Independent Bank Corp (Michigan) (IBCP) 2006 Q3 法說會逐字稿

Welcome to the Independent Bank Corporation Third Quarter 2006 Earnings Conference Call. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded. 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 at 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 proxy, consent, or authorization or agent designation with respect to a meeting of the Company stockholders. It is now my pleasure to introduce your host, Mr. Michael M. Magee, President and Chief Executive Officer. Thank you, sir, you may begin.

Thank you. Good afternoon. We are pleased that you could join us on our conference call to discuss third quarter 2006 results.

Earlier today we reported third quarter 2006 net income of $10 million, which was down $2.1 million or 17.4% from the third quarter of 2005. Our diluted earnings per share of $0.43 this quarter were down 15.7% from the year ago comparative quarterly earnings per share of $0.51.

These per share figures have been adjusted for the 5% stock dividend that was paid on September 29, 2006. Our return on average equity was 15.2% and our return on average assets was 1.15% in the third quarter of 2006. Compared to 19.2% to 6% and 1.47% respectively in the third quarter of 2005. These results reflect further erosion in our net interest income and net interest margin, which we did expect to see given the continued flat yield curve, and the competition for both loans and deposits.

However, the dollar decline was somewhat steeper than we anticipated due in part to somewhat slower loan growth. During the first six months of 2006, total loans grew by an analyzed rate of 7.6%.

In the third quarter of 2006, this analyzed growth rate slowed to 4.6%. Rob Shuster or CFO will discuss our net interest income margin in greater detail during his remarks. The other factor adversely impacting our third quarter results was the substantial increase in our provision for loan losses.

This increase was a direct result of a deterioration of two commercial credit relationships that became nonperforming in the third quarter. Both of these loans are with customers located in southeastern Michigan and have origination dates in the mid 2003 and mid 2004. Although we have a continuous loan review program for our commercial portfolio, we are in the process of completing additional current review of all of our relationships in excess of $1 million to assure that we are taking appropriate proactive steps to maintain our improve the quality of our loan portfolio.

Also as reported in today's earnings release, I have assigned Rob Shuster the additional responsibility of CEO at Mepco Insurance Premium financing. As you know from prior conference call,.

Mepco net interest margin and net interest income have declined during the past four quarters. Rob has had significant turn around experience as a CEo of two financial institutions prior to joining Independent Bank Corporation in 1999. When we acquired Mutual Savings Bank where he was the CEO. Rob began this additional assignment in September of 2006. And he has been assisted by Gilbert [Ziten]. Mr. [Ziten] who is retired CEO of a large multi-national premium finance company was engaged as a consultant to assist us in reviewing operations at Mepco.

Rob will now provide some additional details on third quarter results.

Thanks, Mike. Good afternoon, everyone. I will focus my comments on net interest income in our margin, certain components of noninterest income, and noninterest expense in asset quality. Tax equivalent net interest income totalled $33.5 million in the third quarter of 2006, which was down 2.4 million or 6.7% on a comparative quarterly basis and down $1.6 million or 4.5% on a link to quarter basis. These declines were a bit steeper than what we anticipated. The decrease in the comparative quarterly tax equivalent net interest income was due to a 53 basis point decline in our net interest margin to 4.22% from 4.75%.

Partially offsetting this was a $153.5 million increase in average interest earnings assets primarily as a result of growth in all categories of loans. The decrease in link quarter tax equivalent net interest income was primarily due to a 25 basis point decline in our net interest margin. Partially offsetting the margin decline was a rise in average interest earning assets which increased by $16.2 million due to growth in loans. The increase in loans was partially offset by a decline in the average balance of investment 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 of existing investments with new trades that meet our risk and return objectives given the flat yield curve environment. In addition, the growth in loans has slowed during the course of 2006. This slowing in growth in the third quarter primarily reflects a decline in finance receivables at Mepco. On a comparative 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. On a linked quarter basis, our yield on average interest earning assets was flat. However, our cost of funds increased by 29 basis points.

In particular, the weighted average yield of loans by far are largest category of interest earning assets was relatively unchanged on a link quarter basis reflecting both the flat yield curve as well as competitive conditions. However our cost of funds increased in nearly all categories. The overall increase in our cost of funds reflects some migration by deposit customers to higher yield instruments, repricing on some maturing brokered CDs and borrowings and competitive conditions pushing up the cost of deposits in general. A strategy that is increasing our cost of funds over the past several months is our growing use of interest rate caps in our interest rate risk management.

At the end of September, we had approximately $300 million of outstanding interest rate caps. This compares to only $20 million one year earlier. On average, the cost of the caps is about 20 basis points higher than comparable fixed rate funding. We believe that this additional cost is prudent as it is very difficult to predict the future direction of the fed. The caps provide us with protection if short-term interest rates go higher, but also allow us to enjoy lower funding costs associated with declining short-term interest rates if the fed begins to ease.

Further, given the optionality embedded in our loan portfolio, the flexibility of the caps is of great benefit. Two other items that adversary impacted net interest income in our net interest margin in the third quarter of 2006 was a $250,000 increase in the amortization of premiums on municipal bonds due to some calls in the quarter, which necessitated the write off of the unamortized premium and 300,000 in reversals of accrued but uncollected interest on loans placed on nonaccrual during the quarter.

The combined impact of these two items was about a 7 basis point reduction in the net yield on average interest earning assets and in our net interest margin. As Mike mentioned in his opening comments, I would assume the responsibility of CEO of Mepco. I have immediately focussed on improving spreads in our return on allocated capital in this business unit. As an example, the weighted average yield on newly originated premium finance loans grew by about 100 basis points between August and September as we have resisted the lower pricing necessary to compete for the higher balance loans as the return on the capital required to support these loans is presently not adequate in our judgment.

In addition, we have made changes where necessary in our warranty payment plan business and newly booked payment plans in August and September have yields approximately 300 basis points higher than the existing portfolio. Over time, I believe this will result in improving margins in this business in higher returns on allocated capital. We are also closely examining our operating costs to gain greater efficiencies, particularly since we expect to see some decline in our overall level of finance receivables in the near-term. Because of these changes, we have temporarily postponed the closing on the securitization of a portion of our finance receivables as we are reviewing possibly downsizing the transaction.

Factoring out the decline in finance receivables, our other categories of loans grew by a combined total of $51.3 million in the third quarter, which represents an analyzed growth rate of 9.1%. Moving on to noninterest income, service charges on deposit accounts increased modestly on both a comparative and link quarter basis. Visa check card interchanging was up 22% on a comparative quarterly basis, but flat on a link quarter basis. The comparative quarterly increase reflects growth in debit card usage. We have recently instituted a promotional campaign to encourage even more use of our debit cards and are also piloting a rewards program to also increase debit card transaction volume.

Gains on real estate mortgage loans declined by 26% on a comparative quarterly basis due primarily to a $26.2 million decrease in the volume of loans sold. These gains were down slightly on a linked quarter basis even though the volume of loan sales increased by $2.3 million as our net margin on loan sales dropped by 14 basis points. We anticipate that conditions will continue to be highly competitive in the mortgage banking sector and again expect that mortgage loan origination and sales volumes will remain somewhat subdued. Real estate mortgage loan servicing income was down $275,000 on a comparative quarterly basis and down $60,000 on a linked quarter basis. These variances primarily reflect changes in the impairment reserve on and amortization of capitalized originated mortgage loan servicing rights. During the third quarter of 2005, we had a $378,000 recovery of previously recorded impairment charges.

In the third quarter of 2006, we recorded a $19,000 impairment charge. As I mentioned during the second quarter conference call, excluding changes in the impairment reserve, we would expect real estate mortgage loan servicing income to run at about $550 to $650,000 on a quarterly basis. Noninterest expenses totalled $24.3 million in the third quarter of 2006, which is down $2.9 million or 10.5% on a comparative quarterly basis and is down $2.5 million or 9.5% on a link quarter basis.

As we outlined in this morning's earnings release, in the third quarter we reduced our 2006 incentive compensation accrual by $2.2 million during the second quarter of 2006 we had reduced our incentive compensation accrual by $1.2 million. The impact of these reductions is that we now anticipate making no ESOP contribution, paying no year-end bonuses, and making no equity-based awards for 2006 based on our expected full-year earnings compared to the targets established for our incentive compensation plans. Our normal quarterly accrual in 2006 for an ESOP contribution and incentive compensation based upon mid tier performance target levels is approximately $1.1 million.

Also in comparing the linked quarter decline in noninterest expenses, the second quarter of 2006 included a $612,000 good will impairment charge. The other category with the sharp decline is other noninterest expenses. This decline is spread out over a wide variety of expense categories. However, the most significant was in Michigan single business tax expense as a result of an adjustment in our accruals at our banks due to our expected tax base for the full year.

Our assessment of the allowance for loan losses resulted in a provision for loan losses of $4.6 million in the third quarter of 2006, which was substantially higher than the third quarter of 2005 and the second quarter of 2006. Nonperforming loans increased by $6.7 million to $30.8 million or 1.15% of total portfolio loans at September 30, 2006 when compared to the end of the second quarter. And are up by $12.8 million since the end of 2005.

During the third quarter of 2006 as Mike mentioned, we had two large commercial credit relationships become nonperforming. Both relationships are with borrowers and southeastern Michigan. The first relationship involves loans totaling $3.5 million that are secured by accounts receivable, inventory equipment, and real estate.

During the third quarter, we determined that this borrower had transferred, diverted, or misrepresented the level of certain assets that collateralized this loan in contravention of our loan documents, based upon a current audit of the remaining collateral in using liquidation values in our impairment analysis, we determined that a chargeoff of $2.1 million was necessary leaving a remaining balance of $1.4 million in nonperforming loans. A receiver has been appointed and we are in the process of liquidating the remaining collateral. We are also pursuing legal action. At the present time, we do not believe we will incur any additional loss on this credit.

The second commercial loan totals $8.7 million of which $5 million has been participated out to other financial institutions leaving a balance of $3.7 million at our company. This loan is collateralized by a large parcel of real estate in southeastern Michigan that is zoned for mixed use. Although this loan was not 90 days or more past due, at the end of the third quarter based on the delinquency that did exist and the expectation that it will not be cured soon, we considered the credit impaired and classified the loan as nonperforming.

Our impairment analysis resulted in establishing a $600,000 specific reserve on this loan. This calculation assumed the collateral liquidation price equal to 65% of the appraised value. Most recent appraisal was performed at the end of 2005. And liquidation costs equal to approximately 23% of the loan balance. The other liquidation costs are based on a 12 month time frame and include sales commission, taxes, and lost interest. We believe the specific reserve is adequate. We are vigorously pursuing collection of this credit, including pursuing personal guarantees.

In addition, the rise in nonperforming loans also reflects increases in residential real estate mortgage loans and finance receivables that are 90 days or more past due. The increase in nonperforming residential real estate loans reflects weak economic conditions in Michigan that are resulting in a rise in bankruptcies and foreclosure.

However, based on data from the Mortgage Bankers Association, our residential real estate mortgage loan delinquency levels remain below the overall mortgage loan delinquency rates for the state of Michigan. Further, we have historically had a low level of losses in this portfolio. The rise in finance receivables 90 days or more past due is concentrated in premium finance loans and then particular resulted from four loans at quarter end, totaling $1.7 million, which had been canceled and we were awaiting the return premium from the insurance carrier. We do not expect any significant loss on any of these loans.

Moving on to net loan chargeoffs, they totalled $3.8 million in the third quarter of 2006 or .57% of average portfolio loans, which is up significantly from the third quarter of 2005's total of $1 million or .16% of average portfolio loans. Most of this rise is due to the aforementioned $2.1 million net loan chargeoff on the one commercial credit relationship.

Year-to-date in 2006, net loan chargeoffs totalled $6.7 million or .34% on an analyzed basis of average portfolio loans compared to $4.2 million or .24% in the first nine months of 2005. Our allowance for loan losses rose to $25.4 million or .95% of portfolio loans at September 30, 2006, compared to $23 million or .90% of portfolio loans at year end 2005. An analysis of the components of the change in the allowance is as follows.

The portion of the allowance allocated to specific loans increased by $927,000 since year end due primarily to the specific reserve of $600,000 established this quarter for the commercial loan that I discussed earlier. The portion of this allowance allocated to other adversely rated loans declined by $347,000 since the end of 2005.

So I've mentioned on prior calls we utilize a 12 point loan classification system with one being the best and 12 being the worst. And the total of loans rated seven or higher, which some might call watch credits was approximately $86 million at September 30, 2006, compared to $78 million at December 31, 2005. Although overall watch list credits increased a bit, a change in mix with a decline in loans graded nine or higher was the cause in the aforementioned decline in this portion of the allowance.

The portion of the allowance related to historical losses increased by $715,000 since year-end 2005 due primarily to loan growth and a rise in the level of net loan chargeoffs during 2006. We use a ten-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 has increased by just over $1 million since the end of 2005 due primarily to concerns about economic conditions in Michigan.

We repurchased 110,000 shares of common stock in the third quarter of 2006 and have now repurchased 450,000 shares during the first nine months of this year. As previously announced, we are currently authorized to repurchase up to 750,000 shares during all of 2006.

Stockholders equity rose to $260.4 million at September 30, 2006. Intangible net book value increased to $8.57 per share, which represents a 12% analyzed growth rate since year end 2005. These per share calculations take into account the impact of the 5% stock dividend that we paid at the end of September.

This concludes my remarks and I would now like to turn the call back over to Mike.

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 Rob reported as reported in today's earnings release, we reduced our accrual for performance based compensation by $2.2 million in the third quarter of 2006, which is in addition to the $1.2 million in reductions that we reported on last quarter. Our performance based compensation includes accruals for cash bonuses, equity-based compensation and contributions to our employee stock ownerships plan.

The third quarter change essentially reduced our accrual for incentive-based compensation to zero for 2006. This impacts many employees throughout Independent Bank Corporation. Our employees and directors collectively own about $60 million in our company's common stock.

And I know we all share a common objective of doing the things that will positively impact the value of this organization. I can't begin to tell you how proud I am of the employees' commitment to Independent Bank Corporation.

As I have discussed in prior conference calls, we continue to pursue several actions designed to improve our performance. These strategies are being implemented simultaneously with equal importance. Control and reduced noninterest expense, improve asset quality and reduce our current level of nonperforming assets, position the balance sheet so our net interest margin will improve and return to more traditional levels when the slope returns in the yield curve, increase our franchise value through enhancing the customer experience with Independent Bank Corporation, and retain and recruit top talent to help us achieve these goals. I would now like to open the call up for any questions you may have.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is from Kevin Reevey with Ryan Beck Please proceed with your question.

Good afternoon.

Hi, Kevin.

Rob, do you have anymore callable securities on your books that could potentially hurt the margin in the upcoming quarter or the next few quarters?

We -- Kevin, we have and I don't have an exact figure for you, but within our municipal bond portfolio, we do have a fair number of issues with premiums and, it was just in particular in the third quarter we got more calls than what we've traditionally seen. So it created more of the, I guess disruption in yield. But we've traditionally had premium bonds.

Now the accounting is you amortize the premium over the life of the bond and then if there's a call like that, you have to write off the amortized premium. However, from an economic standpoint, when we buy those bonds, we're really looking at the yield to worst and buying it on that basis. So although the accounting doesn't kind of match up with the economics of how we look at and buy those bonds, historically we've not seen the kind of blip we saw in the third quarter.

And historically when they have been, what's been normal negative impact on the margin.

I mean, typically there's not been a huge impact -- I mean quarter-to-quarter, what you would have is roughly either not a material amount or it would be somewhat similar from quarter-to-quarter. So it didn't stick out as much as it did in this quarter. So I mean I don't have a schedule of exactly, quarter-to-quarter looking forward what calls we might have within the portfolio. Sometimes on the smaller issues they won't call them just because the municipality would have to reissue at times. And it's not economically justified for them to do it. So at times, you get the benefit that they don't call it just because the economics don't warrant it. I think it was just an anomaly this quarter, although it could occur again if we just have a quarter where there's a fair number of calls. I don't have that scheduled out.

And do you still have a fair number of CDs that are coming due this coming quarter that could potentially result in significant increases in your cost of funds?

I mean, on an overall basis in terms of our asset liability management, we don't -- we're still relatively balanced. And to a large degree because we'll every quarter have a fair number of CDs that may be coming due.

Often times those are hedged with either, particularly in the case of brokage CDs, they're hedged with either fixed pace swaps or more often now as I alluded to my comments we're using interest rate caps. So that rise, to some degree is offset by the asset liability management hedges we have in place. What's happen more with the flat curve and the shift within the deposit base, the cost of funds is actually increased a little bit more rapidly than what we would have ordinarily modeled in our asset liability management profile. And that's been more due to change in mix than necessarily just maturities coming up. If I look at our asset liability management model currently and right now it's -- I'm the numbers I have are off of our 8/31 balance sheet.

I don't have all of the September data in the model yet, but it would suggest barring a, acceleration or continued change in mix, particularly within the deposit base of customers shifting out of lower costing deposit base of customers shifting out of lower costing accounts like savings accounts into higher yielding accounts that, you know, the model is suggesting we're bottoming out. And this also assumes that there's not additional increases in the fed funds rate, but the model suggests we're bottoming out on the margin. So again barring, significant shifts within the deposit base, we're hopeful we're seeing kind of the cycle on the pressure on the margin start to come to an end.

And my last question is in your earlier comments regarding changes that you're making it Mepco it sounds like you are raising your rates, which I'm a little surprised by. When I talked to, more priced competitive market. So I'm having trouble --

Kevin, we're really not raising our rates. To give you an idea, the reason that the -- the yield has come up on the premium finance loans is because what we're doing is electing not to bid as aggressively on the higher balanced loans. To give you some, some actual figures, the level of originations on the premium finance side in September were about $25 million and the weighted average yield was about 10%. Now that's up 100 basis points from where we were in August. And the volume in August was higher, but what we're really working on is those higher balanced loans are where you're running or seeing rates, in the mid 6% range.

And if we look on that , look at those loans on the basis of the capital we have to allocate because their 100% risk weighted loans, the return on equity on an after tax basis using our current cost of funds in a relatively modest expectation for losses, like 12 basis points, we're only running about 8% return on allocated capital. So what we're doing is just electing not to aggressively pursue those higher balanced loans. It's not that we've increased our rates, it's just that we're just changing the mix. And in my view as we can find a better deployment opportunities on our capital, in excess of 8%. Buying back stock for example in my judgment is going to give us a better result.

So that's -- that's the, sort of the comparison to Windtrust in terms of the premium finance business so we're not raising our rates. On the warranty payment plan business, we've just worked to, make some program designs that, has resulted in new business coming in at significantly higher returns. And although we've seen some reduction in our volumes there, it hasn't been significant. Does that address that?

Over time you expect, you expect the price to make up for lowest volume?

Yes.

That's very helpful.

Over time I would expect it to more than make up the lost volume. And then whatever capital we free up, we'll use or try to deploy at better returns and we're just kind of foregoing that incremental business at the lower returns.

Great, thanks, Rob.

Our next question comes from Jason Werner with Howe Barnes, please proceed with your question.

Good afternoon, guys. Actually some of my questions were already answered but I wanted to follow-up on the Mepco discussion a little bit. Given what you're doing in terms of your strategy going for -- the business you're going for, do you anticipate receivables to continue to decline the next couple of quarters?

Well, , I would expect some decline in the fourth quarter. There's some seasonality in the business, as well. So the fourth quarter just from a volume standpoint is usually a little bit lower. We're seeing, about -- still a 50/50 mix overall between the warranty business and the premium finance business with about 400 million roughly in gross receivables. And the warranty payment plan side has stabilized and I wouldn't expect to see any significant declines in that business. In fact, there's some opportunities, we believe, for that business to grow as we pursue additional opportunities on that -- on that side of Mepco's business. The premium finance side would probably decline a bit during the fourth quarter, but more because of seasonal issues.

Like I said, a lot of insurance premium renewals are, calendar year type renewals. So typically we see our highest volumes of the year in the premium finance side in January and February. So that would tend to kind of have that balance start to grow again in the first quarter and eventually it's going to stabilize out, but probably at a little bit lower level than we're at right now, which is about 200 million.

Okay. Obviously the decrease in the receivables had a big impact on overall loan growth. First of all, when you guys made your projection at the last conference call about the 10% kind of growth rate for the second half, were you taking into account to make up for that? Or did the receivables go down more than you thought they would and that's why you were ant that 10% run rate?

We didn't expect to see the drop in the finance receivables. So, that -- we're at -- we were lacking for around 10%, we were at 9.1% on the other loan category. So where we were off was what happened in the finance receivables.

Okay. And then do you think that the kind of growth you had in the other categories continues into the fourth quarter a little bit? Or does that slow down a little bit?

Jason, going back to the question too about the receivables, remember that Rob was appointed CEO during the third quarter. He started spending the mar majority of his time there. It wasn't until he was able to roll up his sleeves and really get involved and look at the pricing relationships that we had and said we're not going to tolerate this type of pricing that we started to seeing the declines and the receivables at Mepco. Going back to your question of do we anticipate a run rate of 10% at the four banks and their loan portfolios? I would say we're heading into the time of the year where that would be a little bit difficult, I would expect closer probably to 7 to 8% for the remainder of the year.

Okay. And then another question about Mepco. You obviously are postponing the securitization. Do you have any thoughts on timing when you might go forward with it?

Well, we're just looking at the sizing of it. We had originally anticipated 150 million. And because there is an unused fee, to the extent that because it's a revolver to the extent you have unused capacity in it, you're paying a fee, so what we're trying to do is try and size it to reflect, if we anticipate some reduction in our overall level of finance receivables just sizing it so that we try to minimize any unused capacity within the structure. So I think we'll be able to still make a final call on that before the end of the year and we're pretty much ready to go in terms of having cleared with the rating agencies what, you know, where we ended up in terms of eligible receivables. We're -- we got done, the structuring to get us to the capital relief we were seeking. And so and from a document standpoint, we're ready to go too. So it's really just a matter now of just sizing it.

Okay. And then one last question I'll let somebody else get on. Again, with regards to Mepco you have this consultant now on board for a couple of months, I was wondering if you could give us color what kind of things he might be, letting you guys in on to improve the operation.

Well, he's been extremely helpful for me. Gil [Ziten] was the CEO for several years of a very large multi-national premium finance company and brings a wealth of experience in that industry. And so just having them -- him there to assist me has been a great benefit.

Obviously the, he has seen in that industry what I think has been probably reflected by other public companies with premium finance operations, which is there's been a fair amount of margin compression in the business. Not unlike mortgage banking, we're in a little bit softer market, we're premium renewals are lower so the pie has shrunk. You've got more players in the industry and more players owned by banks who have traditionally had a little bit of an edge in terms of funding costs. So because you have more players and a smaller pie, things have gotten more competitive. And then, in some instances, the -- you have changes in the industry like some of the very large, large agents forming their own premium finance companies are in the process of doing it. And then essentially, sort of bidding out the business to the, you know, to the lowest, the lowest buyer.

They originate and then they sell but basically you're competing pretty much strictly on price and that kind of arrangement. So, that's created a lot of challenges in that industry. And certainly been a great benefit for my perspective and analyzing and understanding those dynamics.

In addition, he's brought experience in terms of what we might be able to do in that business on things that such as carrier programs where you work directly with carriers to develop premium finance programs, that go direct to the customer. So he's been helpful there, he's simply been helpful in introducing us to a lot of people in the industry who are very knowledgeable. So he's provided, like I said a wealth of experience in assessing that business and sort of focusing on trying to bring our margins up there.

All right. Well, thank you, very much guys.

Our next question is from Kenneth James with FTN Midwest.

Good afternoon, gentlemen.

Good afternoon, Ken.

I want to touch on credit for just a minute. You mentioned this quarter that the two loans you mentioned were in southeastern Michigan. I believe I'd be correct in saying that's by far the weakest quadrant in the state if you will from an economic perspective. And I'm just wondering just, A, what's your total dollar exposure to that region of the state, and also curious if kind of commercial loans in that region make up an outside portion of your watch list?

Well, I would tell you that I don't have the figure on the watch list precisely of what is in Southeast Michigan. I don't think it probably makes up in undue amount. And in terms of dollar amount, we bought Midwest Guarantee, they add about $205 million of loans, predominantly in southeastern Michigan. I would expect that we've grown from there, although I don't have a precise figure. My guess would be we're probably north of $300 million now within that quadrant. And I can, I think I have figures for at least on the watch credit list by bank. So I could probably give you what is in our bank in that area. So let me see if I can come up with that, Ken.

[OPERATOR INSTRUCTIONS] If you would like to ask a question, you may press star one on your telephone key pad.

Ken, I don't have the break down by bank on the watch list credit. So I can't, at least give you the mix of what -- of the $86 million is specifically in southeastern Michigan.

Okay. In terms of kind of the loan review you talked about digging a little deeper into the portfolio. When do you expect that to be completed? Is that something that's going to be completed in the fourth quarter?

That will be completed in the fourth quarter. What we're doing is we're taking a look from the largest credit down to the million dollar credit. Just to give you a little bit of color too on our portfolio, our legal lending limit would allow us to originate mortgages to any single borrower in the $35 to $40 million range. And our largest relationship is just under $15 million to any one borrower. I have a report and we monitor it along with the board of directors. The top 20 relationships for any bank corporation. The largest relationship is around 14.7 million. The 20 largest relationship with our company is $6 million. So you can see they go down in size quickly and we'll be looking at all out of our relationships down to a million.

When we obtain that information, Ken, we're going to -- we have enough data about the local economy. We also will have a good understanding of our portfolio. I believe we have a good understanding of it right now. What we need to do is we need to probably do a better job in providing reports in the board of directors and the management team. It's one thing to have the information, but then we need to go that next step and say no that you have the information what are you going to do with it? and we hope to not only utilize the information to improve the asset quality of our current portfolio, but we're going to utilize the information in our credit decision process going forward during these tough times. We're kind of taking a several different fronts, I guess we're going to salt this problem. And we're going to try to at the end of the day use back room, the loan officers, the board of directors, the senior management of the company, and the senior management of the bank to say okay, with this information, what information and tools do you need to improve the asset quality because that we have our nonperforming assets are up to the point where it's at the high end of our comfort level and we believe they're going to be other loans that will flow into nonperforming assets.

And so we need to diligently work on our current nonperforming assets to get them out of there to make room for any future loans that may move into that category. And as Rob mentioned in his comments, the area that has seen the largest increase of my migration from 90 day or 30 to 60 day and the 90 day has been in the 1 to 4 family. And so we're concentrating on the real estate mortgage portfolio as much as the commercial loan portfolio. So, again, we have teams working in both areas because we need to -- we don't need to get a handle. We have a handle, we need to get the number reduced at this point.

Good. Late last year when you kind of undertook a loan sale about taking an aggressive stance towards credit. Do you see anything coming down the pike or any relationships that would rise to that level, where you would consider selling them?

I just, as you could imagine there's been a lot of meetings and attention given to all of the nonperforming assets and also the past due reports. The two loans that Rob mentioned moving into the nonperforming during the quarter a lot of that is because we pushed the issue because taking an aggressive position on our loan portfolio. And we kept, we saw red flags, we kept pushing the issue, pushing the issue. The one loan wasn't even past due the end of last quarter. But we just felt there were enough concerns. On that loan, we have personal guarantees and we don't anticipate any additional of what we already have written down that loan for. But, Ken, I don't anticipate at this time a loan sale. I believe that we can manage this portfolio down back to more traditional numbers and again make room for any future loan.

Ken, one other comment on the loan sale, at least we've found historically and I don't think this would change certainly today given the circumstances in Michigan you're really heavily discounted on the 1 to 4 family on those type of transactions. And that's -- that represents a third of our nonperformers. And although it takes some time to cycle those through because you've got to go through a redemption period and then sell the collateral, it doesn't require enormous amounts of management time on the 1 to 4 family. And so we don't really see the economic or management benefit to selling that piece of the portfolio. The finance receivables really are just a function of timing in terms of return premium on cancellations. So that doesn't require a lot of management time and is not represented any significant risk either.

And then on the commercial side, absent the two new ones that came in the balance in there is actually not that large and there aren't any real significant, time consuming credits within the balance of the commercial nonperformers. And as we mentioned in the press release, we did have the loan from the prior quarter on the low moderate income apartment complex for 3.6 million that did in fact pay off during the third quarter. And it paid off at the level that we anticipated and it already provided a specific reserve for that. So at this point, I think Mike's comments are on the loan sale is, right on because I don't think it's required at this point.

Okay, thank you. If I could jump up to the expenses for a second. Obviously there's no bonus accruals in it. I was wondering, relative to last or 3Q '05 and how much comp accrual was in that. Can you kind of talk about how much just straight kind of head count and operational efficiencies or costs you have cut and how much more you think you can cut out of this expense place or are you even planning to?

We're continuing to look at cost reductions. But at the same time, we can give you an exact head count. I don't have that with me right now. And as we've shared in previous quarters, the one on an analyzed basis was $1 million. I don't recall what after the first quarter the analyzed rate was in those reductions because we've gone through two waves of reductions if you will. And then we have reduced staff in a couple of other areas in ones or twos. But we have also added staff during this time too.

So while we have been cutting staff, we have been where the opportunity presents itself to add value to the Company, we've added staff. Perfect example of that is the increased presence we have over in the [Meskegan] market right now. I think we, you saw our announcement when we brought in Jose and Fonte and part of his team into the [Meskegan] in some of, in part of his team into the market. And at this point, they have added $3 million in new deposits. I have the figures here, 92 new commercial loans and 25.4 million in outstandings and that's just with a benefit of about 4 to 5 months of them coming on board.

So that's an example of where we will add staff. We've also added down in Southeast Michigan, we've add a couple more additional mortgage originators and in our South Michigan market, they brought on an individual who has hit the ground running and is doing an excellent job there for us. So on a net basis, Kenneth, I would have to get that number for you. But when we reduce expenses, we're also trying to add income-producing individuals to the Company, as well.

Ken, on the run rate,this year as I mentioned in my comments it's been about 1.1 million and that reflected a mid-tier type of accrual. I think last year it was higher because last year it was higher we were accruing for the most part at top tier and so that would have added, for example, in ESOP that would have added about 300,000 a quarter in additional accrual and I don't have the exact if figure on the incentive side, but that's maybe another couple hundred thousand.

So on a comparative basis, we're probably more around a 1.5 to 1.6 million run rate on incentive comp in '06 because we're accruing at a -- I'm sorry in '05 because we were accruing at a higher expected tier than what we were doing, at least through the first part of 2006. Does that answer that question?

Yes. Yes it does. One more quick one with regards to expenses. Provided that I would imagine going into '07 that, accruals will be back in the expense base? This is a bottom level per comp and you're not paying anything this year, but I would assume in '07 you would start accruing at least at that mid tier level again, is that fair to say?

That's correct, Ken.

We certainly hope that we're going to be able to perform at a level to get us there.

I'm sure I have several employees listening and that's the answer they wanted to hear.

Okay. Thank you.

Our next question is from Brad Milsaps with Sandlier O'Niell. Please proceed with your question.

Hey, good afternoon.

Hi, Brad.

Just a couple quick questions. Rob, it seems like you've been hit in kind of consecutive quarters with different fraud situations, Assuming -- have you identified anything within your underwriting process that you fixed at this point or anything that you see as systemic there? Are these really just one off situations?

Well, the -- yes the two you're referring to is obviously this quarter on the one commercial relationship where we had some diverting or sale or transfer of assets and then some misrepresentation on collateral levels, for example receivable levels. And that certainly wasn't indicative of the underwriting of the credit. I think that's more indicative of, an erosion at the Company that obviously pressed them to do those type of things. And that's, we have ongoing reporting and other type of checks and balances to try and prevent or, early I try to identify those things. Obviously we didn't catch this one until there was a fairly significant impact.

The other item on that you mentioned was that we talked about was in the second quarter related to a mortgage fraud situation that actually impacted -- I'm aware of at least two if not three other banks in southeastern Michigan on the same, I guess, scheme. And I think nationwide and certainly in Michigan, you're seeing more instances of that thing -- of mortgage fraud occuring. And you just, this involves, what I would call straw buyers and appraisals so you have collusion amongst a group of people. Appraiser, here it was a developer. And again, you try very hard to prevent those things. We do training on those type of things to try and spot, any red flags.

I would say in this case, it worked.

We and we had several in process.

Yes. We said wait a minute.

That's a good point, Mike. That is one where during the so-called scheme, we identified the problem and prevented more loans being booked. So that we at least minimized the impact and I know other institutions with with that case actually incurred bigger losses. So I think we did the system did work, but it just didn't prevent it, it identified it and minimized it to some degree.

Okay. And then secondly, you've also kind of been hurt on some loans that are secured with vacant land. Do you have a sense of how much the dollar amount was? Would be secured with, just land nonincome producing property?

I don't have that figure -- I mean we obviously have that -- we monitor and have reports by standard industrial classification code on our commercial portfolio, including, loans secured by vacant land like that. So I know we have the -- I just don't have it --

I don't have it either, Brad, I know it's in our policy. Based on percentage of capital and that is within our policy, but I don't have the exact number.

Okay. And then Kenneth's question about the incentive comp. Given the comp addition for lenders and producers out there, how much do you think you're going to be able to cut that if you have to in '07? At some point, people start to get picked off. Any comment on that at all?

Well, one thing I would comment is in certain revenue producing positions such as commercial lenders and mortgage loan originators, for example, so people directly sort of in the sales revenue production area they will have plans that are not just based on our organizational profit levels. So it, the banks have plans that provide them with incentive comp, based on their production and levels and revenue generation. So in those areas it's not all going away. We still have whether you call it commission or incentive comp, there's still positions that are earning that indirect revenue producing type of roles.

The impact is, in all of the other positions that aren't direct revenue-producing positions where the incentive compensation is based, at least traditionally has been based on the Company hitting certain profitability targets. The one area that does impact everybody is the level of ESOP contributions that the Company makes and so that does impact everyone. That's sort of not a direct reduction of take home pay because you're paying it into a retirement account and so the impact is more long-term if we have a missed year or a reduction in the level of ESOP contribution. So I don't know that we'll be under that much risk in terms of getting people picked off.

Brad, it is not easy nor agreeable to inform your employees that we had to reverse the accrual for incentives in ESOP for 2006. When that happens, you could expect that if you have 5 entities, the 4 banks. And because of two of them their performance falling short from last year for whatever reasons, you expect it to be kind of human name for the other three organizations in the corporate employees maybe to blame those two organizations or entities. But that is not the case with in Independent Bank Corporation.

As a matter of fact since we have identified the employees, I have seen the team come together, which you would expect from a highly dedicated team of professionals we have. The question I'm getting from our officers and employees is what do we have to do in 2007? And in the last quarter of 2006 so we can hit the ground running in 2007? So that we do get incentives and bonuses in ESOP next year. Independent Bank Corporation's comp committee has hired Mercer to take a look at our compensation schedule and also our short-term and long-term incentive pay out targets for our officers. We're going to have years like 2006, but we're also going to have some great years. And to make sure that the long-term incentive plan is, I would say fair for the officers so that if we have an off year they're motivated though so make sure over a 3 to 5 year period of time the shareholder return is in line and they will benefit from that.

And last, I will be honest with you, my job I feel right now in the executive managements of Independent Bank Corporation their job is to continue to provide the working environment that our employees want to come to work. They enjoy working at Independent Bank Corporation. And that can be difficult. You would expect the moral may go down when you're not paying incentives or bonuses. But I have to say that our management team provides the type of work environment at this company that we kind of pull together and morale I feel is fine and we'll continue to make sure that we're taking care of our employees in their needs and providing the professional work environment they enjoy working in in taking care of them. So we'll get through 2006 and we'll hit the ground running in 2007. That's our goal.

Okay. Final question. With the economic challenges in the state, what's your guys' appetite for buying banks within the state and as a second part of that question, sort of outside of the state borders, how far would you go? Until you sort of the credit issues that you have in hand straight. Thanks.

We would be interested in some M&A activity. We're looking at, again to continue to strengthen our balance sheet both organically and through M&A opportunities. I think it's -- it's strictly, Brad, a matter of cost. And the accretion it would give to our shareholder. I believe there are some great M&A opportunities in the state of Michigan. There are some great markets that would fit perfectly in our footprint, and add a lot of franchise value to this company. We've made it clear to the investment banking community that we'd be very interested in looking outside the state of Michigan.

How far we would go, again I don't think I could answer unless I saw a book and we analyzed it and it made strategically and financial sense for the Independent Bank Corporation. The only concern I'd have is going outside any continuous states would be con to the best of my to Michigan would be how we manage that and how it would be viewed by the shareholder. So I, again, we are very interested in looking outside of the state of Michigan for M&A opportunities because also we'd like to along with the type of loan we'd like to add a little diversity in our balance sheet along with geographical diversification. But it'd be all, it's a matter of earnings cost price and the accretion it would give as far as our earnings per share.

Our next question is from Glenn Guard with Stifel Nicolaus.

Yes, and first of all I have to apologize if this has been already discussed. We had some incorrect information about the timing of the call. If it's gone over just tell me. But the way we look I guess the numbers would indicate that the loan yield in the third quarter was essentially, almost exactly the same as the loan yield in the second quarter despite, 40 basis points more on the average prime. Trying to figure out how that can happen.

Well, I did mention we had some reversal of some accrued and uncollected collected interest. That impact us about 4 basis points. But if you look, that would maybe bring you up just, you know, roughly to about 7.95% or so.

Right.

But if you, look at, where you're seeing loan activity in terms of pricing with the flat curve, I would suggest and this is what makes it very difficult for us to be able to achieve, you know adequate margins, you're seeing a lot of loan pricing, right at that kind of a level. And so that -- that's what one of the real challenges are.

Refresh my memory, are premium finance, your premium finance loans balance sheet loans or do you typically move them off and sell them quickly?

No, they're on the balance sheet.

And has there been a lot of compression then in that -- I realize it's only 14 to 15% of your loan portfolio, but has there been a lot of margin compression there? Maybe how much might it?

Yes, there has been quite a challenge in margin compression. I did kind of go through that, but real briefly, what you are seeing is particularly on the large balance loans. You're seeing pricing in the mid 6s, now granted they're 9 to 12 month loans, but that's the kind of pricing you're seeing on the larger balance loans.

What I had indicated is that's the area where we are sort of electing not to bid because on a return on allocated capital because their 100% risk weighted loans, you're looking at around 8%. And that's just not in our mind. That's just not adequate. We would have other uses of capital we believe at higher returns, including buying back stock. So that's why you saw the, at least to some degree the shrink in finance receivables as just electing to not go after that incremental business that's at lower returns.

And then very, very roughly if you've got it on the top of your mind, what would have the price have been relative to fed funds a year ago and what would your return on equity of benn on that product say a year ago? How badly has it deteriorated?

I would say, you would probably, if you go back and probably even more, you'd have to go back probably more than a year ago, I'd say a year ago you were already starting to see the spread compression, but if you go back maybe into '04 in the first half of '05, you probably seen compression in spreads of, 200 basis points in that line of business because you've had the rise in the funding costs and for a variety of reasons, you just haven't seen that being able to be pushed through dollar for dollar.

Wow. Okay. Thank you very much.

Thank you. Mr. Magee, there are no further questions at this time.

Okay, well thank you very much and thank you to -- on behalf of Rob and myself, we'd like to thank you for participating this afternoon in our third quarter conference call. And if you have any further questions don't hesitate to call us. Again, thank you.

This concludes today's conference, thank you for your participation.