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Executives

Michael L. Scudder – President & Chief Executive Officer

Thomas J. Schwartz – President & Chief Executive Officer of First Midwest Bank

Michael Kozak – Executive Vice President & Chief Credit Officer of First Midwest Bank

Paul F. Clemens – Executive Vice President & Chief Financial Officer

Analysts

Terry McEvoy – Oppenheimer & Co.

Mac Hodgson – SunTrust Robinson Humphrey

Brad Milsaps – Sandler O’Neil

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

[John Kerry] – JP Morgan

Erika Penala – Merrill Lynch

First Midwest Bancorp Inc. (FMBI) Q4 2008 Earnings Call January 28, 2009 10:00 AM ET

Operator

Welcome to the First Midwest Bancorp 2008 fourth quarter earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to Mr. Paul Clemens.

Paul F. Clemens

Earlier today First Midwest announced its results for the fourth quarter of 2008. If you haven’t already received a copy of our press release you may obtain it on our website or by calling our office at 630-875-7463.

At this time, I would like to add the customary reminder that our comments today may contain forward-looking statements which are based on management’s existing expectations and the current economic environment. These statements are not a guarantee of future performance and actual results may differ materially from those described or implied in the forward-looking statements.

Forward-looking statements are inherently subject to risk and uncertainties included, but not limited to, future operating results, market penetration, and the financial condition of the company. Please refer to our SEC filings for a full discussion of the company’s risk factors. We will not be updating any forward-looking statements to reflect facts or circumstances after this call.

Here this morning to discuss First Midwest fourth quarter results and outlook are Mike Scudder, President and Chief Executive Officer of First Midwest Bank Corp., Tom Schwartz, President and Chief Executive Officer of First Midwest Bank, Mike Kozak, Executive Vice President and Chief Credit Officer of First Midwest Bank, and myself Paul Clemens, Executive Vice President and Chief Financial Officer. And now I will turn it over to Mike Scudder.

Michael L. Scudder

As always we appreciate and thank you for your interest in First Midwest. By way of navigation, I want to start with some opening remarks before turning it over to Paul who can provide some detail surrounding performance and credit. Finally I’ll close with some comments on 2009 and then we’ll be happy to open it up and answer any of your questions.

Let me first start by saying we were disappointed in our fourth quarter performance. We have a high standard of performance that we set for ourselves here at First Midwest and we’re disappointed to fall short of that, though certainly that occurred in what I would define as unprecedented economic times. And certainly levels of performance that, while they may exceed our peers, still fall short of the standards that we set for ourselves.

The fourth quarter itself was particularly volatile and recognizing that we have to acknowledge and address the issues of the day both proactively and preemptively. As a result performance, for the quarter was heavily influenced by decisions to significantly increase our loan loss reserves and recognize certain market related charges, as well as take steps to enhance our capital with such steps including the issue on some preferred shares under the treasury’s program and a reduction in our dividend. Paul will speak to certain of these actions more directly in his comments.

At the same time, it’s also important to recognize that our core business has held up very well and has remained solid through a historically challenging year. In 2008, excluding provision expense and market related charges, we generated over $150 million in pre-tax earnings, essentially on par with 2007 and representing a level of earnings well above our peers.

While the headlines of today and tomorrow will continue to be about credit, it’s important to recognize some of these highlights as they serve for a backdrop for 2009. First, year-over-year total loans in 2008 increased 8% through appropriately priced and underwritten relationships. Second, bank generated deposits supports substantially all of our outstanding loans and have remained relatively stable through a period of heavy competition and consumer uncertainty. Not surprisingly our net interest margin is a combination of those two improved in the fourth quarter to 3.71%, that’s up about eight basis points from the prior quarter.

Fourth, it’s important to recognize that we operate the fourth largest bank trust book in the state, our trust and investment management revenues, which are dependant upon asset values, remained stable in 2008 in a depressed market that saw equity values down from 30% year-over-year. That stability masked what has been a very strong sales and performance year for this group.

And then lastly, we continued a legacy here at First Midwest of controlling our overhead cost, which were down 2%, almost 2.5% year-over-year in large part due to lower salary and benefit costs. So with that as a backdrop, let me turn it over to Paul.

Paul Clemens

Let me start with the earnings and per share numbers for the quarter and year. First Midwest today reported results of operations of financial position for fourth in full year 2008. The company’s net income was $49.3 million for full year and its net loss was $26.9 million for fourth quarter 2008. This compares to net income of $80.2 million for full year 2007, and a net loss of $5.4 million for fourth quarter 2007.

The company reported a loss at $0.57 per diluted share for fourth quarter 2008 and earnings of $1.00 per diluted share for full year of 2008, as a compared to a loss of $0.11 per diluted share for fourth quarter 2007 and earnings of $1.62 per diluted share for full year 2007. As usual, we provide supplemental financial information to aid in the analysis.

We’ve also added a schedule showing the amortized costs and fair values for components of our investment portfolio to the schedules previously provided. Let me walk through significant events of the quarter beginning with operations then I’ll briefly cover the items we disclosed in our 8-K filing last week, including information regarding our credit quality.

Mike has talked about our continued focus on sales and service to our customers during 2008 despite the turmoil in the economy. The best way to demonstrate our sales focus, I believe, is to call out the unusual tax benefits, loan loss revisions, and security losses for both years and compare this adjusted pre-tax number for both 2008 and 2007.

Pre-tax earnings totaled $36 million for full year 2008 as compared to $94 million for full year 2007, with the difference largely due to higher provision for loan losses. Provision for loan losses for 2008 was $70.3 million as contrasted to $7.2 million in 2007. Excluding the provision for loan losses and market related securities from both years, adjusted pre-tax earnings for both years was $152 million.

We continued to make loans during the quarter to those strong borrowers where we could garner the full relationship, including deposits and services. Loans for the quarter were up 2.6% from September 30th and average deposits were relatively flat from a year ago. We are seeing competitive pricing for deposits, though we’re not seeing any significant impact on our core transactional base. It’s significant to note that the company’s ability to fund approximately 97% of its loan activity with core customer deposits provides a long-term competitive advantage given the current volatility in the cost and availability of wholesale clients.

Contributing greatly to the company’s operating performance this year has been its ability to manage its net interest margin. Tax equivalent margin of 3.71% for fourth quarter represented an eight basis point increase from the preceding quarter and an 18 basis point increase from a year ago. As a result, the company’s net interest income increased $6.5 million for the year. Management expects the margin to be under pressure in the short-term as it absorbs the latest head rate reduction, but expects a recovery in the second half of 2009 dependent upon several factors including the level of non-performing assets.

Fee base revenues were down 1% year-over-year after excluding discontinued services due primarily to lower trust advisory fees and retail sales of investment products. As Mike noted in his comments, these lower fees do not reflect the solid sales results from our trust group, which should bear fruit in the future.

In our efficiency ratio 53.5% for full year 2008 not only demonstrates our continuing commitment to control the expenses, but more importantly to our ability to align our resources with our revenue generating opportunities. Non-interest expense declined 7.3% for the quarter and 2.4% for all of 2008 from the same period of 2007. The declines were primarily due to reductions in salaries and benefit costs. The company has proactively reduced its number of employees primarily to attrition by 4.4% or 83 full-time equivalents over the past two years.

Let me move on to the activity in our securities portfolio. As disclosed in our 8-K filing last week, the company recorded non-cash, other than temporary impairment charges, totaling $34.5 million in fourth quarter 2008. Of such charges, $24.8 million rate to three trust preferred collateralized debt obligations with an aggregate cost of $38.9 million. The remaining $9.7 million of non-cash impairment charges related to two whole loan mortgage-backed securities with a combined par value of $16.6 million and that single Sallie Mae debt issuance with a par value of $10 million.

The company holds an additional $46.3 million of trust preferred CEOs with a combined unrealized loss of $18.3 million. At December 31, 2008, the company’s $2.2 billion securities portfolio reflected a net unrealized loss of $3.3 million versus a net unrealized loss of $73.3 million at September 30th.

The $70 million improvement in the net unrealized loss position was due to the recognition of the aforementioned non-cash impairment in fourth quarter, and a $67.6 million appreciation in the company’s portfolio, a fixed income municipal in government sponsored mortgage-backed securities, partly offset by decline in fair value of other investments. As I said before, we have provided an additional schedule with this earnings release that provides more detail.

Also during the fourth quarter the company experienced a decline in the fair value with Bo-Lee investments. In order to mitigate the risk future losses and protect capital the company repositioned the funds in shorter duration assets and accepted a lower cash surrender value. These actions coupled with the decline in interest rates will likely result in lower Bo-Lee earnings in 2009.

So let me move to the credit quality and loan loss reserve. During the fourth quarter non-accrual loans increased from $53 million as of September 30th to $128 million as of December 31st and now represent 2.38% of total loans compared to 1.02% at September 30th with residential construction and development customer relationships accounting for $97.1 million or 75% of the total.

Land accounts for 80% of the $97.1 million. In response to this decline in asset quality the company charged off $18.3 million and recorded a provision for loss of $42.4 million during the fourth quarter. In doing so, the company increased its reserve for loan losses to 1.75% of total loans at year-end as compared to 1.34% at September 30th.

Management established a resulting reserve of $93.9 million, an increase of $24 million from September 30th based upon its current assessment of individual loan portfolios. The increase in the reserve was due primarily to the aforementioned deterioration in the $500 million residential land development portfolio.

Approximately 20% of all residential land and development loans are classified as non-accrual with the increase during the quarter due primarily to the impact of slowing market conditions on five residential developers.

Now of the remaining $400 million management estimates some portion is likely to move to past due in our non-accrual during 2009 based upon its review of individual credits, including its estimated appraisal values, remaining interest reserves and estimates of borrower’s alternative sources of repayment.

Based upon its current assessment of market conditions, management leases has adequately reserved for losses in this portfolio.

In addition management took into consideration other loan portfolios, particularly vulnerable to the current economic conditions when evaluating the adequacy of reserve for loan losses, such as loans to retail centers, office buildings, hotels, restaurants, auto dealers and building material suppliers.

Finally, while the $745 million consumer portfolio has shown some increase in past dues management believes the portfolio is well controlled. The $200 million portfolio mortgages is seasoned and does not contain any sub-prime or all day product, so the $500 million home equity segment contained a 55% loan to value at issuance.

The company recently rescored the entire portfolio of both mortgages and home equity loans and lines and saw no significant decline in the average score with the average for each segment well above 700. To summarize, the company's non-accrual loans increased significantly during the fourth quarter due primary to an increase in the company’s residential land development portfolio which comprises less than 10% of the company’s total loan portfolio. And with that I’d like to turn the program back over to Mike.

Michael L. Scudder

What I thought I would do is before opening it up for questions certainly offer you some outlook for 2009. Predictions in this environment are at best questionable value, certainly given the economic climate and the uncertainty of the nature and effectiveness of the potential government stimulus that’s sits on the horizon.

However, I thought I would share, at least as we stand here today, our expectation for 2009 is that it will be more challenging than 2008 as the industry and ourselves fight a number of head winds, which we expect to include comparatively higher non-performing asset levels, credit remediation costs, potential for margin pressure and certainly higher FDIC insurance costs.

Our advantage here at First Mid-West, as we navigate that type of environment in 2009, is both a strong capital base and a strong core earnings foundation. Consistent with 2008, 2009 will see us focused simultaneously and equally really on two fronts.

The first front is sales, that we have a tremendous opportunity to enhance the value of our franchise in this environment. These are the times when the tenure of our people and our relationship-based approach and focus really combine to create even greater value for our customers.

As such a return to traditional banking, for lack of a better term, creates a greater opportunity for us to attract and develop full banking relationships. The second front that we really have to navigate in this environment is one of capital and credit remediation. So those are the combination of the two fronts that we’re really battling with or focused on as we work through 2009.

On the sales front, what can you expect to see? First you’re going to see us continue to lend, but it’s going to be and will remain at levels that are reflective of both customer demand as well as prudent underwriting and pricing, again which is the hallmark of First Mid-West.

Our lending will focus on creating strategic full business relationships. Second, continuing efforts to enhance what is a very strong core deposit base, and third continuing growth in our trust and investment management areas as we lever their stronger relative performance and our commercial platform to attract new clients to these business lines.

On the capital and credit front we really have four specific areas of focus that we concentrate on for 2009 or will continue to concentrate on for 2009.

Number one is further expansion of resources allocated to both pre-emptive and existent credit problems. Organizationally that means we will be allocating a greater portion of our field resources in terms of number and caliber, to dig even deeper into our performing portfolios, work with existing borrowers to develop pre-emptive action plans and then manage the execution of those plans.

It also means we'll be assigning even greater resources to our centralized remediation group who is charged with problem credit resolution.

Number two, we'll be looking to manage the size of our balance sheet concurrent with our needs to fund lending growth in protected capital. We have a $2.1 billion fixed income securities book that affords us flexibility in that regard that a number of institutions don’t have.

Number three; we will continue to manage our operating costs, as we always have, consistent with changes in our revenue. And then finally, number four, we will be reviewing with our board all aspects of our capital plans each quarter staying on top of the demands of the then current environment.

So in closing, 2009 will present significant challenges. At the same time I’m confident that we here at First Mid-West are well positioned to committing to doing what it takes to whether those challenges. We have a strong financial foundation and we have the experience and expertise within our sales and credit areas to get our clients through these difficult financial times.

But finally, I want to take the opportunity to thank all of our employees, a number of whom listen to this call for their continuing focus and commitment to First Mid-West and what we are about. They are fundamentally the backbone of our success. So with that I would close our remarks, thank you and I'll turn it over to the moderator and we can address any questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from Terry McEvoy – Oppenheimer & Co.

Terry McEvoy – Oppenheimer & Co.

I guess I was a little confused to see just the real sizable increase in the non-performing assets in the fourth quarter connected to the residential development business. I think all of us on this call understand how weak that business has been for quite some time and maybe kind of walk us through why weren’t some of these issues or these five residential developers that were in the release today, maybe identified and written down earlier, which may have mitigated some losses versus waiting until the end of the year?

Michael Kozak

They were identified as issues and we have been tracking those loans for a couple of quarters, basically the common denominator behind most of that increase has largely been the absence or the cancellation of sales contracts.

We’ve had a number of cases where we anticipated properties would be sold either through smaller unit sales that were canceled based on contingency issues, or in two particular cases we had some substantially larger sales contracts that n the fourth quarter, toward the end of the quarter, fell through again.

So as a result of that we escalated the treatment and put it on non-accrual, so these were not surprises. These were loans that we were tracking. They were adversely rated under our system. We anticipated however that we would have a more favorable outcome than proved to be the case.

Terry McEvoy – Oppenheimer & Co.

Paul, you ran through a couple of other areas of the portfolio responsible for the reserve building process. It was retail office. You ran through quite a few of them. Could you maybe run through one or two that are on the top of that list kind of supporting that reserve build outside of the residential development portfolio?

Paul F. Clemens

I’m sorry could you repeat that question again Terry?

Terry McEvoy – Oppenheimer & Co.

You ran through, when you mentioned the reserve building that happened in the fourth quarter, you said there's some other pieces of the portfolio that contributed to that and it was retail, office, hotel, industrial. Could you just go into a little bit more details into, is retail in the top of the list prioritized, maybe, those areas in where you see credit stress in 2009?

Paul F. Clemens

We continue to see credit stress, first and foremost, in the residential land and development area and that's the area that we're targeting more than any other of our segments. To this point, we have not seen considerable spillover to other areas. We are beginning to see some early indications of possible spillover, as referenced in our 30 to 90-day category.

We've got a couple in the office retail area that are emerging, that we're watching very carefully, but we're not seeing a significant movement to problem status in those areas. So in terms of our reserve, we do have a sufficient amount allocated, first and foremost, for the residential land and development, which is again where we anticipate seeing most of our problems in '09.

But we have taken the precaution to adding a proportionate amount to cover anticipated issues in the retail and office. We see the trends. We read the media. We understand that vacancy rates are increasing in both of those segments. It has not directly impacted us at this point in time, other than some very early warning indicators in our 30 to 90-day category.

So again, the focus will continue to be first and foremost on residential land and development, but we are looking at those other emerging areas.

Operator

Our next question will come from Mac Hodgson – SunTrust Robinson and Humphrey.

Mac Hodgson – SunTrust Robinson Humphrey

I had just another question on just the flow of credit as it goes to the different past due buckets and then non-accrual. I know the 30 to 89-day bucket was relatively flat in the quarter, same with 90 plus. Is it safe to say that the five land development loans that you talked about went from performing or current straight to non-accrual?

Paul F. Clemens

That is substantially the case, Mac.

Mac Hodgson – SunTrust Robinson Humphrey

Were they basically current on interest reserves, and the determination was made?

Paul F. Clemens

In some cases they were current on interest reserves that have since expired. In some cases, as I alluded to, we had pending contracts that fell through, but a substantial number of those were performing and the process accelerated very quickly in terms of identifying it as a non-performing loan.

Mac Hodgson – SunTrust Robinson Humphrey

Were they primarily all land or were they part of that structures category?

Paul F. Clemens

Substantially land.

Mac Hodgson – SunTrust Robinson Humphrey

One other question, when I look at that book, the residential land and development portfolio, it stayed pretty flat over the past year, the last four quarters or so. How quickly do you think you can bring that exposure down? Are you getting pay downs offset by advances on the loans? And how quickly do you think you can bring that exposure down?

Paul F. Clemens

Well, we're certainly looking to bring that exposure down and you can be assured that we're not making new loans in this environment in that particular product segment. But we're trying to bring the exposure down in a very controlled manner while minimizing our losses and sustaining our customer relationships. It's a difficult environment. The liquidation process has lengthened and, of course, in terms of once that liquidation process is complete and it moves to OREO, it's not a very liquid market.

So we're working on a case-by-case basis with our customers. The new effort, as we march forward into '09 is in cases where we have certainly strong character, we have cooperating borrowers, we've got what we think is capacity. We will try to work with our customers in the form of having more TDRs. So I think you're likely to see, as what I define as a measure of success in this environment, is really seeing more of those non-performing loans move into a new bucket. Maybe not necessarily to OREO and off the balance sheet through steep discounts and steep losses, but more working with those customers and seeing them move into TDRs.

And I think that's going to be a real measure of success for the banking industry, is to how we can move those NPLs into the TDR category. And, of course, you need cash flow from the borrowers to do that, to some extent, but that will be the ultimate test of whether we're doing a good job or not.

Operator

Our next question will come from Mr. Brad Milsaps – Sandler O’Neill.

Brad Milsaps – Sandler O'Neill

Mike, I know you mentioned on previous calls that you guys were typically getting updated appraisals at the time of renewal and weren't really accelerating things in terms of how you were valuing the residential land and development portfolio. I'm curious if that process has changed with some of the things that transpired in the fourth quarter, or maybe you've changed it since some of those conference calls. But just curious if you could talk about what you're doing in regard to that.

Michael Kozak

Brad, Mike Kozak here again, here's what we're doing. We've got, for the residential portfolio, roughly 75% of it has current appraisals, and by current I mean less than a year. In terms of those areas that we've identified as problems, which would be our non-performers, our over 90, our under 90, and adverse rated loans, we're upwards of over 95% in terms of current appraisals. When we have a non-performing loan, non-accrual, and we get a current appraisal, we're writing those down, either in terms of a specific reserve or a charge-off to the actual appraised value, actually 94% of the appraised value.

In the case of a performing loan where we have an interest reserve or some other means whereby the loan is being kept current, what we're traditionally doing, and we continue to do, is we are adversely rating those loans so that they get the monitoring they need. But we are not taking any significant write-down at that point in time.

So again, we've got a substantial amount of the portfolio has current appraisals. It's an ongoing process. Every time a loan comes in for renewal, if there's a delinquency, a new delinquency, or if there's a covenant default, we're very quick to order a new appraisal, and we're going to continue doing that.

The loans that are performing, even when the appraisal comes back, we are continuing to keep that on a performing status until circumstances dictate otherwise.

Paul F. Clemens

And our reserves generally, Brad, reflect the valuation circumstances that are out there in the environment. So we have, not only reserves set aside specific to credits that are in non-performing, but as it relates to the non-performing loan categories, some assessment of what exists there.

Brad Milsaps – Sandler O'Neill

A question for Paul, I was curious if you could maybe help us out a little bit on some of the income statement line items maybe specifically some of the other expenses. They were up a fair amount on a linked-quarter basis, and I know you have some moving parts with the personnel. The non-qualified pension number can move around quite a bit. But just kind of curious what you think the expense run rate would look like in 2009?

Paul F. Clemens

The fourth quarter always is kind of a dicey one to look at because of our snow-season hits, and we had higher OREO expenses in the fourth quarter than we had in the third quarter. So we've been running non-interest expense between 48.5 and 49.9, somewhere in there for the first three quarters. That's probably a fairly decent range to consider.

Brad Milsaps – Sandler O'Neill

Anything specifically in the other income item that sticks out?

Paul F. Clemens

Primarily we had some maintenance costs associated with some of our contracts. We had, like I said, in the other expense category, we had snow removal, we had some marketing expenses were included in there. Just some things that we had deferred some expenses as it relates to marketing, and we encouraged some of those things during the quarter, as we've been running some deposit promotions that built up that. That's kind of caused it to be a little lumpy.

It was $15 million other compared to $11.4 but it's been running around $13 million, roughly, as the other two quarters. That's probably, on average, a pretty good guess.

Operator

Our next question will come from Ben Crabtree – Stifel, Nicolaus & Company, Inc.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

I guess, probably a number of different points, and as long as we've been on credit quality, maybe a couple more related to that. You moved a significant chunk of non-performing loans into OREO in the quarter. Any rough number as to how much of a haircut was taken in that process?

Paul F. Clemens

Ben, we had a fairly flat quarter-to-quarter level for OREO. There was very little movement into OREO for the quarter. The issue is the liquidation process and the culmination of which would create an OREO is it can be a very elongated process. Certainly we would expect the OREO bucket to increase in ’09 but it was fairly flat in the fourth quarter compared to the third.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

Mike, if I interpret what your overall comment was if I take the buck that you earned reported this year and add back in the extraordinary charges of the fourth quarter, you get somewhere around $1.65 and I think what I heard you say is, you’re going to have trouble matching that in 2009.

Michael Kozak

I think 2009 is going to have some headwinds that will make that challenging, but I wouldn’t suggest that we’re going to have a hard time equaling 2008’s performance. I think there’s a number of headwinds we’re going to have to fight to be able to do it. And the wild card certainly on performance is going to be credit.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

Not sure I understand exactly what’s behind the sequential drop in salaries and, I guess, also probably more importantly, thinking about if there are kind of one-time events in there what a reasonable number might be going forward in 2009 on the sale and expense line.

Michael Kozak

Ben, this is Mike. I’ll let Paul talk with the reasonable run rate going forward. Our benefit programs are calibrated in large part to our performance. On the fourth quarter you saw some of those impacts of the drop in our performance for the quarter being reflected in what our benefits programs were. So that’s got a lower contribution rate. So that’s in large part. So I wouldn’t say it was a one-time. It actively becomes one of this one could have ratably predicted what happened over the quarter, so you would have seen that spread more certainly a larger event driven activity.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

Any rough number as to what that would have been then, that amount, I guess, reversal?

Michael Kozak

There were probably $3 to $4 million worth of reversals during the quarter.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

So, if I were to add that back in, let’s say, then I’d be somewhere in the ballpark of a run rate going forward.

Michael Kozak

Yes. We’re if you look at our run rate for the first three quarters, there was about $26 to $27 million and run rate with merit increase and so forth, probably put us right in there again next year.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

A question on the remainder of your troughs portfolio, I guess. Obviously a very squishy subject for the whole industry, but if I look at the haircut of market versus book on what you’ve kept and didn’t mark down, it isn’t all that much different on the stuff that you did mark down and just kind of wondering what’s going on there, and whether there isn’t a realistic potential of having to take a hit on that remaining part.

Paul F. Clemens

Well, this is Paul. I guess what I would say is on the stuff we took a haircut on we mark it down to about $0.37 on the dollar. On the stuff that we didn’t, but we still have an unrealized loss and we marked it down to about $0.50 on the dollar. And frankly, while there’s no assurance, our valuation process as we, and our cash flow analysis does try to contemplate, current market analysis and what’s going to happen in the future with regards to default, so I think we’ve been pretty aggressive in what we’ve written down.

If you stop and think where we were in September, we had a $14 million unrealized loss. During that quarter you saw what happened to bank stocks in general, and these are primarily collateralized by banks, underlying banks. So we went from a $14 million unrealized loss to a $25 million actual OTTI and still another $18 million worth of impairments, so we’ve written it down pretty healthily.

The problem with, if you write these down under accounting guidelines, you’re going to be hard-pressed to recover those and the still are performing. So, we don’t think we’ve been shy about recognizing the diminution in value, but to answer your question, there’s always an opportunity for further decline, but we think we’ve been pretty aggressive.

Michael Kozak

Ben this is Mike, the challenge in dealing with those types of assets, is, first off, it's non-cash. And the second challenge that you get into as you’re trying to make an assessment is first credit, which impacts cash flow, and then you have to use a discount rate to bring it back. And the discount rates that are being used to value some of these assets are at best, high. You’re in the 10% plus discount rate for some of these asset cash flows so that results in fairly healthy haircut.

To take even further haircuts beyond that, you’d have to use the discount rates that would be proportionally much higher starts to stretch the bounds of reason, here. And then, I would also offer my understanding is, though, we would have to have our treasury folks confirm this. I believe the securities are the majority of the troughs themselves are A rated investment grade securities.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

Did I hear correctly that there has been no significant drop in the actual cash flow from those troughs?

Paul F. Clemens

Correct.

Ben Crabtree – Stifel, Nicolaus & Company, Inc.

Was there a significant amount of interest income reversal in the quarter, in the net interest income line?

Michael Kozak

There certainly was some reversal with the additional increase in non-accruals. I’m trying to think how much it was.

Paul F. Clemens

About six or seven basis points came off of or margin related to non-performing loans.

Operator

Our next question will come from [John Kerry] – JP Morgan.

John Kerry – JP Morgan

Can you give us some detail on the 30 to 89-day delinquencies for the income producing bucket of the portfolio?

Michael Kozak

Sure, John. The number was about $116 million, which was up slightly from the prior quarter. Again, the substantial portion of that is, I shouldn’t say substantial, about 20 million of it is in the residential bucket, 20% that is, and we had about 42 million was in commercial real estate. As I mentioned in my comments earlier, we’re starting to see a little slipover in that 30 to 90-day bucket and about 24 million of the 116 was in our office, retail and industrial. That was largely two transactions that we’re monitoring very carefully.

We have about 35 million in our C&I bucket and that’s spread out over a whole variety of loans. And finally, consumer has ticked up. We’ve gone to roughly about 15 million of it is consumer.

John Kerry – JP Morgan

Then the other commercial real estate classification for your 90 days plus past dues, I believe they went from 2.5 million to just under 7 million in the quarter. What is that piece? What drove that?

Michael Kozak

That would be a whole bunch of categories that we had to lump into commercial real estate. It would include mobile home parks, some automobile dealers, some restaurants, medical-related, hotels. There is not one particular concentration, but spread over several categories.

John Kerry – JP Morgan

Well, what I’m getting at here is, the reason for my granular question there is that you had indicated that the bulk of your provisioning still is tied to the resi development that you’re starting to see deterioration in commercial real estate and you just cited some of the numbers to me here and you were clearly surprised somewhat by the magnitude of the inflow with the non-performers for resi’s so, it’s fair to assume that some of the commercial properties tied to that, you could be surprised by as well.

So I’m trying to get some comfort. Could you talk a little bit more about your re-provisioning for the commercial properties, for commercial, for retail and office and how ahead of the curve are you on the provisioning there, does that pose as some clear risk?

Michael Kozak

We’ll be disclosing more information when we file the 10-K, but suffice it to say that we do have in our judgment based on current circumstances, an ample and what I would call significant reserve for not only the ORI category, Office Retail & Industrial, but we also have an adequate reserve for our continuing C&I portfolios.

So when we say that there is a substantial reserve for residential, that’s not to negate the fact that we do have adequate reserves in those other categories. Based on our current assessment of what we have in the pipeline by our risk rating profile, we think the reserves we have at this point in time are adequate for what we’re seeing emerging, including what we have in the over 90 and in the 30 to 90-day category.

John Kerry – JP Morgan

Not to beat a dead horse, but the NPAs are up six-fold over the past 12 months. Clearly a steep jump for a bank of your caliber, can you try to revisit again? Where were you really surprised by this in terms of the non-performers there?

Michael Kozak

I wouldn’t characterize the word as being surprised. We certainly recognized the issues in our residential portfolio. To that point, roughly 40% of the portfolio is adverse rated at this point in time.

The process of remediation is a slow moving process, in the particular case of the jump the last quarter, there were, as I mentioned, substantial cases of contracts that basically went away, and I think we acted very expeditiously once that became known of recognizing these previously performing loans as non-performing loans.

We're really engaged in the workout activity is on the front line. We're not looking to move into a liquidation mode, we're really trying to meet the customer at the battle lines and trying to identify the emerging problems and act upon them quickly. Hopefully as I mentioned, you'll see more and more in the way of TDRs. That is the industry preferred path right now is to keep the customers in their properties. They have the expertise, they have the contacts.

If they have the character and the capacity and some cash flow, that is certainly the preferred route for the bank to take and that's what we're trying to do as we look upon the next wave that may be coming from the residential portfolio. Again, I would reinforce the fact that these were not unrecognized problems. They were on our radar scope, they were adversely rated they've been watched very, very carefully.

John Kerry – JP Morgan

Last question for you, Mike, how heavily are you weighing the options for a potential equity raise here? Just given where your tangible common equity is trending down to now and since you're still above tangible book in your valuation, you still have an opportunity here. How much more consideration you given to that?

Paul F. Clemens

Well, John as I alluded to in my opening comments, we're actively reviewing all aspects of our capital plan, and I think prudence in this environment requires you to do that, and so the best response I can give you is that and that we'll be reviewing that with our board and we'll continue to do that every single quarter.

What I would offer, though it's a little misleading as people tend to look at tangible commons equity ratios, is we have a securities book of substantial size. And one of the benefits that we have of that book, and certainly while we saw enough volatility in the markets generally, we also saw some tremendous appreciation in the value of that book, which offsets some of the tangible impact that we saw from some of the charges we took.

But keep in mind we have the ability, should we so choose to, as I eluded, shrink the size of our balance sheet and improve that tangible common ratio simply through those activities. So we've got some flexibility there to improve our ratios if we elect to do that.

Michael Kozak

Just to get back to you on your question on the non-accrual increase. Keep in mind the number that I'm going to give you, 75% of the increase end of the year residential non-accruals, pertain to five specific loans. This is five loans we've been tracking. One of those loans is one that we do have on a restructure basis that we were able to negotiate, but in many of those cases we had situations where contracts literally just fell through.

Operator

Our next question will come from the line of Erika Penala – Merrill Lynch.

Erika Penala – Merrill Lynch

The $97 million of construction NPAs, you mentioned that most of that was land and lot development. How much exactly was land and lot development?

Michael Kozak

Roughly 80% of it would be characterized as land, and 20% would be construction sticks, if you will

Erika Penala – Merrill Lynch.

Could you give us a sense of what the original value was of that $97 million?

Michael Kozak

Well we generally underwrite the loans in the neighborhood of 65% loan-to-value is our general guideline for underwriting vacant land, and obviously in this marketplace we've seen reductions in value anywhere depending on the particular market segment of between 25 and upwards of 35%. So we would tell you that we are fairly fully advanced on a lot of those land loans.

Erika Penala – Merrill Lynch

The 65% LTV that you gave at origination, do you calculate the V upon the value of just the vacant land or the value of the vacant with a project built out?

Michael Kozak

It's generally valued at the value of the vacant land.

Erika Penala – Merrill Lynch

You mentioned also on the call that the written down value is typically 94% of the new appraisal. Does the 6 percentage point gap between the new appraisal and what you're writing it down to, does that reflect just selling costs, or does that also reflect a potential discount at disposal?

Michael Kozak

Mostly selling costs at this point, we have not disposed of a lot of our OREO.

Erika Penala – Merrill Lynch

In terms of, you mentioned that you're starting to see some softening in term commercial real estate, is your concern driven by cap rates or are you starting to see stress in rent rolls as well?

Michael Kozak

We're starting to see some stress in rent rolls.

Erika Penala – Merrill Lynch

And the $48.5 to $49.9 million quarterly run rate that you mentioned does that included increased FDIC insurance premiums?

Michael Kozak

Probably the answer is no. Our FDIC insurance will probably go up slightly it'll go up for about $6 or $7 million we think. Some of that we're going to pass through, but we're still working through that. That's a good question.

Erika Penala – Merrill Lynch

You mentioned that you're going to see some pressure on the margin. Could you give us a sense on what you were seeing in terms of the dynamics for the margin in the first half of '09?

Michael L. Scudder

I think in terms of dynamics for the margin there's a couple of questions that impact the margin itself, I'll talk about the first one away from credit because obviously dependent on what levels the non-performers are those influence what margin levels are generally.

We saw a 400 basis point decline in Fed funds, 75 basis points in the last couple of weeks of the fourth quarter. Those will put some pressure on our pricing, as our loan book will re-price down to a certain reflective of that in the first quarter, and there's not as much room to move interest rates on the liability so you have to wait for the CDs to mature.

So far and away on the margin side, you would generally see more pressure in the first half of the year than you would see in the second half. Now combating that are we're getting generally better pricing on commercial deals overall, and that we've got some pricing benefit and advantage in this environment that's giving us some aid there. So we're seeing better general pricing on new volumes that are coming in.

The hope, though it has not fully manifested itself, though deposit liability pricing has come back, somewhat, it's still a very competitive environment for deposits out there. If pricing starts to move back to more normalized levels, given where the current level of interest rates are, that will give us some further lift.

So I think generally, as we try to outlook on 2009, first half's margin is more difficult than the second half, but overall the hope is that there's a number of offsetting factors in there that keep margins relatively stable.

Erika Penala – Merrill Lynch

How much, in terms of CDs, to you expect to mature in '09?

Michael L. Scudder

I don't have that information quite that granular here with me, Erika. I would say some percentage of it relatively shorter, so we generally see a good portion of the book re-priced.

Operator

If there are no further questions I would now like to turn the call back over to Mr. Clemens for closing comments.

Paul F. Clemens

I just want to thank all of you for joining us and thank you for your interest in First Midwest Bank. Please have a good day.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. Thank you all for participating.

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Source: First Midwest Bancorp Inc. Q4 2008 Earnings Call Transcript
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