Independent Bank Corp (Michigan) (IBCP) 2006 Q2 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Independent Bank Corporation first quarters 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 key pad. As a reminder, this conference is being recorded.

This webcast may contain forward-looking statements as defined in Section 27A-I1 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 the 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 and contemplated by or underlying the forward-looking statements. In light of these risks and uncertainties there can be no assurance that the forward-looking sta -- information will be proved to be accurate. This webcast does not constitute an offer to purchase any securities nor a solicitation of proxies, consent, authorization or agent desi -- destination with respect at a meeting of companies 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. This is the second quarter earnings conference call. Good afternoon and we are pleased that you could join us on our conference call to discuss the second quarter 2006 results. Earlier today we reported second quarter 2006 net income of $10.6 million, which was down $1.5 million, or 12.6%, from the second quarter of 2005. Our diluted earnings per share, $0.48 this quarter, were down 9.4%, from the year ago comparative quarterly earnings per share of $0.53. A few items that aver -- adversely impacted the quarterly comparison included a $600,000 goodwill impairment charge in the second quarter of 2006 and a $1.1 million decline in securities gains. While the quarter was respectable in general banking terms. IBC did not meet the standards it sets for itself. However, we remain optimistic that our performance will improve and are taking a variety of steps in this regard that I will outline later in this call.

Net interest income declined on both a comparative and linked quarter basis. Rob Shuster, our Chief Financial Officer, will discuss our net interest margin in greater detail during his remarks. But I do want to emphasize that the decline in net interest income was entirely in our insurance premium finance business. Our bank's actually achieved a $500,000 increase in net interest income on a comparatively quarterly basis despite margin pressures. Additionally, we did see some stabilization of Mepco's net interest income in the last month of the second quarter and remain optimistic that once the Fed interest rate tightening cycle ends Mepco's margins will begin to improve. Although non-performing loans rose a bit during the second quarter of 2006, we believe that two of our largest non-performing commercial loans are likely to be cured in the third quarter, one by pay-off and the other by refinance with a new borrower. Rob will now provide some additional details on the second quarter results.

Good afternoon everyone. Mike covered the details for the quarter and I will provide -- or Mike covered the highlights for the quarter and I will provide additional details on net interest income in our margin, certain components of net interest income and non-interest expense and asset quality. Tax equivalent net interest income totaled $35.1 million in the second quarter of 2006, which was down $965,000, or 2.7%, on a comparative quarterly basis and down $174,000, or 0.5% on a linked quarter basis. The decrease in the comparative quarterly tax equivalent net interest income was due to a 42 basis point decline in our net interest margin to 4.47% from 4.89%. Partially offsetting this was a $194 million increase in the average interest earning assets primarily as a result of growth in all categories of loans. The decrease in linked quarter tax equivalent net interest income was primarily due to a 12 basis point decline in our net interest margin. Partially offsetting the margin decline was a rise in average interest earning assets which increased by $43 million due to growth in loans. The increase in loans was partially offset by a decline in the average balance of investments securities. As I have mentioned in recent prior conference calls the decline in investment securities reflects the difficulty in replacing the pay down or maturing or existing investments with new trades that meet our risk and return objectives given the flat yield curve environment.

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. During the second quarter of 2006 we experienced a decline of $28.2 million in the average balance of NOW, savings and money market accounts compared to the first quarter. We believe this decline is due in part to customers moving money into higher yielding financial instruments such certificates of deposit. The shift out of these lower costing accounts adversely impacted our margin by about three basis points in the second quarter of 2006.

Finally, as Mike mentioned, the dollar declines in our net interest income have occur -- have occurred in our insurance premium financing business. Mepco's net interest income was down by about $1.5 million on a comparative quarterly basis and down by $367,000 on a linked quarter basis. Although we have optimistic that Mepco's margins will stabilize and begin to improve once the Fed tightening cycle ends we are reviewing various strategies to improve the margin including whether shrinking their balance sheet and jettising certain business would allow for a better deployment of capital.

At this time I would also like to update you on the securitization of finance receivables. As you know we have been talking about the securitization of 150 million in finance receivables for about a year. Our primary objectives from the outset were to obtain true sales treatment from a legal and accounting perspective and a securitization structure that provides sufficient capital relief so that the end result would be neutral on our earnings per share. For some period of time we have been running into difficulty with one rating agency in obtaining the structure that we needed with the eligible receivable concentration levels that we felt were fair and appropriate. Recently we have made significant progress on this particular issue and I believe we are back on track for a closing prior to our next conference call.

Loan growth did slow to 5.8% on an annualized basis in the second quarter of 2006 from 9.3% in the first quarter. We believe this reflects both economic and pricing conditions as well as some pay-offs of a few large credits in our commercial loan portfolio. Based on feedback from our banks and their commercial lenders along with the additions we have made in the Muskegon, Michigan, market, we remain optimistic about future loan growth despite the slower growth rate experienced in the second quarter. For the balance of 2006 and excluding the impact of the potential securitization of finance receivables, we are anticipating loan growth just slightly above 10% on an annualized basis.

Moving on to non-interest income, service charges on deposit accounts were down slightly on a comparative quarterly basis and were up $563,000 on a linked quarter basis. The linked quarter quarter change does take into account a $226,000 reclassification to the first quarter between service charges on deposits and other non-interest expenses. Prior to the second quarter of 2006, recoveries of previously charged off NSF fees were recorded as a reduction of other operating expenses. Now they are included as part of service charges on deposits and all prior period numbers have been adjusted to reflect this reclassification. Visa check card interchange income was up 27.2% on a comparative quarterly basis and up 10.1% on a linked quarter reflecting a rise in debit card usage.

Gains on real estate mortgage loans declined on a comparative quarterly basis due to a decrease in the volume of loans sold. These gains were up slightly on a linked quarter basis. We anticipate that conditions will remain competitive in the mortgage banking sector and expect that mortgage loan origination and sales volumes will remain somewhat subdued. Real estate mortgage loans servicing income was up $447,000 on a comparative quarterly basis and relatively flat on a linked quarter basis. These variance primarily reflect changes in the impairment reserve on and amortization of capitalized originated mortgage loan servicing rights. During the second quarter of 2005 we had a $285,000 impairment charge. Excluding changes in the impairment reserve we would expect real estate mortgage loan servicing income to run at about 550,000 to $650,000 on a quarterly basis for the remainder of 2006. Although manufactured home loan origination fees and commissions were up slightly on a linked quarter basis they remain well below 2005 levels and well below levels from a few years ago.

We bought First Home Financial in 1998. This company which is based in Grand Rapids, Michigan specializes in the financing of manufactured homes located in mobile home parks or mobile home communities. Their revenues have been adversely impacted by many factors including relatively low mortgage loan rates that have made traditional homes more affordable, a multitude of programs now available for first time home buyers, more stringent underwriting criteria from the buyers of mobile home paper that has reduced the number of people qualifying for these loans and, finally, regulatory changes that have reduced the ability to generate insurance revenues on the loans that we do originate. We test goodwill for impairment and based on the recent further declines in revenues at First Home Financial and evaluation completed by a third party, we determined that the goodwill associated with this acquisition was impaired and that an impairment charge of $612,000 was necessary, leaving remaining goodwill associated with this acquisition of $897,000. As we pointed out in this morning's earnings release, this impairment charge is not deductible for income taxes and thus this expense was not tax affected.

Excluding the aforementioned goodwill impairment charge, non-interest expense totaled $26.2 million in the second quarter of 2006, which is fairly comparable to the second quarter of '05. Mike will discuss some additional cost saves that we have recently implemented in his closing remarks as well as the reduction in the accrual for performance based compensation that we outlined in our earnings release. Also. I want -- wanted to reiterate that included in occupancy expense in each of the first two quarters of 2006 is an additional $240,000 of depreciation expense on the old main office building of First National Bank of Gaylord which we acquired in mid 2004. We made a decision in late 2005 to raise the old main office building and replace it with a more functional branch facility and we were writing off the remaining book balance on an accelerated basis which we completed as of the end end of June, 2006. Our assessment of the allowance for loan losses resulted in a provision for loan losses of $2.7 million in the second quarter of '06 which was slightly higher than the second quarter of '05 but $1.1 million higher than the linked quarter.

I'm going to go over some detail on non-performing loans, net charge-offs and the allowance for loan losses. Non-performing loans increased by $6.1 million to $24.1 million, or 0.91%, of total portfolio loans at June 30 of '06 when compared to the end of '05. This increase is primarily due to the addition of two commercial credits that I discussed in last quarters conference call. The first is a $3.6 million loan secured by a low, moderate income apartment complex located in Port Huron, Michigan, that we have again discussed in previous conference calls. This borrower group is the same as that involved in the two loans that we sold in the fourth quarter of '05. This is our last lending relationship with this borrower group and a new general partner was just appointed manage this property. We have initiated the foreclosure process on this credit. We also established a specific reserve on this loan of $324,000 in the second quarter as we have agreed to accept a pay off at $0.91 on the dollar from the syndicator of the tax credits on this project. We expect this pay off to occur before the ends of the third quarter.

The second loan is for $1.5 million and is secured by Vacant Land in Lansing, Michigan. A sale of this property is still pending the clearance of some subordinate liens which we expect to be resolved before the ends of the third quarter.

Moving on to net loan charge-offs, they totaled $1.8 million in the second quarter of 2006, or 0.27% of average portfolio loans which is fairly comparable to the second quarter of 2005's total of $1.5 million, or 0.26% of average portfolio loans. However, net loan charge-offs did rise compared to the first quarter of 2006. Most of this increase was in the mortgage loan charge off area. We discovered five mortgage loans that involved fraud on the part of a developer, a title company and an appraiser. This scheme has impacted several financial institutions doing business in southeastern Michigan. Second quarter charge-offs include $543,000 related to these loans. We do have real borrowers and recorded security interests in undeveloped lots but the lots were over valued and our charge-offs reflect current liquidation values. We are pursuing legal remedies and hope to recover our losses in the future.

Our allowance for loan losses rose to $24.5 million, or 0.92% of portfolio loans at June 30, 2006, compared to $23 million, or 0.90% of portfolio loans at December 31 of '05. An analysis of the components of the allowances is as follows: the portion of the allowance allocated to specific loans increased by $627,000 since December 31 of '05 due primarily to reserves added for two commercial loans. The portion of the allowance allocated to other adversely rated loans declined by $200,000 since year-end 2005. As I've mentioned in prior conference calls we utilize a 12-point loan classification system with one being the best and 12 being the worst. In the total of loans rated seven or higher which some might call watch credits was approximately $78 million at June 30, 2006, compared to $76 million at March 31 of '06, and $78 million at December 31 of '05. The portion of the allowance related to historical losses increased by $600,000 since year end, 2005, due primarily to loan growth and a rise in the level of net loan charge-offs in the second quarter of 2006. We utilize a 10-year rolling average in calculating this component of our allowance with the most recent 24 month period weighted the highest. And finally the subjective or unallocated portion of our allowance increased by $420,000 since year end '05 due primarily to concerns about economic conditions in Michigan.

We did not repurchase any common stock in the second quarter of 2006 after having repurchased 340,000 shares at an average price of $26.99 per share during the first quarter. As previously announced we are currently authorized to repurchase up to 750,000 shares during all of 2006. Stockholders equity rose to $256.5 million at June 30, 2006, and tangible net book value increased to $8.75 per share which represents an11.9% annualized growth rate since year end 2005. This concludes my remarks and I would now like to turn the call back over to Mike Magee.

Thank you, Rob. Before we open the call up to questions I want to make some closing remarks regarding this quarter and the balance of 2006. As noted earlier it was necessary for us to reserve part of the accrual for incentive compensation in ESOP. This impacts many employees throughout our organization. Since IBC sets high standards for incentive compensation the management team and employees have been and are working diligently to the get the Company's levels back to what our shareholders expect. Extremely tough -- tough decisions have been and will continue to be made. This is the same management team that last year ranked 18th in profitability based on ROE for banks over $3 billion in size in the United States.

We all share a common objective to improve the Company's performance over the balance of this year and beyond. Accordingly we continue to pursue several actions designed to improve our performance. As mentioned in last quarters conference call we are placing significant emphasis on containing non-interest expenses. Just two weeks ago we recently implemented several cost reductions and taken additional steps in the mortgage banking operation area. As a result of which we reduced staffing levels that will lead to approximately $1 million in annual cost savings.

I also feel that it's extremely important for Independent Bank Corporation's franchise value to add customers. Since year-end 2005 Independent Bank Corporation has had a net gain in customers of 4,500. Some of our profit enhancement opportunities needed prior customer notification. That has taken place and we will see the full benefit this quarter and beyond. We have added talent in our Muskegon market with the addition of Jose Infante to increase customer share there along with we've added other proven commercial and mortgage originators throughout the state.

Although these times are difficult to go through we believe this is a time of opportunity. When the economy picks up and the yield curve steepens IBC's balance sheet and staff will be in a position to benefit. I would now like to open the call up for any questions that you may have.

Thank you. (OPERATOR INSTRUCTIONS) Our first question comes from Stephen Gund with Stifel Nicolaus. Please proceed with your question.

Thank you. There was no performance based accrual for the quarter. Can you just kind of go into some detail under what circumstances that would kick in?

Sure. There is various performance targets that are based predominantly on earnings per share goals and is -- we announced in the earnings release we reversed about 1.2 million -- it was actually 1,150,000 of performance based compensation based on the performance year-to-day versus the goals that have been established. You can look and say probably half of that amount really related to the first quarter and then half of that amount related to the second quarter because it was kind of a year-to-date adjustment of the performance based accrual. And I don't want to go into the specific targets that have been established but we -- and this is outlined in our proxy statement, usually have a minimum and maximum tier and then within that there's sort of a ratable amount that -- that can be earned for incentive based compensation and it affects all components of incentive based compensation, the plan which includes both the Company's contribution to our employee stock ownership plan, cash bonuses and equity based awards are all -- are all impacted by it. So looking ahead the -- the level of that accrual going forward is going to be somewhat dependent on -- on the performance of the Company over the balance of the -- the last six months of the year.

Okay. And one other question. The securitization you said you anticipated to do close in Q3.

I said before the next earnings conference call which is probably into the latter part of October.

And just for my clarifi -- clarification you expect no impact to earnings, did I hear you correctly?

Well, that has been our goal from the outset. The -- the -- the cost of the securitization in terms of the kind of the borrowing cost associated with it is actually somewhat higher than what we can internally fund the receivables but we can more than make it up by getting true sales treatment so that the receivables that get sold into this special purpose entity come off the balance sheet. They're actually treated as being sold and that will free up capital and then we could redeploy that capital either through share repurchases or in some other fashion and more than make up the decline related to just the kind of the funding cost of the facilities. So the structure in getting that capital relief is really the key and as I said in my comments that's what we've been really working on over these last several months is trying to balance the definition of what's an eligible receivable and what concentration limits the rating agencies will permit to get the kind of ratings and structure that we want. And recently we've had some, I guess I call them, breakthroughs on that front so that I'm now feeling that we're back on track to get this thing closed.

Thank you.

Our next question comes from Jeremy Steele with Lansing State Journal. Please proceed with your question.

Good afternoon. I just wondered if you could comment on differences in business activities across the various regions of the state and kind of what your outlook is there for the remaining part of the year?

Good question, Jeremy. Since you are from the Lansing State Journal how about if I start there?

That'd be fantastic.

We actually are hoping for with the new plant being built we're hoping for a little bit of a recovery in the Lansing market. However, our budgeting for that area to be more or less flat. Real estate values have gone down a little but I would say overall they -- they have stabilized. We're seeing still some new construction development in that area but we're watching closely commercial real estate values since there seems to be a lot of vacancy.

The -- southeast Michigan of course is having a negative impact from the auto industry. Housing starts, I shared this information with Rob yesterday, our president down there shared some statistics in the counties in southeast Michigan which would be the Detroit area, Oakland County, Macomb, are down anywhere from 38 to 52% so far this year -- housing start applications. There's a -- there's -- they also shared with me there are 70,000 homes in those counties currently listed for sale. So it only makes sense that you wouldn't add any inventory to the already excessive inventory that's available. We have seen a decrease in real estate values in the southeast section of the state. We have had since -- we acquired Midwest Guarantee in Oakland County. They were a commercial bank and had very little in the area of residential real estate mortgages in their portfolio. We've been trying to build that portfolio and add mortgage originators but we have -- we're proceeding extremely cautiously at looking at real estate values, as Rob pointed out in his comments that was the area we experienced some mortgage fraud. And that whole area has experienced quite a bit of mortgage fraud. So we proceed cautiously in southeast Michigan.

From Bay City north, the northern area of the state seems to be doing very well. I think a lot of that has to do with second homes. It's holding its own as far as real estate value and if you get into real popular resort areas or lake frontage property you'll actually see some appreciation.

West Michigan has actually seen a bit of a bounce back from the recovery of the furniture business. And things seem to be picking up. And you will see some development taking place both in the area of commercial and residential in western Michigan. Matter of fact Muskegon itself is one of the fastest growing cities right now in Michigan. So I hope that helps you Jeremy, but we - we are very concerned about the economy overall and we feel it's going to take a little while before we see a recovery in Michigan.

Thank you.

Our next question comes from Christopher Nolan with Oppenheimer & Company. Please proceed with your question.

Good afternoon.

Hi there, Chris.

The issues at Mepco in the quarter effecting net new interest income growth came from the insurance finance --

It really came from both, when I said insurance premium financing I was really using as a generic term. It probably actually came more from the warranty side of the business but it also came from the premium financing side where there's been fairly strong competitive conditions both from the standpoint that probably for the last 12 months or so we've been in what we call a soft market where renewals on premiums have actually been coming down. So if you kept the same number of the customers you might see your volumes come down just because they're getting lower insurance premium quotes on their -- on the -- the next year's business. So that's kind of affected volumes and then particularly on the larger deals, the price competition has been fairly pitched and spreads have really been -- been squeezed on that side. So I really meant the term more generically, Christopher, not to try to divide between the warranty side of the business and the premium financing side.

Great. Rob, are you seeing, I understand where volume is coming down just from a soft market but are you also seeing tighter lending spreads? And the market people offering finance -- this type of financing at lower rates than previously?

What you're really seeing is a lag between the Fed moving up rates on the cost of funds side and the lenders in that business moving up prices. And so I think once the tightening cycle ends and hopefully -- that that's not in the too distant future I think things will stabilize and then hopefully you start to see a little bit of rebound in terms of margins there as people kind of catch up. I think what's happened is because you're in a soft market everyone's fighting for market share and then you combine that with the Fed continually pushing up short term rates. You have a lot of competition particularly on larger deals which is really squeezed down the margins. But I do think that when the tightening cycle ends you won't have the push from the bottom and things will start to catch up a little bit on the top end.

I certainly don't see it getting back to the levels that we enjoyed in the latter -- latter part of '04 and into '05 when that -- that short term steep curve was really -- as good an environment as you can get. So you kind of had at least for a couple of years you had a harder market where premiums were going up plus you had a steep curve and that was probably as good a conditions -- it's kind of like the mortgage banking business back in 2003. I mean it was just about as good as it was going to get and now we are kind of going through a cycle where it's very difficult. And I guess I'd -- I'd point out the mortgage banking business is not a business where -- where most people are making a significant amount of money either. Volumes have come down. You try to adjust your costs accordingly so I think it's just a cycle that we're working through and again when the Fed tightening stops I think margins will start to come back there.

Rob, finally the first quarter Q mentions that some key personnel left from the warranty finance division of Mepco,.

That's correct.

Could you give a little color as to what the impact that has had on terms of the performance of the business?

Well, it's not helped the business from the margin standpoint. It added another competitive entity out there. I mean there is competition in that business. It's not a business that we solely have to ourself. Certainly this added more challenges because it was people that were knowledgeable about our business and customers and that type of thing. To date we haven't experienced any significant loss of customers or business. And I think what it has caused us to do is maybe be more judicious in terms of pricing changes and other changes to try and make sure we don't push - push someone away. The business I think still is a good margin business and again I think over time once the Fed tightening cycle stops I think that'll -- that'll help on that business as well. But we haven't had any significant customer loss but it's -- it's made it tougher on the pricing side.

Okay. Thank you.

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

Hi, good afternoon.

Hi, Brad.

Hey, Rob, just quickly again on Mepco, I guess I'm wondering sort of what your thoughts are, why you kind of think that the business will get better when the Fed stops? My assumption is that business is going to stay competitive just because it typically does come with higher yields than -- than a traditional banking business. And then -- in particular the factor that you're very well secured with the -- with the insurance premium behind the loan. So I'm just wondering in your mind what -- what -- why you feel that that's going to become a better business when the Fed stops?

I guess I'd say two things. One is I just think eventually people will catch up on the pricing side. Most of the -- the players in that industry -- we all have essentially very similar cost of funds. So it all is -- it's partially a relationship business, certainly on the larger transactions, that's where the pricing becomes more -- more competitive. But I just think once that stops things will kind of get caught up where the -- right now it's this kind of cycle where the Fed moves and then it's six or seven weeks and then people start moving rates up but then the Fed comes in with another -- with another upward move. So it's kind of like they are always lagging a little bit behind whether it's one or two price increases from the Fed and I think once that cycle stops things will sort of -- everyone will kind of get back to the point where some of the spreads are returned. I could be wrong but I just have that -- that sense in terms of kind of the feedback you get from the sales force and the like. So that's one element.

And then a second element and I mention this in my -- in my comments is we're -- we're looking through and reviewing the business in the sense that perhaps there's some business we need to exit because the returns on capital aren't -- aren't as good as we feel they need to be. And I think that's what we are kind of -- of looking through. I mean, we may be able to be somewhat smaller there and yet free up enough capital so that our returns actually improve and the profitability in terms of the deployment of capital in that business gets better. So again that's another aspect of it we're looking at. And in -- in particular there but the larger transactions are where the spreads are -- are very narrow and -- and maybe that's an area, for example, we -- we look at and say we're not as -- we're not going to be as competitive there. If we could book the business at the margins we want, great. If we can't, we'll shrink some and free up capital and we'll redeploy that at a higher -- at a higher return. So that's the kind of process that this has -- has really caused us to start working through and I guess those would be the two main reasons why I think we can get some improved returns there out in the future.

Okay. Good enough. In terms of the -- the remainder of the year, it sounds to me like your margins are going to remained under pressure, your expenses are likely to be flat, it sounds like Mike mentioned some things you are going to get some relief on. How much -- how much potential do you think there is for a lower level of loan loss provisioning sort of in the back half of the year or even a higher level if some of your comments about deteriorating conditions, et cetera, using -- giving 2005 a heavier weight in terms of how you're looking at the reserve? I guess I'm just trying to get a sense of what the opportunities are in the second half of the year.

As mentioned earlier, Brad, we -- we just implemented another round of cost saves. I did mention some smaller ones such as we -- we also looked at some operations areas and commercial loan areas and we were able to also eliminate another $150,000 in those two areas. The -- the strategies that we shared with you last month on profit enhancements mainly in the area of service charges on deposits and an increase in fees on ATM transactions, those required prior customer notification. The ATM fee enhancements didn't actually get implemented until the middle of May and the service charges on deposits we were able to implement those on July 1. We, of course, hope not to experience any additional fraud within our portfolios. So if we can eliminate that in the -- in the future that will help in the amount that we will have to add to the provision. What rob mentioned in his remarks, what does go against us is that when we increase losses let's take the fraud loans as an example even though the fraud loans themselves were between 5 or $600,000,our provision, because of having to charge off, or write down, those loans that increased our historical number which made us add another 100 and some odd thousand to the reserve just because our historical went up. So it's not really dollar for dollar when you have a large charge off like that. You actually end up charging more.

We spent an awful lot of time looking at our portfolio and having meetings with all four banks and looking at their commercial credits. All of those that are rated, as Rob mentioned we have a rating system, all those rated seven or higher. And take a good look at those to find out, okay, which one of these could possibly explode on us and create additional losses. At this point while there's always a possibility we don't anticipate any -- any large problems in the portfolio. And we also have implemented a department that has started working on recovering charge-offs especially if you remember we acquired First National Bank of Gaylord and prior to us acquiring them they had millions of dollars of loans that they either charged off or written down. And we are starting to experience quite a bit of success of recovery now previous charged off loans and so that will of course help the net charge-offs.

So I guess the answer to your question, we also have implement a program to increase the usage of debit cards and especially the -- the Visa check card. Every time our customers use their debit card as a Visa credit, that generates interchange fee for our corporation and as you can see on a linked quarter basis and compared to last year that increases our income substantially. We have a campaign that's going to be taking place here beginning in the middle of the third quarter and into the fourth quarter to increase that usage. As mentioned, we won't have the -- the write down of the Gaylord building going forward that we had the first two quarters of this year. So I believe there are quite a few positive things in our future, Brad, but there's always the unknown that keeps us up at night. But at this point I am extremely optimistic about -- about the way things should go in the future.

Okay. Two quick questions and I'll step back. One, has -- has the environment changed your branching plans for the year? And then secondly, Rob, how aggressively do you think you'll manage the buy back over the second half of the year? Thanks.

Why don't you take the branches.

Okay, I'll talk about the branches. We, as mentioned earlier, we've added Jose Infante in the Muskegon market. We've converted that branch from a loan production office to a full service office. We also conducted a -- we hired an individual to conduct a study for us in that market to add a couple of branches. We also are about ready to break grounds on a new branch in Shelby, Michigan. We just opened the operations, or administration office I should say, in East Lansing which also has banking capabilities. But at this point we are looking more at branch opportunities for 2007 and that kind of covers what we have planned for 2006.

In terms of share repurchase, as I had said, Brad, we're on the sideline during the second quarter. We still have a fair amount of stock remaining authorized under our buy back plan, roughly 410,000 shares, and I think we would view weakness in our stock price as a good opportunity to repurchase stock. So we're going to kind of balance that opportunity with -- with any opportunities that might arise on the M&A side that would cause us to want to conserve capital at least for a period of time but certainly if the stock price is weak we would view that as a great opportunity.

Okay. Thank you.

(OPERATOR INSTRUCTIONS) Our next question comes from Jason Werner with Howe Barnes Investments. Please proceed with your question.

Hi, guys.

IHi Jason.

Just wanted to ask a question about loan growth. I think, Rob, that you had said that you were looking for a hair north of 10% annualized for the second half.

That's correct.

Okay. And then what -- what types of loans and where are you seeing that growth from geographically?

Well, we're seeing the growth geographically probably a little bit more on the west side of the state than the east side of the state. I think it's a combination of, as Mike mentioned, adding Jose Infante in the Muskegon market. We've also brought over a commercial lender from there and added some others in -- in greater west Michigan. We've had some additions in the Lansing area. So just based on the feedback that I've been getting from the commercial lenders and -- and what we are looking at in way of pipeline I would -- I would hope that we have a pretty strong growth on the commercial side. Of course you never know if you get a pay-off that could offset some of the growth but that would be one area.

The other area we're seeing pretty good demand on is installment loans. On the installment loan side we're seeing good growth particularly in second mortgages. I think that -- what that reflects is the fact that conventional mortgage rates have moved up so you can't now refinance and take cash out by refinancing a first mortgage. So we're seeing -- and I think you saw it in the numbers if you look at the installment loan line item in the balance sheet we're seeing good growth across the board, across all of our branches in installment loans.

And then probability lastly on the mortgage side, and this is a business we don't talk a lot about, but in third -- in terms of our fractional business which is where we're lending on people buying fractional interests in resort properties, we have some projects coming on line during the course of the second half and expect to hopefully see some -- some good growth on that side of the business. So I'd say those would be the main drivers would be on the installment side, second mortgages in particular, some -- a little bit maybe on the home equity side but mostly on the term second mortgages and then in the fractional area that would increase residential mortgage lending and then finally probably the biggest growth on the commercial side.

How big is that fractional business you're doing right now?

We've got a portfolio of probably about 130 or $40 million. And we built that up over probably the course of 13 or 14 years. So we've been at it a long time. I would say our -- our volume ranges from probably 10 to 12 million on a slow year, up to maybe 30 million on a bigger year. So it's not glowing to drive huge amounts of growth. But like I said we've got some new projects coming on line that -- it could come in waves where you get a couple new projects on line and then you start to see a flurry of activity and then you could go a few months with very little activity until you get some new -- some additional projects on line.

Okay. And looking at Mepco, if you just kind of set aside the securitization and the potential to maybe get out certain types of transactions if you try to pull back on the larger transactions I just what to get a sense of what the organic growth might be, what do you see in terms of that? Is that going to tick up or what's your thoughts there?

And you can see from the start of the year we went from 368 million to 411 million and -- and a -- a -- a fair amount of that growth was in the first quarter. On the premium finance side the first quarter is the best quarter typically because a lot of your insurance policies are calendar year policies so what's happening there is the company is buying the insurance toward the end of the year and then we're funding the loan or funding the policies in January and February. So those tend to be the best two months but we -- we've -- for the first six months had a growth rate of about 23% on an annualized basis. Now that slowed in the second quarter more because of those seasonal factors but I would -- i would guess absent the -- the securitization unless margins improve what we're more likely to see is that business maybe decline, those balances decline rather than go up because what we really concentrate on is we have to -- those are 100% risk weighted assets.

So you could look and say that's -- you have to maintain 10% plus capital. So we're -- we're looking at the various segments of that business and as I said on a previous answer there may be some segments where we say the returns on capital because of the pricing in margins are -- are just not adequate and we're better served by freeing up that capital and either repurchasing stock or deploying it -- deploying it elsewhere. And I think that's the exercise we'll go through. So to me if we get growth there it's going to have to be at returns that are acceptable and given the conditions right now I think that's going to be tough to find. So that business may be more likely to decline a little bit than grow but I think it's going to be-- we'll end up with -- with a more profitable business and free up capital that we could deploy better elsewhere.

So what you're saying then is for example instead of getting out of, avoiding kind of larger transactions and making that up in volume in smaller transactions you would just redeploy that somewhere -- that capital somewhere else altogether. You would just like avoid the larger transactions and then try to ger more smaller ones?

If for example if -- you're finding your returns on your allocated capital are -- are single digit on -- or -- or single digit type returns -- and you have to be a little bit careful that you've got a certain level of fixed costs. So you got to take that into account as well because you're not going to be able to reduce a few loans and -- and have a lot less in costs. So you got to take all that into account as well. But what I'm suggesting is, particularly on maybe larger transactions where the spreads to LIBOR are extremely tight, you just -- you say that business is not as profitable as we feel it needs to be and you don't compete for that and then you deploy that capital elsewhere, whether it's buying back stock or -- or some other opportunity that produces higher returns for us.

Okay. Last question. Regarding credit quality. It sounds like you have credits that could get resolved in the third quarter. And if I understood your comments it sounds like your watch list has been relatively stable so far this year. And, if also I understand it, provision comments that you made the actual ratings improved, because you had to -- you reduced your allocation for that part of it. I guess my question is, if you use a two credit cured that drops around DA's, what's your outlook for the rest of the year? Is there -- is there anything on the watch list that looks like it might be coming on to NPA or is it -- do you think that you can hold that line at a reduced level?

That's what we're just trying mightily to do is hold that line. Again, on that one -- the largest credit, the 3.6 million, we've agreed to a pay off at $0.91 on the dollar and we're -- we're waiting for the -- the tax indicator and the new general partner to -- to complete their financing and -- and pay us off. That obviously would eliminate our single largest non-performer. We've got a specific reserve on it and so that would help. There's a few other credits where we have specific reserves that we're hopeful we may get and some of them are not non-performing but because of their rating and our analysis they have reserves on them and -- and we would be hopeful that those -- those get -- those get cured. But we've -- we've kind of been in a cycle at least the last several quarters where we -- we get -- we get some cured and then there's a new one that pops up and that's what's very difficult to project. Like Mike said, we've combed through that -- that list and it has stayed relatively stable.

We went 78 million to 76 million to 78 million on the seven and higher rated credits and it's something going to pop out of there or you can always have although it's not been our historical experience you can have something unravel quickly that's a higher rated credit that -- that you just don't have an expectation of it. Usually it doesn't happen that way. Usually you start to see it fraying at the edges. The debt service ratio start to deteriorate. Occupancy rates go down, whatever the type of credit is you see it kind of in advance. But this is an economy where it's -- there's some-- some pressures and so that's the thing that's difficult to project. I do think we have a fairly optimistic outlook on the resolution of the ones in front of us. It's -- whether or not, if no new ones come down the road to replace them I do think then the outlook for the provision is -- is more positive.

We're trying to get back to instead of 25 to 27 basis points of net charge-offs, we're trying to get back down to that 15 basis points that we historically have experienced.

Okay. Actually I lied, I do have one more question, still related to credit quality. Could -- could you explain or give a little more color on what led to the linked quarter increase? I think it was up -- NPA was up as 1.8 million, was that anything in particular, was it one creditor, or just a lot of small things?

The -- the linked quarter increase?

Yes.

It was -- it was -- it's one, predominantly it's one -- it's two loans with one borrower that is -- it's a combination of two spec homes, one of which I think is sold. These -- these are in southeast Michigan and some undeveloped lots. I think the -- the credit relationship in total is a little north of $1 million. And -- and that's the one credit that became non-performing from between the second quarter and the first quarter. It's about 1 million 2 in total, Jason, that -- that -- the two loans combined. That's the -- the one relationship that caused the linked quarter increase. The balance of it's just sort of a combination of smaller items.

Okay. Thank you, guys.

Thank you.

Mr. Magee, there are no further questions in the queue. Do you have any closing remarks?

Well, thank you. I just, Rob and I would like to thank everyone for attending this afternoons conference call. And both of us would be happy to visit with any of you at any time. Thank you very much.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time.