Integra Bank Corporation Q3 2008 Earnings Call Transcript

Integra Bank Corporation (IBNK)

Q3 2008 Earnings Call Transcript

November 10, 2008, 4:00 pm ET

Executives

Michael Vea – Chairman, President and CEO

Martin Zorn – COO and CFO

Ray Beck – EVP, Chief Credit and Risk Officer

Analysts

Scott Siefers – Sandler O'Neill

Stephen Geyen – Stifel Nicolaus

Presentation

Operator

Welcome to Integra Bank Corporation third quarter 2008 earnings conference call.

Before we proceed the company would like to note that the statements made in the course of this conference call that are not based on historical facts or forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The risk factors and cautionary statement in the forward-looking statements are detailed in the company's filings with the Securities and Exchange Commission and in the press release issued on Thursday, October 30, 2008.

The company makes no commitment to update any forward-looking statements based on new information, future events or otherwise. Please note that a replay of this call will be available for 30 days through our Web site at www.integrabank.com and by telephone at 1-888-203-1112, pass code 3946197.

Today's conference will be presented by Mr. Michael Vea, Chairman, President and Chief Executive Officer of Integra Bank Corporation and other executive officers. Following the presentation we will open the call for questions.

At this time I would like to turn the call over to Mr. Vea. Please go ahead, sir.

Michael Vea

Thank you, and good afternoon. As you know we rescheduled the conference call to complete our analysis for impairment of goodwill. So again, thank you for adjusting your schedule to join us on Integra Bank Corporation's Conference Call for the Third Quarter of 2008.

I am Mike Vea, CEO of Integra, and with me today are Martin Zorn, our Chief Operating Officer and Chief Financial Officer and Ray Beck, Executive Vice President and Chief Credit and Risk Officer.

Our comments today will refer to the financial information in our 10-Q quarterly report that we filed after the close of trading this afternoon. I will review several themes including the steps that we are taking to respond to the current market and economic challenges, ask Martin to discuss our third quarter financial results and then ask Ray to discuss our credit results and credit quality, and then we will open the line to questions.

We will focus our comments on the key issues for Integra. Those are asset quality, capital and liquidity.

Our third quarter loss of $1.62 per share which includes the $1.48 per share for goodwill impairment was driven by a higher provision of $18 million, which exceeded net charge-offs by $10 million and the goodwill pretax impairment of $48 million.

Revenue excluding security gains and losses was flat quarter-to-quarter as net interest income declined and fee income increased. Net interest income was adversely affected by a higher level of non-performing loan, and increasingly, competitive deposit pricing environment in the ongoing dislocations in the credit market.

Deposit service charges increased 16.3% during the quarter. Excluding the $48 million goodwill impairment non-interest expense was flat despite higher problem loan related expenses.

Our problem loan including almost all the increases in the third quarter continue to be centered in residential builder and construction portfolio which now represents 74% of our total non-performing loan.

We continue to monitor the deteriorating state of the economy and weakness in the housing market. And more specifically, the impact of conditions in Chicago are having on our company. These conditions have stretched our residential builder customers now related residential construction loan portfolio resulting in increased levels of non-performing assets and provision for loan losses.

We have taken a number of aggressive actions to better position the company to manage through this period of uncertainty. We continue to have success with our new deposit and account programs. We made organizational changes that included the promotion of a number of key employees to focus on these activities. We are not pursuing new opportunities for commercial real estate lending until the market for permanent financing improves.

Finally, we are analyzing our options with respect to further reducing commercial real estate loans and problem assets and also participate in the treasury capital purchase program.

Given market conditions, our emphasis is on credit quality, growing loan cost deposits, taking care of customers and improving our operating leverage. This represented a third straight quarter that are provisioned with more than two times of our net charge-offs.

We believe this is the prudent approach to protect against further deterioration in our housing collateral. Enhancing deposit and fee growth while slowing our loan growth should generate increasing revenue and asset capital that we need to manage through this period of uncertainty.

Now we will have Martin Zorn provide an update on our financial performance.

Martin Zorn

Thank you, Mike. In the third quarter, we reported a net loss of $33.3 million compared to a net loss of $899,000 last quarter, net income of $9.2 million in the third quarter 2007. As Mike mentioned the principal drivers of the decrease was a provision expense of $18 million, a reduction in net interest margin of 21 basis points and the goodwill impairment charge of $48 million. All of which I will review in greater detail. The loss per diluted share was a $1.72 for the quarter which resulted in a year-to-date loss of $1.42.

The third quarter 2008 was highlighted by the following items. The provision for loan losses was $18 million for the third quarter compared to $6 million for the second quarter of 2008. On a year-to-date basis, our provision is $27.6 million or $14.5 million more than our net charge-offs of $13.1 million. The allowance to total loans increased 38 basis points to 1.70% while net charge-offs increased to 1.31%.

Non-performing loans increased $35 million to $85 million or 3.46% of total loans, while the allowance to non-performing loans decreased from 63% to 49%. Net interest margin declined 21 basis points to 3.22%. There were three contributors to this decline. The increase in non-performing loans with the related accrued interest reversals on our new MPLs accounted for half of the decline.

Increased deposit pricing driven by a combination of our bias towards longer dated liabilities and market competition for these deposits and the impact of interbank market dislocations evidenced by volatile LIBOR rates.

The goodwill impairment of $48 million which I will review in greater detail. Non-interest income excluding securities gains and losses was $10.2 million for the third quarter of 2008 compared to $9.3 million for the second quarter.

As Mike mentioned deposit service charges increased $825,000 or 16.3%. Non-interest expense for the third quarter of 2008 excluding goodwill impairment charges was flat with the second quarter and the income tax benefit for the third quarter was $22.8 million. Before discussing the financial drivers in more detail we would like Ray to provide you with more color around credit quality.

Ray Beck

Thank you, Martin. As we all know the third quarter of 2008 proved to be a very difficult and challenging quarter for the banking industry as credit quality continued to deteriorate throughout the country. As Mike mentioned we also continued to experience credit deterioration throughout the quarter, principally limited to residential construction and development.

We experienced a continued increase in non-performing assets as non-performing loans increased by $35 million to $85 million. The majority of the increase came from loans to residential builders, both in our Chicago region and from our commercial real estate group managed from Cincinnati.

However, aside from residential construction, the overall portfolio continues to perform satisfactorily and we did not experience significant increase in non-performing loans or OREO any other product line. Included in the non-performing loans are $6.5 million of C&I loans, $71.2 million of commercial real estate loans, $5.4 million of one to four family residential loans and $2.1 million of consumer loans.

Of that $71.2 million in commercial real estate loans, 89% or $63.1 million are tied to residential development and construction. 61% of this amount is managed in our Chicago region and 39% is managed in our commercial real estate group.

While residential development and construction lending represents the bulk of the loans in our Chicago region, it represents less than 20% of the loans managed by our commercial real estate group.

Net charge-offs increased this quarter to $8 million or 131 basis points for the quarter with year-to-date losses of $13.1 million or 74 basis points. While we are disappointed in the magnitude of these losses we are encouraged that to-date losses largely have been confined to our residential construction and development loans and have not spread to the rest of the portfolio.

C&I losses were nominal and losses from consumers continue to be moderate with one to four family residential losses of $344,000 or 61 basis points. And other consumer losses excluding overdrafts of $973,000 or 90 basis points.

As mentioned we increased the loan loss reserves significantly during the quarter as our provision of $18 million exceeded our losses by $10 million resulting in an allowance of $41.8 million or 1.70% of total loans at the end of the quarter compared to $31.8 million or 1.32% of loans at June 30th. The reserve coverage of non-performing loans declined from 63% at the end of the second quarter to 49% at the end of the third quarter.

Although the reserve coverage of non-performing loans has declined, we believe we maintain adequate coverage of the risk of loss of non-performing loans. 74% of our non-performing loans are tied to residential, construction and development, of which 61% are managed in our Chicago region typically, and 80% loan to value at origination.

The Chicago housing market continues to experience some level of housing activity although the spring and summer sales seasons were not as robust as hoped. Chicago has experienced some decline in housing prices but according to published data it appears that the overall market decline has not exceeded the value of our collateral cushion.

The Case-Schiller index of residential housing values shows the decline in the value of Chicago single family homes of 11.3% in the peak of the index in September 2006, the most recent index for August 2008.

In addition, the Zillow Index for the second quarter of 2008 shows a decline of 8.8% from its peak in the second quarter of 2006. On a year-over-year basis, second quarter Zillow Index shows a decline of 7.3% for all loans with the 7.6% decline for single family and a 5.2% decline for condos.

Moreover, since April 1^st, 2008, we have received new or updated appraisals on approximately 70% of the property securing our nonperforming loans in Chicago. And we will continue to update appraisals if the cycle continues.

While some deterioration is evident, by and large that deterioration appears to be in line with the published data. In addition, the overall demand for housing it appears stable in Chicago with potential buyers in Chicago choosing to rent at this point in time rather than buy.

Market information indicates that the demand for rental housing continues with average rental rates for Class A and Class B apartments generally increasing around the city. Further, a recent report indicates that vacancy rates for Class A and Class B space are declining. We have seen many of our borrowers temporarily convert for sales units to for rent units to take advantage of this trend.

Finally, as I have noted, the performance of our other portfolios continues to be stable. In particular, we are encouraged by the continued stability of our core direct consumer portfolios, which are underwritten centrally. Overall, our centrally underwritten consumer portfolios have a delinquency rate at September 30, of only 64 basis points and a non-performing rate of only 48 basis points.

We are continually reassessing and improving our risk management practices and we continue to take steps to maintain control over our credit risk. A few of these steps bear noting.

We are directing our Chicago lending staff to focus on managing the stressed loans in the portfolio and we have added credit personnel to Chicago office to support that effort. We stopped originating new residential construction and development loans. And we anticipate the portfolio shrinking over the foreseeable future.

Consistent with that expectation, Chicago portfolio declined by $19.2 million from December 31st to $381.4 million at September 30th despite the funding of approximately $51.1 million against already committed construction lines.

Second, despite our continued comfort for the remainder of our commercial real estate portfolio we have determined that pursuing additional growth in our CRE portfolio is not prudent at this time. Accordingly, during the third quarter, we discontinued pursuing new CRE opportunities regardless of property type.

While the portfolio may continue to grow in outstandings over the next nine months as we fund against a small pipeline of pending loan and against the existing commitments. We expect this portfolio to begin to decline in the second half of 2009.

Finally, in light of current circumstances we have made a number of policy and process changes including lowering our house limits for larger relationships and tightening our loan approval standards and process.

Now let me turn it back to Martin.

Martin Zorn

Thanks, Ray. There are a few key financial areas that I want to expand upon. First, with respect to the decline of the margin, as I previously mentioned, there were three primary drivers. The increase in non-performing loans and the reversal of accrued interest on new MPLs reduced the margin by 11 basis points. The second driver was our bias towards longer dated maturities. We improved our liquidity position by attracting longer average maturities on our deposits, thereby reducing rollover risk.

In our markets we are experiencing very intense rate competition from National City and fifth third for CD deposits. We felt that it was prudent to pay up for these deposits in order to have longer data deposits and improve the liquidity position.

Finally, the disruptions in the LIBOR markets negatively impacted us as we saw the spread between prime and LIBOR shrink dramatically.

As we look forward, the steps taken by the FDIC have improved consumers confidence in deposits and has allowed us to take a more normal view towards our liquidity position. There will be a cost to the FDIC actions as we would expect our FDIC premiums in 2009 to increase by approximately $3 million compared to this year including the cost from the FDICs recent actions. Given the continued market uncertainty we would expect to see some margin pressure in the fourth quarter.

Our tangible equity to tangible assets ratio was 5.9%. Tier one capital to risk assets was 9.1% and our total capital ratio was 11%. All within our guidelines.

While we maintain ratios in excess of regulatory guidelines we are reviewing the treasury capital purchase program as cost effective means to further strengthen our capital positions.

Goodwill was $74.8 million of September 30^th, a decrease of $48 million or 39.1% from June 30th. The decline was due to a $48 million goodwill impairment charge recognized during the quarter. This charge was recorded net of tax as we are able to deduct for tax purposes, substantially all of the goodwill over a 15-year period.

Given market conditions as well as the fact that our stock prices been trading below book since April, we have been evaluating goodwill impairment on a quarterly basis. Based upon our third-party assessment at June 30th we determine that we did not have impairment.

The test for goodwill impairment is a two step test. The first compares a fair market value of the company to its carrying value. If this test indicates goodwill impairment then the second step compares fair value of the company to the aggregate fair values of its individual assets, liabilities and identify intangibles.

Given the negative economic trends in the general economy combined with the increasing levels of our non-performing loans and increased loan loss provisions we determine that it was prudent to have the independent outside firm perform the second step test as of September 30^th. The result of that test was a $48 million impairment that we recorded.

Now, let me turn the call back over to Mike.

Michael Vea

Thanks, Martin. Hopefully, as you can tell we are taking aggressive steps to weather the unprecedented conditions affecting Integra and the entire financial industry. We are trying to mitigate our residential construction credit issues with increased provisioning, adding more resources, taken a conservative approach to putting loans on non-accrual, and in our collateral valuation. As we say, plan for the worst, hope for the best.

We will continue to invest in our retail and business areas which have positive momentum. We're confident that this will pay dividend for us this cycle term. Mercy, we are happy to answer any questions at this time.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from Scott Siefers with Sandler O'Neill.

Scott Siefers – Sandler O'Neill

Good afternoon, guys. Let's see I guess first question will just be on credit costs. Do you have a – do you have a sense just given the sort of wide range that have been in what we might expect for both charge-off and provision in the coming quarters?

Ray Beck

Scott, this is Ray. At this point we are really not providing guidance on that, but I can tell you that we don't see anything in the near-term that would indicate that the current conditions of residential housing industry are going to change or improve.

Scott Siefers – Sandler O'Neill

And then just on treasury's capital I was hoping you can just talk a bit more in-depth, I know you're looking at it, but any sense for I guess level of interest one you would expect to – have you actually applied it, when you would expect to hear back, et cetera?

Martin Zorn

Scott, this is Martin. We are interested probably in the 3% range, we made our application last week and we are in the process right now of waiting to hear directly from the treasury.

Scott Siefers – Sandler O'Neill

Okay. Thank you.

Operator

(Operator instructions) Our next question comes from Stephen Geyen, Stifel Nicolaus.

Stephen Geyen – Stifel Nicolaus

Hi, good afternoon, guys. Just you sound like certainly the residential in Chicago, there is a higher non-performance there. Also, did you see some – in Cincinnati I think you mentioned that you saw some deterioration in commercial loan portfolio in the Cincinnati area, if you could go into more detail there?

Ray Beck

Yes, Steven, this is Ray. We have experienced some problems in our commercial real estate portfolio as you mentioned out of Cincinnati but it's then almost entirely limited to residential construction portfolio. So they do commercial real estate loans well all product types, but they do have a piece and it's less than 20% of the total portfolio. It is tied to residential construction. And they have seen just like I think anybody in that business in this country they have started to see some deterioration in that piece.

Stephen Geyen – Stifel Nicolaus

Okay. Thanks for the clarification. And you mentioned that the market values, the general market value numbers that you gave from various sources in the Chicago market, the residential values, just wondering any loans have you brought back in your books in OREO and what the values are if you have been able to sell those and what those values were? Would they are expensive?

Michael Vea

Well, at this point in time our Oreo portfolio is relatively small; actually it's under $8 million. And we have sold one or two small pieces, but I hate to draw any conclusions from that different from what I've drawn from the published data and from our recent – over the last three months opinion appraisals over 70% of the nonperforming loans.

Stephen Geyen – Stifel Nicolaus

Okay. Thank you.

Operator

That's all at this time we have for questions. I would like to turn it back to Mr. Vea for closing remarks.

Michael Vea

Thank you, Mercy. In conclusion, we will continue our existing successes in fee income, checking accounts, and deposits. We have and we will continue to adjust our loan programs to meet what our local economies dictate and we will also adjust our loan levels to meet our targeted capital level.

We appreciate your continued interest in Integra Bank Corporation. Thank you for joining us today and have a great afternoon.

Operator

Thank you for joining us. And have a wonderful day.

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