Irwin Financial Corporation F4Q07 (Qtr End 12/31/2007) Earnings Call Transcript

Irwin Financial Corporation (IFC)

F4Q07 Earnings Call

January 28, 2008 1:00 pm ET

Executives

William I. Miller – Chairman & Chief Executive Officer

Gregory F. Ehlinger – Chief Financial Officer

Jody Littrel - Controller

Analysts

Ross Demmerle – Hillard Lyons

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Presentation

William I. Miller

Good afternoon and thank you for joining us. I’m joined today by Greg Ehlinger, our CFO and Jody Littrel our Controller. When we start with our presentation I want to make you aware of important cautionary disclosures in connection with the forward-looking statements we’ll be making on this call. The cautionary disclosures are in our written earnings press release and in our recent SEC filings.

Today we announced a loss of $13 million or $0.47 per share from continuing operations for the fourth quarter of 2007. Adding losses from our discontinued operations our consolidated net loss for the fourth quarter was $16.4 million or $0.58 per share. For the year we had a loss of $14.4 million or $0.57 per diluted share from continuing operations with an additional $30.5 million loss from discontinued operations for a consolidated loss of $44.9 million for the year.

Obviously, we’re very disappointed with these results. They reflect a deterioration of the residential real estate market beyond what we had expected. This deterioration has had the most visible impact in our home equity segment but in the fourth quarter we also saw evidence of weakness in the portion of our commercial portfolios related to housing markets.

There is some good news to share; our commercial finance segment had record earnings for both the fourth quarter and full year in 2007. Loan and lease outstandings have increased nicely in this segment and credit quality has been good even in the current stressed environment. Secondly, we’ve seen a slowdown in the pace of repurchase demands in our discontinued conventional mortgage operations. Nonetheless we must and I believe we can substantially improve our total results.

We took significant actions in 2007 to position ourselves for an improved 2008. We provided significant reserves for a higher level of expected future losses at both home equity and commercial banking. We made meaningful restructuring steps to reduce operating expenses and we managed our balance sheet growth last year in order to enter the new year with a good level of capital. As we look forward to 2008 we are currently projecting that the trend of increased home equity delinquencies will continue with additional deterioration in the first quarter at about the same pace as we’ve observed in the last six months. Assuming this projection holds true and that commercial banking delinquencies do not erode further we believe we can return to near breakeven performance in the first quarter and improve our performance thereafter.

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

Gregory F. Ehlinger

Consolidated net revenues in the fourth quarter for continuing operations decreased on a sequential quarter basis primarily reflecting increased loan loss provisions for the home equity portfolio. Our consolidated loss provision totaled $48 million in the quarter. This was up from $28 million in the third quarter. Net interest income was $65 million for the quarterly; relatively flat on a sequential quarter basis but up year-over-year reflecting modest portfolio growth. We took a total of $5.5 million in severance and other restructuring charges at our home equity commercial banking and current operations during the fourth quarter. These charges accounted for the bulk of the 17% increase in non-interest expense from the third quarter. The cost reductions from these restructuring actions will help us return to profitability in 2008.

Reflecting tightening of our underwriting guidelines and general economic conditions the consolidated loan and lease portfolio was unchanged during the quarter totaling $5.7 billion as of December 31. During 2007 loan and leases increased $460 million or 9%. The bulk of this increase came from growth in our commercial financed portfolio. Although average core deposits which totaled $2.3 billion at year end declined modestly during the fourth quarter our liquidity remains healthy. Our consolidated net interest margin declined to 4.3% during the fourth quarter as compared to 4.53% during the third quarter reflecting increased wholesale funding costs and some hedge ineffectiveness.

The corporation had $469 million or $15.55 per share in common shareholders’ equity as of December 31. At quarter end the tier one leverage ratio and total risk based capital ratio were 10.4 and 12.8% respectively down only slightly from September. Credit quality deteriorated in the quarter. Non-performing loans and leases totaled $76 million or 1.34% of total loans and leases at year-end up from $61 million or 1.07% of loans and leases at September 30. The increase principally reflects $6 million and $7 million increases in non-performing loans at the commercial banking and home equity segments respectively. The increases in both segments are not concentrated in any one market. The allowance for loan and lease losses for the corporation’s portfolios totaled $129 million at December 31, up $24 million from the end of the third quarter.

I’ll now turn to some detail by segment beginning with our commercial banking segment which earned income of $3.6 million down $1.2 million from the third quarter. Net income for the year totaled $17.8 million a 42% year-over-year decline. As part of our plan to improve profitability in 2008 the commercial banking segment reduced staff by 11% in the fourth quarter. The loan portfolio was flat during the quarter reflecting a slowing of credit demand. Net interest margin decreased to 3.83% in the quarter down from 3.97% in the third quarter. And, as I noted, credit quality in the commercial banking portfolio weakened and it weakened across several of our markets. 30 day and greater delinquencies rose to 0.85% compared to 0.41% at the end of September. Non-performing assets also increased from $29 million to $34 million during the quarter primarily related to deteriorating commercial real estate credits related to the residential housing markets in both Midwestern and Western markets. To address this increase we recorded a loss provision of $6.5 million during the quarter bringing the allowance for loan losses to 1.08% of loans at year-end up from 0.93% at September 30.

As Will highlighted, our commercial finance line of business earned record quarterly net income of $4.6 million in the fourth quarter up from $3.8 million in the third quarter. For the year earnings totaled $13.9 million, another record. We continue to see net interest income growth, good credit quality and modest expense growth in this segment. We’re certainly pleased with the performance of this segment and particularly our franchise finance channel. The segment’s loan and lease portfolio ended the quarter at $1.3 billion and net interest margin rose to 4.56% in the quarter up from 4.4% during the third quarter. Overall, our credit quality in the commercial finance segment is within our expectations. Non-performing loans totaled $9 million, up from $6 million at the end of September. We addressed this increase with a $1 million increase in the quarterly loan and lease provision which totaled $3.5 million in the fourth quarter.

Our home equity lending business loss $20 million during the fourth quarter compared to a loss of $8 million in the third quarter. The increase primarily reflects the effects of higher loan losses and delinquency rates as well as $4 million of restructuring costs incurred during the period. For the year, the segment loss $40 million compared to a profit of $2 million in 2006. Due to a combination of significantly tightened guidelines and lower market demands, loan originations totaled only $39 million in the fourth quarter, down from $104 million in the third quarter. Our home equity loan portfolio totaled $1.5 billion as of year-end, unchanged from the end of the third quarter.

Credit costs continued to rise in this segment. 30 day delinquencies on the managed portfolio increased to 5.78% from 4.72% at the end of September. Our quarterly loan loss provision increased by $15.5 million to $38 million during the quarter. In our assessment of the reserve we placed greater than normal weight on the trends we’ve seen in recent months projecting that delinquencies will continue to rise a like amount in early 2008. The majority of the quarterly increase in reserves reflects this adjustment. Charge offs on the managed portfolio totaled $19 million or 4.6% on an annualized basis. We currently anticipate the charge-offs in the first quarter will be at an annualized rate in the mid fives. During the fourth quarter $4 million of severance and other restructuring costs were incurred as we continue to evaluate operating expenses of this segment. At this point, we expect to incur only modest additional restructuring charges in the first quarter of 2008.

The discontinued operations related to our former conventional mortgage banking segment recorded a quarterly after tax loss of $3 million compared to a loss of $17 million in the third quarter. The fourth quarter loss reflects downward adjustments to servicing sale receivables and operating expenses that are required to oversee wind down activities. For the year discontinued operations loss $31 million largely reflecting repurchase reserves taken in the third and second quarters compared to a $36 million loss in 2006. As Will noted, losses due to repurchase claims have moderated. During the last four months repurchase requests were within the range of projections we used in establishing our reserves in the third quarter so there was no need to add to the reserves in the fourth quarter.

In summary, 2007 was a very difficult year. Will and the rest of the senior management team believe we’ve taken the actions necessary to address the unusual environment in which we’re operating. We’ve significantly increased our reserves for potential future losses; we’ve taken meaningful steps to reduce operating expense. We’ve tightened our underwriting and origination guidelines, we’ve expanded our funding resources and we have maintained a strong capital base and good liquidity to enter 2008. While the current conditions and results are proving very difficult we believe the improvements we are making will enable us to return to profitability in 2008.

Will and I would like to open the call to questions now.

Question-and-Answer Session

Operator

Our first question comes from Ross Demmerle from Hillard Lyons. Please go ahead.

Ross Demmerle – Hillard Lyons

On the provision for loan losses going forward in the home equity division I guess if you make the assumption that if you fully look at everything for the fourth quarter and you set aside enough of a provision then provisions going forward should really be minimal in that originations are down quite a bit. Then again, I guess that’s going to depend how much further you’ve looked past the first quarter too. You talk about trends as far as net charge offs and delinquencies increasing for the first quarter but I guess, have you tried to extend those trends further? Or, do you see it leveling off? Can you help us out a little bit with what you think provisions are going to be for the home equity division this year?

Gregory F. Ehlinger

Ross if I can point you back to what we said earlier in the call, one of the reasons the fourth quarter home equity loan loss provision was up so sharply was because we’re looking at the last six months of deterioration and using that as a basis to project in to the future. So, as we said earlier in the call we’re anticipating that first quarter delinquencies and charge-offs will deteriorate over the fourth quarter at a rate similar to how it deteriorated in the second half of 2007. That deterioration was included in our expectation of future losses and therefore was included in the provision we took in the fourth quarter. That’s also a very important part of why we said if that projection of continued deterioration at the same rate as the last couple of quarters proves accurate and the commercial banking credit doesn’t get any worse than it got in the fourth quarter, we think we can be back close to breakeven in the first quarter. That’s a major swing obviously from our fourth quarter results.

Ross Demmerle – Hillard Lyons

Then at the consolidated level what do you think these interest rate cuts by the Federal Reserve are going to do to your margin this year?

Gregory F. Ehlinger

Well, I would hope – this is not a forecast, more of a hope; I would hope it would restore a positively shaped yield curve over the course of the year and help margins for all banks.

Ross Demmerle – Hillard Lyons

Okay. Then, I guess for shareholders in general is there any way you can reassure them about the dividends going forward because we’ve seen a couple of cuts here by other financial institutions?

Gregory F. Ehlinger

Ross, the board typically meets in the first quarter to set the dividend schedule that we have historically adhered to for the year and they’re going to meet later this quarter and we’ll take all of the market conditions and factors in to account. But, it wouldn’t be appropriate at this point for me to speak on behalf of the board as a member of management.

Operator

Our next question comes from Stephen Geyen. Please go ahead.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

About 10% of loans by my calculation are in C&D development. About how much of that is tied to residential housing?

Gregory F. Ehlinger

Stephen the majority of the C&D development is tied to residential housing directly or through commercial developers doing residential development.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Okay. How are other parts of the commercial banking loan portfolio performing outside of residential C&D?

Gregory F. Ehlinger

The bulk of the issues that we’ve had in non-performing loans have been in C&D.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Have there been any material changes in ratings, watch list or below that in the one to seven categories?

Gregory F. Ehlinger

Yeah, we don’t use a one to seven categorization, ours are a little bit more than that. One of the things that drove the pretty significant provision in the commercial bank this quarter up to about $6.5 million when our historic run rate is sort of in the $2 to $2.5 range was that migration that you guessed about within our risk rating. So, we did move a fair number of credits deeper in to our risk rating metrics and that is one of the methods that we use in establishing how we want to target our reserve. So, there was a fair amount of migration within our risk buckets.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

There a number of one-time items in the quarter related to staff reductions in commercial banking and home equity. In visioning your model I’m just wondering if you could help us out how we should look at non-interest expense in 2008?

Gregory F. Ehlinger

Well, a couple of numbers to focus on in the home equity segment just north of $4 million, $4.5 million or so was related to restructuring charges. So that is in the non-interest expense for the fourth quarter and you should be able to reduce that and use that as a proxy for run rate. At the commercial bank it was probably close to $1 million and in the parent company it was also close to $1 million. A little bit lower out of commercial bank and about $200,000 [inaudible].

Stephen Geyen – Stifel Nicolaus & Company, Inc.

And as for the commercial finance business are there some segments or regions that are performing better than others?

Gregory F. Ehlinger

Stephen, the franchise channels is just performing very well from a credit quality and profitability standpoint. The small ticket portfolio in Canada from a credit standpoint is performing at our expectations from a credit standpoint. The funding for the Canadian portfolio has been challenging with the disruption in the secondary market there so margins have narrowed up in Canada for us. In the domestic portion of the small ticket portfolio we have seen some credit deterioration that was frankly, going on throughout most of 2007 and is most directly related to again, residential finance and related industry. Equipment that we financed that is just used in the construction trades is where we’re seeing weakness.

Operator

We have no further questions.

Gregg

We appreciate everybody’s attendance today and we look forward to talking to you again at the end of April and hopefully we’ll have better results at that time for you.

William I. Miller

Thank you.

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