First Financial Bancorp (FFBC) 2005 Q2 法說會逐字稿

Good afternoon ladies and gentlemen and welcome to the Irwin Financial Corporation Second Quarter conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session. Please note this conference is being recorded. I would now like to call over to Mr. Greg Ehlinger, SVP and CFO. Mr. Ehlinger, you may begin.

Thank you, Marisella. Thanks everybody for joining the call today. In the room with me is Will Miller our CEO and Jodi Litroll, our Controller. Before we start we start with our presentation, I want to remind you that there are important cautionary and forward-looking disclosures in our written pres release and in our 10-Q filing that apply to this conference call. You can find those in detail on Page 22 of the 10-Q for the second quarter which we filed this morning with the SEC. Let’s turn the call over to Will for some preliminary comments.

Thank you, Greg. I’d like to start by reiterating the key points we made in the press release. We ended the second quarter with a loss of $1.1 million or $0.04 per diluted share. This compares with net income of $3.6 million or $0.13 per diluted share in the first quarter of this year and $17.9 million or $0.60 per diluted share a year ago. As we announced in early July, the current period of loss is attributable to the results in the first mortgage segment. We expect the strong second quarter loan growth that we had in our other segments and significantly reduced exposure to net servicing impairment will return the corporation to profitability in the third and fourth quarters. We are actively addressing the critical issues in our mortgage banking line of business. Low origination margins and the effectiveness of our management are a servicing asset.

First, we’ve introduced a number of new higher margin products which have been well received by both our customers and the secondary markets to whom we sell the loans. Second, we have reduced our mark to market exposure through approximately $7.5 billion in flow and bulk servicing sales in the first half of this year. Third, we have modified our hedging practices, reducing risk by spending more money to provide substantially more protection against falling rates than we had at this point in previous quarters. If you remove the negative affect of net impairment of servicing assets and also take out the positive affect of the gain on the sale of servicing during the second quarter, the mortgage segment made $3.4 million in after-tax profits for the quarter. On this same basis, we were not above break-even in the first quarter. This calculation is more reflective of the progress we are making in the underlying production-based performance and expense reductions at Irwin Mortgage. The improvements since the first are due to the divestiture of unprofitable portions of the retail production channel and the introduction of the new products with better margins I mentioned earlier. The second quarter level of profitability on this adjusted basis is still below our internal targets, but is moving in the right direction. Finally, portfolio growth and credit quality in our commercial banking, commercial finance and home equity lending were very strong in the second quarter. Although expenses related to portfolio growth have suppressed current period income, we believe we are well-positioned to improve both net income and profitability for the remainder of the year.

In summary, although our results in this very difficult environment in the first half of the year were quite disappointing to us and well below our long term expectations, we continue to maintain a long term orientation by focusing on the changes we need to make to return Irwin Financial to the level of profitability we expect for our stakeholders. We are addressing the critical issues in our mortgage banking segment and are expecting solid growth for our other segments. Our current expectation is that earnings in the second half of 2005 will return to amounts more consistent with the second half of 2004. Now, I’ll turn the call over to Greg for a review of the quarter in each segment.

Reflecting the results in our first mortgage segment, consolidated net revenues declined on both the sequential quarter basis and compared to a year earlier, primarily reflecting net impairment of mortgage servicing assets. Our consolidated loan and lease portfolio totaled $4.1 billion at June 30, a 17% increase in the end of the first quarter. Will noted the good core loan growth we had. The portfolios of our two commercial segments increased $244 million or 8% on a sequential quarter basis or 38% on an annualized basis. Reflecting our decision to curtail sales of home equity loans in order to build our portfolio, our second mortgage loan portfolio increased $300 million or 39% to $895 million and was funded in large part through a matched maturity on balance sheet assets-backed financing that was completed in June.

Loans held for sale in the first and second mortgage segments were largely unchanged for the quarter and ended at $1 billion. Deposits were up 2% from the end of March to $3.8 billion. However, average core deposits rose $117 million or 5% during the second quarter. The slower rate of growth for total deposits as compared to core deposits reflects a reduction in mortgage servicing escrow deposits which naturally declined as we have reduced our mortgage servicing portfolio. We had $500 million or $17.53 per share in common shareholders’ equity at June 30, and at quarter end our tier one leverage ratio and total risk-based capital ratio were 11.3% and 13.8%, respectively, compared to 12.0% and 15.0% at the end of the first quarter. Our consolidated nonperforming assets were $47 million or 77 basis points of total assets at June 30, up from $41 million or 75 basis points of total assets at the end of March.

Our on balance sheet allowance for loan and lease losses totaled $51 million at June 30, up $6 million from the end of the first quarter. Our ratio of on balance sheet allowance for loan and lease losses to nonperforming loan and leases was 154% at the end of the quarter compared to 163% at the end of March. Our consolidated loan and lease provisions totaled $9 million. This was up $6 million from the first quarter and it compares favorably to the quarterly charge-offs which totaled $3 million. The increase in our loan and lease provisions primarily reflects the strong portfolio growth during the quarter as our 30 day and greater delinquencies fell meaningfully in each of our three on balance sheet credit portfolios. As Will stated earlier, we are generally pleased with and encouraged by the recent performance of our credit portfolios.

I’ll now turn to some detail by segment starting by supplementing Will’s comments on mortgage banking. Irwin Mortgage recorded a net loss of $9.2 million compared to earnings of $5.5 million a year earlier. These results reflect pre-tax net servicing impairment of $27 million. Net impairment reflected the quarterly decline for the 30 year fixed rate mortgages of approximately 50 basis points and resulting in growth servicing asset impairment of $51 million only partially offset by derivative gains of $24 million. Because of these unacceptable results, we continue to reduce our holdings of mortgage servicing assets during the quarter to reduce our rate risk and we intend to make additional servicing sales later this year. The carrying value of the mortgage servicing assets in this segment was $239 million at June 30, or 115 basis points of the underlying portfolio balance of $21 billion and that compares with a carrying value of $337 million or 138 basis points at March 31.

Loan production of $2.6 billion declined only modestly from the first quarter level of $2.8 billion in spite of the sale at the end of the first quarter of the majority of the retail distribution channel. Secondary margins declined due in large part to channel mix changes. We now have a larger contribution from the lower margin wholesale channel. Origination fees and gains of sale of loans totaled $17 million or 64 basis points of total originations and that compares with $25 million of gains or 89 basis points of originations during the first quarter.

Our commercial banking segment’s net income of $5.6 million was a $150,000 increase over the first quarter, but a similar decline from the second quarter of 2004 reflecting the impact of increased expenses incurred for portfolio growth. We experienced good growth in both loans and deposits this quarter. Net interest margin was 3.8%, up from 3.75% during the first quarter, reflecting improved pricing and loan portfolio growth. And as we’ve mentioned, credit quality remains strong. Our 30 day and greater delinquencies declined to 15 basis points from a relatively elevated 66 basis points at March 31. The increase in our loans provision to $1.6 million reflects portfolio growth and it compares favorably to net charge-offs of only $700,000.

Our home equity lending business earned $1.7 million, down from $6.9 million in the first quarter. Revenues declined to due to decreases in gains on the sale of loans and other revenue as well as a significant increase in loan loss provision. These factors were influenced by the low level of loan sales relative to previous quarters. Credit quality continues to be strong. Expenses in this line of business decreased quarter over quarter. Loan originations totaled $500 million in the second quarter, up $16% from March 31. To more fully utilize our capital and build our portfolio, we sold only $111 million of loans during the quarter for a net gain on sales of $4 million. Our production in the second quarter continued to reflect the good geographic balance of our portfolio with only 17% of quarterly production coming from California and 8% from Florida. You can find more detail on the geographic distribution of our originations and the portfolio as a whole on Page 42 of the Q. The home equity loan and lease provision of $6 million exceeded charge-off of $1 million and was due to the $300 million sequential quarter growth in the home equity portfolio. Our residual interest totaled $38 million at the end of the quarter, continuing their decline as they amortized. This is down from $46 million at March 31. We recorded $2.3 million in residual trading gains during the quarter compared to $500,000 during the first quarter as we continued to recognize improvements in the credit quality of the underlying loans relative to our previous (inaudible). In addition, we recognized $4.7 million of other revenues during the quarter related to the increased valuations of our incentive servicing fee derivatives. We service $1.3 billion of loans to third parties on which we have the right to receive these incentive servicing rights, and this up from $900 million at March 31.

And finally, our commercial finance line of business had good operating results during the quarter. It earned $1.4 million, a $700,000 sequential quarter increase. Loan and lease fundings totaled $110 million at June 30 or during the second quarter compared with $83 million in the first quarter. Our loan and lease portfolio totals increased by $50 million at March 31 and now totals $694 million. And in this segment, credit quality also continued to improve. Our 30 day and greater delinquency rates declined to 54 basis points, down from 110 basis points at the end of March.

In summary, it was a very disappointing quarter, but due almost entirely to the net servicing impairment in the first mortgage segment. Looking ahead, loan growth in the second quarter was very strong and credit quality continues to be good, which will help with future quarters as we continue to increase the amount of our revenues that come from more predictable spread-based streams of business. Our challenge in mortgage banking continues, but we have taken significant steps to improve margins, reduce expenses and lower our servicing risk profile to improve the performance of this segment.

Jodi, Will and I would like to open up the call to questions, Marisella.

Thank you, sir. [OPERATOR INSTRUCTIONS]. Our first question comes from Joe Stieven from Stifel Nicholas. Please go ahead.

Good afternoon guys, this is John Rose, how are you doing?

Hi, John.

Hey, Greg, was there any extra expenses in the mortgage banking line item for the cost to exit some of the branches in the first quarter, were there any one time items in there?

John, the bulk of those expenses were reflected in the first quarter, but we did have some severance related expenses. They were not material to the quarterly results and obviously won’t be recurring, so there were some but not meaningful amounts.

Okay. And was there any sort of gain or anything in the quarter from the sale?

John, we talked when we sold the branches in the retail system that we intend and expect to earn the premiums that we sold the branches for through an earn out and we collected on that earn out a few hundred thousand dollars in the quarter. That earn out will range, depending on - - if you recall there were two buyers of the different parts of the system. One of those earn outs will continue for four quarters after the sale, so through the second quarter of ’06 and then the second piece and the larger piece will continue for three years since the sale.

Okay. The parent company expense line item looks like it was about $700,000 for the quarter. Was there anything one time in there or is that a pretty good number going forward or where do you see-- ?

That number was less than what a typical run rate would include. We have, as we’ve noted in our 10-K and I think in the first quarter Q, collapsed the private equity portfolio in terms of separate segment recording because of the small size of the portfolio. As you know, we’ve not made new company investments in a couple of years and over the last few years have just made follow on investments. And so I decided at the end of ’04 that would be the last full segment reporting on that. We did have two, again, couple hundred thousand dollars each valuation adjustments in that portfolio for the quarter. They were positive which reduced the parent other and eliminations segment that you’re asking about. One of those was a successful exit of an investment that we made several years ago and one of them was a follow on funding round with new investors in one of our ongoing portfolio investments. And that valuation by that new investor was at a greater implied valuation to the company and our accounting policies of that suggest that we need to reflect that in the valuation and carried value.

Okay. And then one other question and maybe this is for you, Will. You talked a little bit about what you expected as far as earnings for the second half of the year. You said they ought to be similar maybe to the second half of ’04. Are you forecasting any sort of trading gains or incentive servicing fees in that number or what are you looking at there?

We’re looking at the underlying performance of the company without - - sort of core earnings without forecasting in that any up or down adjustments of the mark to market assets, because that’s what really what we’re focused on getting back to acceptable levels of performance. And we’re talking about the entire half. I’m not making prediction about how much falls into the third and how much falls into the fourth quarter, but we think that the entire half will come out similar to the way the second half of ’04 was without any of the mark to market elements counted in that.

Okay.

And you’ll remember that there were mark to market to elements in the second half of ’04, so underlying performance could be better than underlying performance before.

Okay.

Hey, Will and Greg, it’s Joe.

Hi, Joe.

Hi. The growth in your commercial portfolio, the loan commercial loan business was stronger than we expected and maybe even - - I can’t remember the last conference call but maybe even a little bit better than it was talked about. Can you give us any thoughts there?

We kind of had our good first half all in the second quarter. You may remember that our first quarter was light relative to our expectations.

Right.

The pipelines were being worked on and they just didn’t get closed in March. And then we had pretty strong closings in the second quarter.

So more or less, just timing. It’s just how things fell.

I think that’s the best way to think of it.

Okay.

And Joe, I’ll add, too, that we had seen particularly in the second quarter as Will noted that we’ve seen that growth come pretty much across all of our markets. It’s a little bit slower in the Indiana and Michigan markets than in the others, but good growth in all the markets.

Okay, thanks guys.

Our next question comes from Ross Stemorall from (inaudible). Please go ahead.

Good afternoon. I have two separate questions, one related to capital. I noticed that you in the press release you’re talking about projecting out future capital levels and I’m wondering how might imply what you do with the convertible or the trust preferred that’s callable in the third quarter? And then secondly, I was looking at the margins that you earned on the sale of some of the home equity loans and it looked like the margins were stronger in this quarter versus what was sold in the first quarter and yet you sold less. I guess I’m wondering is there a different mix of loans there or was it - - I mean you’re basically saying that you sold less because you want to portfolio it, but I guess if I’m able to sell it for more, why not sell it?

That’s a darn good question. The economics are getting more attractive, that’s true, but that’s part of why we want to hold it into our own portfolio.

The other thing that’s happening, Ross, when you’re taking that ratio of gain relative to loans sold, the fact that we sold a relatively small amount, 20% or so this quarter, it’s influenced by one portion of that which was sold for a fairly high gain, sort of an above the average one rate gain and that’s swaying the number. And, frankly, we sold that product as it came in the door. So if we found customer demand for that product, we would originate more and probably sell at those higher prices if those prices continue to be available. But Will’s comment also stands as what we saw - - the real depressed level was a year ago’s quarter, second quarter of ’04 and we were finding we just weren’t getting paid in the secondary market for some of the higher credit quality products that we were originating and while we have moved our origination profile a little bit and the yield on that product a little bit, that’s more product that we’d like to hold onto at this point.

The first question about capital, I’m not sure I completely followed all of the question, but the part I did hear you were asking for on guidance on two trust preferred issues that we have outstanding that have a part call in September. We addressed the straight trust preferred on Page 28 of the Q and indicated that we have made a commitment to issue a like amount of trust preferred securities in early August and although we have not sent out a call notice for the straight trust preferred which actually we can’t do it until August by rules within the instrument, it’s our intention to use the proceeds from the one that we have committed to issue to try to go ahead and call the one that has a capital trust, too, which has a 10.5% coupon. The convertible trust preferred which also has a part call in September has, I think we have discussed in these calls before, some more interesting dynamics with regard to potential convertibility by holders of that instrument. And I think we’re going to wait closer to the call date to evaluate what the underlying market price and market conditions are.

Okay, thanks.

Thank you. Our next question comes from David Conrad from KBW. Please go ahead.

Good afternoon. I had a couple of question, if I may. First on the home equity side, I wonder if you can give a little guidance what you’re thinking going forward in terms of mixture of production that you made portfolio and traditionally it’s been 60% to 80%, now you portfolio about 80%. How should we think about that going forward? And then secondly, the margins on the portfolio side of the home equity came in quite lean quarter. I just wanted to get a fell on that trend whether it was related to financing costs going up or was it a better quality of borrowers so that the asset yields came down. And then my last question, just kind of recapped on the mortgage banking side. There was a pretty big drop in gain on sale margins and expenses. I guess it just seems like the retail production that was sold - - the distribution that was sold was maybe just a higher gain sale margin but significantly higher overhead than as the expense that we’re looking at now kind of a good run rate to go forward? Thanks.

Thanks, David. I think you actually almost answered every one of the questions. On the home equity side, we just found it to be a good opportunity to leverage the balance sheet a little bit. As Will said, we’ve been expected to get loan growth both in the commercial to commercial portfolios and the home equity portfolio. We didn’t get it quite in the pattern that we expected throughout the year. Had very good product in terms of credit quality and geographic distribution with regards to being conscious of real estate appreciation rates in the country and found it a good quarter to put away and put into portfolio and use the balance sheet on the home equity side. I think in the Q, we do suggest that over time the run rate of sales to production that you have historically seen is probably where we need to settle out. That comes from a variety of factors, looking over the balance sheet’s capacity is - - there are also federal banking regulations with regard to the amount of high LTV product we can have on our balance sheet relative to capital. Then of course it’s to Ross Stemorall’s good question is it’s factored into as well by secondary market demand. But I think you’ll see over time us returning to those more historical percentages that are in the 65% to 75% range.

This is the second question. Margins did come in and you posed two potential explanations for it and they were both on target. One has been expected by us because of trying to raise the credit profiles of the portfolio and I pointed to a table on Page 43 of the Q where we lay quarterly production side by side and you can see that we do continue to make some inroads. I think we won’t see dramatic increases in credit quality at this point. I think what we’ve been putting on in the last three to six months is the type of product we want to continue to produce. A year ago or so, we were beginning to nibble at the edge of the end of those two spectrums and I think the numbers that you saw in the second quarter of ’05 are probably more representative. Our funding costs have gone up as well, so it is both a conscious credit improvement and therefore lower yield on the coupon side. But also in warehouse, our funding costs have gone up and on the securitization side, while we think we’ve got a good term rate for the securitization, it is at a higher cost than what we’ve had in previous quarters.

And then the last section I think were your questions on retail, and I think again they were questions about margins and expenses and yet I think what you saw in the second quarter, especially on the expense side is representative of a good run rate. I think the whole mortgage industry is still suffering under contribution margins from originations that we think are at the low end of where they ought to be given the volumes that we’ve had, but they’re in sort of the range that we would expect for the next couple quarters. And to Will’s comment earlier about second quarter profitability estimates, we are not forecasting material improvements in margin in the mortgage banking. We are expecting some pickup in profitability because some of the new products that we’ve introduced in the last year because they not conforming, conventional products do have more significant margins. But that will be incremental pickup for us.

Okay, thank you.

Thank you. [OPERATOR INSTRUCTIONS]. Our next question comes from Carl Bright, an individual investor. Please go ahead.

Greg and Will, good afternoon.

Hi, Carl.

I have just a couple of questions. The first one has to do with the reduced mortgage portfolio and what I perceive means in essence there’s a reduced amount of capital that the corporation needs. And if that is so, can you make comment on why you folks may or may not be thinking in regards to the capital structure of the organization? And then the second question has to do with really the quarter and any thoughts you might have in regards to the balance revenue model that you folks have mentioned throughout the last couple of years. And thank you for your time.

Thank you, Carl. Carl, on the question of capital, we have kept our capital over the last two years relatively higher than our historic numbers and probably higher than pier and maybe run rate for two principal reasons. One is directly related to servicing assets and the volatility of the servicing asset and frankly the potential for a negative outcome like we saw this quarter. As we’ve sold down the sold down the servicing asset, we would expect and believe that we do have some room to reduce the amount of capital cushion we have because of that volatility, so that observation is right on. The second and probably longer term and more important factor in keeping the capital there is our recent results notwithstanding from a net income standpoint. I think as an organization we feel very confident and enthusiastic about the growth opportunities, the positioning that our segments have relative to some very large national markets, and our ability to expand within those segments and extend market share and so the growth that you saw in the balance sheet and particularly in the credit retained portfolios I think was at the high end of what we would anticipate an ongoing run range for us to be. But certainly it was demonstrated in the second quarter that’s an area of the spectrum that we can get to in terms of growth rages and I think we want to over time reinvest our capital in those good geographically diversified and credit diversified portfolios and so that is really what’s driving our notions about capital and capital structure.

With regard to the balance revenue model in a number of forums including presentations at the annual meetings, we’ve acknowledged over the years that it’s a model that wouldn’t necessarily fit every possible environment. And one of the scenarios in which in the short term it wouldn’t do so well is if interest rates trade and arrange back and forth as opposed to having a directional bias to the up or down. So, and unfortunately for the last three or four quarters, we’ve been in this kind of trading range environment. If that becomes the norm and persists over the long term, I think we’d have to reassess the components of our balance in order to address that as an ongoing environment. However, a trading range environment could turn out also to be a temporary phenomenon of five or six quarters and if we head back towards an overall environment where interests rates trade around a tread line, then I see no reason why the balance revenue model wouldn’t come back into play as an effective strategy for that kind environment. So we’re keeping an eye on this. While we’re in this trading range environment, we’re trying to grow the portfolio businesses which are a more stable source of income and less susceptible to the volatility of the trading range environment and we’re looking hard at what kind of scenarios going forward might cause us to reexamine the ballots and the strategy.

Thank you, and at this time we have no further questions, sir.

Marisella, thank you very much and thanks everybody for joining us. Our third quarter conference call is going to be scheduled for October 28, 2005, and we look forward to talking to you then. Thank you.