First Defiance Financial Q3 2009 Earnings Call Transcript

Oct.20.09 | About: First Defiance (FDEF)

First Defiance Financial Corp. (NASDAQ:FDEF)

Q3 2009 Earnings Call

October 20, 2009 11:00 AM ET


Carol Merry - Investor Relations

William J. Small - Chairman, President & Chief Executive Officer

Donald P. Hileman - Senior Vice President & Chief Financial Officer


Eileen Rooney - KBW


Welcome to the First Defiance Financial Corp Third Quarter Earnings Release Conference Call. (Operator Instructions). I would now like to turn the call over to Carol Mary, please go ahead.

Carol Merry

Thank you. Good morning everyone and thank you for joining us for today's third quarter 2009 conference call. This call is also being webcast and the audio replay will be available at the First Defiance website at

Providing commentary this morning will be Bill Small, Chairman, President and CEO of First Defiance and Don Hileman, Executive Vice President and Chief Financial Officer. Following their prepared comments on the company's strategy and performance, they will be available to take your question.

Before we begin I would like to remind you that during the conference call today, including during the question-and-answer period, you may hear forward looking statements related to future financial results and business operations for First Defiance Financial Corp.

Actual results may differ materially from current management forecast and projections as a result of factors over which the company has no control. Information on these risk factors and additional information on forward looking statements are included in the news release and in the company's reports filed with Securities and Exchange Commission.

Now I will turn the call over to Mr. Small for his comment.

William Small

Good morning and thank you for joining us for the First Defiance Financial Corp conference call to review the 2009 third quarter result. Last night we issued our earnings release for the quarter and this morning we would like to discuss that release and look forward to the balance of 2009.

At the conclusion of our presentation we will answer any questions you might have. Don Hileman our CFO will be joining me on the call this morning to give you more financial details on the quarter. Also present this morning for the question-and-answer is Jim Rovers, President and CEO of First Federal Bank.

Third quarter 2009 net income on a GAAP basis was $329,000 or negative $0.2 per diluted common share compared to 322,000 and $0.4 per diluted share in the 2008 third quarter.

For the nine month period ended September 30th, 2009 First Defiance earned 6.6 million or $0.63 per diluted common share compared to $6.5 million or $0.83 per diluted share for the nine-month period ended September 30th, 2008.

Excluding the after tax impact of acquisition related charges in 2008 First Defiance had earnings of 7.1 million or $0.91 per diluted share for the nine months ended September 30th, 2008.

2009 continues to present many challenges to the banking industry with the current economic conditions and for our market area in particular. These challenges are certainly reflected in our results for the quarter.

Our most core-operating matrix were again solid. We felt the negative impact of higher provision expense, additional expenses for OREO and collections, other than temporary impairment charges and lower mortgage servicing rights valuation.

To offset these charges we had an improved net interest margin coupled with a larger loan base resulting in an increased net interest income of over $1.2 million and a $1.4 million increase in total non interest income and overall and over $400,000 reduction in non interest expense compared to third quarter of 2008.

All of this meted out to basically flat net income compared to the prior year period. Credit quality remains the biggest challenge as it has been for the past several quarters. We did see some improvement in lower delinquency numbers in net charge offs this quarter compared to the last quarter and non-accrual loans were flat compared with the length quarter.

We also have not seen any significant new deterioration in the loan portfolio. These are certainly signs of encouragement but we need to see this improvement on a sustained basis to really identify it as a trend.

The primary factor behind the provision expense this quarter is not specific to any particular loans or relationships but a general valuation allowance to inflate the portfolio.

Even with the positive sign I just noted property values continue to show weakness and some collateral dependant loans no longer had enough collateral value to support the outstanding balance.

Based on this and the economic forecast calling for a slow recovery, we felt it was necessary to build our general reserve as we work through this tough economy.

Despite disappointing net income results for the quarter, there were several strong performance indicators. One of the significant positive story in our third quarter was a strong net interest margin.

Net interest margin at the end of the quarter was 3.88%, a 27 basis points improvement over the second quarter 2009 margin. Also our strong performance in generating non-interest income continued during the third quarter even though the record setting residential mortgage reduction experienced it the first half of 2009 has subsided.

Mortgage originations did drop off in the third quarter compared to the first six months of the year but we are still running significantly ahead of the same period last year.

Annualized average balance loan growth was a little over 5% compared to second quarter as borrowers continue to be cautious on taking on new debt. Most of the growth is coming from new relationships where these customers are refinancing existing debt with our bank.

These new loan customers bring along deposit relationships and as a result non-interest bearing deposits were up at quarter end over 10% compared to end of third quarter 2008. Period end total deposits were up about 7.5% over the September 30th 2008 period ending balance.

Total non-interest expense for First Defiance decreased year-over-year and linked quarter due to expense control initiatives and reduced compensation expense. I will now have Donald Hileman to give you additional financial details for the quarter before I wrap with an overview and look at what we see developing for the balance of 2009, Don.

Donald Hileman

The third quarter continued to be difficult as we saw a continuation of high unemployment and weaker economic activity in our market. This has been especially true in Southern Michigan and the extreme North West corner of Ohio for most of the counties are well into double-digit unemployment.

We anticipate overall weak economic activity throughout the remainder of the year in our market area. While we do not have a direct concentration of auto related commercial lending. We do have retail customers whose livelihood depends on the automotive and related industries.

We anticipate more stabilization in these segments as the auto industry improves. As we review our financial performance, credit quality remain a key component, while we also have several other additional significant items that contributed to the year-over-year third quarter core income.

I will begin with the discussion of credit quality. This quarter we had a large loan loss provision with the corresponding build in the allowance for loan loses. In light of the continued environment of higher unemployment, declining real estate values and sustained economic weakness in the mid-west as well as our current regulatory environment, we believe it is prudent to build our general loan loss reserves.

Our provision expense totaled 8.1 million up from 4.9 million in the third quarter of 2008 and 4 million in the second quarter of 2009. Our allowance for loan loss increased to 31.2 million, a 1.92% of total loans as September 30th 2009 and from 25.8 million and 1.6% on June 30th 2009 and 23.4 million and 1.47% on September 30, 2008.

The third quarter provision exceeding that charge offs by 5.5 million. Annualized net charge offs were 66 basis points of loans for the third quarter of 2009, down from 96 basis points in the second quarter and up from 55 basis points in the third quarter of 2008.

The total net chare offs, 57% or 1.6 million were related to four credit relationships of the commercial real estate total charge offs of 1.2 million, 763,000 or 66% related to two of those relationships. A 611,000 or 92% of the total commercial charge offs of 658,000 related to one credit relationship.

We maintain a continuous processes for analysis and review of our loan portfolio and have made decisions to reallocate resources to work with past due clients to determine a course of action that we hope will mitigate potential losses on client relationships.

We have two experienced individuals dedicated to handling problem, commercial credit and developing action plans to move the credit to the workout process. We've also been actively working with residential borrowers to determine qualification for loan modifications. We have modified approximately 93 residential mortgage loans in 2009.

We calculate our allowance for loan losses by analyzing all loans that are classified in special mentioned list and making judgment about the risk of loss based on the cash flow of the borrower, the value of any collateral and the financial strength (indiscernible).

Based on those judgments we recorded specific amount of loan loss against each loan that we analyze. The provision for loan losses is the adjustment we make to the allowance for loans losses necessary for the allowance to be adequate based on the losses we estimate to be in the portfolio.

In our review we have determined that it is appropriate to increase the economic environmental and regulatory factors we use in determining the general portion of the reserve for loan loss or determine the adequacy of the reserve.

We believe this is consistent with the operating environment we foresee the remainder of 2009 and 2010. At September 30th our allowance for loan loss represented 1.92% of the total loans outstanding, an increase of 32 basis points over the last quarter and 78% of our non-performing loans, which is up from 64% of non-performing loans at June 30, 2009.

Non performing assets end of the quarter were 49.4 million or 2.45% of total assets, up from 48.9 million last quarter, which was 2.42% of total assets. Total non-performing loans remained basically flat from last quarter at 40.1 million at September 30th.

The non-accrual loans basically remained flat as well as for the quarter compared to June 30, 2009 and restructure loans decreased 271,000 from last quarter. Restructured loans are considered non-performing because of the changes in the original terms grant to borrowers. These loans are still accruing interest.

This is the way we can work with borrowers that have the ability to repay to mitigate the lost potential. The delinquency rate for loans 90 days past due and were non-accrual decreased slightly to 2.15% this quarter from 2.19% in the second quarter of 2009.

The slight decline in the level of 90 plus days past due from the last quarter, is due to a decrease in commercial real estate past dues of 2.4 million and an increase in commercial 90 days past due of 2 million and an increase in the one to four family residential of 400,000 with home equity and home improvements going down slightly.

The total delinquency rate increase to 2.77% at December, increase from 2.77% at December 31st 2008, to 3.49% at September 2009 but was down from 3.78% at June 30, 2009.

The compensation of the 94 stage past due non-accrual totals at the end of the third quarter breaks down into certain sectors. With the comparison on one quarter basis, commercial real estate 2.90 down from 3.34, one to four family residential 2.50, up from 2.33.

Commercial 1.50 up from 0.94, home equity 0.38 down from 0.41, construction 0.36, up from 0.13, and consumer 0.13 up from 0.10.

We believe that our portfolio continues to be well positioned with a diversified portfolio and low average loan size, very little presence in problematic segments, which is big box retailers in large office buildings and (inaudible) are generally underwritten on cash flow basis that require meaningful equity and personal guarantees.

We've also strengthened our credit review process and increased the overall scoop of loans we individually view on the quarterly basis.

Mortgage banking was still strong in the third quarter, continued momentum from the earlier in the year. We had a gain on sale of income, of 1.5 million in the third quarter of 2009 compared with 2.9 million in the second quarter of 2009 and 624,000 in the third quarter of 2008.

We also recorded a negative evaluation adjustment in mortgage servicing rights of 772,000 in the third quarter compared with a negative adjustment of 36,000 of third quarter of 2008.

As September 30, First Defiance had 1.2 billion in loan service for others. The mortgage servicing rates associated with those loans had a fair value of 8.4 million or 70 basis points of the outstanding loan balance serviced.

Total impairment reserves which are available for recapturing future periods totaled 1.9 million at the end of the quarter. While we are pleased with the mortgage loan activity on the first nine months of the year we have seen signs of slowing refinance activity with the slight increase in purchase activity.

The economic environment continues to add stress on our investment and Trust Preferred Debt Obligations or CDO and require additional other than temporary impairment write downs on the third quarter. The CDOs are made up of pool of investment of trust preferred securities issued primarily by commercial banks (inaudible).

As the issuing institutions experienced financial difficulties they can defer payments in many cases we have seen these institutions default on their issue, which is a negative impact on the collateral supporting the pooled investments.

The other than temporary charge recognized in the third quarter of 2009 totaled 994,000. The other than temporary charge for the quarter related to one security with the book value of 163,000 at June 30, 2009, which was written down to zero in the third quarter and four other Trust Preferred Collateralized Debt Obligations with the remaining book value of 2.2 million.

First Defiance also has another CDO investment that had another than temporary charge in the first quarter of 2009, which has a remaining book value of 243,000 and a market value of 170,000 at September 30, 2009, which is being positive for moving discounted cash flows resulting in no additional, for the quarter and previous quarter. Other and temporary charges are deterioration and the underwriting collateral in relate to the credit (inaudible) security.

The rest of the trust preferred CDO investments in the portfolio have a total book value of 2.9 million and market value is of 1.2 million at September 30th 2009. The decline of value in those investments is primarily due to continued lack of liquidity in CDO market. These investments continue gain principal and interest in importance with contractual terms of the security.

Management has not been the impairment in value of these CDO investments to be other than temporary and therefore has not recognized reduction in the value of those investments and earnings. The other than temporary charge was partially offset by 154,000 gain from the sale of securities.

Turning to other operating results, our net interest income of 17.6 million for the quarter was an increase of 1.4 million on a linked quarter basis and up from 16.4 million in the third quarter of 2008. For the quarter our margin was 3.88% which was a 7 basis point increase from the third quarter of 2008 and a 27 basis point increase on a linked quarter basis.

Falling interest rates continue to impact us on both the asset and liability side. We've been successful on continuing to lower our cost of funds, this remains challenging, we feel that we hit the floor in some place, we still have some opportunities on term accounts.

Fee income continues to be strong, but declined slightly to 2.6 million in the third quarter of 2009 from 3.7 million last year. Insurance revenue was 1.1 million in the third quarter of 2009, (inaudible) with the third quarter of 2008.

Overall non interest expense decreased to 14.8 million this quarter, compared with 15.2 million in third quarter of 2008 and 16.1 million on a linked quarter basis. The third quarter compensation and benefit expense were down primarily due to reversal of variable compensation based on the overall corporate performance as well as reduction of FTEs.

FDIC insurance expense increased to 649,000 in the third quarter of 2009 and 327,000 the same period of 2008 as the result of FDIC rate increases and higher insured deposit balances (inaudible) linked quarter basis, from 1.5 million which had a five basis points special assessment of 900,000.

We are still waiting for the final determination of any future special assessments. Other non-interest expense increased to 3.7 million in the third quarter from 2.8 million in the third quarter of 2008.

Increase in expenses of 778,000 for credit collection in OREO, 462,000 related to deferred compensation valuation, which was partially offset by cost reductions and (inaudible) such as advertising and loan related expenses.

We saw balance sheet growth with total asset growing 95.4 million from September 2008 2.02 billion, 6.1 million on a linked quarter basis. Bearing deposits grew a 107.3 million from September 2008, but decreased 7.1 million on a linked quarter basis, which is somewhat reflective of our pricing decision and efforts to reduce our cost to fund.

Loan balances increased 13.2 million on a linked quarter basis or cash in equivalent decreased 11.5 million. We are pleased with the loan growth and the new activity during the quarter. We have been able to develop strong new relationships with good commercial clients.

We believe that control growth is reflective of the environment and we are well positioned for future growth. That completes my overview for the quarter and I'll turn the call back to Bill.

William Small

As we progressed to 2009, we will continue to address the challenges that face us. The overall economic climate throughout our market area continues to be tentative, but we have seen some signs of improvement. Unemployment numbers continue to run higher in this region compared to national numbers, but seem to have at least leveled off.

Some manufacturing entities in automotive related industries that recalled employees in recent weeks and agriculturally the harvest season is facing weather challenges following a good growing season, the crops that have been harvested have produced good yield.

So there are some positive indicators out there, however we remain cautious in this economic environment and expanded our credit monitoring functions even beyond our traditionally focused approach.

Additional asset review functions and more delinquent loan reporting requirement have been added to assist in this monitoring. Detailed action plans are been utilized on all (inaudible) and are updated monthly to chart the progress.

We continually review credit concentrations by industry and have placed limitations on lending within certain industry segment. The large provision expense this quarter positions us to work out the problem credit and dispose of OREO properties.

We are seeing more interest from buyers for these properties and we hope to continue working and getting these non-performing assets off the book. We worked hard to execute our strategy in this challenging environment and to adapt to the fluctuations in the business cycles.

This was a disappointing quarter from an earnings performance perspective and certainly not acceptable to us, but I believe it is a time of opportunity for community banks like ours.

We remain well capitalized and First Federal Bank and First Defiance are positioned to be able to attract new relationship and grow by following the business plan that has prepared us for times like this.

Our core fundamentals remain strong and the underlying strengths will keep us on course for the future. In addition to working to improve our asset quality we are focused on finding and growing revenue sources as well as focusing and operating efficiently to step up and meet today's challenges. There's certainly better environment to operate in, but we will continue to work with our customers and offer the best in products and services as we look forward to better times.

We thank you for joining us this morning and now we will be happy to take your questions.

Question and Answer Session


(Operator Instructions). Your first question comes from Eileen Rooney - KBW.

Eileen Rooney - KBW

If you could us the amount of that comp reversal that was in the compensation line.

William Small

It was approximately 800,000.

Eileen Rooney - KBW

What was the inflows into non performing this quarter.

William Small

I can't remember off hand. Really I can't give you the specific credits that would (inaudible).

Eileen Rooney - KBW

Okay, I know I was just kind of wondering the dollar amounts, if you took out charge-off and all if you back that stuff out?

William Small

The non-performing were essentially flat and we had charge-offs of well 2.5 million right. So I would say that if they were flat then we've added inflow about 2.5 million into the non-performing.

Eileen Rooney - KBW

Okay, I just wasn't sure if there were things that paid down or moved for you.

William Small

Some of it, so it's probably a little north of that but not a lot.

Eileen Rooney – KBW

Question on loan growth this quarter, I'm sorry if I missed this in your comments. The commercial real estate category seem to have a quite a bit of growth. I was just wondering where that was coming from, what types of credits, any particular region?

William Small

The commercial real estate loans that we are booking now are primarily are multi-family residential apartment complexes that's a category that's performed well for us. There is a major real estate developer and owner in the Toledo area that passed away and literally put about 30 million of the apartments complexes on the market. So we've financed a few of those for good borrowers, that's a category that has performed well for us.

Donald Hileman

We have, how we underwrite those credits over the course of this year and in line with the economic environment that we are in and we've improved and required with more down payment, we require more collateral, little stronger guarantors on some of those credits I think we newer credits are underwritten a little bit stronger than they were in prior periods.

Eileen Rooney – KBW

And what would be like a typical under value you know?

Donald Hileman

Maximum 80, more in cases 75% and then cases were it's a property that needs improvements, we require in that case to be put an upfront, we hold back until the improvements are made.


(Operator Instructions) It seems you have no further questions.

Carol Merry

All right, if we have no other further questions, we'll thank you for joining us today and this will conclude our conference call. You can now disconnect.


Thank you very much.

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