First Financial Bancorp (FFBC) 2004 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Irwin Financial Corporation announce its first-quarter earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that this conference is being recorded. I would now like to turn the call over to Mr. Greg Ehlinger, Senior Vice President and Chief Financial Officer. Mr. Ehlinger you may begin.

I am joined today by Will Miller, our CEO and Jody Littrell, our principal accounting officer and controller. In our presentation today in the course of answering your questions we will be making statements that are forward-looking, statements of our plans, initiatives, expectations, objectives, strategies, improvements, estimates, expected results, beliefs and similar expressions that identify forward-looking information. These statements are not guarantees of future performance or events and are actual accomplishments of the plans we are about to discuss with you today, involve certain risks and uncertainties that are difficult to predict. Therefore actual future events may differ materially for what we discuss here today. For an explanation of the various factors that may affect our future results, we refer you to the MD&A in our 10-Q that was filed today and the factors described in our written press release.

I would like to turn the call over to Will Miller, Irwin Financial's Chief Executive Officer for some opening comments.

I like to start by reiterating some of the key points we made in the press release. As anticipated in our 2004 outlook as the economy continues to recover we are benefiting from lower credit costs and from the investments we made during 2001 to 2003 in our mortgage servicing portfolio. Net income for the first quarter was $20.3 million or 67 cents per diluted share, a year-over-year increase of 63 percent.

This increase principally reflects the improvement in credit quality in our home equity segment where delinquencies and losses have moderated over the past several months and where residual cash flows continue to exceed our earlier expectations. Thirty-day and greater delinquencies and charge-offs declined on a sequential quarter basis in each of our credit portfolios.

Understanding that I said this several times over the past year, I'll do it once again. The core of our strategy is to combine lines of business in complimentary ways to minimize the impact on our bottom line the volatility in the markets we serve. The effectiveness of this strategy was demonstrated dramatically in 2003 when we took significant mortgage servicing right impairments and credit related expenses, yet had our 14th straight year of record net income.

This quarter's results are similar to what we experienced in the mid-90s, the late '90s and what we would continue to expect should the economy continue its recent growth. We believe we can handle the environment this year, which is the opposite of last year, one of slower mortgage production and improving credit and still produce yet another year of record net income. This balanced reaction is not a new phenomenon. Its been happening in our business for going on 15 years.

We believe our balanced revenue model has us well positioned in 2004, and as I said we continue to expect 2004 earnings to exceed those of 2003. I will now turn the call over to Greg for a more detailed review of the quarter.

Net revenues increased 7 percent on a sequential quarter basis to $134 million. Net revenues increased in our commercial banking and home equity lines of business successfully offsetting a decline in net revenue in mortgage banking. On a consolidated basis, loan growth continues to be relatively slow. Our loan and lease portfolio totaled $3.2 billion at March 31, up 2 percent from the end of the year but up 8 percent from the first quarter of 2003.

Deposits totaled $3.3 billion on March 31, a 400 million or 14 percent increase since year end principally reflecting increases in mortgage escrow deposits. Average core deposits rose at an annualized rate of 11 percent during the first quarter. We had $453 million or $16.04 per share in common shareholders equity at the end of the quarter, and our total risk-based capital ratio of 15.3 percent at quarter and was up from 15.1 percent at the end of the year. We are well positioned for additional balance sheet growth.

I am pleased to report the consolidated nonperforming assets were $45 million or 87 basis points of total assets as of March 31, down from $52 million or 105 basis point of total assets at year end. Our on balance sheet allowance for loan and lease losses totaled $64 million at March 31, unchanged from year-end and net charge-offs for the first quarter were $8 million, down $1 million from the fourth quarter.

Let me turn to some detail by segment starting with mortgage banking where net income declined modestly compared to the fourth quarter. Loan originations totaled $2.9 billion unchanged from the fourth quarter '03. We recorded $10 million of revenues on gains on servicing asset related derivatives net of impairment that we took on the servicing asset. We also recorded $6 million of gains on sale of servicing during the quarter, reflecting our historic use of servicing assets to offset declines in production income.

Our mortgage servicing asset in this line of business had a carrying value of $298 million on March 31 or 101 basis points of underlying loan balance compared to $348 million or 117 basis points at the end of 2003. Our gross carrying value prior to impairment allowance was $394 million at March 31. If the interest rate increase we saw in April is sustained for the remainder of the quarter we would anticipate some MSR impairment reversal net of derivative losses during the second quarter.

Reflecting an improved credit picture the commercial banking line of business earned $5.4 million in the first quarter, unchanged from the fourth quarter. We had nominal sequential quarter loan growth reflecting economic conditions. But importantly core deposit growth was good, increasing at an annualized rate of 11 percent during the quarter, reflecting our focus on increasing lower-cost and longer lasting sources of funding.

Our thirty-day and greater delinquencies in our commercial line of business totaled 29 basis points at the end of March, down from 36 basis points at year end. And nonperforming assets declined $21.7 million at the quarter end compared to $26.6 million at the end of the year.

Our home equity lending business continues to see improving credit quality and as a result earned $6.6 million during the quarter compared to a loss of $9.5 million a year earlier. Our thirty-day and greater delinquencies and our on balance sheet portfolio totaled 2.46 percent at quarter end down from 2.91 percent at December 31. The thirty-day delinquency ratio for the off balance sheet portfolio declined to 8.65 percent compared to 10.18 percent at 12/31. This improvement in credit quality led to the reversal of $4.6 million of impairment for our $69 million residual interest portfolio.

Cash flow from our residuals totaled $9.7 million in the first quarter, 2.3 or nearly 30 percent, 2.3 million or nearly 30 percent greater than what we had projected in our year-end residual models. Loan and line of credit fundings totaled $307 million in the quarter compared with 288 million in the fourth quarter. We sold an equivalent of about two-thirds of our current production in the secondary market for a net gain of 4.3 percent. We also recognized $1.8 million in revenues from the mark-to-market to an incentive servicing fee derivative which resulted from a whole loan sale completed in early 2003.

Our commercial finance line of business showed strong operating results with pretax income of $1.9 million in the quarter compared to a pre-tax loss of 600,000 a year earlier. Loan and lease fundings totaled $72 million, a 24 percent year-over-year improvement, and we have thirty-day and greater delinquency ratio of 86 basis points compared with 87 basis points at year end. The onetime tax provision to reflect liabilities acquired but not recorded on the books of the Company at the time of our purchase negatively affected our provision for the commercial finance line of business during this quarter. We believe that going forward the line of business tax provision will approximate 45 percent for the remainder of the year, reflecting effective tax rates in Canada.

In summary during the first quarter we experienced a decline in our mortgage production, but the value of our balanced revenue model was again highlighted as we experienced lower credit cost in our consumer portfolios and effectively leveraged our investments made in 2001 through 2003 in mortgage servicing rights. While loan growth was slow, deposits continued to grow nicely. And as Will noted, we continue to expect 2004 earnings to exceed those of 2003 due in large part to the balance brought to our results through anticipated improvements in credit quality and the valuation of mortgage servicing rights.

Sandy, Will, Jody and I would like to open up the call for some questions now.

(OPERATOR INSTRUCTIONS) Joe Stieven from Stifel Nicolaus.

First of all, good quarter. Just sort of a couple questions, number one, Greg, you alluded to a little bit but you said in the rising rate environment you expect to recapture some of the MSR impairment that you had in the first quarter but you also talked about the hedging. Just talk conceptually about trying to hedge short of in this rising rate environment, that is question number one.

Question number two is that your equity base or your capital ratios are now I think at almost all-time high levels. Does this imply or what does this mean for you guys? Does this mean you can portfolio more home equities et cetera, share repurchases? Give us some thoughts as to what you might do with this -- let's say this higher level of capital. I will go ahead and let somebody else ask questions.

Joe, the rising rate environment that we are seeing right now, the increase in the month of April was about 65 basis points on mortgage rates is exactly what we would anticipate as the economy strengthens. Its the reason why we built the servicing portfolio up to nearly $30 billion in the last two to three years. Its the same environment that we saw as Will mentioned in the mid-90s and then again in the late '90s. And strategically a core part of our business is the balance mortgage production and mortgage servicing and as Will noted, we have done it we think pretty well. We had 14 straight years of record earnings despite a variety of interest rate cycles.

The hedging of it is fairly difficult in large part because of the accounting for mortgage servicing rights, which as I think you know have a lower cost or market cap to them. Most of the derivatives or all the derivatives we've been able to identify to help hedge that portfolio are clearly mark-to-market derivatives. They don't have any particular capture floors that we can evoke for GAAP accounting. So in the current environment we are in a position where we began the quarter not too far from that aggregate cap. We look at caps in each one of the risk strata in our servicing portfolio. And on an aggregate basis we were not very far from that cap so it makes it a little bit difficult to design a hedge strategy that will allow us some write-up if rates rise. But not cause significant derivative losses.

We think we've done a pretty good job thus far in the second quarter and as I noted in my comments if rates stabilize and the rate increase we've had this quarter is sustained throughout the quarter, we anticipate having some write-up to offset the higher level of production expenses relative to production revenues as we would anticipate doing in this type of environment. I think one of the things that's important to recognize in our hedging strategy is although we may not push earnings through our GAAP P&L due to FAS 140 cap of our servicing asset valuation due to that cap, we in fact continue to see economic increase in the value of our servicing portfolio.

So there may be a situation in this quarter or subsequent quarters where we would go through that aggregate cap on our mortgage servicing rate valuation and that would limit the amount of write- up that we would have through our GAAP financial statements but in fact we would have the opportunity to unleash some of that value from servicing sales, something that we did in January of this quarter through the sale of about $900 million of servicing rights were the value of that had risen specifically above our carrying value. And we did as we have in many quarters in the past going back to 1990, we chose to allow ourselves to continue to invest in the production franchise, opening up new production offices but offsetting some of those costs to good service and sales.

On the capital ratio side, it obviously gives us many more degrees of freedom to think about growing the balance sheet or in the case of what you propose shrinking the equity account. I think our preference because we have successfully been able to grow the Company and produce very attractive in our minds very attractive ROEs over 13 or 14 years, our bias would be to grow the balance sheet. Perhaps retain on balance sheet more of the assets that we've been originating in the last several years where we've been selling the bulk of those assets it gives us the opportunity to retain more of those. We are studying what those alternatives are, and we do think that we will take advantage of the fact that we are well capitalized at this point.

Thanks, Greg.

Bill Roy (ph) from JAM Partners.

Just a couple of interesting items, do you have the loan servicing fees before any amortization expense?

Are you talking about in the first mortgage business?

Yes, sorry.

Get that for you real quick. Loan servicing fees before amortization expense $26 million. Amortization expense was about $27 million.

And the hedge gains, have them estimated around 56 million, am I close?

About 58 million.

58 million?

Yes.

Okay, and I think you mentioned the MSR before impairment reserves. Is that, 394, did I get that number correct?

I believe that's what I said. I will check it for you. $394 million in the first mortgage business.

So the primary reserves is about 96 million.

96 million.

Okay, great. You originated about 2.9 billion in the quarter. How much of that was sold or securitized?

That's in the first mortgage business, and essentially everything is packaged into a Ginnie Mae or a Fannie Mae or brokered out to other folks. And we don't have any of the credit risk on that going forward.

Okay, so and 100 percent was sold with servicing retained?

Some of it is sold, modest amounts are sold without servicing retained, but so there is a mix of servicing retained and servicing released.

Okay, great. Switching over to the service detail, it appears that you booked about a 72 basis point gain on that. Given that the overall MSR is at a (technical difficulty) cap rate of 1 percent it would appear that that would be just kind of on a macro basis selling at below the cost.

No, if we sold it below the cost we would not have had a gain.

We would have had a loss.

Right, that is why I bring up the question, you booked a $6.5 million gain on a $900 million asset for a gain of 72 basis points.

That is so, that is the net gain, the gross gain is north of that. Then you write off the capitalized assets.

Do you have the gross gain?

We haven't put that in the Q.

Okay. And just finally the trading gains in, which heretofore have been losses in home equity you reported a gain of about 4.6 million. What was that, and should we assume that that is going to continue going forward?

At the end of every quarter we are required to take the 90 days more experience that we've had and run them through our models, expected losses and prepayment rates and various other things. And re-evalue the entire residuals. Those residuals of course are valued on as a net present value basis. So changes in the best assumptions we can make about forward credit performance and prepayment speeds which are the primary drivers of discount rates can have a significant impact. What that reversal of impairment or that gain on the residual tells you is that over the last 90 days the actual results have caused us to need to estimate somewhat lower losses over the entire life of the portfolio because the credit performance was better than our expectations at your end. And to the extent that credit continues to improve, beyond what we currently expect now, as the real data rolls in there will be additional adjustments in evaluations in the future. If our assumptions are perfect, which of course they never are but if they were perfect today there would be no more adjustments.

I think we may not have hit your first, your second question head-on with regard to mortgage shipments. Will was talking about the credit retention versus shipping and transfer of credit risk. If you were looking for the delta between what we actually closed in the quarter and what we actually shipped in the quarter in that line of business it was about $150 million difference with shipments being about 2.78 billion compared to closings of about 2.93 billion.

That's what I needed. Thank you very much.

Barry Isbond (ph) from Endicott (ph) Group.

Just a couple quick questions. Can you talk about the hedging effect business of the quarter? It seemed you had more than an offset for the MSR impairment and could you also talk about how you are positioned for next quarter?

We are very pleased with the results of the hedging in the quarter not because of the net result which was more of a valuation of the servicing portfolio equation. What we saw during the quarter, we take our portfolio out to third parties to get independent price observation on it. We did that at the end of February, and began to see what we thought was a firming of the servicing market based on third party marks. Took it out again at the end of March in order to close the books and saw that confirmed. What happened from a hedge standpoint was that we were fairly neutral relative to the valuation that we were using internally in the months of January, February and March with regard to impairment and derivative gains. But on the basis of both our servicing sale in the first quarter, which we noted produced a gain of $6.6 million and the third party marks that we received at the end of February, at the end of March, we thought that the appropriate valuation on the servicing was the 101 basis points that we had at the end of the quarter.

But from a hedging effectiveness standpoint we were pretty much dead on again this quarter. The second quarter hedge position is as I described in response to the first questioner's question. We feel good about where we are positioned today given the looking back with some hindsight over what happened in the month of April. We did start the quarter not very far from our low of cost or market cap and so needed to design a derivatives book that will allow us to produce some reversal MSR impairment without giving it all back in derivative losses. And to date we feel comfortable with the way we've structured that.

And also could you comment on the residual asset, the nature of the out performance in the quarter relative to expectations? Was it because of credit or prepays or how did that work?

It was primarily, essentially the credit side. Prepayment speeds were not noticeably off of what we expected, and there were some yield curve shifts that actually went in the other direction. So the improvement is essentially attributable to the better than expected credit performance.

Thank you.

(OPERATOR INSTRUCTIONS) Fred Cummings from KeyBank National Markets.

Will, did I hear you say anything about changing your dividend policy in light of the strong capital position your in? Or might you consider taking that up? It is relatively modest these are the other banks and I know historically you guys have wanted to reinvest in the business. But how are you thinking about your dividend at this point?

Well traditionally as you can see from our record we essentially examine the dividend question once a year. We raised it at the beginning of the year and repeated that same level of increase this quarter again. Part of the issue with what to do with the additional capital is that if we are earning 18 percent return on equity as we did in the first quarter, we are not entirely sure that all of our shareholders have alternative places to put that to earn better returns on that. So we don't -- we have the preference for using the capital base to pursue business opportunities where we think we can earn attractive rates of return above our cost to capital.

I understand tactically there are alternatives that can always be considered with share repurchases and dividends, and we do think about that from time to time. But you are correct in inferring that our bias is to try to produce a good ROE for our shareholders on what we got.

Second question, Greg I want to make sure I understand the source of the gain on sale of servicing between bulk servicing versus flow. I think you said you sold 900 million of loans and I am wondering if that was entirely a bulk sale or how much was on a flow basis and you can give us some sense for the pricing on flow sales versus book.

I can answer the second one pretty easily because we did not do flow sales in the first quarter of '04. We did negotiate a contract to do flow sales in the second quarter of this year and have not disclosed the price for competitive reasons. It's obviously one that we chose to do and feel good about it. The gain on sale in the first quarter was a bulk sale that we did in late January, early February.

And Greg, can you talk about at least on the flow still basis the anticipated volumes, I don't know if you can talk about in terms as a percentage of your production how much you expect to sell on a flow basis.

The flow sales contract is for conventional servicing, and it's for approximately three-quarters of our conventional production. Our desire there is to take a different strategic tact on the growth of the servicing portfolio. We grew it from low teens, 10, 12, $13 billion before the mortgage refi boom of the last three years taking it up to about 30 billion, and as production slows now is the time we think we ought to be having capped off that exposure. And we'll do sales both on a flow basis and on additional bulk basis as opportunities present themselves.

Okay. Greg, one last question on the commercial banking side. I think I can't recall if you guys have tightened credit, but seemingly loan growth is slowed pretty consistently in that portfolio the last few quarters. Can you speak to, is it just the lack of demand or does it reflect any change in your underwriting posture?

We really have not materially changed our underwriting posture, Fred in the last several quarters. We believe we tightened it in the 2001/2002 timeframe to address the tighten the finance of our potential customers. We made material changes to our credit underwriting and our home equity consumer segment in November of '02. The slowing loan demand in our commercial sector is I would say is twofold, one is maybe an internal issue of focusing more attention in the last year on the top growth and to the extent that two balls are harder to juggle than one, we've had more success on the deposit liability side than we have on the loan growth side.

Two, and this we hear echoed by our colleagues that we network with or appears that we network with, just underlying loan demand. Underlying loan demand has been a little bit slower than what we had seen in some quarters three, four years ago. Our sense talking to our customers is that they are beginning to see pickups in their business. But they want to make sure that it is sustainable before they expand their business. I think we feel very good. We've mentioned the balance sheet position we have to absorb growth. We have, I think a strong lending staff as we've had in the commercial banking business, and I think we anticipate seeing stronger loan growth. We just haven't gotten to a get.

Lastly, Greg, the interest rate risk position of the bank separate from the mortgage company, I would imagine you guys are pretty well-positioned given your focus on commercial lending if the Fed were to take rates up that would be beneficial to the margin.

It would, it would generally. We are fairly flat if you take the MSRs out, but with some benefit to rising rates as much as anything, Fred reflecting where our deposit rates are right now and where they've been for the last year. There is only one direction for those to go in our asset book ought to reprice more rapidly than we can maintain the deposit rate increases.

Okay. Thanks, Greg.

(OPERATOR INSTRUCTIONS) Ross Demmerle from Hilliard Lyons.

Two questions. One the loans held for sale increased about 100 million from the end of the year to the end of the first quarter. Can we, does that imply that the second quarter perhaps from a gain on sale or maybe on the origination side is going to be stronger than the first quarter? And then secondly, I'm looking at refinancings as a percentage of originations, and I think they are a little at 70 percent, or 60 percent depending on which quarter we are looking at here is relatively high. I think for Irwin, and I am wondering if there is a chance you might be able to pick up a little bit more in the way of purchase originations as the year progresses to help offset some of the decline in refinancings.

Ross, the loans held for sale somewhat relates to the question of the gentlemen from JAM Partners asked about shipments versus production. Those rose in large part because of the rate drop that we experienced in early March after the employment report and those didn't get shipped in the month of March. We certainly with the rate increase we saw in April we're seeing more of a purchase market in the second quarter, and that is the focus of the production system at this point.

We are actively and successfully finding new office expansion to do, which has been typical of our experience in these types of markets, something that we can fund from a P&L standpoint with our servicing portfolio. So yes, I would presume that when you read our second-quarter results our refi percentages will have gone down. Purchase monies will have gone up, and the loans held for sale, you will have seen that the buildup in March flushed through in April shipments.

Thanks.

Eric (indiscernible).

I had a question on the MSR, on the impairment reserve, I think you mentioned it was somewhere around 90 million and obviously I guess I just wanted to know to what extent is that hedged, and consequently, how much would actually be recoverable net of the hedge if rates were to move up significantly from here for the remainder of the year? I know you can't give an exact answer, but just some sense of -- 50 percent of that recoverable, net of hedges, is it less than 50 percent?

The number you quoted is right, about $90 million. We generally don't discuss a specific hedge strategy intra quarter because our positions are managed dynamically. We do both in our planning short-term and long-term planning, we do try to derive, try to structure our derivative position in such a way that we will recognize some modest increases in servicing assets relative to inclusive of derivative losses in this type of environment. Certainly we wouldn't anticipate and it probably would not be a fair appropriate or sound hedging strategy for us to anticipate recapturing all of that $90 million. In order to do so we would have to go unhedged, and that is not the way we've run the business and wouldn't intend to.

I understand that. Do you have any just sort of broadly would it be it obviously dynamically managed, but would you expect even under dynamically managed scenario if rates were to move up that you would recover less cap that (inaudible)?

Likely less than half of it. It certainly does depend on the direction that the way rates get to where they are getting.

Understood.

More volatility would cause us to recover less of it. A position at the beginning of the quarter as we had here in the second quarter near our aggregate cost cap would cause us to get less of it. I think it's important to recall, too, that our impairment allowance is a GAAP value and that as we design our derivatives positions we are putting on structures to maintain both GAAP based book capital and regulatory capital positions and earnings positions. And that as we pass through the point of our aggregate cost capital, we will build up economic value that we can sell in subsequent bulk servicing sales.

The only thing I would add is that its too simplistic a notion to think that there is a percentage that we hedge, because the number of factors we have to take into account are as in this dynamic model causes that percentage to move around quite a bit. If you get the 10-Q and go to page 41, we've got a discussion there of the quite a few different eight or so factors that, seven or eight factors we have to take into account as we dynamically manage the hedge over time. That will give you some insight into the way we think it in a conceptual frameworks and then in terms of how well we execute, I think you could look at our track record because we have been doing this in various forms for almost a decade.

That same reference in the Q if you turn the page to 42 and 43 you will also see different sensitivity impairment, sensitivity tables one which the first one which shows the economic value change. If you look in the third line of that table for mortgage servicing rights you see the economic value change for mortgage servicing rights and then in the subsequent table you can see the GAAP based value change that reflects that cap. So from a GAAP earning standpoint we are constrained by that lower cost to market cap and as I described earlier, the structure of our derivatives position on the previous table you get some notion of the positive benefit we would get from a rising rate environment due to the investments we made in servicing over the last three years.

Did you talk about your venture business at all?

No, we didn't. It had a relatively uneventful first quarter.

Any further comment?

It is such a small component of what we do we don't intend to focus on it for these kinds of (inaudible).

It made $18,000 in our net carrying value didn't change.

Okay, thanks.

Mr. Ehlinger, at this time we have no further questions.

Thank you very much, we appreciate everybody's attended (indiscernible) call and interest in the company. Look forward to reporting our second-quarter results, I believe will be on or about July 30th. Thank you.

Ladies and gentlemen, this concludes today's teleconference. Thank you for participating. You may now disconnect.