Independent Bank Corp (Michigan) (IBCP) 2005 Q4 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Independent Bank Corporation fourth quarter earnings release conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star, zero on your telephone keypad. As a reminder, this conference is being recorded. And now a Safe Harbor statement.

This webcast may contain forward-looking statements as defined in section 27Ai1 of the Securities Act of 1933 as amended. Including statements regarding, among other things, the Company's business strategy and growth strategy, expressions which identify forward-looking statements speak only as of the date the statement is made. These forward-looking statements are based largely on this company's expectations and are subject to a number of risks and uncertainties, some of which cannot be predicted or quantified and are beyond their control. Future developments and actual results could differ materially from those set forth in, contemplated by, or underlying the forward-looking statements. In light of these risks and uncertainties, there can be no assurance that the forward-looking information will prove to be accurate.

This webcast does not constitute an offer to purchase any securities, nor a solicitation of a proxy, consent, authorization or agent designation with respect to a meeting of company stockholders. It is now my pleasure to introduce your host, Mr. Michael Magee, President and Chief Executive Officer of Independent Bank Corporation. Thank you. Mr. Magee, you may begin.

Thank you. Good afternoon. We are delighted that you could join us on our conference call to discuss fourth quarter and full year 2005 results. Earlier today we reported fourth quarter 2005 net income of 11.4 million, which was up 600,000 or 6% from the fourth quarter of 2004, but down 5% on a linked quarter basis. Our diluted earnings per share of $0.51 this quarter were up 6% from the year ago comparative quarterly earnings per share of $0.48. Per share data has been adjusted for the 5% stock dividend that we paid on September 30, 2005. For all of 2005, our earnings reached a record 46.9 million, which was up 8.4 million or 22% over 2004. Our diluted earnings per share reached a record $2.07 in 2005, which was 18% higher than 2004.

I would like to take this opportunity to thank all of our employees whose efforts and contributions allowed us to achieve these record results. The fourth quarter reflects continued growth in our level of interest-earning assets with linked quarter annualized loan growth of approximately 11%. For all of 2005, our loans grew by 15%. However, the positive impact of the growth in interest-earning assets was offset by erosion in our net interest margin due primarily to the challenges of the flat yield curve environment. Rob Shuster, our CFO, will discuss our net interest margin in greater detail during his remarks. Profitability measures were strong in the fourth quarter of 2005, with a return on average equity of 18.1% and a return on average assets of 1.37%. For all of 2005, our return on equity exceeded 19% and our return on assets was 1.45%. Our profitability measures remained among the very best in the banking industry. I am very pleased to report that our nonperforming loans declined by 34% during the fourth quarter of 2005.

As detailed in our press release this morning, we closed on the sale of 11.7 million of nonperforming and other loans of concern. Included in these sales were 9.3 million of non-accrual loans, which also included the two commercial mortgage loans on low moderate income apartment complexes in Saginaw County. As a result of these sales, we recorded an additional 600,000 in provision for loan losses and 100,000 in sales-related expenses during the fourth quarter. These sales returned our overall level of nonperforming assets to more normal historical levels. Rob will now provide some additional details on fourth quarter results.

Thanks, Mike. Good afternoon, everyone. Mike covered the highlights for the quarter and I will provide additional details on net interest income and our margin, certain components of non-interest income and non-interest expense, and asset quality. Tax equivalent net interest income totaled $35.8 million in the fourth quarter of 2005, which was up $1.3 million or 3.8% on a comparative quarterly basis, but down $138,000 or 0.4% on a linked quarter basis. The increase in comparative quarterly tax equivalent net interest income was due to a $282 million increase in average interest earning assets, primarily as a result of growth in all categories of loans. Partially offsetting this was a 29 basis point decline in our net interest margin to 4.65% from 4.94% on a comparative quarterly basis. The slight decrease in linked quarter tax equivalent net interest income was due to a 10 basis point decline in our net interest margin that was largely offset by a $56 million increase in average interest earning assets resulting from growth in all loan categories.

The increase in loans was partially offset by a decline in the average balance of investment securities. The decline in investment securities reflects the difficulty in replacing the paydown or maturing of existing investments with new trades that meet our return and risk objectives given the flat yield curve environment. In addition, the fourth quarter of 2005 included a $200,000 reduction in our net interest income, which reduced the net interest margin by 3 basis points related to a change in the estimated life of certain finance receivables that altered the rate that the discount associated with these loans is accreted into income. Without this adjustment, tax equivalent net interest income in the fourth quarter would have been slightly higher than the third quarter. On a comparative quarterly basis and a linked quarterly basis, our yield on average interest earning assets and our cost of funds both increased due principally to the rise in short-term interest rates.

However, the rise in the cost of funds has eclipsed the increase in the yield on interest earning assets, reflecting both the flat yield curve, as well as competitive conditions for both lending and deposits. As I mentioned earlier, on a linked quarter basis, our tax equivalent net interest income declined by $138,000. This entire decline occurred in the premium finance area. Mepco's net interest income fell by about $750,000 on a linked quarter basis. Thus, tax equivalent net interest income actually grew by about $600,000 on a linked quarter basis at the banks, reflecting interest earning asset growth. The rise in short-term interest rates has had a particularly adverse impact on spreads on our warranty finance receivables and pricing competition in the insurance premium financing industry has been stiff. As Mike mentioned earlier, we have instituted further pricing increases at Mepco at the end of 2005. And we are confident that these steps, combined with our expectation of only modest additional increases in short-term interest rates, will stabilize Mepco's net interest income.

Looking ahead, we continue to be relatively balanced in terms of interest rate sensitivity. We remain optimistic that growth in average interest earning assets during 2006 will more than offset any further erosion in the net interest margin. Loans grew by 15% in 2005 and we believe we can achieve growth of 10 to 14% in loans during 2006, despite challenging economic conditions. Moving on to non-interest income, service charges on deposit accounts were up 3.3% on a comparative quarterly basis but were down by 6.4% on a linked quarter basis. Although we saw a similar linked quarter decline between the third and fourth quarters of 2004, the magnitude of the decline was steeper in 2005. I believe this reflects a couple of factors. First, the increased use of debit cards is reducing the level of checks being written, which in turn can impact overdraft fee income. And second, I believe customers are reducing overdraft occurrences, perhaps partially due to more difficult economic conditions in Michigan.

On a positive note, VISA check card interchange income was up by 26% on a comparative quarterly basis and up by 6.3% on a linked quarter basis reflecting the aforementioned rise in debit card usage. Gains on real estate mortgage loans declined on both a comparative and linked quarterly basis due to a decrease in the volume of loans sold. Our loan sales margin, excluding the impact of FASB 133, declined modestly by 5 and 3 basis points on a comparative and linked quarter basis respectfully, due primarily to a competitive pricing climate. We expect conditions to remain competitive in the mortgage banking sector. In addition, we would also expect the normal seasonal slowdown in mortgage loan origination volumes as we move into the first quarter of 2006. Real estate mortgage loan servicing income was up on a comparative quarterly basis but down on a linked quarter basis. These variances primarily reflect changes in the impairment reserve on capitalized originated mortgage loan servicing.

During the fourth quarter of 2005 we had a $43,000 recovery of previously recorded impairment charges. Excluding changes in the impairment reserve, we would expect real estate mortgage loan servicing income to run at about 450,000 to $500,000 on a quarterly basis in 2006. Non-interest expense totaled 26.4 million in the fourth quarter of 2005, which is up $105,000 on a comparative quarterly basis but down $658,000 on a linked quarter basis. All of the linked quarter decrease was in the area of compensation and employee benefits. Salaries were down $510,000 on a linked quarter basis. If you recall, the third quarter included $400,000 related to a one-time charge for early retirement benefits provided to Mr. Van Loan. In addition, performance based compensation and benefits declined by $649,000 on a linked quarter basis. This decline was due primarily to reversing some incentive payout accruals in the fourth quarter due to a decision by our board to issue stock options that vested in 2005 and, therefore, did not have to be expensed, as opposed to using some other type of equity award.

As we look ahead we would expect non-interest expenses to rise by just over 3% in 2006. And as Mike mentioned earlier, containing these costs will be a significant emphasis. Our effective income tax rate was 27.8% in the fourth quarter of 2005, which was comparable to the linked quarter but higher than the fourth quarter of 2004. The lower fourth-quarter 2004 rate was primarily due to a decline in state income taxes associated with lower earnings at Mepco. Our assessment of the allowance for loan losses resulted in the provision for loan losses of $2.3 million in the fourth quarter of 2005, which is substantially higher than both the comparative and linked quarters. I am going to go into some detail on nonperforming loans, net charge-offs, and the allowance for loan losses. Nonperforming loans, as mentioned by Mike, declined by 34% to $18 million or 0.7% of total portfolio loans at December 31, 2005, compared to $27.4 million or 1.1% of total portfolio loans at September 30, 2005.

As Mike mentioned earlier on the call, we completed the sale of $11.7 million of nonperforming and other loans of concern during the fourth quarter. Approximately $9.3 million of these loans had been on non-accrual and thus were included in nonperforming loans at September 30, 2005. In addition, these sales included the $6.2 million for two commercial mortgage loans secured by low, moderate income apartment complexes in Saginaw County, Michigan. Finally, as I have mentioned in prior conference calls, the finance receivables included in nonperforming loans, which totaled $3.3 million at December 31, 2005, are expected to be substantially recovered upon receipt of return insurance premiums. Moving on to net loan charge-offs, they totalled $9.8 million in 2005 or 0.41% of average portfolio loans, which is up substantially from 2004's total of $3.7 million or 0.19% of average portfolio loans. The components of these net loan charge-offs in 2005 are as follows. Commercial loan net charge-offs increased to $4.9 million or 0.5% of average commercial loans in 2005, from $660,000 or 0.08% of average commercial loans in 2004.

About 90% of this increase is due to the sale of nonperforming and other loans of concern that we discussed earlier, which resulted in net loan charge-offs of $3.8 million in the fourth quarter. Installment loan net charge-offs increased to $3.1 million or about 1.1% of average installment loans in 2005, from $2.2 million or 0.9% of average installment loans in 2004. About one quarter of these net loan charge-offs relate to overdrawn checking accounts. I am not sure that all banks classify checking account charge-offs in this manner. Real estate mortgage loan net charge-offs increased to $1.5 million or 0.19% of average mortgage loans in 2005, from $638,000 or 0.09% of average mortgage loans in 2004. And finally, finance receivable net charge-offs were $319,000 or 0.11% of average finance receivables in 2005, compared to $219,000 or 0.10% of average finance receivables in 2004.

We are optimistic that net loan charge-offs will return to more historic levels of 20 to 30 basis points in 2006. However, if nonperforming loans begin to rise again, we will aggressively manage these assets, including the consideration of a sale similar to our actions in the fourth quarter of 2005. One ratio that is likely to draw some questions is the drop in the percentage of our allowance for loan losses to total portfolio loans to 0.9% at December 31, 2005, from about 1.1% at December 31, 2004. The components of the allowance declined in two areas, increased in one area, and remained relatively unchanged in the fourth area. The portion of the allowance allocated to specific loans declined by about $1.5 million since year-end 2004 and declined by $3.6 million since September 30, 2005. This is due to the sale of nonperforming loans and other loans of concern that we have discussed in detail. The portion of the allowance allocated to other adversely rated loans declined by about $1 million since year-end 2004, due primarily to a decline in the balance of such loans.

We utilize a 12-point loan classification system with 1 being the best and 12 being the worst. In the total of loans rated 7 or higher, which some might call "watch credits", declined to $78 million at December 31, 2005 from $88 million at December 31, 2004. The portion of the allowance related to historical losses increased by $600,000 since year-end 2004, due to the increased level of net loan charge-offs in 2005. We utilized a ten-year rolling average in calculating this component of our allowance with the most recent 24-month period weighted the highest. Finally, the subjective or unallocated portion of our allowance just increased slightly from the end of 2004. Another way to look at the allowance is the allocations to different components of the loan portfolio. This requires some assumptions in the allocation of the subjective portion of the allowance to different categories of loans, but it is useful in comparing our allowance level to a bank that has a loan portfolio comprised primarily of commercial loans.

Commercial loans only represent about 40% of our total loans at the end of 2005. Under this basis, our allowance breaks down as follows: We have an allowance of 1.43% on commercial loans; We have an allowance of 1.22% on installment loans; We have an allowance of 0.43% on real estate mortgage loans; and we have an allowance of 0.25% on finance receivables. We believe our allowance for loan losses is both adequate and logical given our portfolio mix and the risk components in our loan portfolio. However, if the level of net loan charge-offs in 2005 were to persist in 2006 and beyond, the allowance as a percent of loans would likely move up, as would the provision for loan losses. This concludes my remarks and I would now like to turn the call back over to Mike.

Thanks, Rob. Before we open the call up to questions, I want to make a few comments regarding 2006. Although we believe 2006 will be a challenging year, we have taken several proactive steps to meet these challenges. First, the erosion in our net interest income over the past two quarters has occurred primarily at Mepco, and in particularly in their warranty finance area. The yields in this portfolio, which are quite high to begin with, are more difficult to move up. However, we have recently instituted price increases in both the warranty and premium finance areas at Mepco. Second, we believe the actions that we took during the fourth quarter of 2005 to reduce our level of nonperforming assets has strengthened our balance sheet. And third, we are placing significant emphasis on containing non-interest expenses during 2006.

As a result of these measures, combined with the confidence that I have in our senior management team, I believe we can overcome the challenges of the flat yield curve environment and the weak economy during the year. I would now like to open the call up for any questions that you may have.

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer section. [OPERATOR INSTRUCTIONS] Our first question comes from the line of Kevin Reevey of Ryan Beck. Please proceed with your question.

Good afternoon.

Hi, Kevin.

Mike, last quarter you mentioned that you were comfortable with earnings per share growth of 10 to 15%. Do you still feel that way and if so why, and if not what are your revised -- what is your revised earnings per share growth outlook for '06?

Well, Kevin, I don't recall last quarter saying -- or giving any guidance. As a matter of fact, last quarter we announced that we were going away from giving any type of earnings per share guidance in the future. I think what I mentioned is that it continues to be the goal of this Company over a three to five year period to achieve a 10 to 15% earnings per share growth over, again, a three to five year period. And that we are going to experience times where we are going to be 18% to 20% in one year and then the next year we may go down to 5 to 8 or 10.

But as far as how do I feel about the future, I still feel confident that this management team, over the long haul, and every decision that we make is for the longevity of the shareholder value and increasing franchise value. I don't want to give any guidance for specifically for 2006, but only to share with you that our long-term plan has not changed, nor our goal to achieve double-digit earnings per share growth over a period of time. Now that's not specifically in one year, but that's over a three to five year period.

And then you talked about the price increase. Is it Mepco?

Yes.

To what extent do you think that will not result in customer defections. In other words, what is the elasticity of price demand there?

Well, Kevin, I think that we don't expect it to have any significant adverse impact on business volumes. The difficulty in the warranty side of the business is a combination of things. One is that business comes in from a limited number of counter parties which we have contractual relationships. And secondarily, that business comes in in a highly automated way. All of it comes in electronically in -- so there is two factors there. One is we have contractual relationships where there is time elements through which we can pass through price changes secondarily on both sides. There's programming and software type of changes that have to be made relative to these payment plans for vehicle service contracts. So the difficulty there is really one of just logistics, as much as anything, but we feel that it is something where we can't pass through price changes every time the Fed moves up a quarter, but what we've done there is we've kind of waited to a point where now we think we are getting closer to where the Fed is ending and we pass through one rather significant price increase in that business.

On the premium finance side, there we have been moving those prices up more in line with how the Fed has been moving. So there's not as much of a dramatic impact on that side in terms of price move. We did do an additional price increase at the end of the year on the premium finance side, and that business is always competitive. I mean, there's lots of companies providing premium finance lending services and probably the average, mid to large agent who we deal with has three to four premium finance companies that they may be dealing with. So that business is always competitive, but all of us are facing the same issue of a rise in short-term interest rates. So, all of us have about the same inventory costs there and it just is a matter of what kind of profit margin do you want to generate. But, as a final comment there, we strive very much to do business in the premium finance area based on service and relationship and hopefully not as much on the price competitive basis. But I will say '05 has certainly been a competitive year in that industry.

Rob, I think -- why don't you -- it is also important to point out the average size of the warranty loan so we can increase.

Yes, the average size of the credit is important to kind of take into account too, Kevin. In the warranty area, the payment plans we offer, the average payment plan is about $1600. So passing through a price increase of a couple of percent on an individual payment plan basis, there's not much change in terms of the dollar amount relative to achieve that. But when you spread it over literally a couple hundred thousand payment plans, and we have an outstanding balance of approximately $200 million in these payments plans, then it starts to make a big difference. So individually not that significant on a unit basis, but when you spread it on the entire portfolio, becomes fairly significant.

Thanks, Rob, that's very helpful.

Our next question comes from the line of Kenneth James of FTN Midwest Securities. Please proceed with your question.

Good afternoon, gentlemen.

Hi, Ken.

Hi, Ken.

I just had a quick follow-up on the Mepco and the price increases. Can you offer any information about how that works out against the competitors in that field? Are you seeing price increases across the board? And is yours of a similar magnitude? And a second-part question there is in relation to the kind of the one -- the nonrecurring item that occurred in Mepco, the $200,000 adjustment. Is that something where you looked at the whole portfolio and only a handful of finance receivables required that kind of adjustment or is this the kind of thing that could pop up from time to time going forward.

Well, I will take your second question first because it's the easiest one. We, on a periodic basis, will review -- and what this relates to, that adjustment really relates to the warranty finance portion of the portfolio. The way those payment plans work, there's a discount involved. So we fund, say, a $1600 payment plan at about $1400, and then that $200 difference is, in essence, the income that we receive for servicing that payment plan. And we then accrete that discount into income over the life of the -- or the estimated life of the payment plan. So we are always periodically adjusting and looking at the average lives of that portfolio. What really happened in the fourth quarter is just because the portfolio was grown a little bit bigger, it's up to, as I mentioned, $200 million now, it doesn't take as much of a change in estimated life for it to result in adjustment on that discount accretion.

Going forward, we are actually starting in 2006 to do it on a -- we have developed some software to do the discount accretion on a loan level basis. So we are going to -- I think we will get away from having to estimate that average life. So I don't expect that we would see adjustments of that nature going forward. With respect to your first question on the premium finance business, everyone has the same, I think, relative funding costs for what they are doing in the premium finance business, whether it's AFCO or AI Credit or [Canawell] or First Funding, who are some of our significant competitors. All of these companies have generally been passing through price increases as the Fed has moved short-term rates up. As you know, most of these loans are about nine to ten month loans.

We call them nine or ten pay loans, so they are relatively short-term. They turn over fairly quickly. So everyone has been passing through those increases. And really it's been more of a matter of do you hold off a couple of quarter-point jumps and wait and do a larger increase or you do more rapid increases where you are bumping up a quarter every time the Fed moves. I think one of the reasons the competition has been fairly keen in 2005 is beginning probably toward the latter part of 2004, we've had somewhat of a soft market in the insurance industry where renewals on premiums have actually come down as much as 15% to 20%. So the dollar volume has kind of softened a bit, which I think has made the industry more competitive along with those rate increases. But I don't think we're doing anything out of the ordinary at all on the premium finance industry. And hopefully we have seen some stabilization in premiums, so I think the soft market is kind of changing and we'll have a little bit better dynamics in terms of just the size of premium renewals in 2006.

Kenneth, I would also like to add, since we have implemented the pricing changes, we have seen the portfolio grow.

Okay. Thank you.

Our next question comes from the line of Brad Milsaps of Sandler O'Neill. Please proceed with your question.

Hi, good afternoon.

Hi, Brad.

Brad.

Mike, you mentioned that you thought that you could, again, produce somewhere between 10 and 14% loan growth in 2006. Just wanted to see if you can maybe give me a little bit more color there. And would that be exclusive of anything you do in terms of securitizing the Mepco loans?

The growth of 10% is based on -- as you know, of course, our four banks put together a budget for 2006. And during the year, especially in the last quarter, we added some originators. We also take a look at what's in the pipeline. And so to answer your question, we do believe that it is attainable to achieve 10% growth in loans. And that that is with the Mepco securitization in it.

So 10% on beyond what you might carve out of Mepco?

Yes. Because the Mepco transaction, the way we have designed is it would end up being an off-balance sheet transaction. So in effect, our loans would go down 150 million upon the completion of that transaction. So we expect a 10% growth taking into account that 150 million.

Okay. Now, Mike you mentioned originators. Are you thinking that this is going to be driven by all loan categories?

I would say, yes. The quick answer is, yes. We have added commercial lenders in one of our markets and then we are looking at adding, and have added real estate originators in the southeast market of Michigan.

Okay. And --

With that being said, I do want to point out, Brad, because the question's, I am sure, going to come up in a little bit and that is about the Michigan economy and how we are going to be able to achieve that type of growth in this economy. While I want to make it perfectly clear that we have spent a lot of time discussing the challenges ahead for Independent Bank Corporation, or any financial institution that is operating right now in this economic environment. What it is basically, what we are doing internally is we are saying, okay, we understand that it's a tough market. We have actually seen improvement, though, in Michigan in unemployment rates. And the concern we have is that we also have seen a tremendous amount of homes on the market that have extended as far as how long it takes those homes to move. I saw where there are eight homes on the market for every one buyer.

Real estate values are stable if not decreasing by about 3% statewide depending in which market. So this growth has to come, basically it has to come from rolling up our sleeves, getting out and making calls and getting new business. What we are not going to do is we are not going to maintain our same credit standards. We are actually tightening our credit standards. We are not going to get aggressive on home equity lending or any other type of real estate equity lending. This is not the time to put our borrowers at a 90% loan to value or higher. Or to make balloon mortgages or do a lot of real estate development with some one developer that is highly leveraged and doesn't have deep pockets. This is the type of market where prudent lending is the name of the game.

We have to apply tight credit standards. We have to control our asset quality. And with that being said, our banks still feel that based in the markets that we are operating in, they have the potential and the ability to experience a 10% growth in total loans outstanding.

Okay. Any thoughts on the funding side?

Well, the funding side is going to be a challenge as well. There is nothing easy in this industry right now, Brad. But I think on the funding side, we are going to really work at core deposit growth. But I think everyone that probably you would talk to in the banking industry would say the same thing, number one. Number two, it is always challenging on that front. We opened up about 26,000 new checking accounts in 2005 and had a growth of about 3.5% in our total number of outstanding checking accounts. And we are going to continue to try and work and execute on that. But that growth is not likely to keep up with the core or with the lending growth. And in addition, we are seeing some migration out of money market accounts into CDs because of just pricing opportunities where the CD, shorter term CD rates are higher. So that is probably going to continue into '06. So it is going to make funding a challenge. I think the Mepco securitization will help some there.

We are going to look at if there is other components of the portfolio that might lend itself to securitization as well. And we are going to continue to look at wholesale funding sources. We are seeing -- I think I saw something that said Michigan had the third highest retail deposit rates in the country. And we are seeing high rates being offered on retail CDs, 4.75 to 4.8% for like an eight month CD. And right now, we are seeing better opportunities in all-in pricing for brokered CDs. And we could raise our retail CD rates and bring more money in in that channel, but we think its all-in cost is likely to be higher than what we are seeing in the brokered CD market. And when all the dust settles, what we are mostly interested in is what is the most economical source of funding for us.

Brad, I would just like to add on that. We don't have any plans on becoming real competitive. We are going to stay competitive on our pricing, but we are not going to be the highest -- we won't have the highest rate for certificates of deposits in our market. It has been my experience if you obtain a relationship based on rate, your chances are you are going to lose the relationship based on rate. What we are going to spend a lot of time and emphasis on is continuing our treasury management services. We have had a lot of success in the area of treasury management in expanding the number of municipalities that currently do business with Independent Bank Corp. We have had success in southeast Michigan with Wealth Management. We want to expand that throughout the Company and in other markets. We are going to work with the front-line staff. We are spending a lot of time in 2006 emphasizing what we are calling "internal mining". We have an excellent customer base.

We have opportunities within our own customer base to expand the number of transactions or products and services per household. And we are going to be spending an awful amount of time on front-line training and support in order to have success in expanding the amount of products and services that our current customer base offers. What we don't want to do is put ourselves in a position where because of earnings pressure, we have to continue to raise the rates or fees to our current customers for the products and services they have or raise the rates on loans or lower the rates on deposits in order to achieve our earnings targets. That may work in the short-term, but it is not going to provide long-term relationship benefit. But what we are going to do is we are going to spend a lot of time at looking at expanding the relationship through our own customer base.

We have hundreds of thousands of names of customers. And we know exactly what products and services they currently have with us and what products and services, based on their life cycle, they could use. And so the last couple of years, I would say, we have been so busy in other areas that we haven't taken the time to concentrate on mining our own customer base and that's what we are going to spend a lot of time and emphasis on during 2006.

And Brad, one other thing that is likely to be finalized in the first half of 2006, not that it is huge dollars, but we are sweeping out of our deposit base and off-balance sheet about 30 to $35 million where we are sweeping out to an external money market fund and we are in the final stages of having an On-Balance-Sheet Sweep product where those balances then would remain in our deposit base. And one other comment I'd make about that is we have historically not really pushed hard to market the Sweep because it was going off balance sheet and now that we will have a product that will keep it on balance sheet, we are going to market that a lot harder as part of our treasury management services.

Okay, great. Thank you, I really appreciate it.

Once again, ladies and gentlemen, if you would like to ask a question, that is star, one on your telephone keypad now. Our next question comes from the line of Christopher Nolan of Oppenheimer & Co. Please proceed with your question.

Good afternoon.

Hi, Christopher.

Hi, Christopher.

Hi. Just a follow-up on the funding question. Looking at the fourth quarter balance sheet, it appears that the period-end balance for the fourth quarter non-interest bearing deposits as well as savings and now accounts, the balance has actually declined on a linked quarter basis. Is that characteristic of the overall quarter or is that sort of a period-end sort of phenomenon?

Well, it's -- that is concentrated predominantly in municipal deposits. We had $24 million decline in municipal deposits. There wasn't any loss of any customer relationships. It was just, I think, either needs that they had or some seasonal change in their balances. And then in addition to that, we had probably about another 10 million of some other large customer relationships where, again, it is just some seasonal changes. For example, we had about a $4 million decline in some title company deposit relationships. So those alone were about 34 million. And then the balance, as I mentioned earlier, would predominantly be within the savings and now category would probably be some shifts out of money market accounts, in particular into CDs.

Okay, so for 2006, since there is an emphasis on treasury products for municipalities, that will increase the exposure for these type of swings?

That's correct. The one positive is they tend to carry quite high balances. The other side of it is those balances are fairly cyclical. Now when they come down, they might be for a large county, for example, they might be coming down from 16 million at a high point down to 6 million at a low point. Something like that. So they still would retain fairly high balances, but they can have some pretty big swings.

Okay. Second question turns on to equity capital levels on the balance sheet. According to my calculation, the fourth quarter your tangible equity to assets was about 5.5%. In 2006, if there's an anticipation of incremental margin compression offset with increased volumes, do you anticipate that ratio going lower than that level?

5.5 is toward the lower end of the range we like to operate in. We generally like to operate in about a 5.5 to 6. We'd probably drop a little below 5.5 for some, maybe a short period of time. We do create capital at a pretty rapid rate because of our high return on equity. But I don't see that going down. Right now we are paying about 35% of our earnings out in dividends, so we are still creating a fair amount of capital. And we are just going to balance between growth in the balance sheet. We are authorized to purchase up to 750,000 shares, but we are going to kind of balance between what we are going to need in balance sheet growth to support balance sheet growth and what we are going to need if there is opportunities to do a share repurchase.

One other thing, and I mentioned it in the last conference call, is the Mepco securitization is likely to free up about 8 to $9 million of capital because it is going to come off balance sheet. We will get sales treatment when we do the securitization. So that will free up some capital. And then finally, with the amortization of other intangibles, we wouldn't expect to see the overall amount of intangibles between goodwill or other intangibles going up unless there is an acquisition. So I would expect the 5.5 to be stable or perhaps slightly increasing but not moving around dramatically from that level.

Right. And do you have a timing for the securitization?

We're, we think, on target for getting it done in the third quarter. If it gets too close to right at the end of that third quarter, in other words, if we are in the last couple of weeks of March, we will probably delay it into the first couple of weeks of April. It is just that it is a complex enough transaction on the accounting side of things that if it gets too close to the quarter end, we will probably shift it into early second quarter. But it will definitely occur between February 1 and April 30, I think.

For these type of loan securitizations, gain of sale accounting is used. What type of premium do you typically see in the market, if any?

Well, the issue there is we are doing, and I mentioned this last quarter, we are doing a $150 million securitization and Mepco has got now closing in on $400 million of loans. So there's still $250 million of loans that are not going to be sold via the securitization. We are not going to have sales treatment. What we would like to do, if we can from a structural standpoint, is tend to put the larger lower rate loans into the securitization to try to minimize the gain on sale. We have, because of having a $400 million portfolio only putting $150 million in, we have the ability to kind of select what initially goes into there. And so by selecting the loans with the lower yields, there's going to be a much lower gain on sale. We would expect the service fee within the securitization facility to be about 2%.

So hopefully, if the mix of loans is right, you will kind of see a swap where there will be a decline in net interest income, but it will be largely offset by an increase in service fee income. And we will also work to try and minimize the gain on sale by the selection of the loans that we do. So that's our hope in terms of an approach. And then two other comments. One is a lot of times securitization has got a bad name because of the gain on sale accounting in the residuals and trying to project what that is going to be. The one nice thing with finance receivables, or premium finance receivables, is they are very highly predictable. They have very short maturities, like I said, at least on the insurance premium finance side, generally nine to ten months. They have relatively low levels of prepayments and the cancellation rates are predictable.

So it's much easier to measure residuals and gain on sale than, say, a class of assets like home equity loans, where prepayments and default rates can change a lot. And then the second comment I would make is this $150 million securitization is going to be a revolver, so we are going to be continuedly shovelling new loans in as loans within the securitization facility get paid down. It's going to be a three-year revolver. So to the extent we do have gain on sale, while there will be maybe a blip up in the initial quarter we do it, and again we are going to try and minimize it by selecting the type of loans on an ongoing basis, we'll be putting new loans into the facility to keep it up at that $150 million level. So hopefully that kind of describes how it is going to work.

Great. Thank you for the details.

Yes.

Our next question comes from the line of Bryce Rowe of Stifel Nicolaus. Please proceed with your question.

Thanks. Hi, guys.

Hi, Brice.

A few questions. Rob, what is the average yield on the finance receivables portfolio right now?

Well, I'll break it into two pieces and I am doing this off of memory, so I could be off more than a couple basis points, but I will be in the ballpark.

Okay.

On the premium finance side it is in the 7s, it is in the 7 handle. And on the warranty side it is up in the 12 to 13% range.

Okay.

So those are -- and the portfolio is relatively balanced 50/50 between the payment plans that we offer on vehicle service contracts. And when I give you a yield there, there is no interest rate on those payment plans. The yield is really just us accreting discount for the difference between the amount of the payment plan, which might be, like I said in an example, $1600, and we fund it at $1400 and then you work out the numbers. If it is a 12 month payment plan, if you work it out at the high end we may have yields in 17% range. And then on some of our bigger customers, we might have yields more in the 10 or 11% range. So that's kind of the range of yields, but overall it blends out to about 12%. Next the area where we had the bigger price increase at year end, the finance receivables. We have been moving those prices up all along during 2005. And like I said the yield in that portfolio is in, I think, the mid-7s or so.

Okay. As far as the securitization gains go, will we see one likely every quarter as you guys revolve in and out?

Yes.

Okay.

You will see it every quarter, but like I said, ideally what we'd like to do is put receivables in where if you take kind of the blended rate of what's going in less the service fee, and then what the securitization facility cost is, that there won't be much excess, and then you take into account credit losses, which are low, like I said. Mepco had 11 basis points of credit losses in 2005 and 10 basis points in 2004. If we do that blend right, there won't be a lot of excess yield and we won't have a lot of gain on sale. The best example I could give is let's say the funding rate -- let's just use 475 and say the funding rate within the facility's 475, we have -- because we are going to continue to service loans, service the loans so Mepco is charging a service fee of 2%. So then we come up and say we need a gross rate of 675. You know if the loans -- and then let's say we use 15 basis points for credit, then you would be up to a 690 gross rate. If we could kind of blend the receivables so that what goes in there is around 690 to 7% blended rate, then you are going to have less gain on sale.

Okay.

So it really helps us, the vehicle really helps us to compete on the bigger loans. When you are getting up north of $1 million loans in the premium finance area, those spreads are really tight. So it is going to help us more getting those off balance sheet and so hopefully we can minimize the gain on sale.

Okay. Then two unrelated questions. The securities portfolio, where would you expect that to trend as a percentage of assets?

Down because right now, until the curve changes -- we literally have not bought -- I don't think we've bought -- I might be wrong, but I don't know that we bought an investment in six months. I feel bad for all the bond salesmen out there, but it's just tough. It is very tough to construct a trade today and recognize in our situation, we are fully lended out, so if we do a new investment, we have got to borrow money to do it. And you just cannot construct a trade that really makes sense unless you are taking credit risk, or interest rate risk, neither of which we want to do. As much as we love General Motors and Ford Motor, we are probably going to stay away from those bonds. Not probably, we will. But you would have to take a lot of credit risk or interest rate risk to get decent ROEs today and we just can't find that trade. So it's going to trend down. The drop you saw between '04 and '05 is -- you are likely to see that or more in '06.

Okay. So what kind of cash flow are you expecting off that securities portfolio next year?

Well, we were down -- I am assuming that -- I am not going to talk about the interest side of things, but we could -- and that's another good point. Someone asked about funding the growth in loans. I would suspect you are going to see maybe 50 to 75 million coming in off of that portfolio that can be used to grow loans. So that takes a little pressure off in terms of a funding source.

Okay. That makes sense and then final question related to the allowance. You talked about possibly getting back to a normalized charge-off range of 20 to 30 basis points, and given where the allowance is as a percentage of loans, should we expect that level to trend down even lower as charge-offs stay in that normal level?

I would say probably not. I went through the four components of the allowance, and for us one component is specific allowances on loans, okay. That went down because we got rid of 11 million and change of problem loans. So that component went down. We don't have a whole bunch of specific allowances remaining because we don't have a lot of loans remaining in that category that requires specific allowances. So that's hard to predict because it really depends. Most of those will generally be commercial loans where we are doing a FAS 114 impairment analysis. So that's typically where you are going to see that. The second component is based on other adversely rated loans and I kind of gave you totals for what -- I don't like to use term "watch list" because I don't know how other banks define "watch list". What I did is I told you here is what our 7 and higher rated loan totals were. That's down $10 million. So depending on that particular component, depending on the balances of those loans, I don't see that necessarily trending down.

The third component is likely the trend up, which is that component based on historical allocations and part of the reason that is going to trend up is even though the most current year is weighted the most, if we ran another 20, 30 -- if we ran at the higher end of the 30 basis points of that range I said, 20 to 30 basis point in '06, if we ran at the higher range there, that is going to push the allowance up. If we stay at around 20 to 22 basis points, I would suspect we are going to stay around the 90 basis point level. And then the last portion is the subjective portion which doesn't move around that much. That will trend up a little bit based on size of portfolio, maybe a little bit, or macroeconomic items, but it doesn't move around very much. So I don't see a scenario where the 90 is going to come down. I just think given our current portfolio mix, it would take more time for -- we'd have to have much lower net charge-offs over an extended period for that to come off much off 90 basis points.

Okay. I appreciate the detail.

Yes.

We have a follow-up question coming from the line of Kenneth James of FTN Midwest Securities. Please proceed with your question.

Hi, I just had a quick follow-up on the expenses, particularly as it relates to FAS 123. In the last regulatory filing you said that that expense was going to run $0.05 to $0.08 a year. At $0.05 that is about half of the projected 3% increase in expenses you are looking for and if it is at the high end that is most of it. Is that factored into your expense outlook and does that mean the rest of the expenses are just going to pretty much be flat?

One, it is included in our outlook or the outlook I provided on operating expenses. It is included. In the $0.05 to $0.08 per share range that we included, and you are referring that was in our last 10Q, that was based on if we continue to do options based on our historical level of issuances of options. We actually expect to dis-- and it is ultimately up to our Board of Directors, but we expect to discontinue the use of stock options in '06 and move to some other form of award. And in doing that, we think that recipients place a lower value on a stock option, which only has an intrinsic value or binomial or black shoals value and no cash value whatsoever. There is no certainty that the stock option will have any value. We think that the recipient places less value on the stock option compared to what FAS 123R requires you to expense. So our view is we can have a lower level of some other form of award that is more certain in nature. And so we would expect that to be perhaps a little bit lower. So maybe more like a $0.04 or something than that $0.05 to $0.08 range. That's where we would anticipate things going in '06.

The other comment is between incentive compensation and our ESOP contribution, there is a fair amount of variable expense. And if we don't achieve earnings per share growth targets, the entire ESOP contribution and all the incentive compensation would go away. So, now we assume in the numbers that I talked about, just north of 3% growth in operating expenses, that we do have some form of achievement that results in incentive payments, but that's the wild card that we always are working with.

Okay.

Does that answer your question, Kevin?

Yes, that clarifies it quite a bit, thank you.

Mr. Magee, there are no further questions in queue at this time.

Okay. Well, thank you. On behalf of Rob and myself, we would like to thank everyone for participating today and also to wish everyone a very happy and prosperous 2006. And thank you for your support. We look forward to speaking with everyone in the future, thank you.

Ladies and gentlemen, this concludes today's teleconference. We thank you for your participation and you may disconnect your lines at this time.