Deborah Wardwell – Director, IR
Harold Gilkey – Chairman and CEO
Dan Byrne – EVP and CFO
Jeff Rulis – D.A. Davidson
Sterling Financial Corporation (STSA) Q1 2009 Earnings Call Transcript April 24, 2009 11:00 AM ET
Good day, everyone and welcome to the Sterling Financial Corporation’s first quarter 2009 earnings conference call. Each of you will be on listen-only mode until the question-and-answer session following today’s presentation. This conference is being audio webcast and can be accessed at Sterling’s website at www.sterlingfinancialcorporation-spokane.com. The replay will be available at the Sterling website, immediately following the call.
I would now like to turn the call over to Ms. Deborah Wardwell of Sterling Financial Corporation. And you may begin, ma’am.
Thank you, Katherine. Good morning. With us today, I have Harold Gilkey, Chairman and Chief Executive Officer and Mr. Dan Byrne, Executive Vice President and Chief Financial Officer, who will be discussing Sterling Financial Corporation’s first quarter 2009 earnings results.
Before I turn the call over to Harold, I must remind you that during today’s conference call, Sterling’s management will be referencing forward-looking statements that are not historical facts and pertain to our future operating results. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations, and intensions and other statements contained in this report that are not historical facts.
These forward-looking statements are inherently subject to significant business, economic, and competitive uncertainties, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change.
Sterling’s actual results may differ materially from the results discussed in these forward-looking statements because of numerous possible risks and uncertainties. These risks include, but are not limited to, the possibility of ongoing adverse economic developments which may, among other things, increase delinquency risks in Sterling’s loan portfolios, shifts in industries, which may result in lower interest rate margin, shifts in demand for Sterling’s loan and other products, increased cost or lower than expected revenues or cost savings in connection with acquisitions, changes in accounting policies, changes in the monetary and fiscal policies of the Federal Government and changes in laws, regulations and the competitive environment.
In closing, I would like to remind you that Sterling’s executive management team will be at D.A. Davidson’s Financial Services Conference this May 6th through 7th in Seattle, Washington and will be at the KBW Financial Services Conference, July 28th through the 29th in New York City.
With that said, I’d like to turn the call to over Mr. Harold Gilkey.
Thank you, Deborah. Good morning, everyone and welcome to our conference call. Yesterday afternoon, Sterling Financial Corporation released its first quarter 2009 results that showed solid performance of our core banking operations. Revenues rose 6% and they were aided by higher income from our mortgage banking operations, as well as gains on the sale of securities.
Sterling’s earnings generation capacity remained strong with over $40 million in quarterly pretax pre-provision income. Our risk-based capital ratio remained at 13%, unchanged from the previous quarter and our liquidity continued to improve. Cash equivalents and high-grade investments were $3.1 billion, up 4% from last quarter and up 23% from quarter a year ago.
While the provisions for credit losses declined significantly from the fourth quarter of 2008, which levels were at $229 million, it remained elevated at nearly $66 million. Because of the provisioning, Sterling reported a net loss of $20.4 million compared to net income of $2.9 million a year ago. After payment of the preferred dividends, earnings available to the common shareholder were a negative $0.48.
We are indeed beginning to see positive results of our credit administration team efforts. This has been in place for more than a year now, resolving non-performing construction assets. Construction non-performing assets represented the majority of our non-performing assets. During the quarter, growth of non-performing construction assets slowed considerably. The increase over linked-quarter basis was 10% compared to quarterly increases between 36% and 65% for each of the last four quarters.
During the second quarter, we believe our homeowners loan program helped dampen growth in residential construction non-performing assets. This homeowners program applies to newly constructed homes financed by Sterling and offers qualified buyers an opportunity to choose either the low rate of 3.875% on a 30-year conventional mortgage or a 3% contribution up to $20,000 from Sterling that can be applied towards closing costs or rate buy-down on FHA, PA, or conventional loans.
Importantly, these loans are salable into the secondary market. In the quarter, we closed 52 loans, representing sales of just over $18 million. Based on our pipeline of loan applications, we will close significantly more loans in the second quarter. Given the success of the program, we have elected to continue it through May 20th for loans closing by June 30th, 2009.
I’d also like to highlight our stepped-up efforts to resolve REO. We have formed an asset distribution group within our construction credit administration team to help accelerate the sale of REO properties. We are cautiously optimistic that the momentum on the distribution of REO could increase during the current quarter.
As I mentioned previously, at a time when Sterling is beginning to see a slowing in the growth of both its classified and non-performing construction assets, we are starting to see some growth in classified assets within other loan segments. Higher unemployment is beginning to grab its effect on residential mortgage portfolio. Our commercial real estate portfolio, particularly in Northern California, is being affected by a much lower lease opportunities. We’re also seeing some of that on the overall economic weakness in our commercial banking portfolio.
We have long said that recessions tend to come late to the Pacific Northwest than at other areas of the nation and tend to be shallower than the average for the whole nation. The national recession has clearly come to the Pacific Northwest. Sterling is focused on what it can control and is taking appropriate steps to mitigate future growth in classified assets in all loan segments.
We at Sterling continue to anticipate an ongoing higher level of provisioning. Given the economic uncertainties, it’s difficult to determine when provision will begin to return to more normalized levels.
Now I would like to highlight two areas of operational achievement. Our team made significant progress in lowering funding costs. We reported record deposit growth of 8% to $8.5 billion. The number of transaction accounts grew 2% on a year-over-year basis and crossed the 200,000 mark. Importantly, relative to the fourth quarter, the mix of our deposits improved.
Our net interest margin improved to 2.97% from 2.8% in the previous quarter in reflection of lower funding costs with respect to both deposits and borrowings. Our long-term strategy is to enhance Sterling’s profitability by improving our cost structure. During the quarter, we made progress towards that goal.
Second, I would like to touch on our mortgage banking operation whose income contribution along with the gains on the sale of securities helped to drive a 6% revenue growth for the quarter. Mortgage banking operations were up 115% year-over-year. Historically low levels of interest rates grow mortgage originations which reach $711 million representing a 73% increase. When we look at the mortgage loans closed, we see that refinancing activities made up roughly 75% of the total.
In March, purchase activity which has been subdued since November of 2008, experienced a healthy gain of 27% from a year-ago period. We view this gain as indicative of two trends, the start of a more typical spring selling season albeit from a much lower basis and the success of our newly introduced homebuyers loan program that is stimulating new purchase activity. With interest rates remaining low, we continued to see robust mortgage applications in month of April.
I will now turn the call over to Dan Byrne, who will provide more clarity on the quarter. Dan?
Yes, thanks, Harold. To supplement the information provided in the press release, I am going to focus on some key highlights for the quarter and then provide you an opportunity to ask questions during the Q&A session.
Our balance sheet remains very strong in terms of liquidity and capital. We have sufficient cash at the parent company level to meet our needs for the next several years. At the end of the first quarter, Sterling's total assets were $12.8 billion, no change from the levels at December 31st.
During the first quarter, we took advantage of market conditions to add a net $93 million to our securities portfolio. You will also note that in the quarter, we sold certain municipal and other securities that were added opportunistically during the fourth quarter of 2008 in the early parts of the first quarter of 2009, based on dislocations in those markets. Because of the concerns we had over future evaluations of these securities, we sold them and captured gains and these are reflected in the other non-interest income.
Our total loan portfolio showed a net decline of $123 million as we continue to lower the mix of the assets related to construction. During the quarter, the construction portfolio declined a total of $178 million, primarily in our residential construction portfolio.
Our funding of the balance sheet was positively influenced by our deposit gathering initiatives. We are very, very proud of our results. We grew total deposits as Harold indicated by 8% or nearly $138 million achieving a record deposit of $8.49 billion. Our efforts were focused on increasing deposits for businesses, consumers, and public entities.
I would add that we were on the forefront of change in the way the State of Washington handles its collateral fall which is designed to protect the deposits of the state’s various public entities. Sterling continues to be well positioned to serve the needs of these public entities. We have also been a bit more aggressive in adding on-balance sheet liquidity which is added to our CD balances. Now that being said, you will note that our deposit cost declined nicely during the first quarter by 35 basis points on a linked-quarter basis despite intense rate competition.
Now with respect to operating results, we continued to increase top line revenues as you saw in the press release. Net interest income for the first quarter was higher than the fourth quarter of 2008, but lower than the same quarter of last year.
As Harold indicated, the net interest margin improved to 2.97% on a linked-quarter basis primarily because of lower funding costs. These lower funding costs were most notable with respect to deposits, which you will also note the cost of borrowings declined 56 basis points during the quarter. These improvements were somewhat offset by the reversal of interest of non-performing assets which negatively affected the net interest margin by approximately 33 basis points.
We continue to emphasize making loans to businesses and to consumers. In the press release, we highlighted the residential loan originations by our subsidiary bank, Golf Savings Bank. A couple of points I would make in addition to Harold’s with respect to residential loan originations.
First, that the mix of originations has been weighted generally toward refinance, although we did see a noted increase in purchase transactions during the month of March. Second, the margin on loan sales has been holding in or slightly better than our expectations at the beginning of the year.
We also highlighted lending initiatives aimed at small businesses. Sterling has a very experienced and knowledgeable team of bankers and we are actively deploying capital into our communities through making small business administration loans, which can be used to purchase, construct, or renovate owner-occupied business premises, as well as to provide financing for debt, working capital and equipment and inventory purchases. Let me just say that Sterling Savings Bank and Golf are committed to making every loan we can to qualified borrowers.
We continue to control our operating expenses. FDIC insurance has increased some $2.4 million on a linked-quarter basis, representing the higher insurance limits and Transaction Account Guarantee Program. The fourth quarter of 2008 – employee compensation is flat compared to our linked quarter when you consider that the fourth quarter had a sizeable reversal of accrued bonuses and incentives of nearly $3 million.
Our efficiency ratio improved again during the quarter as measured by the ratio of non-interest expense to revenues, which dropped to 62.7% during the current quarter from over 81% in the linked quarter and nearly 64% in the same period a year ago. We continue to pursue operating process improvements to drive operating expense reductions.
Now, with respect to income taxes, an effective tax rate of approximately 2% was reflected really our outlook for 2009 earnings overall. For the year, we expect Sterling’s effective annualized tax rate to be between 2% and 5% after taking tax credits into consideration.
We expect to remain well capitalized through 2009. We believe we can manage through this credit cycle. Our capital position at the end of the first quarter and our earnings generating capacity provide a cushion to absorb additional credit costs depending on their timing and without implementation of draconian measures. The way we look at capital is to look at the amount of excess risk-based capital. At 10%, this would be $289 million and if you want to maintain a higher level, say 11%, the excess is $193 million.
We also have allowances, which have been excluded from this base capital of $108 million. This allows us to absorb additional provisions of $400 million at the 11% risk-based capital measure or $550 million at the 10% risk-based capital measure. I would just add that I have assumed a 36% effective tax rate on those provisions. Separately, each subsidiary has done its own stress testing and we have concluded that the potential loan losses are within their capital capacities without raising additional capital.
Sterling has been successful in expanding its on-balance sheet liquidity, which increased $120 million to $3.08 billion compared to the linked quarter. This allows for additional borrowing capacity of over $3 billion. Now, with respect to our securities portfolio, we have the majority invested in high-quality agency securities.
Our private label CMOs are also high quality and are continually monitored for impairment. And I am pleased to say that we have no OTTI impairments in our portfolio. We do expect that the recent relaxation by the FASB with respect to fair value will have no immediate impact on our securities portfolio, which should have a positive impact with respect to the Federal Home Loan Banks, which will reduce the exposure to OTTI on our investment in the stock in the Federal Home Loan Bank of Seattle.
Now let me address the provision for credit losses and trends in the asset quality. There were several factors that led to an upsize provision during the first quarter. These factors are consistent with our previous guidance. The first factor was the increase of non-performing and classified assets.
At March 31, 2009, classified assets, which is really the driver of our provisioning, increased from $984.9 million at the end of the fourth quarter to a little over $1 billion, $1,070.4 million – make that billion in the first quarter, representing an increase of 8.7%. Gross non-performing assets, that is non-performing assets before specific reserves, were $670 million, which was up less than 10% from the last quarter.
The second factor was the loss default rates increased as we continued to see appraisal values decline in a number of our markets. Now, nearly 80% of non-performing assets are related to construction. Residential construction was 68% of non-performing assets, while commercial real estate construction added an additional 12% of non-performing assets.
Non-performing assets increased by approximately $59.3 million from the levels reported in the fourth quarter. Of this increase, 80% was related to construction, approximately $43 million in residential construction and $4 million in commercial real estate construction. The remaining 20% of non-performing assets was spread across other loan types.
C&I made up, for example, 8.4% of non-performing assets. And these non-performers are partly related to the construction correlated industries. Non-owner occupied residential was less than 8%. The balance of non-performing assets came from permanent commercial real estate, consumer, and multi-family construction, each making up around 3%.
The market where we experienced the largest increase in the overall non-performing assets was in Boise, Idaho with the additions of $14 million, primarily related to one residential construction project. Other markets experienced increases in the overall non-performing assets included Oregon, excluding the Portland and Bend markets. And this was primarily a residential construction area of $12.2 million and it primarily related to one A&D project in – at sector.
Phoenix, Arizona had an increase of $12 million that was primarily related to one shopping center project of approximately $9.5 million. The Puget Sound had an increase of $10.5 million. This is primarily related to four projects ranging in size from $1.5 million to $5.4 million.
The loss given default rate has increased in most of our markets. And to give you a sense of our loss recognition, looking at our top 20 non-performing assets, which represents over $363 million or about half of all non-performing assets, the aggregate loss given default rate is a little under 26% of the original book balance. Some markets have higher loss given default rates such as Idaho and Southern California, which are in the 30% to 40% loss content range.
Now regarding Puget Sound, which is our largest market, which has approximately $780 million in residential construction commitments, I would say that this market continues to hold up better than most markets, especially in the core areas around Seattle.
Gross non-performing loans did increase as I mentioned to $84 million from $74 million last quarter and represented about 11% of outstanding commitments to this region. Fortunately, most of our residential construction portfolio in the Puget Sound region is weighted toward vertical construction, not land. Now that being said, we are a bit guarded over the future prospects given some of the recent announcements from large employers in this region.
When you look at our classified assets, they have a similar profile to non-performing assets. The increase in total classified assets was most notable in the construction portfolio with residential construction representing 57% of classified assets and commercial real estate construction representing another 13.6% or a combined 71% of classified assets at quarter-end.
You will note that in the quarter, our construction portfolio was reduced by a net $178 million. This reduction was accomplished through roughly $213 million in net maturities and pay-offs, a $117 million in new loans funded, as well as partial or total resolution of a number of non-performing construction loans totaling $82 million.
I would just add that during the quarter, our REO balance increased $21 million to $75.9 million net of allowances and represents approximately 136 properties or projects. The loss percentage on these REO assets are consistent with the levels at the fourth quarter. But the loss percentage does vary depending on location and the stage of completion.
Generally, the loss given default is roughly 48% with vertical construction losses being lower in the range of 15% to 20% and we have one land related project, it’s located in California, which has a loss of up to 80%.
Now, with respect to our guidance, we are going to continue our practice of not giving specific earnings guidance for the remaining – remainder of 2009. As Harold indicated, there continues to be a number of uncertainties that make it very difficult to project the drivers of our income statement.
The national and regional economies will continue to be a significant factor in our success during the remainder of 2009 and will likely affect the demand for our bank products including loans, deposit flows are likely to fluctuate depending upon prevailing interest rates and customer perceptions regarding the current state of the banking industry. Deposit flows in turn will influence our cost of funding and the impact on net interest margin.
So with that, I will turn it back to Harold.
Thank you, Dan. Each quarter has its own special achievements. I remain confident in the skill and determination of our team to see our way through this economic cycle. Importantly, we have the capital cushion and the liquidity position to get us through this cycle.
I believe our newly introduced home loan incentive program will help to resolve problem assets and will prevent further deterioration in our residential construction portfolio. This effort complements the numerous interventions we are taking to cure the problem assets within our portfolio.
I want to personally thank all of our employees for their undiminished determination and their constant commitment to fixing and resolving issues and continuing to grow and build our franchise. Across the bank, we have talented people focused on making positive differences for our customers. As a group, we’ve remained focused on two priorities, growing deposits and improving asset quality.
In closing, the Sterling’s team remains tenaciously focused on doing what it can control. We continue to shift our asset mix towards higher-quality lending relationships in the business and consumer groups. We continue to grow our treasury management and other business related services thereby increasing the fees and service charge income. We continue to control our overhead expense through systematic process improvement.
I will end with a reminder of the strengths of the Sterling franchise. Our capital and liquidity positions remain solid. The operations of our core banking provision are solid and are performing well. Our deposit franchise is strong and continues to expand through high-quality relationship based commercial deposits.
We have a strong management team that has the experience to address the current market disruption and the asset quality challenges. Our credit team is capable and seasoned and has significant experience in loan resolution and workout. We are continuing to build our commercial banking franchise in Sterling Savings Bank and our residential home loan business in Golf Savings Bank.
With that, I will turn it back to Katherine and begin the question-and-answer session.
Thank you. (Operator instructions). Today’s first question is from Jeff Rulis of D.A. Davidson. Your line is open.
Jeff Rulis – D.A. Davidson
Good morning, Jeff.
Jeff Rulis – D.A. Davidson
You mentioned in the press release some Northern California commercial real estate issues, hoping to get a little more detail there. Along what line in a retail, office, industrial, and then sort of refined geography is that like in Sonoma County specifically, if you could comment on that?
Jeff, essentially it runs from our acquisition of Sonoma National Bank and runs from the area of Santa Rosa toward Sacramento and there is one industrial project that is a problematic issue. Office and retail are about equal and essentially it’s rent-up of the locations are just slower than normal and thereby, the evaluation of – as is impacted. On the other hand, the overall valuation of the project in completion stage is well above our level of involvement.
Jeff Rulis – D.A. Davidson
In other areas of your footprint, (inaudible) is holding up reasonably well?
Yes. The one element that struck me this quarter was the one commercial project in Phoenix. It is cash flowing and is a shopping strip center on a corner that has a anchor tenant and the developer just looks like he has too many projects and to focus his time on and has indicated on five different transactions that he is turning those back. We are proceeding with the foreclosure proceeding, but it just seems to me that what’s happening is there’s a little of a – we are running out of cash basis kind of thing and we don’t have the resources to manage everything we have. But this one looks it – it’s just a matter of time to take it over and then resell it.
And I would just add that when Harold mentioned the five being handed back some of those go to other banks.
Jeff Rulis – D.A. Davidson
Well – but no, no, the majority of them. We just picked up one, Jeff.
Jeff Rulis – D.A. Davidson
All right. Okay, and then on the deposit side, if you can touch on – a little bit more on the sort of the success on the interest-bearing account increase, do you have a program in place there? Is there a seasonal shift happening that’s a pretty big jump on a sequential basis?
It absolutely reflects the process that we’ve been going through. We announced I think two quarters ago our 1000-day project and the focus of that 1000-day project is to substantially increase our deposit gathering and part of that went through a training exercise, a coordinated exercise as we went through it and so there – that’s a very positive impact from the standpoint of achieving an increase in number of accounts.
You would also note that there was a great disruption in the public funds deposited in the State of Washington because of the fall of a bank in Vancouver and that caused a shift in deposits of public funds, which were beneficial to us. We were able to manage that extremely well.
I would just add to Harold’s comments that we have had a number of initiatives trying to improve the mix of our deposit base through our business banking, which is leading with the non-interest bearing transaction accounts. And I think in some cases, business is in consumers because of the uncertainty of the economic environment, our bank savings.
Jeff Rulis – D.A. Davidson
Okay. And then, I guess one last one if I could. You mentioned the increase in construction classified assets on a quarterly basis is slowing. What was the rate in Q4 and what was it in Q1?
Hold just a second, Jeff. While Dan is looking it up, I would tell you I’m looking forward to the first week of May in Seattle. I hope you will make sure it doesn’t rain while we are there.
Jeff Rulis – D.A. Davidson
I’ll see what I can do, yes.
You have that, Dan? I have (inaudible).
Yes, I mean the non-performers increased a $173 million in the December quarter and a $133 million in the September quarter and $80 million in the June quarter. So, this is the lowest level we’ve seen for nearly a year and the classifieds at a similar growth rate. In the fourth quarter, they were up $313 million, $174 million in the September quarter and $94 million in the June quarter. So again, the rate that we saw in the first quarter was lower. You can do the calculations on the percentages.
Jeff Rulis – D.A. Davidson
Sure, sure. Okay, I appreciate you guys.
Jeff, to make sure – that’s the total classified and total NPA, you have to take about 80% of that to get it into the – into the construction.
Into the construction portfolio.
And then you could follow that function.
Jeff Rulis – D.A. Davidson
I got it. Thank you.
(Operator instructions). And gentlemen, I’m not showing any further questions at this time.
Thank you, Katherine. Well, thank you everyone for joining us today and I’d like to thank you for your participation. We look forward to talking to you again at the end of the second quarter of ’09. Our next earnings release is currently scheduled for Thursday, July 23rd, followed by an earnings call the next morning at 8:00 AM Pacific Daylight Time. Please remember that Sterling’s Annual Shareholders Meeting will take place next Tuesday, April 28th.
Thank you for joining us today. This concludes our call.
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