to our Safe Harbor Provision on slide two of the presentation for additional information and forward-looking statements.

I will begin today’s discussion with the review of our third quarter financial results which are summarized on slide four of the company presentation. Certainly, the third quarter was a challenging period for Independent Bank. The continuing credit turmoil evolved into a financial markets crisis which prompted government action of historic proportions and our results were not entirely immune to these negative broader economic factors. Although we are disappointed in our bottom line results for the quarter, we continue to make progress at a number of fronts and we remain optimistic that we will emerge from this period even stronger.

When the third quarter ended September 30, 2008, we reported a net loss of $5.3 million or $0.23 per share compared to net income of $3.7 million or $0.16 per share in the third quarter of 2007.

The decline in operating profitability is attributed to a $9 million increase in provision for loan losses as a result of several commercial real estate loans moving through the workout cycle from the watch list to the nonperforming status during the quarter. As we have stated throughout the past several quarters, these delinquencies are primarily the result of real estate developers experiencing cash flow difficulties as the slowing Michigan [ph] economy continues to weigh heavily on the real estate values throughout the state.

While we are disappointed in the increase of the loan loss provision and we continue to remain cautious regarding the current economic conditions, we are pleased to note specific improvements and asset quality during the quarter. Commercial loan 30- to 89-day delinquency rates were at their lowest levels since 2005. Additionally, our level of commercial loan watch credits declined for the first time in more than two years. Under the guidance of our chief lending officer, Stefanie Kimball, we have continued to work diligently to manage our way through this difficult credit cycle. Later in the call, Stefanie will provide a more detailed update on our initiatives to enhance key credit metrics and improved asset quality as well as a couple of examples of how we are working with our customers to achieved improved outcomes in the workout process.

In addition to the increase in nonperforming loans and the credit cost associated with managing them throughout the course of the last year in the most recent quarter, third quarter results were also negatively impacted by security losses. The market decline in the conservatorship of Fannie Mae and Freddie Mac led to the decreased values in the preferred stocks we own. These losses were partially offset by higher net interest income and the benefit in income tax expense.

Additionally, our third quarter results reflect yet another quarter of increased net interest margin. Increases on both the year-over-year basis and the sequential quarterly basis were due primarily to a decline in short-term interest rates and a steeper yield curve. For high level overview of the quarter, please turn next to slide five of our company presentation.

We are clearly not out of the woods yet in terms of the regional economic challenges we face as evidenced by our continued recognition of nonperforming loans. We will continue to actively monitor and manage our watch list credits and maintain strong reserves to ensure the strength of our balance sheet, and continue to support our well-capitalized position. Looking ahead, I remain encouraged not only by our operating discipline in the strength of our internal processes but also by the recent plans and acted out of Washington. We will continue to closely monitor the specifics of these plans and the potential benefits as they relate to independent bank.

I am confident that these combined factors will help guide us towards deposit growth, improved asset quality, and enhanced operating efficiencies through discipline cost containment and return us to profitability in the near term.

With that, I will now turn the call over to our CFO, Rob Shuster, for review of our financial performance during the period. Rob?

Rob Shuster

Thanks, Mike. Good morning, everyone. I am starting at slide seven of our PowerPoint presentation. I will focus my comments on net interest income in our margin, certain components of non-interest income and non-interest expense, asset quality, and conclude by making a few comments about capital in the TARP Capital Purchase Program.

As outlined on page seven, there were some positive factors evident in our third quarter 2008 results. Most notable was the continued strength of our net interest margin. However, the positives were overshadowed by security losses and the rise in credit costs. AJ outlines a few unusual items impacting the third quarter including the aforementioned security losses and increment charge on capitalized mortgage loans servicing the rights and write-downs of ORE properties.

As noted in our first quarter 2008 conference call, effective January 1, 2008, we elected fair value accounting for several preferred stocks that we own. Slide nine provides details on these preferred stocks. The decline in the fair value of the preferred stocks and particularly the conservatorship of Fannie Mae and Freddy Mac led to large security losses in the third quarter. Partially offsetting this fair value declines were gains of $1.1 million on the sale of $48.4 million of municipal securities. Page 10 has details on our securities available for sale at September 30, 2008 and provides both the cost basis and current market values.

In the third quarter, we did record a $125,000 other than temporary impairment charge on a $250,000 trust preferred position in a small Michigan Community Bank. All of our CMOs are investment grade and we have not had any credit downgrades. We have one relatively small sub-investment grade as setback [ph] security on which we recorded impairment charges a few years ago. But the market value of this security continues to exceed its adjusted cost basis.

If you move to pages 11 and 12, tax equivalent net interest income totaled $35 million in the third quarter of 2008 which was up $3.1 million or 9.8% on a comparative quarterly basis and was up $0.5 million or 1.3% on a linked quarter basis. Average interest earning assets were down on both the comparative quarterly in linked quarter basis. Average loan balances were up, but this increase was exceeded by the decline in average investment securities. The overall declines in averaged interest-earning assets were more than offset by the increase in our net interest margin. As you can see on page 11, our net interest margin was 4.76% in the third quarter of 2008, up 45 basis points year-over-year, and up 8 basis points on a linked quarter basis.

In the third quarter of 2008, nonaccrual loans averaged $115.4 million compared to about $104 million in the second quarter of ‘08 and $58 million in the third quarter of 2007. Our elevated level of nonaccrual loans of approximately $112 million at quarter end creates a drag of about 26 basis points on the net interest margin. Our ability to bring our cost of funds down at a pace faster than the decline in our yield on interest-earning assets has allowed us to improve our net interest margin.

Page 13 provides information on the year-to-date decline in our level of brokered CDs. Because we issued a lot of callable brokered CDs, we have been able to exercise our call rates and payoff the higher costing brokered CDs with lower cost borrowings from the Federal Home Loan Bank and the Federal Reserve Bank. During the third quarter, pricing conditions in the brokered CD market improved and we did issue some term CDs to diversify our overall funding nets.

Looking ahead and assuming that short-term interest rates remain relatively low, the yield curve remains upwardly sloped and that nonaccrual loans do not rise significantly, we would expect the net interest margin to remain in the 4.75% area were consistent with this quarter. We are seeing some pressure on and outflow of uninsured deposits. However, if we can continue to borrow from the Fed at rates of 1.75% or less, these deposit outflows should not have an adverse impact on our net interest margin.

Finally, assuming a relatively steady net interest margin, a drop in our overall level of interest-earning assets will likely result in some decline in the dollar amount of our net interest income.

Moving on to some of the more significant categories of non-interest income on page 14 of our presentation. Service charges on deposit accounts decreased by $149, 000 or 2.3% on the comparative quarterly basis and increased by $252, 000 or 4.1% on a linked quarter basis. The linked quarter increase is primarily due to traditional seasonal variations in NSF occurrences in related fees. However, the comparative quarterly decrease is due to a decline in NSF occurrences in related fees that many banks are experiencing and that I believe reflects belt tightening on the part of the consumers.

VISA check card interchange income was up 14.1% on a comparative quarterly basis and was down slightly on a length quarter basis. The introduction of a rewards program in early 2007 was pushing these revenues higher but now that the rewards program has been in place for over a year we may see some flattening out of this line item.

Gains on sale of mortgage loans totaled $1 million in the third quarter of 2008 on $52.8 million of loan sales. This compares the gains on the sale of mortgage loans of $1.1 million in the second quarter of ‘08 on $80.2 million of loan sales. The profit margin on loan sales was up in the third quarter mainly due to higher mix of FHA loan sales. These loans are self-servicing release and generally have a higher profit margin than the conventional loans.

Our volume of mortgage loan originations in the third quarter of 2008 was $74.5 million which is down on both the year-over-year and in linked quarter basis. Ongoing changes in underwriting criteria by Fannie Mae and Freddie Mac in the private mortgage insurance companies continue to make it more difficult for borrowers to qualify.

Real estate mortgage loan servicing income declined on both the comparative and length quarter basis. We recorded a $348,000 impairment charge in the third quarter of ‘08 compared to a recovery of $996, 000 on previously recorded impairment charges in the second quarter of this year.

Mortgage loan interest rates declined a bit in the third quarter which resulted in using somewhat higher pre-payment speeds in the valuation of our capitalized mortgage loan servicing rights. Absent impairment charges or recoveries of such charges. This line item should be running at about $650,000 per quarter.

Moving on to page 15 of our presentation. Non-interest expenses total $30.7 million in the third quarter of ‘08 compared to $28.4 million in the third quarter of ‘07 and $31.2 million in the linked quarter.

We have worked diligently to manage non-interest expenses. Over one half of the year-on-year increase is due to loan and collection costs, loss on other real estate in higher FDIC insurance rates. Our overall FTE employer numbers are pretty much down across the company except in the collections and our special assets group.

As evidence on page 16 of presentation, the assessment of the allowance for loan losses resulted in a provision for loan losses of $19.8 million in the third quarter of ‘08. This level represents about 316 basis points of portfolio loans on an annualized basis.

Non-performing loans slide 17, increased a bit to $114.6 million or 4.5% to 8% of total portfolio loans at September 30 of ‘08. The rise in non-performing loans during the third quarter was primarily concentrated in the mortgage loan portfolio. Stefanie will provide more information on her loan portfolio during her comments.

Page 18 of our presentation provides information on the components of our allowance for loans losses which rose to $53.9 million or 2.15% of total loans.

Slide – or page 19, is a new slide. Although the entire allowance for loan losses is available for losses on any loan, we do allocate the allowance to specific loans and loan portfolios. This slide provides information on those allocations at September 30, 2008. It should be noted that the allowance represents our best estimate of losses as of quarter end. Future changes in collateral values or loan defaults will impact our assessment of the allowance.

Slide 20 is also new. This slide takes the portion of the allowance allocated to commercial loans and breaks it down further by loan rating. The $29.5 million of 11 rated loans denoted charge-off have been charged down to expected net realizable value and the remaining allowance represents only estimated sales, liquidation, and holding costs. Net loan charge-offs totaled $17.4 million in the third quarter of ‘08 or 2.69% of average portfolio loans.

Page 21 of our presentation breaks down the net charge-offs by loan type. Again, Stefanie will address this topic in more detail during her remarks.

Moving on to page 22, despite our third quarter loss, we remained comfortably well-capitalized and we believe that the TARP Capital Purchase Program could be of significant benefit to our organization in further boosting our regulatory capital ratios.

Page 23 as our estimated September 30, 2008, regulatory capital ratios for Independent Bank which you can see are all up from year-end 2007. In addition, I’ve included our Pro Forma regulatory capital ratios assuming that we raised 72 million of tier 1 capital in the TARP CPP. We believe this additional capital would put Independent Bank in a position of strength to weather even the toughest downturn in our economy in any potential further stress in our loan portfolios. We submitted our TARP CPP application last Friday and are confident that we will be approved.

This concludes my remarks and I would now like to turn the call over to Stefanie Kimball.

Stefanie Kimball

Thanks, Rob. My remarks would follow slides 25 through 41. I will be discussing our credit quality results and lending initiatives which are designed to enable Independent Bank to navigate through this challenging credit cycle.

Starting with page 25, highlights are outlined with regard to commercial lending. As we have discussed on previous conference calls, credit quality best practices in a new direction for this business line was put in place mid 2007. That direction emphasizes lower risk clients who utilize a broad spectrum of bank services particularly deposits. The results from executing this strategy are now becoming more tangible and measurable. There are several notable approvements [ph] in the third quarter that demonstrate the benefits of the credit quality best practices we’ve implemented as well as the intense focus on our lending initiatives that we have had in place now for the past five quarters.

For example, our overall level of watch credits declined by 8%. This is the first decline we’ve experienced in two years. Commercial loan delinquency rates declined to their lowest level since 2005. There was a slight $300,000 decline in the non-accrual loans with several larger credits moving into ORE. Given our progress in moving credits through the workout cycle, we experienced a higher level of charge-offs in ORE this quarter with charge-offs increasing $4 million and ORE increasing $8 million, both of which are primarily attributable to one large relationship which we will discuss further. Each of these items will be discussed in more detail as we look at the graph later in the presentation.

Further, we have had a number of short and long term initiatives in place to manage through the slow economy and potential recession. Longer term, we believe that as the market stabilizes, there will be resurgence in community banking and increased commercial lending and private banking opportunities. We are repositioning the business to take advantage of these market opportunities with our commitment to continuing education for our commercial lending team. These training supplements are broad strategy which includes tightening credit criteria, enhance the count monitoring, improve watch and workout processes, and independent risk assessments. All of which have already been implemented. Our initiatives are designed to not only produce a portfolio with more consistent and sustainable profitability through a variety of market cycles but also to further improve our delivery of excellent customer service. The end results of this shift in the target loan types has been improved loan pricing with return hurdles implemented, an exit strategy implemented for select watch credits, restrictions on new commercial real estate loan, and a growth focus for C&I loans.

With that overview, I will now turn to page 26 to look at the specific credit matrix starting with the trend of outstanding. Commercial loan balances declined $50 million since last quarter to $1.9 billion as we are now executing our deleveraging strategy. However, we continue to add new credits to the portfolio that meet our target criteria. Recently, pricing in the market has been more favorable than we have seen in many years. We have used both increased pricing and exit strategies for select watch credits to contract the portfolio.

Turning to page 27, the progress that we are making reshaping the portfolio was illustrated. Specifically contracting the commercial real estate categories which include land, land development and construction, and increasing our C&I and owner-occupied categories of lending creating more diversified portfolio, which we anticipate will have a positive impact than credit quality longer term. I should note that earlier this year, we closed out a number of completed construction projects and moved them into the completed income-producing, owner-occupied, and other categories as appropriate.

As the graph on page 27 and also 28 illustrate, we have achieved a 34% decline in vacant land which now totals $40 million, a 20% decline in land development which is now at $63 million, a 49% decline in construction with a completion of a number of the projects to $55 million. Income-producing loans were down a slight 1% to $423 million and owner-occupied and C&I categories have increased 6% and 4% respectively for a combined total of $430 million.

Turning to page 28, now looking more specifically at these segments, you can see that our overall exposure in the higher risk CRE segment is manageable. More than half of the land and land development loans are classified as watch, the remainder of the land loans are relatively small, and these loans are quite granular, with only four loans above a $1 million. Likewise, our exposure in the land development portfolio is manageable and fairly granular with five loans above a $1 million. Also, with regard to the construction portfolio, it should be noted that about half of it is in support of C&I or income-producing segments.

With that, I will now turn to the watch credits which are shown on slide 29. This shows the two misses [ph] trend of watch credits in which we reported our first decline since the fourth quarter of 2005. Improvements can be seen in each category. The internal watch credits which are shown as monitor watch declined $8 million as the inflow further slowed from the pace experienced earlier in 2008 and the more rapid double digit increase as we saw in 2007. Substandard loans declined by approximately $10 million as a result of several larger loans moving into the non-accrual or ORE categories. Non-accrual loans declined $300,000 as the number of credits moved into ORE.

Slide 30 details our commercial loan 30-plus delinquency rate for accruing loan which declined to 138 basis points in the third quarter, an improvement over the 179 basis points we reported in the second quarter. As outlined in last quarter’s conference call, these improvements are results of an increased focus on credit quality and the reallocation of our resources allowing us to keep our client’s payments as timely as possible. Also, in this challenging environment, it is then necessary to re-negotiate terms with clients well prior to the maturity date which negatively impacted the end of the first quarter to a greater extent. We continue to emphasize a proactive approach to renewals and administrative issues with our lenders and coach our lenders in handling difficult conversations with their clients.

Turning to page 31, our nonaccruals are showing. In this quarter, we reported a net decline of approximately $300,000. Although we continue to see loans migrate from the other risk rating category this quarter, that migration was offset by a transfer for a number of loans into ORE charge-off and a $1.6 million recovery.

Turning to page 32, further details are shown on the composition of our nonaccruals. Approximately 95% of our nonaccruals are some form of commercial real estate which often takes a significant amount of time for revolution. About 49% are in the higher risk category of land, land development, and construction. We have factored the link the whole time into our evaluation with loans on average written down by 38%. For example, if the loan was 80% loan of value to begin with, this then would equate to roughly a 50% valuation for the property after the write down. As we have previously discussed from an accounting perspective, we are writing these loans down to our best estimates of the market valuation on a regular basis which include discounts for the anticipated holding time in liquidation cost. Out of our $73 million in nonaccruals, approximately two-thirds fall into a category where we are in negotiations or some forbearance with the customers, with the remaining one-third involving legal action such foreclosure or litigation. Let me pause for a moment to share a few examples that help illustrate the relationships that underlie these numbers and the more personal issues that need to be managed along with the assets.

As I was taught early on in my banking career, people pay back loans not companies. So let me talk about the people. First, I wish to share a success story. We have two clients that owned a problem business that it had several failed attempts at selling. In two of the attempts, the purchasers could not get financing. We continued to work with them and on the third attempt, the business sold and we were able to work out a plan and have the partners covered the deficiency. This quarter, the sale closed and we were able to recognize over a million dollar recovery as we did not attribute value to the personal guarantees earlier on while we were in negotiations. This example illustrates the benefit of our approach in handling problem credits. As we have managed through this difficult cycle, we have consistently taken an approach of working with our clients as long as they are willing to work with us. We believe in many cases the clients can be the best brokers of their own properties or businesses as they are well connected to potential buyers and motivated to minimize their personal liability for a short loss.

We have a number of examples of plans that we are working with using this approach. In this case, patience paid off. We were able to collect the deficiency amount from the guarantors by negotiating a payment plan that was secured by a pledge of personal assets some of which were marketable securities. This example also illustrates our process of charging down loans based upon the collateral value with little recognition of intangible assets such as the strength of the personal guarantors.

Now, we will go – an example of a not so happy ending. This past quarter, we also saw examples of two different clients where the emotional side of the financial stress they were incurring was too much for them to continue to manage their businesses and in both cases, the borrowers turned their assets over to the bank. We were able avoid the time and cost of foreclosure and move the properties directly into ORE. Although we have taken significant write downs in both these cases, this approach was our best collection strategy in those instances. As commercial credit is customized for each client at the time of origination, so too must be the workout plan which adds to the complexity and challenge. We have staffed our workout group with many of our best lenders to ensure that creativity is applied in our problem solving.

Now, turning to page 33, I will discuss the charge-off which rose this quarter to $12.3 million. These loses were primarily reserved in previous quarters; however, updated appraisals were obtained on several large loans as they near the redemption period or were ready to move in to ORE. In the two examples that I highlighted earlier, a client bidding properties to us, the larger of those accounted for 40% or $5 million of our loss this quarter as we took an additional write down. In this case, in particular, the real estate depreciated very rapidly and our current valuations are less than one-third of the original appraisal and just slightly less than – more than half of an updated appraisal that we obtained about 12 months ago. Overall, the provision for the quarter attributable to commercial loans was approximately 800,000 more than the charge-off. Again, losses like the nonaccrual composition are heavily driven by the CRE segments.

At this point, I will spend a few minutes augmenting Rob’s comments about our overall allowance for loan-loss methodology which is updated each year.

Standard reserves are used for all loans risk-graded 8 or internal watch or better and all substandard loans under a million dollars. All substandard loans over a million dollars in the more adversely-rated credits are reserved for with a specific reserve or a loan-at-a-time approach with the collateral carefully evaluated, and I will share some details regarding each component.

First, the standard reserves use our bank’s actual loss history in patterns of default to calculate a reserve for each grade. More specifically, we study the pattern of default over a year’s time. We have used recent experience as the rate of default and this economic cycle is higher than the historical average. These actual defaults [ph] are used to estimate the likelihood or probability of default.

We then look at the actual loss experience in liquidating a large variety of collateral. We look at five years of experience to ensure a broad-enough data set with more heavily weighting in our current economic environment.

Given the current composition of the portfolio, a large portion of the reserve is calculated using the detailed collateral evaluations to include liquidation and holding cost. This fab needs 114 [ph] evaluations to a considerable time looking at the assumptions used by appraisers and applying our own experience in liquidating similar collateral.

Turning to page 34, our special assets team continues to make considerable progress. To date, during 2008, we have collected $19.5 million. Part of the process involved foreclosing and obtaining ownership of collateral when liquidation is necessary to repay the loan. The end of the foreclosure process is our ORE other real estate category. Earlier as I highlighted, the two largest credits that went into ORE this quarter increased ORE by $8.6 million. The larger of these two credits accounted for 60% of the increase.

I will now turn to our retail portfolios. First for some highlights on page 35 and then a review of the key credit metrics.

The retail businesses new loan originations contracted last year with tighter credit underwriting parameters. Given our current desire to deleverage the balance sheet, we implemented even more select criteria in the third quarter with both consumer and mortgage originations that we intend to hold for our portfolio. Certainly, the secondary market as Rob outlined has also tightened credit parameters which has resulted in slowing volume with the industry as well as our market. With the continued depressed economic conditions throughout Michigan, we experienced an increase in retail delinquency and losses.

Turning to page 36, we will look at some specific numbers with regard to the retail loan portfolio balances. At quarter end, the balances were down slightly with mortgage loans totaling $858 million and consumer loans $369 million.

As illustrated on page 37, delinquency rates for consumer loans and mortgages rose slightly in the 30- to 89-day category. To keep pace with these increases, we have made further additions to our collections staff and made enhancements to our loss mitigation processes.

Turning to page 38, nonperforming assets continue to rise in the third quarter. The lengthy foreclosure and disposition process results and accounts in this status continuing decline. We have established a number of channels to assist in handling ORE as we complete the foreclosure process. We have concentrated our ORE management with our bank properties manager. We also have designed a website where we advertise the properties for sale in our community. In addition, we have established relationships with realtors and auction houses that know the communities we serve. On average, we have written down our nonperforming mortgage loans to 62% of the original praise value.

In general, most of our nonaccrual loans are very granular. Most of the homes are in the $200,000 and below range, a segment which has had a more stable demand from home buyers. As you look into the details of the housing sales statistics in the state of Michigan, we continue to see most of the activity is concentrated in those lower-priced homes.

Turning to page 39. Retail net charge-offs for the third quarter increased to a $1.1 million for consumer and $3.7 million for mortgage. Further, as Rob detailed, an additional write down for residential or re-properties was recorded in the third quarter, again reflecting the most current market conditions.

Turning to page 40, as we consider the economic climate of Michigan and the challenges ahead, it is important to look back at the foundation of the credit best practices that has been put in place in both commercial and retail. On page 40, there are highlights of the numerous initiative and changes that we have implemented since 2007 and continue to enhance. I will highlight just a few of these best practices. Our watch process has now been in place for five quarters and is functioning effectively. Our special assets team is highly motivated in working hard to address the problem loans and help our clients and our banks through this difficult economy. As businesses value credit availability more than in the past and our competition lessens, we have a market with significantly less price sensitivity and we have been able to raise prices for commercial loans. We have done this using our new pricing model.

On the retail side, page 41 highlights some of the key initiatives and actions taken. Our charter in bank consolidation in 2007 has produced significant risk management benefits. Centralized credit decisions have allowed us to effectively tighten credit. The centralized collections teams have produced operational efficiencies and allowed us to leverage internal best practices. Management has also conducted external benchmarking to obtain and incorporate new collection of ideas.

In summary, this is certainly a challenging time in the financial industry. There has been some time since we have seen a credit correction this deep. However, Michigan bankers have weathered numerous past credit storms as of many of our business and consumer clients. Independent Bank has put in place the enhanced credit processes that we believe are necessary to weather the storm. We have a justice underwriting to parameters that have stood the test of time and many market cycles and we are actively working with our troubled borrowers. We can continue to invest in our employees with training programs for both the short and long term. Longer term community banking opportunities appear more attractive and we are building the infrastructure to leverage these opportunities. I will now turn over the call to Mike Magee.

Mike Magee

Thank you Stefanie and thank you Rob.

Thank you for your patience during this detailed and lengthy presentation. However, we feel that during these extraordinary times, it is important to show as much transparency to the market as possible. As one of the oldest and most well-respected banking brands in Michigan and we remain dedicated to our overall goal of providing not only the best community banking services in the industry, the financial results that make IBC a strong addition to your investment portfolio. Rest assure, we intend to weather the current storm and continue to distinguish ourselves as the community bank of choice in the markets we serve. That concludes our prepared comments. At this time, we will open the line for questions from investors and analysts.

Question-and-Answer Session

Operator

(Operator instructions) Our first question will come from Terry McEvoy from Oppenheimer & Company. Please go ahead.

Terry McEvoy – Oppenheimer & Company

Hi, good morning.

Mike Magee

Hi Terry.

Stefanie Kimball

Good morning.

Terry McEvoy – Oppenheimer & Company

I have a quick question on page 25, that last bullet, maintained restriction on new CRE coupled with increased focus on C&I loans, what specifically do you mean by increased focuses? Does that mean it is an area you would like to grow or you are going to increase your focus on managing the credit risk on C&I? I did not know how to read that statement.

Stefanie Kimball

Terry that is a great question and really, the intention is both. Obviously, our focus is to move towards more C&I loans and we also have to enhance our monitoring and following of those credits.

Terry McEvoy – Oppenheimer & Company

And Rob, what happens if you do not get this $72 million of TARP-related credit? Is there a plan B, does there need to be a plan B?

Rob Shuster

Well, A, I am confident we will get it but you always need to have a plan B regardless. Again, I think our plan B would be to continue to deleverage the balance sheet. You can see we made progress on that in the third quarter. I think it would allow us to continue to boost our capital ratios. This quarter, obviously we had the security losses which we think were fairly unusual in nature. Absent those, we would have had a much smaller loss and the provision was quite a bit higher than where we have been running so the combination of eliminating the security losses and even bringing the provision down a bit but to still very high levels would have us in the black and we combine that with some deleveraging and I think we would be able to grow our capital ratios in stages fine while we weather the storm. We would look at if there are alternatives but frankly, the terms on the TARP CPP program are very attractive and I think the terms with the private equity offering or some type of public transaction would be not as attractive but depending on the length of the downturn and the pressure on the loan portfolio, we would look at all options but we think the deleveraging option is the best because it allows us to weather the storm, keep our capital ratio strong and not have to go to plan B. That would be our plan B. Like I said, I am confident that we will qualify for the TARP program.

Terry McEvoy – Oppenheimer & Company

One just last quick question. The $400,000 increase in advertising was that Independent Bank playing offense or defense? And by defense, I mean just putting out more brochures for the branches and the commercial runners [ph] to make sure your customers feel comfortable and understand the safety and soundness of the bank.

Mike Magee

Terry, this is Mike and I will answer that. In working with our marketing department, the executive management team made a decision that we actually need to implement both strategies to our marketing collateral, and that is it is that we need to reassure our current customer base that their deposits are safe and they are doing business with any bank corporation is still something that they do not need to worry about. And then a lot of that had to do with the failure of Indy Mac and then the takedown of the negotiated sales of WaMu and other financial institutions. It heightened the concerns of our customer base considerably because at least with any Indy Mac we have a feel of who is the bad banks and who are the good banks but with the negotiated sales that took place of WaMu and Wachovia, it made our customer base extremely nervous about – they could not tell anymore who is the good bank and who are the bad banks. So for that reason, we needed to spend quite a bit of time working with a lot of our large depositors and also improving our marketing programs to our current customer base and then also to take advantage of these unprecedented times to basically grow our deposits through customers. There are certain customers that no matter what you tell them or how much information you give them, their minds made up and they are going to move their money to where it is insured, and so we are taking advantage of those customers from other financial institutions as well. So basically, I would answer that question, it was an increased marketing expense to cover both strategies.

Terry McEvoy – Oppenheimer & Company

Thank you.

Operator

Thank you. Our next question will come from Brad Millsaps from Sandler O’Neill. Please go ahead.

Brad Millsaps – Sandler O’Neill

Good morning.

Mike Magee

Good morning, Brad.

Brad Millsaps – Sandler O’Neill

Stefanie, I am just curious, do you have a sense of what you might be able to get back in terms of property during the fourth quarter. I am just curious where your balances might end up at the end at the end of the year.

Stefanie Kimball

Well, Brad, a couple of things. We are in negotiations with a number of other clients but it is really too early to tell what would move in to ORE other than there are a number of things in foreclosure that will move but nothing that would be as significant as the jump that we saw in this quarter.

Brad Millsaps – Sandler O’Neill

Yes, I know the foreclosure process in Michigan. This can be fairly lengthy but I guess I am a little surprised that you have not taken more property back at this point.

Mike Magee

Well Brad what has made it very difficult on a lot of this large relationships has been the amount of second, third, and fourth liens that have been placed against the properties. And so as much as we would like to negotiate with the borrower to get a deed in lieu of foreclosure when we performed a title search on the property we find that (inaudible) and then their multiple relationships with other financial institutions. Everybody is throwing liens against everything in individual loans right now just to cloud the title so that may be they can – they’re desperate that they will be able to obtain some type of proceeds to help go against their loan. So as much as we would like to accelerate the process unfortunately, we find ourselves in many cases, having to go foreclosure route so that our first mortgage position by – through the foreclosure we can wipe out all of the additional liens that have been placed against the property.

Brad Millsaps – Sandler O’Neill

Okay, you have answered my next question at some respect but if you do get the $72 million of target money, my thought would be, would you accelerate maybe the even faster on the write down on somebody’s property in order to clear them off the balance sheet or Rob is it your thoughts that you would hold on to that capital and play and wait and see game at this moment?

Rob Shuster

I think what we do is what’s economically in the best interest of the bank. In other words, if we feel we could get reasonable value, we would pursue that and Stefanie mentioned we have a lot of instances where we are working with the borrower and they are slowly able to peck away at it and I do not think we changed that strategy because trying to just sell a wholesale amounts of those assets I do not think is in the economic best interest of the bank.

Now, we may look at doing something creative like forming a sister company to the bank that is a direct subsidiary to holding companies. It is not going to change the holding company numbers but we could potentially move, sell assets from the bank to that sister company. We could then – that would accelerate the improvement in the bank’s balance sheet which could have some benefits on things like FDIC insurance costs while we still manage those assets in the best economic interest of the organization. So I think that is going to be our approach.

The $72 million I think gives us some ability to look at sales if we can get what we think is reasonable economic value, but I do not think it will push us to just accepting distress crisis to just make the numbers look better. I don’t think that is in the long-term interest of our shareholders. And the other thing I think it does give us the ability to do is looked at opportunities to grow the organization. We are now focused more on the deleveraging but I think we would revisit that strategy. We’d still vigorously manage the balance sheet but I think it would allow us to may be look at opportunities for growth in certain loan segments. And I think that is one of the designs of the TARP CPP program is to get banks lending and growing, and help get this economy turned around.

Stefanie Kimball

Brad I would also just add that we do a regularly check the debt market to see if there are not select opportunities to move loans out of the organization. To date we have found those prices to be very distressed but we do continue to look to see there are not select opportunities. So I could – if I would add to Rob’s comments that although we’re not looking at any wholesale transaction to move a bunch of loans or sell them and take large write downs, there are select opportunities that we continue to look at.

Brad Millsaps – Sandler O’Neill

And Stefanie on the – if I have my numbers correct, one of the large charge offs this quarter, you said it was $5 million related to one borrower. You’re not carrying out it less than one-third of the original appraise value in 50% of an appraisal obtained about a year ago. I mean that seems reasonable but would you say that is a typical in terms of the date of that appraisal or would you have more up to date appraisals on the majority of your loan and things like that is a large relationship there to have. I guess, an appraisal of that would be 12 months old and this type of market, it seems to be changing by the hour.

Stefanie Kimball

Well, just to de-clarify my comments. I am glad you asked the question, Brad. We do have an updated appraisal on the property that we just got. And what my comment was, we had also had one a year ago and we also had one in 2004. And so, I was comparing those three points in time for several properties that are all related to this one borrower.

Mike Magee

I think Brad’s question is the space of time of the 12 months between the one in late ‘07 versus the current one. Was that typical or would we have more recent appraisal?

Stefanie Kimball

Typically, we would get appraisals at least once a year for a stress asset like this and we would also want to time those appraisals, so we would wait and get an appraisal right as we were moving something into ORE like we just did.

Mike Magee

That one was a little unique, Brad, because we had done a forbearance agreement and had gotten additional collateral. I would say, typically, the processes differ and so the appraisals are more current relative, to say that last point you revalue the property. This one was unique because we did a workout for the end of last year, took on additional collateral and I do not think it is a situation that is indicative of the typical process or that you would see that type write down, that is an anomaly in my view.

Stefanie Kimball

The collateral was concentrated in one of the markets than the most stressed. So, we really have dropped significantly in value. That would not be typical for the state in general.

Brad Millsaps – Sandler O'Neill

Okay and final question on the heels of Terry’s question regarding advertising who knows you are opening a branch this week, just curious, what are your plans? Are they going forward? Is that the best use of resources in this environment? And thank you very much.

Mike Magee

Thanks Brad. Regarding the branch that will be opening on Thursday or after this grand opening on Thursday, that actually has been a loan production office in Houghton Lake for several years and a very effective loan production office in originated real estate mortgages. We licensed that, it was just an office in a strip mall and we basically obtain the approval for it to be a branch to accept deposits several years ago. And along with originated mortgages, it has received in those storefront deposits. It made more financial and economic stance when we took a look at the projections to move out of the leased space that we were in and to build our own brick and mortar facility, full service branch, again, based on already the reputation and business that we are generating out of that market. So what we really do is moving out of a storefront into full service branch. It is not opening a brand new branch in an unknown market to Independent Bank. At this point, to the overall corporation, we do not have any additional branch or new branch plans on the drawing board for any of our locations. We are looking at remodeling some of our current locations and renovating but we do not have plans for any additional new branch expansion.

Operator

Thank you. Our next question will come from Jason Werner from Howe Barnes. Please go ahead.

Jason Werner – Howe Barnes

Good morning.

Stefanie Kimball

Good morning Jason.

Jason Werner – Howe Barnes

Most of my questions have been answered. Just a follow up, with the loan we just talked about, there was a large one that was the bulk of the charge offs. Is that the same loan as the bulk of the REO too?

Stefanie Kimball

Yes. That was also the example of the customer that emotionally just couldn’t continue to try to market their own properties. And so, it moved right in to ORE and we took that significant charge.

Rob Shuster

Well that’s an example where we did do a deed in lieu because there weren’t at the secondary lane so it moved quickly and it had been performing prior to that capitulation.

Jason Werner – Howe Barnes

I assume this is some development project but what is the collateral?

Stefanie Kimball

The collateral is vacant land and also a retail strip center.

Jason Werner – Howe Barnes

Okay.

Stefanie Kimball

And the vacant land is what I would call on the fringes of the urban development and that is the real estate that we have really seen drop quickly in value, so somebody who bought land and plans to develop it and it was going to be the next new subdivision, well, that development is very sold and that significantly has impacted the prices and costs for that significant write down.

Jason Werner – Howe Barnes

And the retail strip center, I am guessing, is this suffering from low vacancies then?

Stefanie Kimball

Yes. It just was recently constructed and needs to get tenants.

Jason Werner – Howe Barnes

Okay. You guys said that this project was in areas that have some more distress prices? I guess you should be a little more clear on where this property is?

Stefanie Kimball

It is in the Macomb County area which is one of the areas that had very rapid growth prior to the slowdown, and that is probably one of the counties that we have seen the greatest drop in value.

Jason Werner – Howe Barnes

Okay. I also have a question about the slight tent, I’m just curious is it available for sale, obviously the unrealized loss through this quarter. You said that the – on the private label, a CMO that was the sub-investment rate you would hardly take a hit on that and it is not –

Mike Magee

It was not a CMO. It is a mobile home asset-backed security.

Jason Werner – Howe Barnes

Okay.

Mike Magee

And we took impairment charges of about $400,000 collectively or so back in ‘04 and ‘05, and it is performing just fine. And now, the market value comfortably exceeds the adjusted cost basis but when you take other than temporary impairment, you cannot write it back up unless you sell it.

Jason Werner – Howe Barnes

Right.

Mike Magee

So that’s the only security in that grouping that we’ve had any downgrade on whatsoever.

Jason Werner – Howe Barnes

Okay, but obviously that’s not part of that $6.9 million –?

Mike Magee

No. Most of that – it is just the CMO market, in general is off, so some of these are driven by rates being higher than when we originally bought the CMO’s. Others, just in general out of favor. But we’ve gone through and analyzed every one of them and looked at. We didn’t buy in support franchise on any of these. Ours is at the top of the food chain and in almost every instance our – the subordination support below is actually better than when the CMO was originally constructed.

Jason Werner – Howe Barnes

Okay. So looking at that, you don’t see much of a chance of an OCTI [ph] on that.

Mike Magee

No. They all have maturity dates and there all – the credit support is good on all of those.

Jason Werner – Howe Barnes

Okay. What can you tell us about this money market preferred that’s off almost $5 million?

Mike Magee

The money market, and I have a footnote, the money market preferred is backed by Bank of America’s Series E preferred stock and Lehman Brothers have put together, basically, two tranche asset that had a floating rate piece, an A piece [ph] that represented 75% of the – that has tied the LIBOR. Actually, it was an auction, they held a quarterly auction to establish the rate and then there was 25% of it was an inverse floater which was the higher risk of the structure. We own the low risk. What was supposed to be low risk piece of it, and earlier this year the auction began to fail and so the rate for our piece was actually set by a formula and so we were getting a much higher rate, it was an above market rate at the time.

What happened in the third quarter was – with Lehman Brothers’ bankruptcy that created under the Trust [ph] a distribution event. And so in November, we were actually getting distributed the Bank of America’s Series E preferred stock and all preferred stocks as you can imagine were down dramatically in the third quarter because of the Fannie Mae and Freddie Mac conservatorship. So that fair value was the value of the underlying Bank of America preferred series E. And at least at this juncture – and you may be aware of the SEC send a letter to the feds beyond perpetual preferred and they said what to the credit worthiness of the issuer and certainty of the cash flows. And so when we evaluate this, and look at the credit worthiness of the issuer which is Bank of America, we are comfortable with that and the certainty of the cash flows were comfortable with. The pricing on it is LIBOR plus 35 with a 4% floor and recognized that 70% of it is not taxable. It is a dividend received deduction. And their coverage ratio on their preferred dividend was like 7 or 8 times. So we felt comfortable that we did not have other than temporary impairment on that but that is the reason for the steep declined in the cost basis versus the fair value. And finally, we have the ability and intent to hold that until such time as the price recovers.

Jason Werner – Howe Barnes

Once you get the possession of the series E preferred would you have dividend available for sale or would you move that into with the other preferred stocks?

Mike Magee

Our intent is to keep it in available for sale.

Jason Werner – Howe Barnes

Okay. And then, also you said and I think I heard you right. You had a head year margin in the 475 range. You said that given the shrinkage in earning assets that the dollar level of things that is likely to come down. Is that would you said?

Mike Magee

I said that if we continue to deleverage, I don’t know that we can make up that with growth in the margin although if the fed moves in other half point tomorrow, I would have to revisit that. That would give us I think a bit of a boost but nonetheless, I think I had it in the slide just to give you an example. We were able to borrow a$100 million in the fed term auction at 1.11%. So the fed liquidity has been extremely helpful to us. We have taken as much advantage of it as we can and like I said if the fed moves again, it is likely going to help us.

One other odd thing Jason is LIBOR spreads are elevated and that has helped us a bit. We have more assets that are tied the LIBOR loans and some securities that have re-priced at higher rates and we have very little debt or borrowings tied to LIBOR. And we have paid fixed interest rates swaps. We are paying a fixed rate and receiving LIBOR. So all of that has helped a little bit to – but again my basic premise was absent of fed move, there is probably not a lot more upside potential on the margins. So if our earning and assets are shrinking a bit that is going to have a little move down in our dollar amount of net interest income.

Jason Werner – Howe Barnes

Okay, thank you guys.

Operator

Thank you our next question will come from Steve Geyen from Stifel Nicolaus. Please go ahead.

Steven GeyenStifel Nicolaus

Yes just one small question. Stefanie I think I heard you chatting a lot of things down at time. It’s like you made some changes to the standard reserve, just wondering, what assumption are they using?

Stefanie Kimball

The standard reserves that I was outlining are the methodology that we have had in place all year. We would go through a once a year review and update of that. So it is not something new.

Steven GeyenStifel Nicolaus

Okay, got you. Thank you.

Stefanie Kimball

You’re welcome.

Operator

We show no further questions at this time. I would like to turn the conference back over to Mr. McGee for any closing remarks.

Mike Magee

Stef, Rob, thank you.

With that, this concludes our conference call today. Thank you for your interest in Independent Bank Corporation and we look forward to speaking with you again next quarter. A reminder, for an archived webcast of today’s call, please go to the Investors Section of our website www.ibcp.com. The webcast will be archived on our website for approximately 90 days from today’s date. If you have any questions in the interim, please feel free to contact Stefanie, Rob or myself.

Again, thank you and have a great day.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.

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Source: Independent Bank Corporation Q3 2008 Earnings Call Transcript
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