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Independent Bank Corporation. (NASDAQ:IBCP)

Q1 2008 Earnings Call

April 25, 2008 10:00 am ET

Executives

Mike Magee - President and CEO

Rob Shuster - Chief Financial Officer

Stefanie Kimball - Chief Lending Officer

Analysts

Terry Mcevoy - Oppenheimer

Brad Milsaps – Sandler O’Neill

David Scharf - FTN Midwest Securities

Kurt Harvardson - NTF

Jason Werner - Howe Barnes

Operator

Hello and welcome to Independent Bank Corporation first quarter 2008 earnings conference call. (Operator Instructions) Now I would like to turn the conference over to Mr. Mike Magee. Mr. Magee?

Michael Magee

Thank you. Good afternoon and welcome to our first quarter 2008 earnings conference call. I am Mike Magee, President and CEO of Independent Bank. Joining me on the call today are Rob Shuster, our Chief Financial Officer and Stefanie Kimball, our Chief Lending Officer.

Following my introductory comments, Rob will provide a detailed review of our financial performance during the first quarter. Following Rob’s comments, Stefanie will provide a progress report on our lending initiatives and risk management. We will conclude the call with a brief question-and-answer session.

Also please note that an accompanying PowerPoint presentation will be referenced throughout today’s call. To access this presentation, please go to the Investor Relations section of our website at www.ibcp.com.

Please also note that this presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to our Safe Harbor provision on slide three of the presentation for additional information on forward-looking statements.

I will begin today’s discussion with a review of our first quarter financial results which are summarized on slide four of the accompanying slide presentation.

With the first quarter ended March 31, 2008, we reported income from continuing operations of $341,000 or $0.01 per fully diluted share compared to $3.9 million or $0.17 per fully diluted share in the first quarter of 2007.

They year-over-year decline in the operating profitability is primarily attributed to a $3.2 million increase in provision for loan losses and the higher loan and collection expenses as a result of several commercial real estate loans moving from the watch list to nonperforming status during the quarter. These delinquencies are primarily the result of real estate developers experiencing cash flow difficulties as they confront a significant decline in real estate values throughout various regions in Michigan.

While we are disappointed in the increased nonperforming loans, it is important to note that these credits had already been identified as potential concerns when they were originally placed on the credit watch list.

Throughout the course of the last year, we have on several occasions discussed our initiatives to improve our credit quality. Under the guidance of our Chief Lending Officer Stefanie Kimball we have worked diligently to more accurately assess our loan portfolio and enhance our underwriting policies going forward.

While the actions taken will be effective in helping us avoid the situation in the future Michigan’s current economic conditions continue to create challenges for us, particularly, within the residential housing and commercial property markets where real estate values and market demand remains sluggish.

For a high level overview of the quarter please turn next to slides five and six of the presentation. Despite the increases in non-performing loans and the credit cost associated with managing them throughout the course of last year in the most recent quarter, we have remained profitable. Additionally our first quarter net interest margin increased on both a year-over-year basis and on a sequential quarterly basis due primarily to our ability to reduce our funding cost at a faster phase than the decline in our yield on interest earning assets resulting from the Federal Reserve Bank’s aggressive action to cut short term interest rates.

Another positive take away from the quarter is the growth in some of the categories of non-interest income more specifically growth and the positive related revenues on a year-over-year basis and title insurance fees.

Looking ahead I remain encouraged by a number of strategic and operational initiatives our team has implemented that enable us to remain focused in measurable results and assist us in remaining the Community Bank of choice in Michigan. These initiatives will guide us to continue to grow deposits, improve asset quality and improve operating efficiencies through our discipline cost containment. We are clearly not out of the woods yet in terms of regional economic challenges. However, I believe we have better visibility into the non-performing assets in our portfolio and are actively managing and monitoring credit quality.

Our prime loans are clearly on our watch list, we are focused on managing what we can control namely future loans in a more comprehensive credit review process as well as branding and marketing to ensure we increase our market share in this current down cycle and are hit our strides when the market rebounds. With that I will now turn the call over to our Chief Financial Officer Rob Shuster for a review of our financial performance during this period.

Robert Shuster

Thank you Mike good morning everyone. I am starting at page nine of our PowerPoint presentation. I will focus my comments on net interest income in our margin, certain components of non-interest income and non-interest expense, asset quality and conclude by making a few comments about our current cash dividend.

As outlined on page 10 there were several unusual items impacting first quarter 2008 results. Our fair value election on preferred stocks and impairment charge on capitalized mortgage loan servicing rights, the reversal of previously accrued and uncollected interest on loans based on non-accrual, severance costs in an elevated loan loss provision all negatively impacted the quarter. Conversely the VISA IPO fair value election on loans helped for sale SAB 109 implementation for commitments to originate mortgage loans and the released of a previously established income tax reserve favorably impacted the quarter.

We outline our implementation of FAS 159 and SAB 109 in greater detail on page 11. Effective January 1, 2008 we elected fair value accounting for several preferred stocks that we own. These preferred stocks were purchased long before the disclosure of any of the sub-prime mortgage problems that have impacted some of these issuers. The market values of these preferred stocks have declined sharply due in large part to the general aversion to risk and liquidity challenges in the current marketplace.

Because these are perpetual securities assessing these preferred stocks for other than temporary impairment is very difficult because there is no maturity date and thus forecasting when the market value might recover is difficult. Further, OTI accounting is one way. Once you write down a security for other than temporary impairment, you establish a new carrying value or cost basis for accounting purposes and cannot subsequently recover the impairment unless you sell the security.

As a result we elected fair value accounting for these securities and reported a $2.2 million charge during the first quarter of 2008 which represents the change in market value between the beginning and end of the first quarter. Each quarter, we will report the changes in fair values of these securities as a component of non-interest income. Since the end of the first quarter through about the middle of April, the market value of these preferred stocks have increased by about $690,000.

We also elected fair value accounting for loans held for sale. Previously, loans held for sale were accounted for at the lower of cost or market. The fair value accounting now aligns with the accounting for the related commitments to sell these loans. Additionally, we implemented SAB 109 which resulted in reporting the fair value of commitments to originate mortgage loans.

Collectively, these items added approximately $821,000 to gains on mortgage loan sales.

If you move to pages 12 and 13, tax equivalent net interest income totaled $31.8 million in the first quarter of 2008 which was up $576,000 or 1.8% on a comparative quarterly basis and was up $264,000 on a linked quarter basis.

Average interest earning assets were down slightly on both a comparative quarterly basis and linked quarter basis. On a linked quarter basis, average loan balances were flat and average investment security balances were down a bit. This decline in average interest earning assets partially offset the increase in our net interest margin.

As you can see on page 12, our net interest margin was 4.3% in the first quarter of ’08, up 7 basis points year-over-year and up 8 basis points on a linked quarter basis. In the first quarter of 2008, non-accrual loans averaged $83 million compared to $69.5 million in the fourth quarter of ’07 and $39.5 million in the first quarter of ’07. We reversed $800,000 of accrued and unpaid interest on loans placed on non-accrual in the first quarter of ’08 compared to $300,000 during both the fourth quarter of ’07 and the first quarter of ’07.

Our elevated level of non-accrual loans of approximately $95 million at quarter end creates a drag of about 24 basis points on the net interest margin. Our ability to bring our cost to funds down that are paced equal to or faster then the decline in our yield on interest earning assets has allowed us to improve our net interest margin.

Page 14 provides information on the sharp decline in our level of brokered CD’s. Because we issued a lot of callable brokered CD’s we have been able to exercise our call rates and pay off the higher costing brokered CD’s with lower cost borrowings from the Federal Home Loan Bank and the Federal Reserve Bank.

Moving on to some of the more significant categories of non-interest income on page 15 of our presentation; service charges on deposit accounts increased by $759,000 or 15.5% on a comparative quarterly basis and declined by $771,000 or 12% on a link quarter basis. VISA check card interchange income was up 44.3% on a comparative quarterly basis and was relatively flat on a link quarter basis. These large year-over-year increases primarily were flat to the acquisition of branches that we completed on March 23, 2007.

With respect to the link quarter decline in service charges and deposits we are historically seen approximately a 7% decline from the fourth to the first quarter due to seasonal variations in the pattern of certain fees. However the 12% link quarter decline experienced in the first quarter of ’08 does seem the point to some belt tightening by consumers and of leading certain fees such as NSF charges.

Gains on the sale of mortgage loans totaled $1.9 million in the first quarter of ’08 on $84.4 million of loan sales. These gains were up on both a year-over-year and linked quarter basis due to the $821,000 adjustment I mentioned earlier related to FAS 159 and SAB 109. Our volume of mortgage loan originations in the first quarter of ’08 was a $118.2 million which is up slightly on a year-over-year basis.

We experienced an increase in refinance volume in the first quarter of ’08 due to lower mortgage rates. However this was largely offset by lower purchase money mortgage volume as home sales levels decline in the majority of our markets.

Real estate mortgage loan servicing income declined on both a comparative and linked quarter basis. We have recorded an impairment charge of $725,000 on capitalized mortgage loan servicing rights in the first quarter of the year. A decline in mortgage loan interest rates resulted in using higher prepayments fees in the valuation of our capitalized mortgage loan servicing rights.

Moving onto page 16 of our presentation, non-interest expenses totaled $30.3 million in the first quarter of ’08 compared to $28 million in the first quarter of ’07 and $29.6 million in the linked quarter.

Several categories of expenses such as occupancy, data processing, communications, and the amortization of intangible assets were up year-over-year due to the acquisition of branches. Loan and collection expenses are substantially higher due to our elevated level of nonperforming assets.

Finally, FDIC insurance expense increased significantly in the first quarter of ’08 because of higher rates in our full use of assessment credits in the fourth quarter of ’07.

As evidenced on page 17 of our presentation, the assessment of the allowance for loan losses resulted in a provision for loan losses of $11.3 million in the first quarter of ’08. This level was higher than the previous two quarters and remains at a very high level of about 178 basis points of loans on an annualized basis.

Nonperforming loans, page 18, increased to a $102.2 million or 4.03% of total portfolio loans at March 31 ’08. The rise in nonperforming loans during the first quarter was primarily concentrated in the commercial loan portfolio. About 70% of the commercial loan increase is due to certain land development or construction and development loans becoming nonperforming.

Stefanie will provide more information on our commercial loan portfolio during her comments. Further, the Form 8-K that we filed yesterday includes a table that provides a breakdown of our commercial loan portfolio by loan category and information on both performing and nonperforming watch credits.

Page 19 of our presentation provides information on the components of our allowance for loan losses which rose to $49.9 million or 1.97% of total loans. Excluding Mepco’s finance receivables in the portion of the allowance that relates to these receivables, the ratio of the remaining allowance goes up to 2.15% of loans.

One statistic that gets a lot of attention is the ratio of the allowance for loan losses to nonperforming loans which for us was at 49% as of March 31, 2008. In reviewing this statistic, it is important to note that nearly $50 million of our nonperforming loans get very little allowance associated with them because they have already been charged down to the expected net realizable value including considering estimated holding and liquidation costs. Thus the ratio of the remaining allowance to the remaining level of non-performing loans would rise to about a 100% in this scenario.

Net loan charge-off’s totaled $6.8 million in the first quarter of ’08 or 1.07% of average portfolio loans. Page 20 of our presentation breaks down the net charge-off’s by loan type. I’ll go down a bit in the first quarter, the elevated level of charge-off’s in mortgage and consumer loan portfolios principally reflect lower residential real estate values. As I have outlined in previous conference calls when we asses commercial loans for impairment we consider four factors; the amount of cash flows indicated from the current collateral values, the timing of those cash flows, the discount rate at which the cash flows should be present valued and liquidation and holding costs. In particular the real estate related collateral, we continue to see new appraisals with low expected sales prices extended sales timeframes and higher discount rates to present value of the cash flows due to risk.

Page 21 of our presentation has some historical balance sheet data. The $253 million decline in total deposits in the first quarter of ’08 is entirely due to the reduction in brokerage CD’s that I outlined earlier in my remarks. The total of our checking, savings and money market accounts are core deposits increased by $14.4 million during the first quarter.

Our holding Company tangible capital ratio increased slightly to 4.97% at March 31 ’08 from 4.96% at year end ’07. A small decline in total assets was a primary factor leading to the increase in the tangible capital ratio. At the bank level the tangible capital ratio was at 7.46% at March 31 of ’08. We remain well capitalized at March 31 ’08. Our banks tire one and total risk based capital ratios where 7.40% and 10.62% at March 31 ’08 respectively compared to 7.35% and 10.5% at year end ’07. Thus both ratios moved up during the first quarter.

As previously announced and as outlined on page 22 of our presentation we reduce our April 30 ’08 cash dividend to a $0.11 per share or about $2.5 million per quarter. Our after tax interest cost on trust preferred securities outstanding is about $1.1 million per quarter. Thus, the total current quarterly parent company cash requirement is approximately $3.6 million per quarter which equates to about $0.16 per share of net income. Parent company liquidity was at $12.5 million as of March 31 ’08. We do not anticipate any need to downstream capital to the Bank and in fact will be paying a $1.8 million cash dividend from our Bank to the parent company on April 29 of ’08.

Our Board of Directors will establish our July 11, 2008 cash dividend in late June after considering our earnings in the first two months of the second quarter, our parent company tangible capital level, our liquidity, and our updated outlook for credit costs.

I stated in our last conference call when discussing the outlook for the cash dividend that earnings must be expected to exceed our dividend level and our tangible capital ratio must rise. Obviously, we did not meet the first of these two objectives in our most recent quarter. We are committed to the concept of maintaining our current cash dividend level.

However, we believe that the preservation of capital to a reduced dividend is much preferable and in the long-term best interests of our shareholders when compared to a highly dilutive new equity offering.

This concludes my remarks and I would now like to turn the call over to Stefanie Kimball.

Stefanie Kimball

Thanks Rob. As I make my comments regarding credit quality, I will be referencing the handout starting on page 24 and I will start with the commercial lending business.

As a brief overview, there are several encouraging signs as we look at the details behind our first quarter results.

The first is that the speed of the inflow and the growth in the level of the watch credit has slowed. Secondly, as Mike noted, the new loans that we are adding to the portfolio are of a higher quality and they are also related to our strategy to develop relationship focused new clients which will be in the best long-term profitability interest of the Bank. Third, we have recently rolled out a new risk based and relationship focused pricing model which is helping us redirect our commercial lending team to our target customer base.

Like the rest of the industry, we continue to be faced with challenges which include rising delinquency and non-accrual rates. Charge-off and collection expenses that are elevated as Rob highlighted. Both of these have required significant investments in our time and our resources to address each client’s individual situation.

With that as a backdrop, I will now turn to some of the details of the commercial loan portfolio starting with page 25.

Overall, commercial loan outstanding have declined slightly as we have been replacing our run-off but also looking as well at some strategic exits. For example, during the first quarter, we did choose not to match the extended credit terms offered to one of our clients for a $10 million real estate loan which we did not consider to be prudent. That customer paid us off which accounted for most of the decline in the outstanding during the quarter.

As we turn to page 26, you can look at the segments of our business that have been highlighted in the past. We do take comfort in the fact that the relative side of the land and land development segments our portfolio is small in comparison to the whole. Further we have refocused the commercial lending team to pursue new loan volume in the CNI and owner occupied segments while we are looking to decrease the land demand developments. New loan volumes that we are pursuing it with relationship credits in these areas which will believe position us well for future growth.

Change to page 27 our credit watch products continues to be an effective way to manage our higher risk clients. In the first quarter we conducted our four series of quarterly review meetings in each of our markets. Overall the watch credits increased by 5% which is significantly less than the 15% average phases that we have seen here last quarters. Our internal watch grade is down actually 6% and the substandard credits are down 8% with both of those declines as we saw credits migrate into the non-accrual levels without the like amount of new credit moving in. We also could see the improvement of a few large relationships. You can see on page 27 that the yellow and orange bars are declining which are those two categories that I mentioned.

Turning to page 28 the story behind our elevated problem loans has remained consistent. The land and land development segments coupled with construction loans comprise 41% of our watch portfolio as illustrated. As we have highlighted in the past these three segments of commercial real estate are particularly challenging and they don’t produce any income which requires their investors to subsidies these projects.

Given the slow down in the market in particular with the residential housing segments these properties have required at least two to three years now a subsidy from their owners, many of which have began to run out cash.

As you look at page 29 the commercial delinquency rate is shown. Delinquencies have increased during the quarter for a number of reasons. First of all continued stress with our clients is being experience as we would expect. Secondly we have seen a few clients approach the bank looking for deals or short fail given that they experience some of that in the market from some other organizations and then thirdly we have to (inaudible) in some of the renewals where we have begun to tighten credit terms further.

Educating our clients who can’t pay that they must pay has taken some additional time. Further we have been tightening these credit terms in some cases with renewals which has contributed to the rise in delinquency as it has taking longer to work through the details. These last two items are manageable but they have been time consuming.

As you look at the non-accruals which are outlined on page 30 you can see that they continue to increase. As we have approved in the past our concentration of residential real estate workouts create a higher and a longer time frame for credits in this category. This is very different than past recessions where you have seen C&I credit into a difficulty. Specifically with the C&I or business credits you have the benefit of quicker time frames to collect receivable, liquid inventories, auction or sell off equipment, where with a real estate loan a 100% of that loan remains in the category for the full balance of the work out as you go through a pre closure process and then it’s often one year redemption period. Thus, credits stay in this category longer than we have seen in the past. As Rob highlighted, out of our $72 million in nonperforming loans, about $50 million of them have already been charged down.

Turning to page 31, our commercial charge-offs are highlighted. They were 33 basis points which on an annualized basis would be about 132 basis points, up slightly from the fourth quarter but comparable to the periods that we experienced in the third quarter 2007 and the overall average for 2007. Charge-offs are processed according to our regulatory guidelines at a 180-day past due or we are in a loss if know the debt is sooner. Rob has already talked about our transfer provisions in his comments.

Next, I will turn your attention on page 32 to a couple of background items regarding the impairment in the economic headwinds that continue to challenge us and our clients. Key is the prolonged weakness in our Michigan economy. Weakness in the automotive industry and the structural changes that are taking place in our state help to create a slowdown in the residential real estate market which has impacted businesses now in multiple industries.

Residential real estate properties will take some time to be absorbed in many of our communities given the negative population and job growth trends in our state. One potential future bright spot is the fact that there are some markets where new construction is very limited and eventually, that segment of the market that would like a brand new homes will be forced to either buy existing homes or will concentrate in those few options that are available in the market. This, hopefully, will start to stabilize the market for new homes in some of our communities.

Turning to page 33. As we look at managing through this difficult economic environment, we are comforted by the fact that our credit best practices that were put in place in 2007 are a good foundation for us to weather this storm. In particular, our special assets team is a key component as it allows us to professionally manage the weakest of our problem loans.

Moving these loans to a dedicated professional does free up our commercial lenders to work with those clients that are in the earlier stages of challenges and the performing portfolio without being overwhelmed by the demanding pace and sense of urgency that’s required for the substandard and the non-accrual loans.

Further, at hind, a more objective or a new set of eyes is important in looking at a problem situation and lessens the emotional challenges that we face in dealing with the problems of our clients that have been customers more many years.

Our seasoned credit offices are also managing our credit quality review process which allows us to apply the best available thinking to the entire watch portfolio that is managed by our lenders. Further, those credit officers are grading new loans and assisting in the monitoring of the performance of the remaining clients.

Turning to page 34. The list of credit best practices implemented in 2007 is provided, many of which I have highlighted here today or certainly in past discussions. The organization has embraced these best practices given the challenges that we face and a significant amount of change has been able to be accomplished in a short period of time.

I will now turn my remarks to the retail portfolio, starting on page 35. There are a number of positive factors which include the long-term benefits of our tightening -- our credit under lining criteria which are beginning to improve the overall quality of the performing loan, also we have to -- a decline in the charge-off’s for the first quarter.

On the challenge side -- in these business lines we continue to see delinquency in non-accrual rates rise and that same focus on portfolio management in collections as they mentioned on the commercial side is appropriate.

Turning to page 36 we will begin looking at some of the detailed metrics on the retail portfolio. You can see flat -- is slightly declining retail loan business as we saw on the commercial businesses. On page 37 you can see the delinquency rate in particular, the delinquency rate for the mortgage portfolio which did increase in the first quarter after declining in the fourth quarter.

Turning to page 38 again some more to the commercial portfolio; the non-performing assets in the mortgage business have begin to rise as they move into workout stage again pre-closure and redemption processes we do keep loans in this category for sometime. On page 39 a positive point is the decline in the mortgage charge-off experienced in the first quarter which is down from the peak experienced in the fourth quarter 2007.

I will now turn the call back to Mike Magee for closing comments.

Michael Magee

Thank you Stef, thank you Rob. With over a century of community banking experience and as one of the oldest and most established banking firms in Michigan we have whether to a variety of market cycles and business trends over the years. Of all the current credit cycle remains a challenging one. We have taken the appropriate measures to enhance our portfolio and risk management functions within the bank. We are confident that these measures and our continued commitment to the fundamentals of Community Bank our trusted relationships, reputation for excellence and local knowledge in expertise position us for improved performance in the future.

That concludes our prepared comments. At this time we will open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Terry Mcevoy at Oppenheimer.

Terry Mcevoy - Oppenheimer

Good morning.

Mike Magee

Good morning Terry.

Stefanie Kimball

Good morning.

Terry Mcevoy - Oppenheimer

Stef you have mentioned that the improved watch credit slowed in the level of internal watch and substandard loans declined, could you may be break out the commercial portfolio and make that same statement for the vacant land development and constructions as opposed to the income producing owner occupied in C&I and did that happen in both portfolio’s or was just may be some $0.06 on those three stress portfolio that’s may be over shadowing some of the increase in the other three?

Stefanie Kimball

As Rob highlighted in his comments there is some additional detail in our financial statements that has been provided in those portfolios and I will let Rob highlight those specific balances.

Robert Shuster

Okay Terry just to give you some mix we were down a fair amount in total watch credits in the categories of land and land development. We were flat in construction and owner occupied. Owner occupied was actually down a bit where we did see some rise was an income producing, so that’s the mix of the change. Although I will say within the income producing and owner occupied, I don’t think we have seen anything way out of the ordinary in terms of sort of the -- some of the historical issues and one of the I guess question is, is this the soft economy beginning to gravitate in the other areas. Certainly we have not seen that yet in the owner occupied and we have seen a bit of an increase in the income producing but I don’t think at a level that would be way out of the ordinary from what we may have seen in other historical time frames.

Stefanie Kimball

The other thing I would add in terms of the income producing in the movement in is if that was primarily driven by one large credit that’s in the process of redoing some of the properties and does have some significant other sources of income. So, it’s not a trend that we have seen yet in the portfolio.

Terry Mcevoy – Oppenheime

Rob you had mentioned $50 million of NPL, there is no reserve set….

Robert Shuster

Well, there is little reserves. To give you an idea for example when we charged down a commercial credit based on that criteria I outlined we will leave at the minimized allowance to cover holding and liquidation costs so as you incur those expenses during the liquidation process you have essentially approved for some of them. So there is very little reserve related or allowance related to $50 million of the total of the $102 million. So I know that ratio gives us enormous amount of attention and that 49% compared to historical levels it looks very low, but I think the key there is -- and you are seeing this trend in a lot of financial institutions. We have been actively charging down credits as they cycle in from a statutory basis under the bank regulations we’re subjected to your required to take a statutory charge down on real estate secured collateral at 180 days past due or we will do it before then if we’re -- if its reasonably certain that we are going to incur a loss. So, those level of charge downs that you are seeing over the last four quarters or so is that active process of charging down credits to net realizable value. So my -- I guess my synopsis would be on $50 million of the $102 million unless we are either wrong in our estimate of the net realizable value and our estimate takes into account current conditions very distressed conditions and estimated liquidation and holding costs or unless we see a continued down turn in prices $50 million of the $102 million really ought to not create any additional losses for us. It’s going to take some time to liquidate it as Stefanie said, but the point is that in mind when looking at that ratio you kind of carve that out. Then you’re looking at $50 million of remaining non performers against $45 million, $46 million of allowance that you’re around that 100% coverage rate and even within that remaining portfolio most of or a big chunk of that is secured with collateral and we have evaluated it or its in categories like rating categories where we have done relatively recent estimates of probability of default and the loss rate given the default in the computed reserves based on that up dated analysis.

Stefanie Kimball

The other thing I would add to Rob comments is that the -- although its relatively early in our workout stage the credits that we have began to see move out of the portfolio or resolve a credit that we have taken the charge down. Our process appears to be coming in right at those levels, so we take some comfort in the methodology from that.

Terry Mcevoy – Oppenheime

This is also the last question and the next question what are you writing your one to four family residential real estate values down to?

Mike Magee

Currently of our one to four family residential portfolio that are 90 days passed due or on a non-accrual status we currently have written those down to a net book value of 60% of the original appraised values, so I feel we have been aggressive and conservative in what we have written down the one to four family on the pro properties act. Also very optimistic about the future I think, especially in the one to four families commercial seems to take a little longer to work through the litigation process, because several of the one to four family mortgages that has been on non accrual for a while are starting to come out of the legal process to the redemption period. We are starting to obtain titles on those properties and our in a position to actually start selling them we are holding our first auctions here in a few weeks on some mortgages -- one to four family as one of the strategies were used or initiatives to liquidate and start moving out some of these none performing assets. Up to this point unfortunately we have been only adding to the non-performing asset category in starting the litigation process but in several cases we have been -- now for several months we have been -- for closing that property and it’s just getting to the point now where the redemption periods are expiring and we can obtain title to the property and start moving it out of the non-performing asset category.

Terry Mcevoy – Oppenheime

Okay, and Rob will you continue to bring down brokerage CD balances and will that provide some further support for the margin like we saw in the first quarter?

Mike Magee

Yes. We still expect see that going down probably not because there is only $248 million but I think we could -- over the next quarter that might come down again about 50% so about an half because of what we project as calls on the portfolio so that will provide support in terms of migration out of a higher costing broker CDs and into lower costing borrowings which we are predominantly doing with the Federal Home Loan Bank and the Federal Reserve Bank because borrowing rates there are at for sub LIBOR whereas brokers CD rates remain at elevated levels, we are still looking it about 3.5% for a short term broker CD and moving higher has you extend out of that.

Terry Mcevoy – Oppenheime

Thanks a lot.

Operator

Our next question comes from Brad Milsaps of Sandler O'Neill.

Brad Milsaps – Sandler O’Neill

Two questions; Stefanie I think you said that your watched -- the inflow into the watched list credit has declined, but I am looking at the table I guess it’s on page 29 that shows commercial loans 30 days plus the delinquent on accrued, that is -- that number has gone up. So I am wondering if you could just kind of reconcile those two statements and then also on the month before as you indicated you wrote them down to 60% of original appraised value. I am wondering what those write downs represent relative to the current appraised value.

Stefanie Kimball

Okay, well first of all I’ll start with on page 29 in the delinquent account. We do see a number of those on the delinquent account and the majority of them are in the watch category but what we have been seeing is some of the non watch credits also are in to the delinquent status as we try to renegotiate terms and so that’s really the difference between what was in the inflow. Generally we don’t find commercial delinquency to be too predictive of movement into the watched category. It seems to be more of a lagging than a leading indicator and with regard to the residential real estate and our practices of writing down. The 60% of the original appraisal would be writing the properties down to their current distressed values less all of our liquidation and holding cost.

Robert Shuster

And we would often discount depending on different attributes we could discount that current distressed value a bit as well. So we would look at it and depending on the what market it might be in or the type of property it might be we might write that down even a little bit more.

Brad Milsaps – Sandler O’Neill

Okay, so essentially they are written down to realize at more value at this point so this means they are not likely to be recovered?

Robert Shuster

Well, unless there is a recovery in the market, I mean -- it’s spotted you’ll get a few that sell at north of where we’re valuing them. We have seen as Stefanie had indicated, we have had some liquidations of some larger commercial properties and we have been pretty much spot on what we value in that. We have had a few modest recoveries there where we have done a little bit better than what we anticipated, but I -- in this market given the competition of more than just a few financial institutions probably starting to liquidate collateral it’s probably not the type of market that’s going to provide for a lot of recoveries but we have been finding that. Our valuations have been done very accurate relative to where we have been able to dispose of these things at.

Brad Milsaps – Sandler O’Neill

Okay thank you.

Operator

Next question comes from David Scharf, at FTN Midwest Securities

David Scharf - FTN Midwest Securities

Hey, thanks for taking my call. I wanted to go over the exhibit that you put in the press released the one that talks about the total commercial loans. If we could talk about: one, are there anymore lending going towards these portfolios and have they made it a land development loan in the last year?

Stefanie Kimball

In terms of the land development, no we are not making new loans in those categories. We have seen some of the existing commitments in those businesses that have been drown upon so what shows up in the information that you are referencing is more of the balances as those loans have been drawn.

David Scharf - FTN Midwest Securities

When did you start making or extending credits to these sort of projects?

Stefanie Kimball

That was in July of last year.

David Scharf - FTN Midwest Securities

Okay, and how old or how much would you say these portfolios are?

Mike Magee

I would say probably the vintage would be somewhere in the 2004 to 2006 range. I would say by the end of 2006 it really started to taper off.

David Scharf - FTN Midwest Securities

Okay, and when did they come up for renewal if you will?

Mike Magee

Well I mean most -- a lot of them that are non-performing probably they have come up for renewal or are not going to be renewed because of the circumstances with the power. I think Stefanie touched on it earlier that one of the things that is been popping up like a 30 day deliquesce bit is on some credits that do come up for renewal we are demanding additional collateral or other type of terms to better protect themselves.

Stefanie Kimball

But in some cases we have also been able to take additional collateral if somebody has an investment that doesn’t appear to be able to be moved in the short run, if there is some additional collateral that will sure up -- the loan will look at that as well as looking for pay down.

David Scharf - FTN Midwest Securities

And what were the (inaudible) the other non-performance that you have right now?

Stefanie Kimball

I would say generally the write downs have been about 35% to 40%.

David Scharf - FTN Midwest Securities

I am hearing that people are coming in and making offers at like $0.60 -- about $0.40 on a dollar, so that kind of implies that there is more downside than fair value?

Mike Magee

Although we have been able to liquidate more than just a couple of development loans at levels that we had written them down to. So I do think there is some element probably of -- if you were doing it in mass we might have to look at those kind of valuations but I think in a more orderly scenario you are still able to get a little bit better execution than that.

Stefanie Kimball

And when I referenced that 35% to 40% I am referencing the charge down that we would take in the loan. Obviously you wouldn’t have a 100% loan when you made it, so your -- what you would advance from originally let’s say it was 80%, for us to take a 40% write down is probably close to the numbers that you are referencing in the market.

David Scharf - FTN Midwest Securities

I guess what I am looking at it to is I mean unemployment is the highest in the nation. You still have all these properties coming on. There is no immigration of people and business. You look at this and then balance that against the reserve and I understand the reserve methodology is that current appraisals but I mean you do have to look a year to two years out and speculate and I don’t see how you don’t incur another 20% write down possibly on all of these, is that -- do you not agree with that?

Stefanie Kimball

Well one of the things that the appraisals and the current appraisals look at is exactly that issue and that is the absorption period, so very deep discounts are applied to the values to account for a very slow absorption.

Mike Magee

So I don’t necessarily disagree with your promise. I think though that the valuations are taking that into account.

David Scharf - FTN Midwest Securities

Okay, what do you…

Mike Magee

I would say that there was a study recently done on the risk of further declines in residential real estate values based on the 50 largest metropolitan areas and this was looking at the percentage risk of further declines moving out towards the end of ’08 and into ‘09 and actually in Michigan it was reasonably -- well it was in the 14% to 16% chance of risk. That’s not the percent of decline but the percent of risk of further declines. You had states such as Florida, California, Arizona and Nevada that were north of 80% and then Texas was the lowest state at 1%. So if that study at least would suggest based on how much decline we have already seen here that the risk is not that -- not up there with some of these other states.

David Scharf - FTN Midwest Securities

Do you agree with the 14% down side to stay?

Robert Shuster

Well it’s not -- it’s yeah. What they are suggesting is there is 14% to 16 % risk of further declines, that’s not the percent of decline that’s just of further decline. So they are suggesting that its relatively on -- your study was done by PMI as the name of the company but they were suggesting that Michigan’s risk of further price declines -- and this was mostly in south eastern Michigan is relatively low. Now weather you agree with that or not that’s the study that I have seen most recent.

David Scharf - FTN Midwest Securities

What would -- could you give us some color on the level of inventory that is kind of focusing on South East, the South East as far as homes, as far as months -- the 50 months of inventory.

Robert Shuster

It varies so dramatically by price point. The higher price points here in a well over a year, multiple years of absorption if you are getting a north of say $1.5 million. If you are down below $300,000 the absorption periods are a lot more modest, so it just varies all over the map depending on price point. I would say that our average loan balance in our portfolio is about $130,000, so we don’t have a lot of that real high end type of inventory and at least average suggests that your outlook for absorption period relative to the size of our loans is certainly better than if you had a portfolio that was heavily in the jumbo or super jumbo loans and the smallest representation of our portfolio, total portfolio is from south east Michigan in one to four family residential.

David Scharf - FTN Midwest Securities

Yeah, but you have a lot of land and land development loans and constructions on there.

Robert Shuster

A lot -- I mean we have remaining in South East Michigan in land and land development we have about $38 million of which about $30 million is already in the watch credit, so it strikes to me that that’s not relative to our size and enormous exposure even in that category in South East Michigan.

David Scharf - FTN Midwest Securities

What are you seeing in your own mortgage business? I mean you mentioned that resize were a large driver of your mortgage volume, what are you under writing now?

Robert Shuster

Well, we are actually seeing. I mean just the volumes are relatively flat. Now we did in the first quarters as I pointed out it was more heavily skewed to refinance volume and the overall market is a little lower. The other thing you are contending with on refinances is in some instances the appraised value of the property is lower, so the customer is even eligible to refinance the loan, but offsetting that is we have seen an enormous amount of people exit the market. When the market was stronger you always have because it’s a low barrier entry industry you had a huge number of mortgage brokers and bankers entering the market. Well many of those have gone away, even some more substantive mortgage bankers in this market have gone away and what that’s done is even thought the market is smaller institutions that have been enable to remain and place the mortgage banking like ourselves are gathering a better market share, so you are still seeing reasonable activity there. I don’t think it’s going to be anything substantive but I still think it will be steady.

David Scharf - FTN Midwest Securities

Are you under writing any loans where the LTV is less than or greater than 80%?

Mike Magee

Well, you are still doing loans above 80 and if that meets Fanny and Freddie’s criteria and you could get PMI insurance I could tell you just about every week the PMI companies are coming out with changes in their underwriting matrices and in addition to that you also have changes on a pretty continuous basis from Fanny and Freddie on the risk based pricing. The other thing that we have at our mortgage banking arm is FAJ lending which is continuing to do well and again those loans are sold so we are not retaining that exposure and then finally in the instances where we may do a portfolio loan above 80 we would get PMI insurance and then some instances we have a lap insurance policy that we have that our disposal to also insure the exposure down well below 80% outside of PMI, so if it happens we are -- we put in place a wide verity of scenarios to ensure the risk well below that level and I add it’s based on current evaluations which are distressed.

David Scharf - FTN Midwest Securities

That’s all I wanted to touch on but I just add that it appears that really clearly that real estate, residential real estate is going to continue to fall and the reserves like you had mentioned obviously it does effect your borrowing. Now it encourage you to increase that to a higher percentage to cover the problem assets, but….

Mike Magee

I will respect it, but we disagree.

David Scharf - FTN Midwest Securities

Okay, fair enough. Thank you then.

Operator

Our next question comes from Kurt Harvardson [ph] from NTF.

Kurt Harvardson - NTF

Yeah, just a quick question on the preferred as if they are variable or fixed and what the original rationale was?

Mike Magee

They are variable; all of them I think are variable and the original rational is these are preferred where we get the dividend received deduction of 70% and they had relatively high ROEs across the board and obviously the market values have come down quite a bit but we were comfortable with the names at the time. Fanny and Freddy are holding that we’ve had for a fairly lengthy period of time on the preferred and the Merrill Lynch we had it long before the sub-prime problems that hadn’t at the time and both Merrill and Goldman were very highly rated and Goldman continues to be very highly rated and so we felt comfortable with those investments.

Kurt Harvardson - NTF

Okay and one another comment on just board of directors showing confidence in your stock would be a nice thing.

Mike Magee

Okay thanks.

Kurt Harvardson - NTF

Thank you.

Operator

Your next question goes from Jason Werner of Howe Barnes.

Jason Werner - Howe Barnes

Good morning guys.

Mike Magee

Good morning.

Stefanie Kimball

Good morning Jason.

Jason Werner - Howe Barnes

My first question is kind of a verification and one of Terry’s questions on the broker CDs I just want to confirm that you do have room to continue borrowing from the Federal Home Bank and -- or do you need to some point increase your securities for collateral and that sort of thing.

Mike Magee

We have more modest capacity of the Federal Home Loan Bank but we still have a fairly large capacity at the Federal Reserve Bank probably in excess of $400 million there, so we have quite a bit of remaining capacity.

Jason Werner - Howe Barnes

The rate different between those two sources, is there much of a difference?

Mike Magee

Well the Federal Reserve right now -- we had been doing the term auctions which the fed is doing twice a month. We’ve not done those lately because the cover did on the term options set them about to discount rate or primary borrowing rate so we’ve been borrowing at the discount window which is at 2.5%, so it’s just a little bit north of where the fed funds rate is. Federal Home Loan Bank advances would be generally a little bit below LIBOR rates, sometimes it could be a little bit above depending on the type of advance that you are doing and so they are probably a little bit higher than the discount window rates. You can go longer term with the Federal Home Loan Bank advance rates or advances so you could get longer term funding there were as the discount window you could do I think the max is a 90 day borrowing which is a variable rate borrowing, so you do have to turn those reserved window borrowings over in a regularly frequent basis but we still have lots of capacity there if you will be able to observe the further declines in the broker CDs which is down to $248 million.

Jason Werner - Howe Barnes

How long are you going out with the Federal Home Loan Banking in this?

Mike Magee

We will go out probably as far as three, four years. One thing we’ve also done is we’ve done three years where we have a call rate at the end of one year. We have to pay up a little bit more for that but it gives us a little bit more flexibility in the funding that we have in case rates come down even more. Jason a similar example to that would be our strategy with the callable brokerage CDs and then we hedge those with swaps. I mean that structure host us a little bit more but it gave us the ability when we first did it -- but it gave us the ability to do what we are doing right now which is to call them as rates have come down and not be saddled with a lot of term -- longer term funding. So we’ve always paid up probably a little more to give ourselves more flexibility in the structure of our liability base and that served us well in responding to changes in interest rates.

Jason Werner - Howe Barnes

Okay. Giving that maybe able to continue to bring those brokerage CDs down I mean are you looking for more margin expansion in the second quarter?

Mike Magee

I would say we are still -- our modeling would still suggest that we will benefit from lower short term interest rates, so that we would expect depending on what the fed does to still have some upside potential in the margin. The sort of the offset to that is the drag of the non-performers that I pointed out although that’s already in the margin, so as long as they don’t role a lot we still should see some benefit there. The other thing is depending on how much in loans are migrating. The non-approval if that slows or stays down, we won’t get that reversal of interest like we saw in this first quarter which would help the margin as well.

Jason Werner - Howe Barnes

Okay and another question on the quarter quality; looking at that table in the press release that has the commercial loans broken out, when I combined in land, land development destruction and compare that to the previous quarter I notice it was down about $9.2 million. Obviously you didn’t had that much in charge offs in the quarter. I was just kind of curious to gives us some color as to what explain that the rest of that -- you did mention that you were able to get rid of a few things. Is that just keeping stock open?

Stefanie Kimball

Yeah, there was a couple of things in the first quarter; first of all we were able to sell one loan that was secured by land development and then also we were able to negotiate up here on another land development loan that was partially secured by mark over securities as well.

Jason Werner - Howe Barnes

Okay.

Stefanie Kimball

So a couple of those things moving out did help us contribute to the decline.

Jason Werner - Howe Barnes

Okay and I also noticed and this is just kind of ancillary, but I noticed that I also calculated the portion of those three categories that were non-watched still performing and the land category actually went up about $4 million and obviously the balance of outstanding loans didn’t change but what was performing went up and I was wondering if something moved from to watch list back to the performing non-watch.

Stefanie Kimball

Yes we did have one of the credits that additional collateral was provided and it moved back into the performing part of the portfolio.

Jason Werner - Howe Barnes

Okay and my last question is, guess I was just hoping to get a little bit of color about the tax issue that was up in the benefit in the quarter. What would have -- why was that accrual reversed?

Mike Magee

Oh you saw the same thing on Citizens Republic and my guess is it was the same item but it relates to a caps case that was held and or decided and whatever rates to -- there is something called a taper adjustment were you allocate some -- there is a calculation you have to do with allocating interest expense to tax exempt securities, and that renders that interest expense, not tax deductible and the case related to whether you do that constitution on a consolidated basis or an entity level basis and because what occurred there and the facts involved, it allowed us to release the reserve that we had previously established on that issue.

Jason Werner - Howe Barnes

Okay, thank you.

Operator

At this time, as there are no further questions, would you like to make any closing remarks?

Mike Magee

Thank you. With that this concludes our conference call today. Thank you for your interest in Independent Bank Corporation and we look forward to speaking with you again next quarter. For an archived webcast of today’s call, you can go to our website at www.ibcp.com under Investor Relations. This webcast will be archived on our website for approximately 90 days from the date of today’s call. Again, thank you and have a great day.

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Source: Independent Bank Corporation Q1 2008 Earnings Call Transcript
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