First Financial Bancorp (FFBC) 2007 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Irwin Financial third quarter conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session.

I would now like to turn the call over to Mr. Will Miller. Mr. Miller, you may begin.

Thank you, Trish. Good afternoon and thank you for joining us. I'm 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 and in our SEC filings, including the 10-Q filed this morning. Today we announced the loss of $800,000 or $0.05 per diluted share from continuing operations as compared to earnings of $5.5 million or $0.17 per diluted share during the second quarter. When adding in losses from discontinued operations, we had a consolidated net loss of $18 million or $0.64 per share this quarter.

Results were negatively affected by the turmoil in the real estate and mortgage industries, slow loan and deposit growth, and expense rates that have not yet been fully aligned with current market conditions, a process we are continuing in the fourth quarter. The sustained mortgage crisis continued to take a toll on our results during the third quarter. The primary driver of this quarter's small loss in continuing operations was the significant increase in our home equity provision. In addition, our home equity originations and sales were lower during the quarter reflecting, the unsettled secondary market and the frequent changes to the underwriting guidelines we made to address the volatile market conditions. We are actively reassessing the operating expenses of this segment, and since July have reduced the number of employees by approximately 130 or about 30%.

Results in our two commercial segments were mixed. Our commercial finance line of business continued its strong performance with record quarterly income and good credit quality. Good loan growth in this segment was the driver behind a 13% annualized increase in our consolidated loan and lease portfolio. In the commercial banking line of business, loan and deposit growth remained slow. Credit quality weakened somewhat during the quarter but remains within an acceptable range. In the discontinued operations, we experienced a sharp increase in loan repurchase requests in August. Additionally, the principal cause of repurchase requests changed meaningfully during the quarter. Now the majority of requests are based on allegations of misrepresentation by borrowers or third parties who were involved in the loan origination.

This has been a very difficult period for us. We made the strategic decision over a year ago to exit the conforming mortgage banking business. In hindsight, with the knowledge of what has transpired in the market since then, I'm very glad we made this decision. Market conditions have, however, made the wind-down of the discontinued operations as well as the reengineering of the home equity segment a more challenging and costly endeavor than we anticipated. I believe we have responded quickly and responsibly to the current market conditions. We have modified our home equity underwriting guidelines at considerable cost to our production volume. We have addressed deteriorating credit conditions with substantial reserves. We've maintained a healthy amount of liquidity and capital which have provided capacity for the adjustments we've had to make while leaving us in a solid position. And we are making progress on our expense restructuring in areas where performance has been below our expectations. Each of these important steps are continuing into the fourth quarter and should position us for a return to profitability. Now, I will turn the call over to Greg to discuss our financial results in greater detail.

Thank you, Will. Consolidated net revenues for continuing operations decreased on a sequential quarter basis, primarily reflecting increased credit cost. Net interest income was $65 million for the quarter. This was down slightly on a sequential quarter and flat on a year-over-year basis, reflecting compressed loan funding spreads due to shifts in the yield curve over the past several months. Our non-interest expense levels remain too high for current levels of activity. We are in the midst of taking significant steps, particularly in the home equity segment, but also elsewhere in the corporation, to align staffing with the current environment. We have not completed our plans but we expect future restructuring charges in the range of $10 million to $15 million pre-tax for severances, write-downs of leases and potentially unused fixed assets. We expect that a material amount of these charges will be reflected in the fourth quarter results.

Our consolidated loan and lease portfolio grew to $5.7 billion as of September 30, up 13% on an annualized basis from the end of the second quarter. The bulk of our growth came in our commercial finance portfolio. Liquidity remains strong with no dependence on warehouse funding. Deposits totaled $3.5 billion as of September 30, up from $3.3 billion at the end of June. We continue to expand our funding sources. We made meaningful inroads during the quarter with our new online deposit gathering system and we expanded our collateral capacity for funding from the Federal Home Loan Bank. Late in the quarter, we hired an executive with 30 years experience at a money center bank to run our retail branch operations and to enhance our core deposit capabilities. We believe each of these steps should bolster our liquidity profile and help offset the lack of liquidity in the securitization and conduit markets.

We had $489 million or $16.25 per share in shareholders' equity at quarter end. In light of the turmoil in the capital markets, we elected to husband our capital for risk management purposes by being inactive in common stock repurchases during the third quarter. We expect that we will continue this approach in the near term. We are well-capitalized to weather current conditions. Credit quality deteriorated in the quarter. On a consolidated basis non-performing assets were $82 million or 1.33% of total assets at quarter end. This is up from $61 million or 0.99% at the end of June. Now, $9 million of the increase came from the home equity portfolio and $12 million in the commercial banking portfolio. Seven of that $12 million increase in the commercial banking non-performing assets came from a single loan in a western market which we believe will be resolved shortly. We increased our allowance for loan and lease losses to $104 million, up $12 million from the end of the second quarter. Our consolidated loan and lease loss provision from continuation operations totaled $28 million during the third quarter, up from $19 million in the second quarter and $11 million higher than actual charge-offs in the quarter, which totaled $17 million.

I'll now turn to some detail by segment beginning with our commercial banking segment which earned net income of $4.7 million, which was down $1.6 million from the second quarter. This decline primarily reflects increased loss provision and flat net interest income. During the quarter, the loan portfolio increased by $60 million but the bulk of the growth came late in the quarter and had only a modest impact on net income. Net interest margin increased to 3.97% during the quarter, up from 3.86% in the second quarter. Credit quality in the commercial banking portfolio weakened during the quarter but remains within an acceptable range. Our loan and lease provision totaled $3.1 million during the quarter, compared to net charge-offs of $2.1 million.

Our commercial finance line of business earned record quarterly income of $3.8 million in the third quarter, up from $2.9 million in the second quarter. This reflects an increase in net interest income due to portfolio growth, coupled with good credit quality. The segment's loan and lease portfolio ended the quarter at $1.2 billion, reflecting originations of $185 million and loan sales of $32 million. Our net interest margin declined 4.4% in the quarter in this segment, down from 4.69% in the second quarter, largely reflecting increases in LIBOR-based funding during the third quarter. Overall, our credit quality and commercial finance is good, our loan and lease loss provision totaled $2.9 million during the quarter, compared to net charge-offs of $1.7 million. Our home equity lending business lost $8.1 million during the quarter compared to a loss of $2 million in the second quarter. The increased loss primarily reflects a higher loan loss provision. Loan originations totaled $104 million in the quarter, down from $123 million in the second quarter. Disruptions in the secondary mortgage market during the quarter caused us to make a significant change to our home equity products, which in turn reduced production and loan sales.

Delinquencies and charge-offs increased on a quarter-over-quarter basis, 30-day plus delinquencies for the on balance sheet portfolio increased to 4.72%, up from 3.64% at June 30. A disproportionate amount of this increase came from the loans transferred to the portfolio during the first quarter. Our core portfolio of loans originated with the intention of holding in portfolio continues to perform well with the 2005 and 2006 vintages among the best we have ever originated from a credit quality standpoint. The only exception to this is that portion of the portfolio with CLTVs or combined loan-to-value ratios, between 95 and 100%, which is performing worse than our expectations. We believe this is related to the general decline in housing prices and erosion of homeowner equity. Net charge-offs increased to $13 million, up from $9 million in the second quarter, but significantly below our loan loss provision which increased to $23 million as compared to $16 million in the second quarter.

The discontinued operations related to our former conventional mortgage banking segment recorded a quarterly after-tax loss of $17 million, principally reflecting the increased provision for potential future credit costs for repurchases and indemnifications. This increased provision is the direct result of the increase in the type and frequency of repurchase requests we had during the third quarter. Repurchase requests hit a high of 33 units in August, although they have subsequently dropped in September and October to a rate that is slightly less than the monthly average during the first half of the year. We are actively addressing the increase in repurchase requests with staff who have extensive experience in this area. We've provided significant detail on our repurchase exposure and the reserve models that we use on page 47 of our 10-Q that was filed this morning. Outside of repurchase activities we are on plan to wind down the remaining pieces of the mortgage operation over the next couple quarters.

In summary, it was another difficult quarter, but we believe we have taken the actions necessary to address this unusual period. First, we have significantly increased our reserves for potential future losses. And we have made meaningful reductions in our expense levels and we're not resting. We will find more. We have husbanded our capital, despite our relative evaluation in the market, in order to be operating from a position of capital strength and we have enhanced our funding sources to address liquidity short falls in the capital markets. While current conditions and results are proving very difficult, we are optimistic that the improvements we are making in our diversified national platform will enable us to return to profitability. Assuming external conditions do not materially deteriorate further, and excluding the anticipated restructuring charges I noted earlier, we expect to earn a modest profit from continuing operations in the fourth quarter and good earnings in 2008. Trish, Will and I would now like to open the call to questions.

Thank you. We will now begin the question-and-answer session. (OPERATOR INSTRUCTIONS) Our first question comes from Dan Bandi, Integrity Asset Management. Please go ahead.

Hi, thanks for taking my question. I'm wondering, on the loan repurchase requests that you're receiving, are you in effect reserving for all of the requests, even though, as you're saying, I assume you're investigating them to see if they're all valid or not, but do you reserve for them when the request is made or are you doing the investigation and then reserving after the investigation is done?

Dan, the -- I'll try to answer your question with a holistic answer. The reserve is an estimation of what our future losses will be from any repurchase put to us from this point forward and, frankly, the ones that we received in the third quarter that haven't been resolved. So we don't wait until we see the repurchase request to put up the reserve. What we are trying to do is use the experience that we've seen in the last three, six, nine months, plus our long-term historic experience, calibrate it to the current environment with regard to frequency and severity of loss, and extrapolating out through the production that we did up through September of last year when we did our last loan and putting up that now $29 million reserve for losses that we are likely to incur in the future.

So just to be clear, though, included in that reserve, are requests we have not yet received.

Okay.

But a forecast of the volume of these requests that we will get going forward based on the uptick in the third quarter, and we do have some assumptions in that reserve about our ability to fend off a few of the requests, frankly, it's a conservative assumption. We also have some assumption in there about our ability to negotiate with people over the dollar amount that these things settle at, that's also a conservative assumption. At this point, we don't have enough track record to have recoveries in there. So all those things go into that model.

And you had mentioned in your comments on the call about having experienced people looking these over. Are these folks that currently work for Irwin or is this a consulting firm that you've retained to do some of this for you?

No, they are people who now are employees of Irwin. They're-- the leadership comes from folks who actually did this job in another company and who we had hired for other purposes but have now reassigned to this role within our organization.

Okay. And on a -- on the home equity portfolio, looking at the -- at the nonperformers, how long is it taking nonperformers to work their way through there from when they enter into some type of resolution, whether it's getting some money back or just charging it off?

Dan, we typically will have a pretty full reserve, close to 100% reserve on the loan. Again, depending on the loan type, but typically after 90 days we'll have 100% reserve. Our charge-off policy is that we'll charge it off as we recognize the lack of recoverability or 180 days as a hard stop.

Okay. Great. Thanks a lot.

Our next question comes from Jim Fowler for JMP Asset Management. Please go ahead.

Good afternoon. Thank you for taking the question. With regard to the repurchases that you have settled or that you will soon settle, what will be the disposition of those assets, those loans? Are you going to be selling them through to the scratch-and-dent market or will you be retaining them and servicing them?

Jim, we are not going to retain them and service them. To the extent that we take a loan back, we will be selling those in scratch-and-dent sales. The desire is, if we believe the economics are not disadvantageous, we would typically make an indemnification or make whole payment to the investor after our negotiation is completed.

Have you actually realized a sale of these loans to get a sense of where the -- where the market is on these, just to get a sense of the depth of the market?

Yeah, we have been doing scratch-and-dent sales all along. We did a small one in, I guess we did two small ones in the third quarter, and the prices that we received on those sales in the third quarter were part of our input into the loss estimation, the loss given default estimation of the reserve model.

Does that feel like a relatively, I don't know how to best phrase it, a relatively stable market or do you think it could be where the price could fade pretty quickly under any amount of supply?

It's the latter. We see a fair amount of volatility in the pricing. Frankly, depending on sort of where things are in the capital markets and liquidity to the investors, it was not a good time to be showing properties to folks in the middle of August when people that we were showing the paper to, themselves were having issues with regard to their funding lines. We do see, through the diligence process in certain markets with the real estate conditions the way they are, we see a little bit of fade from an evaluation we would have had at the time we put the loan on the books to the final sale price. But all that's been factored into the LGD model.

Thanks. From your text -- and this is my last question, thanks for your indulgence -- from your text it would seem pretty clear these aren't early payment defaults but more, I don't know how best to phrase it, fraud for housing type of issues.

Yeah, we are -- Jim, we did our last origination September 15th-ish of '06 so we're largely through the EPD period. We saw a spike in EPD type of claim in February, March and a little bit into April. With one investor we had a contract that extended that a little bit further than six months and we saw a little bit of traffic in EPDs in June and July. But I think in the last three months we've seen zero.

And what do you think the ability is to put these loans back through to the parties from whom you would have bought them or originated them?

We certainly are going to pursue that. We do have experience in more normalized markets getting some recoveries, not huge amounts, but some. However, in the reserving, because we don't have any reliable data on which to base an estimate of recovery in these abnormal markets, we have assumed nothing.

Great. Okay, gentlemen, thanks a lot for your help.

(OPERATOR INSTRUCTIONS) Our next question comes from [Steven Gian] with Stifel Nicolaus.

Good afternoon. Can you help me understand --

Steven, we can't hear you very well.

I'm sorry, I was on speaker phone.

Thank you, sir. That's much better.

Can you help me understand the timing of when you recognize non-performing home equity loans and when there's a provision made? What I'm trying to get a sense of is how much of the reserve was forward-looking versus the current risk that you see in the market for that incurred in the third quarter?

Yeah, the -- we're having a little trouble trying to answer your question because I'm not sure we understand it precisely. Could you just rephrase it so we make sure we're dealing with what you're interested in?

Okay. So there's obviously some degradation in the home equity portfolio during the quarter and reserving is based on a lot of different issues, a lot of different things that are occurring. If you can quantify it, just in some way, I know this is probably very, very difficult, but how much of the reserving that occurred in home equity was from changes that you saw in the portfolio versus kind of what you're seeing down the road as far as losses that you might expect.

I think part of our difficulty in answering that question is those two things seem to us to be sort of interrelated and hard to pull apart.

Sure.

In that the deterioration in delinquency in the third quarter is largely analytically what we base our estimate of future losses on. So we use roll rate models and projections based on how things have gone in terms of collections in the last three months to, in fact, estimate that future piece. So in that sense, in a way, all of it is based on what happened in the third quarter.

Okay.

Does that make sense?

I do understand what you're saying, and I can go a little bit in more detail off-line. But also, home equity, I believe, Irwin assumes 100% loss on their loans when they become nonperforming, so it would seem any increase in nonperformance would be roughly met dollar for dollar. Is that a reasonable assumption at least some point, or dollar for dollar increase in provision?

In the provision in the allowance?

Yeah.

Yeah, that's reasonable.

Okay. And one other question. What is the lag between seeing a jump in nonperfoming home equity loans and a spike in charge-offs?

That could be variable. The process usually takes somewhere around six months. I mean, as Greg said, we charge them off at 180 days as a hard stop. We also charge them off earlier than that if it becomes clear to us we're going to have a loss. But the actual process of working it through to knowing what that ultimate disposition is, can take six, nine months.

Okay. And the home equity, the interest margin dropped from last quarter, how much of that was from reversal to interest? I'm just trying to understand if that is similar to commercial lending and if you can quantify that?

I don't have a quantification of that. And through our inquiries I would suggest that it's not been a material matter.

Okay. Thank you.

(OPERATOR INSTRUCTIONS)

Steven, let me follow up on that. I think that I touched on the compression of NIM in the commercial finance side, I think we saw some, hopefully unusual movement of LIBOR in the third quarter and a fair amount of our funding in the home equity segment having been funded through asset-backed bonds tied in many cases to LIBOR when the markets went -- got unsettled in August, and LIBOR and treasury rates became pretty unseparated -- became pretty separated, and prior to the fed's move with prime on September 18th, we would have seen a squeeze there between prime and LIBOR, which would have cut into the margin.

I think he dropped off, so Trish if you had another question.

We have no further questions at this time.

Well, thank you very much. We appreciate your attendance today and we'll be back next quarter.

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