First Financial Bancorp (FFBC) 2007 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Irwin Financial Second Quarter Results Conference Call. (Operator Instructions). I will now turn the call over to Mr. Will Miller. Mr. Miller, you may begin.

Good afternoon and thank you for joining us. I am joined today by Greg Ehlinger, our CFO, and Jody Littrell, our Controller. Before we start with our presentation, I want to make you aware of important cautionary disclosures in connection with the forward-looking statements we'll be making on this call. The cautionary disclosures are in our written earnings Press Release today and in our recent S.E.C. filings including the 10-Q filed this morning.

Today we announced earnings of $5.5 million or $0.17 per diluted share from continuing operations. The second quarter was an improvement over the first quarter although not yet to a satisfactory level of net income. The major factors that constrained our results were loan and deposit growth remaining slow and the effects of the mortgage market correction that we are still experiencing.

In our commercial businesses we saw areas of loan growth, particularly in our Western banking markets and in our franchise finance channel. Loans outstanding declined in our Mid-West markets, particularly in Michigan where conditions are more challenging. We are seeing evidence that our overall commercial loan credit quality is returning to our historic lower levels of delinquency and loss rates. Our commercial loan portfolio at non-performing assets declined nearly 20% during the quarter. And additionally, core deposit growth picked up during the second quarter.

On the consumer mortgage side, our originations were low. We've taken steps to reduce our origination costs and increase our production. Near the end of the quarter, we released to our broker channel our new point-of-sale system aimed at significantly improving customer service quality. We also introduced a number of new products in the second quarter that are better aligned with current conditions in the secondary market. Together, these products and the new point-of-sale system appear to be well received as our pipelines of new production were up meaningfully in July.

We took nearly $16 million in provision for the home equity mortgage portfolio during the quarter, reflecting an increase in delinquencies, particularly in that portion of the portfolio that was transferred from loans held for sale during the first quarter. I should note, however, that our consumer mortgage net charge-offs declined nearly 30% on a sequential quarter basis. When adding in losses from discontinued operations, which were also negatively affected by the turmoil in the real estate and mortgage industries, we had a consolidated net loss of $400,000 or $0.03 per share at this quarter. In discontinued operations, we are experiencing an increase in loan losses due to repurchase demands. We've increased the resources dedicated to addressing these repurchase demands and mitigating these losses.

Last quarter I discussed the action plans we put in place to address the current environment, and I would like to review those plans and update you on our progress. First, in our home mortgage, home equity segment, we have made significant product modifications and pricing changes to reduce our secondary market risk. We are now offering an attractive combination first and second mortgage product below 100% combined loan to value for which we have good secondary market outlets.

We've taken steps to reduce our overhead and the cost of originations in this segment. As I've already mentioned, late in the quarter we introduced a new point-of-sale system for our broker partners, which we believe will significantly enhance service quality and funding rates thereby reducing net acquisition costs. Additionally, we've created a consumer portfolio reserve level of 340 basis points in anticipation of further loan quality deterioration. We believe these steps and others we're evaluating to decrease our costs will enable us to return this segment to profitability by year end.

Second, in our commercial segments, we continue our focus on tighter underwriting and portfolio management practices in slow growth markets. We're also continuing to emphasize improvements in sales management techniques, which are beginning to show up in improved loan and deposit growth prospects.

To wrap up my comments, let me add that I understand the patience of our long-term shareholders as being tried due to our recent financial results. I'm not satisfied with them either. I want to assure you that we understand the immediacy of our issues. Over the past quarter I have met individually with our senior managers across our entire Company. Each one understands and has embraced the tasks we have determined are necessary to return to acceptable levels of profitability. The transformation from a mortgage dominated Company to a more balanced bank has not been easy, but I believe we are on the right path.

And now, I'll turn the call over to Greg to discuss our financial results in greater detail.

As Will noted, our earnings from continuing operations from the first quarter were $5.5 million or $0.17 per diluted share, an improvement over a net loss of $0.22 per share in the first quarter. Return on equity from our continuing operations was 4.3% for the quarter. Combining these results with the operations and disposal costs of Irwin Mortgage, the Corporation had a consolidated net loss of $430,000-- or of $400,000 or $0.03 a share in the second quarter, an improvement over the loss of $0.36 per share in the first quarter.

Consolidated net revenues for continuing operations increased on a sequential quarter basis primarily reflecting decreased credit costs as compared to the first quarter.

Net interest income was $66 million for the quarter. This was flat on a sequential quarter and year-over-year basis reflecting compressed loan and deposits spreads.

Our consolidated loan and lease portfolio grew to $5.5 billion as of June 30, up 7% on an annualized basis from the end of the first quarter. The increase came from growth in our franchise finance portfolio and in our Western commercial bank markets. Several of our Mid-Western branch markets experienced portfolio declines reflecting the effects of changes in market leadership and economic conditions in that part of the country.

Our liquidity remains strong with little use of warehouse funding. Deposits totaled $3.3 billion as of June 30, down from $3.4 billion at the end of March. Average core deposits, though, rose at an annualized rate of 18% during the second quarter, although low cost demand deposits declined modestly putting some pressure on our margins.

During the quarter we completed a $268 million asset backed home equity term funding. In an effort to increase core deposits in the future during the second quarter we launched an Internet deposit platform called Element Financial to offer CDs nationally.

We had $508 million or $16.90 per share in common equity as of June 30, 2007. With a tier one leverage ratio and a total risk base capital ratio of 11.1% and 13.3% respectively, we are well capitalized to weather current market conditions.

During the quarter we repurchased 304,000 shares of common stock at an average price of $16.49. Thus far we have repurchased 629,000 shares this year. Despite our current stock price, given our current losses in discontinued operations and uncertainties in the mortgage market, we expect to be less active in repurchases in the near term. This is meant only to signal caution in an unsettled market. Should market conditions normalize, we will consider becoming more active with share repurchases.

Credit challenges in the mortgage industry have been widely reported. In our consumer portfolio delinquencies have risen, but charge-offs were lower in the second quarter as compared to the first. The bulk of the increase in delinquencies has come from the portion of the portfolio we transferred from held to sale to held for investment during the first quarter. Our core portfolio of loans originated with the intention of adding to portfolio has performed acceptably during the past several months. We were pleased to note that in July when Moody's and S&P downgraded hundreds of residential mortgage bonds, none of the bonds we've issued for asset backed financing were among those downgraded.

Credit quality in the commercial portfolio is acceptable. Our Michigan portfolio is exhibiting weakness due to the local economy, but other portions of the portfolio are performing well.

On a consolidated basis, including both the commercial and consumer mortgage portfolio, non-performing assets were $61 million or 0.99% of total assets at June 30 and this is down from $63 million or 1.05% of assets at March 31. It's well noted that we are increasing our reserves to provide for future deterioration. Our allowance for loan and lease losses totaled $92 million as of June 30, up $7 million from the end of March. The majority of the increase reflects additional provision taken at the home equity segment.

The ratio of on balance sheet allowance for loan and lease losses compared to non-performing loans and leases was 216% at year end-- at quarter end compared at 179% as of March 31. Our consolidated loan and lease provision from continuing operations totaled $19.5 million in the second quarter, down from $23.2 million in the first quarter.

I'll now turn to some segment detail beginning with commercial banking, which earned net income of $6.3 million, an increase of $3.2 million from the first quarter. This increase was primarily the result of reduced loan loss provision, which was elevated in the first quarter due to a loss on an apparent fraud in Michigan.

We continue to see good growth in the newer Western branches, but growth has been flat to negative in our Mid-western markets. Loans outstanding at the end of the quarter were $2.9 billion, unchanged from the first quarter.

Net interest margin was 3.86% in the quarter, down from 3.99 during the first quarter. We are actively reassessing our pricing and expect a slight expansion in margin in coming quarters.

Credit quality in the commercial banking portfolio has stabilized and is in good overall condition. Portfolio credit quality is weak, however, in Michigan. Our Michigan based loans count for 17% of our commercial banking portfolio but account for 73% of the non-accruals. It is getting particular focus by the portfolio management staff.

Our commercial finance line of business earned net income of $2.9 million in the second quarter, up from 2.6 million in the first quarter reflecting an increase in net interest income due to portfolio growth. The segment's portfolio of loans and leases ended the quarter at $1.2 billion reflecting originations of $175 million compared to originations of $129 million in the first quarter. And our net interest margin increased modestly to 4.69% in the quarter up from 4.64% in the first quarter.

Overall our credit quality and commercial finance is good. Our loan and lease loss provision totaled $3.1 million during the quarter, down from $3.5 million during the prior quarter. Net charge-offs increased approximately $100,000 to $2.1 million during the quarter.

Our home equity lending business lost $2 million during the second quarter compared to a loss of $10.1 million during the first quarter.

Loan originations totaled $123 million in the second quarter, down from $189 million in the first quarter. While production this quarter was well below our expectations, current pipeline indicators are more encouraging, reflecting the changes in production in delivery systems that Will noted earlier.

Credit costs in this segment remain high, although charge-offs have declined. Thirty day and greater delinquencies in our on balance sheet portfolio increased to 3.64%, up from 2.95% at March 31. The bulk of the increase came from the loans transferred to the portfolio during the first quarter.

Our loan loss provision increased to $16 million from $15 million in the first quarter. Net charge-offs declined 30% at $9.1 million during the second quarter compared to $12.6 million in the first quarter.

As we've noted, home equity is currently performing at an unacceptable level. If we are able to return it to acceptable financial performance, we believe in the long run it offers two strategic advantages. It provides credit and geographic diversification relative to our commercial portfolios, and it can generate excess capital to grow the commercial segments. Achieving this strategic intent is proving quite difficult in the short term, as we are in the midst of making significant structural changes in this segment in the face of an external market environment undergoing extensive disruption. It will require both the successful implementation of our initiatives and the external market environment normalizing to achieve our financial goals of double-digit earnings growth and return in excess of the cost of capital.

Also included in results from continuing operations was a loss of $1.9 million for the parent of consolidating operations compared to a loss of $1.7 million during the first quarter. This reflects a decrease in the allocation of our interest bearing capital of the operating segments.

The discontinued operations related to our conventional mortgage banking segment that we sold in 2006 recorded a quarterly after-tax loss of $5.9 million, principally reflecting credit costs for repurchases and indemnifications. Should the mortgage markets continue to deteriorate, we could see some additional repurchase risk in coming quarters.

In summary, it was another difficult quarter but I believe we are getting traction in our initiatives to improve profitability. In our commercial lines of business we continue to see pockets of good loan growth in the West and in franchise finance. Overall credit quality in the commercial portfolio is good. We are making gradual progress on increasing core deposits. And on the consumer mortgage side, we're making significant internal changes in the midst of an unsettled external market. Rather than waiting for market conditions to change, we have made extensive product changes, rolled out a new point-of-sale system and have aggressively been cutting costs. While current conditions and results are probing very difficult, we are optimistic that improvements to the bottom line can be made.

John, Will and I would like to open up the line to questions now.

(Operator Instructions) We have Ross Demmerle from Hilliard on the line with a question.

I was hoping you might be able to elaborate a little bit more on the discontinued operations. I mean, at March in the 10-Q you are looking at about $41 million in assets and at the end of June, we're looking at $27 million in assets and I'm wondering if there is anyway to quantify the potential liability or loss based on the loans and other assets that are there? I mean, are you-- I guess you're having more loans put back to you or is there maybe a certain percentage of loss we might be able to look at as far as the loans that are the balance sheet right now? What's the real liability there?

Ross, there are two factors that you touched on there that are coming into play. We had certain assets that we did not sell with the various sales that we did last year, and we had receivables on our mortgage servicing asset, not the platform, that we needed to collect on the receivables. Let me start with those. The second aspect are credit costs for loans that are not on the balance sheet.

So, of the $27 million on the balance sheet, there are loans on that balance sheet that came from a variety of sources, construction to perm loans that were not in final stage of delivery at the time we sold the company, and we needed to work those through to their permanent financing. There were loans that we had purchased out of Ginnie Mae pools. There were receivables on previous servicing sales. These are receivables largely to banks and the way to collect those receivables is to collect all the final documents that needed to be supplied and the transfer of the files from electronic to physical form. Those activities we're working through quite rapidly now. We have a loan sale out to the market this month. And by and large, those activities will be wrapping up here in the next couple months. The losses that we're incurring are coming in part but not in majority from those activities. Those activities are taking the efforts of a fair number of staff, and largely are not producing, but those activities should be winding up here in coming months.

The credit issues that we were talking about have to do with repurchases that we're obligated to address, either defend or to accept, on loans that we made in prior years where there were representations and warranties about the underwriting. When those loans go bad, the investors have the opportunity to review the reps and warranties and the underwriting associated with it, and if they find that they believe there is error in those underwriting have the ability to come back to us for recovery either through indemnification or repurchase. That number is a little bit harder to get our arms around, whereas I can sort of see the project path for getting rid of the loans and other assets that are on the balance sheet. Those loans will play out over time as the loans get reviewed by the investors. That's the group that Will talked about earlier in the call of having strengthened the group, that we've got to address those repurchase demands. And we have reserves on the balance sheet, liability reserves to address those potential future repurchases.

So, I think that the short answer is on the left side of the balance sheet we've got a path and know within a few months we'll have the majority of that cleaned up. On the credit costs on the repurchase side, I think a lot of it has to do with what the future repurchase activity looks like and that's going to be a variable that's in part dependent on the housing market and payment conditions of the homeowners.

Will, do you have anything to add?

Other than I think it's obvious to go-- what Greg said, to go back to your original question. The liability potential associated with the assets on the balance sheet, you can assess quantitatively from our financial statement, but it's not really possible to do that with the repurchase demand because they don't become a liability until somebody demands a repurchase, and we assess whether or no to accept it. So, that part of it is not reflected in the financial statements.

But you've established a reserve for that?

We have, yes. Yes, we have reserves for what we expect, but the current market conditions have caused us to increase those reserves because they have been running higher than historical levels.

So Ross, we've for a long time had two types of reserves. We have a contra-asset reserve for the loans that are on the balance sheet and we have a liability reserve, and those reserves are determined based-- the reserves on both sides of the balance sheet-- they're determined based on historic patterns adjusted for what we're seeing in current market conditions. And so, a large part-- approximately $5 million or $6 million of the pretax loss in the discontinued operations this quarter came from strengthening those reserves and taking care of repurchase or charge-off demands that we had from investors.

And the current reserve level is about $12 million

Okay.

About $20 million in total when you add in the liability, the contra-assets, about $22 million in total.

Yea, the 12 is specifically for future potential buy-backs.

Right

Right.

And I guess on a separate subject. The commercial bank in some of your Western markets that are, I guess doing pretty well right now, in some of those markets, they've been, I guess, categorized as generally high growth markets like Phoenix and Las Vegas and I'm wondering are those markets starting to soften right now?

Our highest growth market at the moment is Albuquerque where the bank is relatively new, and that's both a market opportunity and a market share element. Sacramento, Costa Mesa and Las Vegas are also quite strong. Phoenix has softened some, but we are still seeing pretty good growth across most of it.

Alright, thanks for your comments.

We have Stephen Geyen from Stifel Nicolaus on line with a question. Please go ahead.

A follow up question or a question related to the most recent one, those loans regarding the discontinued mortgage segment-- is it only if there is a problem with the loan or can they review all loans and potentially put back loans that don't have any issues for the time being?

Only if there is a problem with the loans will they put them back. There are-- in the first quarter there were two types of loans that were being put back to us, ones that we had made many quarters ago that had then gone bad, and the underwriting was reviewed against the representations we made. There was also in the sale contracts, most of the sales contracts that we and other banks have, an early default provision such that if the loan was in default in any period in the first six months in which it was made, even if it's then subsequently cured, and was at that point current, the investor could put those back to us. And we did see a spike in those in the first quarter.

Most of those contracts are-- have six month protection, and we stopped our production in September of '06 so we saw the majority of those flush through in the first quarter. And in that pile there were some loans that were current but had been for a time in default during the first six months. Now we've worked through those, and the bulk of the early payment default issues that, as you know, could be current or not current were first quarter issues and we haven't seen any meaningful amount of them since April. So, the bulk that we will see in current periods, what we saw in July and if we see any more in future periods, will be loans that have some credit deficiency to them.

Okay. And with the problems that many competitors are having in the home equity, specifically with the net charge-offs pumping up a little bit, are you still pretty comfortable with the ratio, the guidance that you gave the last couple of quarters or so as far as the potential high point?

Well, we are bumping up against that potential high point. You know we had charge-offs come down this quarter. They were running about 220 basis point range this quarter. In the first quarter, they were up in the three range. I think we're still comfortable given the current economic forecast that the number will be in the maybe the high twos, low three handle for the near term and we think we've thrown an awful lot of provision at the allowance to be able to cover that.

Okay. And last question then, Will, you had mentioned that the new product with the LTVs below 100, does that replace the previous program, the high LTV program?

No, we were emphasizing there that we're moved to offering a combination first and second and the combined loan to value of both loans is up to 100%. We sell off the first, and we are still getting pretty decent premiums on that. And by simultaneously closing a first and a second and selling off the first, that's part of how we are going to bring our acquisition costs down.

(Operator Instructions). We have [Jim Dessulu] from [Cambridge Place].

Is there kind of the equivalent in the market place for a scratch and dent market for any of these seconds that are-- any of these home equities that are coming back to you?

Let me-- Jim, thanks for the question because it will give us an opportunity to be clear about what's coming back to us. The bulk of the comments that we've made thus far are related to loans that are coming back into our discontinued operations, which largely were conforming conventional first mortgage loans. And those loans, in those cases where after review we agree with the investor that we need to either indemnify or in the case of your question, repurchase those loans, we will repurchase those, and we will put them into a scratch and dent pool. And ultimately our loss will be a combination of how well we've negotiated with the investor in terms of recapture of funds that they've paid us for the loans and what we will get in those loans in a scratch and dent sale and that will determine or depend, of course, on the condition of the property and what kind of marketplace it's been in in terms of property appreciation since the time we originated the loan.

You made reference to home equity loans. We are not seeing any slight in repurchase request on second mortgage home equity loan, which is the ongoing consumer mortgage operation.

And are there any publicly, public securitizations of your seconds, I mean your home equity loans that I could follow?

There are and the bulk of our deals are-- data is available on our website, home equity website-- that in addition to other sources. And I made reference in the comments earlier that the majority of those ponds are rated by the rating agencies, and when they did there valuation in July, none of those bonds were downgraded. I'm not making a promise in the future, but the numbers that were downgraded in July by the two, the three agencies--

It is probably worth mentioning that we even had one of our bonds upgraded in that environment.

And not many people can say that. In your home equity, your 30 day, your delinquency as of-- for 30 day and 90 day, what were those numbers as of June?

We're going to pause here and pull up the 90 day. The 30 day delinquencies were 3.64, and that was up 295 at the end of the first quarter. We'll be able to get you the 90 while we're--

Great.

Do you have any additional questions?

No, that will be my last one if you want to go on to the next question and just let me know when you get that one.

Ninety day past due rate, I've got a report that it is close enough so I'm going to use a round number, was about 1.7%.

Versus where in March?

Versus 1.4% in March.

Okay, thank you very much.

[John Mcquitish] from [Encore Advisors] on line with a question. Please go ahead.

My question has to do with if you could elaborate a little bit on your home equity product in terms of some of the characteristics, what the portfolio looks like in terms of high loan to value, the average FICO score and just kind of help us understand a little bit better the typical borrower that's in that product.

I am going to give you a few statistics, but I'll also point you to about pages 37 to 40 of the 10-Q that was filed this morning. And for some historic information it's been, these same tables have been in there for some time.

Our borrower is typically somebody that has had plus or minus ten years of a credit file. They're obviously homeowners. Currently 10% of them are in California. That's our heaviest concentration. About half of our portfolio have a combined loan to value of less than 100%. About half of it is between 100 and 125. About 5% of the portfolio today is first mortgage portfolio. Our average FICO runs around 700 depending on the product type, just about 700 for those first mortgages, a little higher for high LTV first mortgages. The home equity product that is below 100% is just slightly below 700 in FICO on a weighted average basis. The home equity product that's up to 125 loan to value is in the 685 to 95 range depending on whether it's a home equity line of credit or a home equity loan. But we also look at disposable income. Disposable income for our borrowers is generally in the $5,500 to $6,500 per month range.

The majority of our originations today come in through a broker channel. Slightly over 50% come in through brokers. We also use correspondents. So, I point you to those pages in the Q but I think that ought to give you a sense.

The other thing I would add, Greg, is that if you look at the ten states that have had the highest depreciation-- excuse me, appreciation in home values over the last period, and therefore, according to Economy.com are expected to have the highest depreciation over the next three, those states represent 50% of the total mortgage industry originations. In 2005 and 2006, they only represented 17% and 15% of our originations so we're pretty well diversified and not concentrated in these mortgage markets that are most at risk.

And the last thing that I'd add is that we generally do not lend on second or vacation homes or non-owner occupied properties. Those make up 1% or 2% of the entire portfolio. And we do some stated income programs, but those are in terms of portfolio in the teens, and it does generally have a much higher FICO score, generally about a 15 to 20 point FICO point lift from our overall average that we do a stated program.

Got you and then the last question I had was that with the shareholders' equity that you stated in the press release of $500 million roughly and looking at the market cap, I mean, it's as if the market thinks there is another $150 million in losses or additional reserves or something along those lines. I mean, is there a scenario that you all envision in your worst case that there is $150 million of either liability from the old loans or exposure? I mean, that would be almost 10%, I guess, write down on your entire home equity line right now in terms of that book of business so, it-- I would just be curious of your comments.

I would say I cannot imagine a scenario outside of some global collapse. You can always imagine a scenario in which there is another terrorist incident and something completely unknown or unexpected arise, but within the parameters of a normal functioning market economy, I have a hard time seeing that.

Okay. Thank you very much.

[Robert Wolfe] from Stonebridge Advisors. Please go ahead.

I just had a question on getting back to the home equity portfolio. What do you forecast for the second half of the year in terms of delinquencies or do you have anything to-- any comments to make on the outlook for delinquencies, where you see those heading?

Our current reserves essentially assume in it that delinquencies will continue to rise over the course of the year, but the amount of rise will moderate. As Greg said earlier, we expect this to lead to a loss rate that's a bit higher than it is right now. It was 220 in the second quarter, and we think the loss rates could go back up to the high 2s or low 3s.

You should also note that at the rise that we saw off from the first quarter is one that we typically see in the business over many, many years. We get a decline in delinquencies in the first quarter typically, and we believe we saw that again in the first quarter of this year.

(Operator Instructions). At this time I show no further questions.

Well, thank you all for joining us. We appreciate your interest in our Company, and we look forward to talking to you again in late October when we announce our third quarter results.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may all disconnect.