First Financial Bancorp (FFBC) 2004 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Irwin Financial Corporation announces 2004 fourth-quarter annual earnings conference call. (OPERATOR INSTRUCTIONS). 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.

Thank you, Sandra, and welcome, everybody. In our presentation today and in the course of answering your questions, we will be making statements that are forward-looking. Statements of our plans, initiatives, expectations, objectives, strategies, estimates, expected results, beliefs and similar expressions identify forward-looking information. These statements are not guarantees of future performance or events, and our 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 from what we discuss here today. For an explanation of the various factors that may affect our future results, we refer you to the press release filed today on Form 8-K in the MD&A from our third-quarter 10-K and the factors described in our written press release.

Finally, due to separation of time between today's press release and the anticipated timing of our annual report on Form 10-K, Will and I will be keeping our comments fairly brief today, and some of the questions that you may pose to us we may differ to asking you to read in the 10-K. I would like to turn the call over to Will Miller, our Chairman and CEO for some opening comments. Will?

Thank you. I would like to start by reiterating some of the key points we made in the press release. First, we continue to experience good growth in our commercial portfolios. They are up at a 20 percent annualized rate in the fourth quarter in our small-business commercial loan and lease portfolios. These two segments completed a very successful year of strong loan and deposit growth with good credit quality, notwithstanding two significant credit losses in our Commercial Finance portfolio.

Second, as I just noted, we made very good progress on one of our longer-term goals, growing and changing the mix of our liabilities to emphasize the growth of core deposits. These low-cost long-term funding liabilities increased nearly $.5 billion or 28 percent in 2004.

Third, our mortgage banking operation continues to have excess capacity, and industrywide margins are low. In addition, we experienced a nearly 20 basis point compression in mortgage rates and the derivatives we used to hedge that portfolio due to the unusual combination of a decline in mortgage rates and a slight rise in swap rates. As a result, we recorded net servicing impairment of nearly $14 million in the fourth quarter, more than we would normally expect for the modest decline in mortgage rates.

Net income in the fourth quarter totaled $14.4 million or 48 cents per share. This compares with net income of $16.7 million or 56 cents per share during the same period in 2003. For the year, net income totaled $69.9 million or $2.32 per share compared with $72.8 million or $2.45 per share during 2003. Return on average equity totaled 11.7 percent and 14.8 percent in the fourth quarter and for the year respectively compared to 14.7 percent and 18.4 percent a year earlier.

The turnaround in our Home Equity operation and improvements in our Commercial Finance segment nearly offset the expected decline in the first mortgage operation, allowing us to come close to our target return on equity in the long run.

Conditions in the fixed-income market remain problematic for us in the short-term. Most observers believe that domestic economic conditions are such that mortgage rates will increase, and consequently the value of our mortgage servicing asset will increase in 2005. Unfortunately not only have we experienced a sustained decline in interest rates at the long end of the curve since June, in the past four months mortgage rates have declined much more rapidly than other treasury or swap-based rates. This compression of spreads served to reduce our earnings in the fourth quarter, and if it does not change during the first quarter, we will have significant negative effects on our results in the current period as well. However, if mortgage interest rates rebound to levels anticipated by most market participants, we continue to believe we can meet our long-term earnings objectives over multiple quarters.

Finally, although we are not concluded as yet, the data that our Board, Greg and I have reviewed to date regarding the adequacy of our controls over financial reporting as required by Sarbanes-Oxley 404 indicate that we should be in a good position to state affirmatively that we have effective controls over financial reporting when we submit the filing with our annual report on Form 10-K.

Now I will turn the call over to Greg for a more detailed review of the quarter.

Thank you. Our total loan and lease portfolio of $3.5 billion at year-end was up only 49 million or 1 percent from the end of the third quarter. However, as Will noted, our commercial portfolios increased 129 million or 5 percent, 20 percent on an annualized basis, during the period, whereas our second mortgage loan portfolio declined $78 million principally due to runoff.

Our first and second mortgage loans held for sale totaled $900 million at the end of the quarter. This was down 8 percent from September 30. The decline was principally in the Home Equity sector.

As Will noted, the average core deposits of $2.2 billion rose at an annualized rate of 23 percent during the fourth quarter and has increased 479 million or 28 percent during the past year. We continue to shift our funding focus to core deposits from wholesale sources.

We had 503 million or $17.67 per share in common shareholders equity at year-end, and our Tier 1 leverage ratio and total risk-based capital ratios were 11.6 and 15.9 percent respectively compared to 11.2 and 14.6 percent as of September 30. The risk-based capital ratio rose principally as a result of ongoing loan sales and the runoff of higher risk in Home Equity loans.

We continue to be pleased with the credit performance of the portfolios, and credit quality continues to meet our expectations. Loan and lease provision totaled $2 million unchanged from the third quarter of 2004. Net charge-offs, which totaled $6 million or $1 million higher than the third quarter, included a charge-off of nearly $3 million representing the majority of our NorVergence exposure in our Commercial Finance portfolio.

Nonperforming assets were $45 million or 86 basis points of total assets at year-end, up from $43 million or 79 basis points of total assets at the end of September. Our on balance sheet allowance for loan and lease losses totaled $44 million as of December 31, down $3 million from the end of September. The ratio on balance sheet allowance for loan and lease losses to nonperforming loans totaled 132 basis points at December 31 compared to 136 basis points at September 30. The decline in loan and lease allowance principally reflects improvements in the credit profile of our Home Equity portfolio and the resolution of several small commercial credits, including the NorVergence credit.

I will now turn to some detail by segment, starting with Mortgage Banking, whereas Will noted net income declined 76 percent on a sequential quarter basis principally as a result of service and asset impairment net of hedge costs of $14 million compared with a net recovery of $5 million during the third quarter. We also have lower secondary marketing gains despite a sequential quarter increase in originations.

We discussed in the press release the 19 basis point tightening between mortgage and swap rates underlying our servicing hedge. The current spread between mortgages and swaps is at a historic low given the current level of interest rates. And as Will noted, should this spread remain at historic low levels now continuing into the first quarter, it could have a significant negative impact on our first-quarter results.

During the fourth quarter, we sold approximately $2 billion of servicing rights in an effort to reduce our servicing risk profile. We recorded $8 million of revenues from this sale, a $7 million quarterly increase. At year-end the servicing asset in this segment had a carrying value of $319 million or 120 basis points of underlying loan balance relatively unchanged in basis points from the end of September. We originated $3.5 billion of mortgage loans during the quarter, recording origination fees and gains on sale of $34 million compared with originations of $3 billion and $39 million of gains during the third quarter.

We continue to work on rightsizing the mortgage operations to current market demand in pricing. Noninterest expense declined by $11 million or 20 percent on a sequential quarter basis. During the quarter, we closed 13 marginally profitable branches, and the number of employees in this line of business declined by approximately 196 or 10 percent. For the year, this line of business had 500 fewer employees, a 27 percent reduction.

Included in the noninterest expense reduction of $11 million was approximately $5 million resulting from lower reserves for origination errors and agency repurchase obligations. This reduction was made to reflect refinements in our loss curve models and pending repurchases.

Our Commercial Banking net revenues increased 6 percent sequentially from the third quarter aided by loan growth and related increases in net interest income, as well as lower personnel expenses. Net income of $6.7 million for this segment increased $1.2 million in the prior quarter, which itself was depressed due to onetime personnel expenses.

Net interest margin was 3.81 percent, up 7 basis points from 3.74 during the third quarter, and our loan portfolio grew $2.2 billion, up 100 million or 12 percent on an annualized basis from September 30.

Credit quality continues to be strong. 30-day and greater delinquencies in the segment totaled 11 basis points at December 31, down from 24 basis points at the end of the third quarter. Our loan and lease provision of $800,000 increased modestly during the quarter, but due to strong credit quality totaled only $3 million during the entire year of 2004 compared to $6 million in 2003. We do anticipate our provision will increase modestly in 2005 as we continue loan growth.

Net income in our Home Equity segment totaled $6.4 million, down from 8.3 million in the third quarter. Loan originations totaled $335 million during the quarter, down from $397 million in the third quarter reflecting our decision to deemphasize lower yielding loans due to competitive conditions. We sold $470 million of loans during the quarter for a net gain on sale of $9 million, and included in this $470 million were $145 million of seasoned loans that were transferred as part of a sale of loans previously funded with a secured financing and held in portfolio.

As we discussed in October we transferred these loans and the associated loan loss reserve to "Held for Sale" classification. In the fourth quarter, they were sold out of "Held for Sale," and a mortgage servicing asset of $1.3 million was recorded.

Our residual asset continues to decline and totaled $52 million at December 31, down from $69 million of the end of September, reflecting strong cash flows and cleanup costs of $4 million on certain residual loan pools that had paid down to less than 10 percent of their original balance. We recorded $10 million in residual trading gains during the quarter compared to $4 million during the third quarter, reflecting both improved credit performance and an assumption about ongoing loss recoveries.

These recoveries have been strong for the past year as a result of changes we made to our processes in 2003. We now have enough data to incorporate a forecast of continuing recoveries into our valuation and reserve models. We believe we will continue to see good recoveries, although at a rate less than we have experienced over the past year as we have assumed that home price inflation and, therefore, recoveries will subside.

Recoveries on loans underlying our residuals totaled $2.5 million during the fourth quarter of 2004 compared with $1.8 million in the year earlier period. And while we have been declining our allowance for loan and lease losses in this segment over the last several quarters as our portfolio of credit quality has improved and the portfolio has shrunk on a quarterly basis, we still have 192 basis points in reserve at year-end compared with 197 basis points a year earlier.

The decline in quarterly net income was primarily related to increases in personnel cost for minority interest and short-term compensation costs related to improved annual performance in 2004 compared to 2003. At the end of 2004 we agreed to purchase the interest of minority owners. Approximately one-quarter of the minority interests were purchased as of December 31, and we expect to purchase the remainder during the first half of 2005.

Finally, our commercial finance line of business earned $1.1 million in the fourth quarter, about even with results in the third quarter.

Loan and lease fundings reached a new quarterly high of $115 million, and our loan and lease portfolio in this segment now totals $625 million, a $65 million increase from September 30. Loan and lease loss provision increased $400,000 during the quarter, and our 30-day and greater delinquency ratio in this segment was 70 basis points compared with 95 basis points at the end of the third quarter.

Our net interest margin was 5.58 percent, up from 5.25 percent during the quarter, and as noted above, earlier in our call our non-performing assets declined approximately 37 percent in this segment to $4 million, principally as a result of charge-off of the bulk of our exposure to the NorVergence-related credit.

So in summary our commercial portfolios and small-business commercial loan and lease portfolios completed a very successful year of strong loan growth, strong deposit growth and good credit quality.

Second, we made very good progress on our longer-term goals that Will noted, growing and changing the mix of our liabilities to emphasize the growth of core deposits, ad our Mortgage Banking operation continues to struggle with excess capacity in both our operations and in the industry as a whole.

We continue to believe factors are in place for the economy -- in the economy for mortgage rates to go up and consequently for the value of our mortgage servicing asset to increase during 2005. This anticipated increase in servicing values, coupled with portfolio growth and stable credit quality, should enable us to have increased earnings during the year. In the meantime, however, low rates and spread compression between mortgage rates and rates inherent in our derivative structures may put meaningful pressure on our near-term results.

Now Will; Jody Littrell, our Controller, and I would like to open the call up to questions. Additional detail and operations will appear in our form 10-K, which we intend to file on or about March 9. Sandra, could you open the call up, please?

(OPERATOR INSTRUCTIONS). Bill Roy (ph), Jacobs Asset Management.

Good afternoon. Do you know what percentage of originations were sold with servicing retained? I show it at around 40 to 50 percent this quarter given where your servicing portfolio ended at 26.2 billion.

Bill, we will get that answer by the end of the call for you.

Okay. Can I follow up with one? Can you break out the impairment -- I'm sorry this $13.8 million in the net hedging loss into the hedge versus what was (multiple speakers) written up or written down on the impairment reserve?

Yes, I can. We had gross impairment of about $10 million, and the remainder was -- were net hedge losses. These servicing asset where we carry it in the mortgage segment is $319 million. The allowance for impairment now is about $52 million.

52 million. Great. And on the Home Equity business, can you give me some sense for when you raised WACs during the quarter? I'm trying to get a sense for, your volumes came down sequentially third quarter to fourth quarter. Is it fair to -- I mean if this happened during the quarter -- that when you sell the production in the fourth quarter into the first quarter, should we expect gain on sale to go up but volumes to continue declining as you raise WACs in a competitive environment?

It is not anticipation that we will continue to see the sequential decline in volume. The decline in volume between the third quarter and the fourth quarter came about as we are still trying to feel our way around the optimal strategy with regard to prime loans.

We were doing more prime loans in the earlier part of the year as we were trying to shift the portfolio in that direction. We have found that competitive conditions in that market have gotten to the point likely because of portfolio desires of national regional banks to move out of first mortgages and into seconds.

We have found that it does not pay us from a long-term standpoint to continue to portfolio those prime loans because we don't think we can earn a good RAROC on those loans. And so what we have sort of settled out on is a strategy in the interim at least as prices are where they are in the market today of originating those loans and slowing them on a flow basis to the secondary margin.

We did not have a dramatic increase in WACs during the quarter. We have been a little bit less interested in the lower WAC business as margins in that business have continued to decline and not keep pace with the increases in LIBOR and Fed funds and other short-term rates.

So what you should see I believe in our forward thinking on this is that we can continue to grow production, probably will not portfolio very much of the prime business due to the RAROC characteristics of it. And we think that the gain on sale percentages that we enjoyed in the fourth quarter are likely to continue at least in the short run as there seems to be a fair amount of good secondary demand for the product.

Do you expect them to stabilize?

Our expectation is that what we will see in the first half of the year is similar to what we saw in the fourth quarter with regard to those gains.

And one final question. You mentioned that you expect earnings to increase next year in a rising rate environment due primarily to the reversal in the impairment reserve. I'm a little bit -- I understand that part of it, but the other part I have not heard you discuss is what kind of assumption you would put on the gain on sale given that the gain on sale is under meaningful pressure in the fourth quarter as the rates have not gone up and volumes are pretty decent in the single-family business. With higher rates, you would expect lower volumes and lower margins from current levels. What kind of offset could you --?

Yes. The offset to that, that we anticipate would happen based on historical experience is that just as we have done some pretty substantial expense reductions, we would expect other companies to be doing the same. It is an ongoing discussion as to where we price what our margins look like relative to the contribution that they bring into the fixed and relatively fixed overhead. And you know our expectation is that the margins that we are seeing now will have countervailing influences of, as you know, rate increases driving them lower, but perhaps a little bit less irrational pricing as folks get their arms around their overhead structure and can put a little bit more realism in their margin pricing relative to what they need for contribution allowance towards their fixed overhead.

So going forward, you know that is a rate that is set daily in the secondary market. But we have not seen a lot of movement in the last couple of months on that.

Okay. Thanks. And if you have an answer for that other question, it would be great.

I can roll forward for you the servicing portfolio from 9/30. If you started at 28.5 billion and we had originations, excluding the brokered portfolio, we had originations of 3.1 billion, sales of 3.7, and runoff of 1.7, and that will get you to the 26.2 billion ending portfolio at 12/31.

It is sales of 3.7? Okay. That would explain the difference.

Yes and we point it out because of the P&L impact, a bulk sale. On an ongoing basis for at least four quarters now we have been selling servicing on a low basis at time of origination, and you would have seen that if you do that same roll forward. In previous quarters, you would have seen that as well. It is a typically conventional product that we would put into conventional Fannie MBS.

In terms of gain on sale, I should divide the gain on sale by the 3.7 billion?

If you are looking at the line item on the P&L where we have recognized $7.8 million of gain on sale of servicing, that would relate to the bulk sale that we discussed in the quarter. It's just slightly over 2 billion. So that would show you the -- in basis points, it is about 40 basis points of amount that that was in the money over carrying value, the market value over carrying value.

When we sell servicing on a flow basis, that gets embedded in our secondary marketing gain, so it would be up in the line on our P&L right north of their gain on sale of loans.

Bill, thanks for the questions. Sandra, are there any others?

(OPERATOR INSTRUCTIONS). Mr. Ehlinger, at this time, I'm showing that we have no further questions.

Sandra, thank you very much and thank everybody for their participation and active listening. We anticipate our next quarterly conference call on April 29 when we release our first-quarter earnings. Thank you.

Thank you.

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