Irwin Financial Corporation Q3 2008 Earnings Call Transcript

Irwin Financial Corporation (IFC)

Q3 2008 Earnings Call

November 10, 2008 1:00 pm ET

Executives

William I. Miller - Chairman of the Board, President, Chief Executive Officer

Gregory F. Ehlinger - Chief Financial Officer

Jody Littrell - First Vice President and Controller

Analysts

Ross Demmerle - Hilliard Lyons

[Roger Solf - Worldwide Christian Aid]

Bill Chen - Barrington Partners

Stephen Geyen - Stifel Nicolaus & Company, Inc.

Greg Summerville - Tecumseh Capital

Presentation

William I. Miller

Thank you for joining us. I’m joined today by Greg Ehlinger, our CFO, and Jody Littrell, our Controller.

Before we start with our presentation I want to make you aware of important cautionary disclosures in connection with any forward-looking statements we may make on this call. The cautionary disclosures are in our written earnings press release and our recent SEC filings.

In addition I also need to note that since a registration statement related to the corporation’s shareholder rights offering has been filed with the SEC but has not yet become effective, we are in a quiet period. For these reasons we would like to limit the questions we take in the Q&A session to the information in our third quarter earnings press release and other previously reported information. I’m not permitted to answer questions related to the rights offering, other capital raised related areas or other forward-looking areas with any information not already in the registration statement we filed until our registration statement is declared effective by the SEC.

This morning we reported a third quarter loss of $54 million, down from a $107 million loss in the second quarter. Losses were primarily attributable to restructuring costs of approximately $30 million, additions to loan loss reserves of approximately $16 million, and valuation reserves for deferred tax and other assets of about $10 million.

We’ve made substantial progress on our strategic restructuring during the third quarter. We successfully exited the small ticket leasing business and continue to shrink our exposure to home equity. We securitized 85% of our remaining home equity whole loans with non-recourse funding thereby capping our credit exposure on these loans. Our home equity portfolio is now in runoff mode.

We’ve made progress on our plans to strengthen our capital base as well. We filed a registration statement with the SEC relating to a $50 million rights offering to shareholders. Last week we received shareholder approval to increase our authorized shares which provides us the flexibility to pursue our rights offering or other capital raising activities. I am pleased to announce that we have secured additional commitments from standby purchasers for the planned rights offering increasing the total commitment from $31 million to $37 million. Now we have 74% of the anticipated offering already committed.

We are making steady progress on our restructuring to focus on small business and community lending. As an example of the success of this renewed focus in the third quarter we expanded our loan portfolio in Columbus, Indiana, our headquarters location. In fact we’re pleased that in the third quarter Irwin Union Bank was the leading producer of consumer residential mortgage loans to our neighbors in the community producing 44% more residential loan volume than the next largest competitor locally.

I believe that through our strategic restructuring we will return to profitability by simplifying our business and returning to the core strategy that has driven our success for the past 137 years serving small businesses and consumers in our branch communities.

Now I’ll turn the call over to Greg to discuss our results in greater detail.

Gregory F. Ehlinger

Net interest income of $48 million decreased 22% on a sequential quarter basis reflecting the sale of the equipment leasing portfolio, securitization of $268 million of home equity loans, and a reduced level of boats.

Non-interest expense increased from the second quarter reflecting restructuring activities which totaled approximately $30 million during the quarter. Excluding these restructuring costs, non-interest expense was flat relative to the second quarter.

The consolidated net interest margin declined to 4.16% as compared to 4.38% during the second quarter reflecting the smaller loan portfolio and excess liquidity retained to address environmental conditions in the banking industry. Due largely to the sale of the small ticket leasing business the consolidated loan and lease portfolio declined nearly $800 million during the quarter. The loan portfolio totaled $4.7 billion as of September 30.

We had $8.82 per share in common shareholders’ equity as of September 30 and at quarter end the Tier 1 ratio and total risk-based capital ratios were 6.8% and 10.8% respectively. Those same capital ratios were 9.3% and 11.3% respective at Irwin Union Bank & Trust and the ratios were 11.2% and 12.4% at our thrift where we’ve committed to the OTS to hold 9% and 11% respectively.

To address economic conditions we substantially increased our allowance for loan losses during the third quarter. The allowance totaled $232 million at the end of September, up from $216 million at the end of June and $104 million a year earlier.

Turning now to each of the segments, commercial banking lost $15 million during the third quarter reflecting increases in loss provisions for commercial real estate related loans. The segments’ loan balance declined during the quarter as we reduced our concentration of commercial real estate loans. Net interest margin was 3.58 during the third quarter, down from 3.66 during the second quarter reflecting unsettled market conditions and a decline in earning assets.

We added $20 million to loan loss reserves in excess of the quarter charge-offs of $9 million for a total loss provision of $29 million. The segment’s allowance for losses grew to 2.57% of loans at September 30, up from 1.75% as of June 30.

In the commercial finance line of business the franchise finance channel, the part of the commercial finance business we are retaining after the restructuring, earned $3.3 million, up from earnings of $1.7 million in the second quarter. In total, including the $650 million equipment lease portfolio which we sold in July, the segment lost $2 million in the third quarter. As a reminder we sold the lease portfolio of this segment in July and have ceased any additional originations of equipment leases.

The franchise finance loan portfolio totaled $611 million as of September 30. Franchise finance loan sales totaled $48 million with net gains on sale of franchise loans of 3.2% of loans sold, in line with other quarters. We are pleased we continue to be able to sell franchise loans at an attractive premium even in this environment. Net interest margin for this line of business was 4.31%, up modestly from 4.24% during the second quarter.

The home equity segment where we have put the credit risk portfolio into runoff lost $24 million during the third quarter, 47% less than in the second quarter. The loss reflects the effect of a loss provision of $27 million and $15 million in restructuring charges related to the planned exit of this segment. 30-day and greater delinquencies in the home equity portfolio increased from 6.06% at June 30 to 7.43% at the end of September. The allowance for loan losses totaled $155 million or 12.1% of the portfolio at quarter end.

In our other bank and non-bank consolidating entities we lost $14 million during the third quarter and this loss was primarily due to a deferred tax valuation allowance of $8 million. We also recorded other-than-temporary impairment of $2 million on a portion of the securities portfolio which has not traded for several quarters due to illiquidity in the secondary market. Each of these securities which we now carry at an aggregate discount to PAR of about 85% remained current on scheduled interest notwithstanding this mark-to-market.

In summary, our third quarter losses were half of our second quarter losses and were driven by restructuring charges of $30 million, loan loss reserve additions of $16 million and valuation reserves of other assets of $10 million.

Our credit exposure to home equity continues to shrink as we completed a non-recourse securitization structure during the quarter, and in the past couple weeks we’ve received additional standby commitments for our capital raise which now total $37 million or 74% of the anticipated offering.

Finally, we remain on our path to return to our core historical strength of small business lending and serving customers with banking services in the neighborhoods where we have branches. As Will noted, we saw an example of this refocus during the third quarter as we expanded our loan portfolio in our headquarters market here in Indiana.

Will and I would now like to open it up to questions please.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Ross Demmerle - Hilliard Lyons.

Ross Demmerle - Hilliard Lyons

It looks like non-interest expense at the bank jumped up quite a bit. Is there anything nonrecurring in there? In the Q it says FDIC insurance premiums but I’m wondering if there’s a chance that might go down going forward?

William I. Miller

There were some severance charges but the FDIC insurance premiums were the major component of it.

Ross Demmerle - Hilliard Lyons

It sounds like the level experienced in this quarter is a pretty good run rate going forward?

William I. Miller

Yes. I can’t forecast when the FDIC insurance premiums would change.

Ross Demmerle - Hilliard Lyons

They’re probably going to go up even higher next year.

William I. Miller

That’s one of the reasons I can’t forecast when they’ll change.

Operator

Our next question comes from [Roger Solf - Worldwide Christian Aid].

[Roger Solf - Worldwide Christian Aid]

I’ve got a question on the $8 something a share. Is that like what book value is of IFC?

William I. Miller

Yes. That’s our current book value.

[Roger Solf - Worldwide Christian Aid]

Why would shares be a quarter of that or less right now?

William I. Miller

I can’t speculate on how the market’s trading. It’s a mystery to me.

[Roger Solf - Worldwide Christian Aid]

If they broke up IFC and distributed all the equity out over the shareholders, it would be about $8 each though?

William I. Miller

That’s the accounting figure. I think people would have different estimates of what a liquidation value in a fire sale would be. The accounting number as presented in the books is the $8.

[Roger Solf - Worldwide Christian Aid]

That’s like the optimal then probably, right? What’s a franchise loan?

William I. Miller

Those are loans made to people who take out franchises from major quick service and casual dining restaurants across the US like Burger King, Wendy’s, Qdoba, Dunkin Donuts. We loan money to the small business people who take those franchises and operate the restaurants.

[Roger Solf - Worldwide Christian Aid]

So if somebody wants to buy one of those franchises, you might lend them part of the money for the franchise fee then basically?

William I. Miller

It’s not just a franchise fee but the purchase of equipment and in some cases construction of a building. Our target markets there are experienced operators who already have five or six units of a particular brand and are expanding. We have a very good mix of brands.

[Roger Solf - Worldwide Christian Aid]

Is there a timeline on when the SEC is supposed to give its okay or not for the dilution of the shares or the issue of the additional shares?

William I. Miller

They have I believe until the end of next week to give us comment letters and then if they have any, we will deal with those. Whether or not they give comments would influence what the next deadline would be.

[Roger Solf - Worldwide Christian Aid]

I was doing the math and if it says like 200 million shares and they only need $50 million, isn’t that about $0.25 a share?

William I. Miller

The authorization of shares does not mean we will use all of them. That’s just the upper limit we can deploy without going back to shareholders. The pricing of the rights offering will be completely independent from the authorized shares.

[Roger Solf - Worldwide Christian Aid]

Can you guys get money at 1% at the Fed window or something like that? It seems like this is a fantastic opportunity to get cheap money. Can you access those low interest funds?

William I. Miller

I’m trying to make sure I know which ones you’re referring to.

[Roger Solf - Worldwide Christian Aid]

Is it the discount rate that’s down to 1%?

William I. Miller

Yes.

[Roger Solf - Worldwide Christian Aid]

Can IFC get money from the Federal Treasury in some way at 1% interest at least for short term?

William I. Miller

We can access the discount window. You are right in believing that the Fed wants you to keep that very short term so it’s not a source of funding you do a lot of your balance sheet in.

[Roger Solf - Worldwide Christian Aid]

It’s too short to do even loans with a three-year adjustable or something?

William I. Miller

Yes. One of the principles of good interest rate risk management is you want to match the term of your funding with your liabilities.

[Roger Solf - Worldwide Christian Aid]

Borrow long; lend short.

Operator

Our next question comes from Bill Chen - Barrington Partners.

Bill Chen - Barrington Partners

Other assets; could you give a little bit more detail what’s in there?

Gregory F. Ehlinger

The biggest part in our other assets is our deferred tax assets. We also have a $50 million bank whole life insurance asset in there. Those are the two biggest pieces and make up about 75% of what’s in other assets.

Bill Chen - Barrington Partners

One thing that you guys really provided a lot of helpful information on on the last call was the construction loans. Last time around I believe you guys gave geography and also a little bit of color what was going on. It would be great if you could provide a little bit more of that again today.

Gregory F. Ehlinger

If you look in our 10Q around page 42 of the version you can get in pdf on our website, you’ll see more detail there.

Bill Chen - Barrington Partners

In terms of the brokered CDs at IUB, from what I call with OTS you cannot take on brokered CDs there anymore.

William I. Miller

We cannot take brokered CDs in the thrift which only has about 15% of our assets. We are still permitted to issue brokered CDs in our state chartered bank.

Bill Chen - Barrington Partners

So I would assume it would be 15% of that $900 million. Is that about right? That’s how much brokered CDs are in there?

William I. Miller

No. The brokered CDs are remaining spread between the two charters and we didn’t have to do anything with the ones that were already outstanding. We just aren’t allowed to issue any more in the thrift but we have plenty of liquidity in the thrift and don’t need to issue more brokered CDs there. We are not precluded from doing that in our state chartered bank.

Bill Chen - Barrington Partners

In terms of the $37 million of the offering that’s been committed, is $25 million of that coming from Cummins?

William I. Miller

Yes. $25 million is from Cummins; the remainder is from individuals.

Bill Chen - Barrington Partners

The thing I’m trying to understand is when I went through the documents for the Cummins standby letter of commitment, it said that Cummins can own up to about 19.9% of the stock. Is that correct?

William I. Miller

Right.

Bill Chen - Barrington Partners

Assuming the current market cap of around $55 million to $58 million, I’m not getting to the full $25 million.

William I. Miller

We also said we’re working on a possible exchange of trust preferred for common which would add some additional ownership to the company and affect what ultimate percentage Cummins would have and therefore how much of the $25 million they would be able to put in. Of course Cummins’ $25 million in total depends on what the response from the other shareholders is.

Bill Chen - Barrington Partners

Of course. Excuse my ignorance. How does that work exactly? What are the mechanics in terms of the preferred? I guess when I look at this I’m just looking at the market cap. I’m just trying to figure out how much Cummins can put in to prevent them from getting over that 19.9%. It sounds like I’m thinking it the wrong way. Can you explain to me how I should be thinking of it?

William I. Miller

The ultimate amount will depend on several things that we don’t know yet. One is the pricing of the rights offering which will have to do with these total number of shares they ultimately receive. Second, whether or not we convert any of our trust preferred securities to common which we said is possible but we have no definitive agreements to do that yet. But if that happens, that will add additional shares from that exchange to the mix and therefore Cummins could own more shares and still be below 19.9%.

Bill Chen - Barrington Partners

But if you convert some of the preferred shares to common, that would then in theory bring the stock price down, right? So I don’t know how it solves that problem exactly. I understand increase in the number of common shares outstanding.

William I. Miller

The share price which we would issue the rights offering and whether or not we convert trust preferred to common I don’t think are directly related. The way you asked the question you thought they were.

Bill Chen - Barrington Partners

I think I understand what you mean.

Operator

Our next question comes from Stephen Geyen - Stifel Nicolaus & Company, Inc.

Stephen Geyen - Stifel Nicolaus & Company, Inc.

There was a significant increase in nonperforming loans in the commercial banking business from Q2 to Q3. I’m curious what prompted the increase? Was there a sudden deterioration in credit quality Q2 to Q3 or did you go through a loan review process in the Las Vegas, Phoenix markets or where did the increase come from?

William I. Miller

I would say it’s probably attributable to both. We did do a very thorough loan review process in the third quarter with particular attention on construction land development and commercial real estate loans and with particular attention on the markets you mentioned. I also think it’s fair to say that particularly in commercial real estate the credit quality deteriorated in the third quarter.

Stephen Geyen - Stifel Nicolaus & Company, Inc.

You said it was partly from the review. Are you pretty much through the review?

William I. Miller

Yes. I think one of the important things, we did mention this in the press release and the Q, to keep in mind is that our definition of a nonperforming asset is nonaccruals. Every nonaccrual in the commercial banking line of business has a specific reserve so if you look at the change in specific reserves from a year ago to now, the nonperforming assets are up 385% and something and the specific reserves are up 522%. We’ve attempted to get all over this and increase the specific reserves appropriately.

Operator

Our next question comes from [Roger Solf - Worldwide Christian Aid].

[Roger Solf - Worldwide Christian Aid]

On the accounting on the reserves, these reserves are taken out for the potential loan losses but maybe some of the borrowers will pull it out and they’ll perform and pay off their loans? So the things I wanted to know is when you take the reserves, do they come off the balance sheet as of this year’s income and then suppose they paid them off next year for example or part of them? Does that go back on to the balance sheet as income?

William I. Miller

The loans themselves do not come off the balance sheet when we either establish a reserve for them or put them on nonaccrual. They only come off the balance sheet when we charge them off. When a loan is on nonaccrual, then we’re no longer booking income for it in the income statement but the loan is still on the balance sheet.

We do have some reserves in what’s called the FAS 5 portion of our reserving which are for loans that are still paying us or for which we’re still accruing interest because we expect ultimately to get paid on those. But there is a methodology for estimating in the future what portion of those are likely to go to default and likely to have losses even though they’re presently not representing a loss. The reserves will include a portion of that.

Those are estimated both statistically by historic migration from our internal risk ratings to loss and then there’s also on top of that a qualitative reserve where we make judgments about the economy’s getting worse so things could be worse so we’ll put in some additional reserves for stuff we don’t fully know about yet but we believe they are losses inherent in the portfolio as of the moment.

You asked if in the future one of them pays off or gets better. It will depend on whether it was something we put on nonaccrual or whether we charged it off. If it was in nonaccrual and they pay off, we’ll simply put it back on accrual and begin booking interest income on it again. If it was something we charged off, then it becomes a recovery which goes back into the loan loss allowance to provide additional cushion for future losses on other loans.

[Roger Solf - Worldwide Christian Aid]

Are the reserves then losses or just money in a different place?

William I. Miller

No. The real losses are the charge-offs and the reserves are an accounting entry to put money aside for losses we have not yet charged off. You should understand though that under the federal capital rules there’s a limit to how much of the reserves we can count in our capital base and we’re over that limit. It’s 1.25%. So at the moment adding to our reserves actually reduces our capital as we set aside money for potential losses that haven’t been recognized yet.

[Roger Solf - Worldwide Christian Aid]

So that makes the balance sheet look worse but actually that money is like a security deposit and it could come back? It’s not a deposit but -

William I. Miller

No, it’s a reserve. It’s a valuation allowance.

[Roger Solf - Worldwide Christian Aid]

I do some lending on a small basis on single family homes and I buy them and sell them on real estate contracts. What I’ve done in this time with people having a hard time is just work with them if they’re paying a good part of the loan because eventually prices are going to be back up and we’re going to get all the money plus all the interest even if we have to put some of it on negative amortization with the people or add to what they owe each month. Like if they’re supposed to pay $2,000 a month, let them pay $1,500 and then we had $500 on to the end of the loan.

William I. Miller

Those are often sensible loss mitigation techniques. In our home equity line of business for instance where we have the authority to, we do similar kinds of things; work with the borrowers to try to avoid foreclosure and help them out to work through their financial difficulties. But the other observation I’d make is those kinds of loss mitigation activities are one of the reasons why we set up reserves and only charge the loan off after it’s clear that none of those things will work.

[Roger Solf - Worldwide Christian Aid]

Yes. I would just encourage that because if we’ve got loans recorded down there in the courthouse, they’ve got to pay those off before they can get clear title to the house for the next loan or something.

William I. Miller

That’s right. Even if we’ve charged them off.

[Roger Solf - Worldwide Christian Aid]

If you just sit on them, yes eventually you’ll probably get paid plus interest.

Operator

Our next question comes from Bill Chen - Barrington Partners.

Bill Chen - Barrington Partners

In terms of the data on the construction loans, I can’t find it in the Q. The only thing I’m finding is on page 38 there’s portfolio [inaudible] for the overall commercial banking loans and on page 33 there’s construction real estate and land development loans of $512.9 million.

Gregory F. Ehlinger

I pointed you to the Q having misunderstood your question. The Q has some information on our loan portfolio by geographic region. The call report which is on file with the FDIC would have the more detailed information about portfolio by product item and I don’t have those pages memorized.

Bill Chen - Barrington Partners

I’ll just follow up with you off line then.

Operator

Our next question comes from Greg Summerville - Tecumseh Capital.

Greg Summerville - Tecumseh Capital

With regard to the timing on the rights offering, assume for a moment you don’t get any comments back next week. What’s the likely timing going forward? I’ll throw a couple side questions in here. Would you proceed with just a partial backstop in place? I’m assuming this is also contingent upon coming to some resolution with regard to the preferreds that you’re negotiating on as well?

William I. Miller

If there were no comments from the SEC, we’d move ahead directly with it but I can’t really speculate on exactly the timing of that. It’s dependent on too many variables. It is our plan to proceed with the offering with the standby commitments we have on hand if and when the SEC gives us the go-ahead. So it’s not in that sense dependent on reaching the possible agreement with the [inaudible].

Greg Summerville - Tecumseh Capital

Have you disclosed who those additional investors are who have come on board or are you going to disclose who they are?

William I. Miller

We didn’t believe their identities would be material so we didn’t formally disclose it, but I’m happy to tell you. They are a former chairman and a retired partner of [Worber Finkas] in New York. They are investing as individuals.

Greg Summerville - Tecumseh Capital

With regard to the preferred, I realize your comments will be limited. I’ll ask the [David Keer] question. What’s the probability that you’ll come to some sort of an agreement there?

William I. Miller

That’s exactly one of those forward-looking statements I’m not permitted to answer right now because of the quiet period.

Greg Summerville - Tecumseh Capital

What are the issues that are the heart of the negotiations with the preferreds right now in terms of trying to come to some agreement?

William I. Miller

I’m sorry. I’ve got to give you the same answer.

Greg Summerville - Tecumseh Capital

Another thought that crossed my mind, given the magnitude especially where the common is trading today of this offering and the loss carry-forwards, is there any risk of change of control coming into play here and limiting your ability to take those losses in the future?

William I. Miller

That was a very serious constraint prior to the change in the rules by the IRS a month or so ago where they took ALLL out of the equation of what was capped and only left in net operating losses. We do have some net operating loss carry-forwards that wouldn’t be capped but it’s not a material amount. So the change in the rules was very helpful to us.

Greg Summerville - Tecumseh Capital

So the part from write-downs and loan losses you will be able to apply against -

William I. Miller

Will continue even if we issue more than how the IRS figures it which is a very complicated formula. To trigger the change in control, the ALLL will continue to be deductible.

Operator

We have no further questions at this time.

William I. Miller

We appreciate everyone’s interest and attention and we look forward to talking to you all again soon. Thank you very much.

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