Independent Bank Corp (Michigan) (IBCP) 2007 Q4 法說會逐字稿

Hello and welcome to the Independent Bank Corporation fourth quarter 2007 earnings conference call. All participants will be in listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. (OPERATOR INSTRUCTIONS) Please note this conference is being recorded.

Now I would like to turn the conference over to Michael Magee.

Thank you. Good afternoon. Welcome to our fourth quarter 2007 earnings conference call. I am Mike Magee, President and CEO of Independent Bank. Joining me on the call today are Rob Shuster, our Chief Financial Officer; and Stefanie Kimball; our Chief Lending Officer. Following my introductory comments, Rob will provide a detailed review of our financial performance during the fourth quarter. Following Rob's comments, Stefanie will provide a progress report on credit quality. We will conclude the call with a brief question-and-answer session. Also, please note that an accompanying PowerPoint presentation will be referenced throughout today's call. To access this presentation, please go to the Investor Relations section of at our website at www.ibcp.com, and go to the presentations tab. You will find it right there.

Furthermore, please also note that this presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to our Safe Harbor provision on slide three of the presentation for additional information on forward-looking statements.

I will begin today's discussion with a review of our fourth quarter and year end financial results which are summarized on slide four of the accompanying slide presentation. For the fourth quarter ended December 31, 2007, we reported income from continuing operations of $2.3 million, or $0.10 per fully diluted share, compared to $1 million, or $0.04 per fully diluted share in the fourth quarter of 2006. Throughout fiscal 2007, the IBC team made significant strides to improve the operational efficiency and strategic positioning of the bank. Efforts which included a consolidation of our four charters, divestment of our insurance premium financing business, a comprehensive rebranding campaign, enhancements to the bank's IT infrastructure, and a major realignment of our internal management and reporting structure.

While these initiatives yielded early success during the year, such efforts were largely overshadowed by a steady deterioration in asset quality. The impact of which was one of the primary obstacles to growth in 2007. As we have documented in great detail throughout 2007, our exposure to the residential real estate market was heavily impact by a substantial decline in property values during 2007 resulting in a marked increase in nonperforming assets and increases to the loan loss provision when compared to the year-ago period. Despite the challenging conditions we faced throughout 2007 I am pleased to note we have remained profitable.

Our year-over-year increase in noninterest income is reflective of our efforts to increase deposit-related revenues. For a high-level overview of the quarter I will now be referring to slides five through seven of the presentation. While efforts to improve asset quality remain a top priority for us, weakness in the real estate market resulted in a marked increase in our nonperforming commercial loans and real estate mortgage loans at year end when compared to fiscal 2006. However, the rate of nonperforming loan growth showed signs of moderating during the fourth quarter of 2007 when compared to the earlier periods in the year. Although we are hopeful that these recent trends will eventually lead to lower credit cost and a general stabilization of the market in 2008, we remain concerned about ongoing challenges within our commercial, primarily real estate development credits and real estate mortgage portfolios.

Although we cannot predict when macro credit trends will fully stabilize, we believe our internal efforts to further enhance the credit quality monitoring and review process at IBC, a process discussed in great detail by Stefanie Kimball last quarter will allow for improved conservatism in our lending practices going forward. I am pleased with our efforts in this regard and believe the early progress we have made in this area will continue to gain momentum in 2008. I am also pleased with how our team has sought to proactively address ways of managing through the current barriers to growth. At IBC, we value our management team of talented managers. As such talent brings with it a unique and valued perspective which helps us learn from our experiences in a meaningful and productive manner.

While we were not immune to the risk of the current credit cycle, we have moved quickly to correct, contain, and even preempt areas of our business model in need of improvement. For example, management's efforts to make strategic investment hires, our continued investment in branding awareness initiatives, the integration and enhancement of advanced IT platforms, as well as our continued investment in the training and development of key personnel are all important initiatives which we made top priorities heading into 2008, in addition to the corrective credit quality measures we put into effect during 2007. We are not idle in our efforts to reposition the bank for profitable growth in what is arguably one of the most difficult banking environments in recent memory. By making the most of many tangible and intangible assets at our disposal, and by drawing on the expertise and business relationships that derive from more than a century of community banking experience, our team is committed to reinvesting for growth entering 2008.

With this in mind, we remain focused on the fundamentals of community banking. Guided by a bank-wide directive to grow deposits, improve asset quality, and improve operating efficiency through disciplined expense management. With that, I will now turn the call over to our CFO, Rob Shuster, for a review of our financial performance during the period. Rob.

Thank you, Mike. Good afternoon, everyone. I am starting at page nine of our PowerPoint presentation. I will focus my comments on net interest income and our margin, certain components of noninterest income, and noninterest expense, touch briefly on asset quality, and conclude by making a few comments about our current cash dividend.

If you move to pages 10 and 11, tax equivalent net interest income totaled $31.5 million in the fourth quarter of '07, which was essentially unchanged on a comparative quarterly basis and down slightly about $360,000 or 1.1% on a linked quarter basis. Average interest earning assets were flat on a comparative quarterly basis, but up by $29.6 million on a linked quarter basis. Our average balance of loans grew by $37.4 million in the fourth quarter, with most of this growth in real estate mortgage loans and finance receivables. This interest earning asset growth partially offset a decline in our net interest margin.

As you can see on page 10, our net interest margin was 4.22% in the fourth quarter of '07, down 1 basis point year-over-year, and down 9 basis points on a linked quarter basis. The most significant impact on our net interest income in margin in the fourth quarter was the narrowing of the prime rate LIBOR spread. This is evidenced by the 10-basis-point drop in yield on average interest earning assets due primarily to lower rates on loans tied to prime. But our cost it of funds dropped by only 1 basis point as LIBOR rates remained stubbornly high.

As I stated last quarter, due to the structuring of our balance sheet, and our use of interest rate caps to hedge certain of our short-term borrowings, we anticipate a benefit to our net interest margin from lower short-term interest rates and/or a steeper yield curve. Fortunately, since year end, LIBOR rates have declined, and the LIBOR spread has returned to more normal levels, at least prior to yesterday's three-quarter percent drop in the fed funds rate. In the fourth quarter of 2007, non accrual loans averaged $69.5 million compared to $57.9 million in the third quarter of '07, and $30.8 million in the fourth quarter of '06. The rise in nonaccrual loans has had an adverse impact on both net interest income and our net interest margin. Our elevated level of nonaccrual loans of approximately $76 million at quarter end creates a drag of about 20 basis points on the net interest margin.

Moving on to some of the more significant categories of noninterest income, on page 12 of our presentation, service charges on deposit accounts increased by $1.3 million, or nearly 25% on a comparative quarterly basis, but declined by $147,000, or 2.2% on a linked quarter basis. Historically, we have seen a slight drop in service charges on deposits in the fourth quarter compared to the third quarter. Visa check card interchange income was up 53% on a comparative quarterly basis and was up 7% on a linked quarter basis. The large year-over-year increases primarily reflect the acquisition of branches that we completed in March of 2007.

In the fourth quarter of '07, we recorded a $1 million other than temporary impairment charge on our Fannie Mae and Freddie Mac preferred securities. At year end, we owned $8.6 million in par value of these securities that had a net book value after this impairment charge of $6.5 million. There was a steep decline in the market value of these securities during the fourth quarter due in part to a lack of liquidity in the marketplace, a high aversion to risk, and a massive amount of new preferred securities issued at higher market yields by Fannie Mae and Freddie Mac to shore up their capital. However, since year end, there has been some recovery in the price of these securities.

Gains on the sale of mortgage loans totaled $900,000 in the fourth quarter of '07 on $64.5 million of loan sales. These gains were down on both a year-over-year and linked quarter basis, as the volume of loan sales declined. In addition, a FAS 133 adjustment reduced gains on loan sales by 117,000 in the last quarter of the year. This adjustment will turn around in the first quarter of '08 when the loan sales commitments are filled. Our volume of mortgage loan originations actually increased in the fourth quarter to $147.2 million due primarily to a higher volume of business in our resort lending division.

Real estate mortgage loan servicing income declined on both a comparative and linked quarter basis. We recorded an impairment charge of $297,000 on capitalized mortgage loan servicing rights in the last quarter of the year, a decline in mortgage loan interest rates in the fourth quarter of '07 resulted in using higher prepayment speeds in the valuation of our mortgage loan servicing rights. Mutual fund and annuity commissions have grown in '07 due primarily to adding new investment representatives and ongoing efforts to increase our fee-based business.

Moving on to page 13 of our presentation, noninterest expenses totaled $29.6 million in the fourth quarter of '07, compared to $31.1 million in the last quarter of '06, and $28.4 million in the linked quarter. The last quarter of '06 included a $2.4 million write-off of a receivable at Mepco, and a $3 million goodwill impairment charge. Several categories of expenses, such as occupancy, equipment, data processing, communications, and amortization of intangible assets were up year-over-year due to the acquisition of branches. The rise in advertising costs is associated with our branding initiatives and a relatively new debit card rewards program. Loan and collection expenses are higher due to our elevated level of nonperforming assets.

As evidenced on page 14 of our presentation, the assessment of the allowance for loan losses resulted in a provision for loan losses of $9.4 million in the last quarter of '07. Although this is down from the third quarter it remains at a historically elevated level at about 146 basis points of loans on an annualized basis. For the entire year, our provision for loan losses was $43.2 million, or about 172 basis points on our average loans.

Nonperforming loans on page 15 increased to $80.5 million, or 3.16% of the total loan portfolio at December 31 of '07. This total includes a $1.7 million loan that was sold for cash on January 18, of this year at its face value. The rise in nonperforming loans during 2007 was primarily concentrated in the commercial and real estate mortgage loan portfolios. This is principally due to certain land or land development loans becoming nonperforming as well as an increased level of foreclosures on residential mortgage loans. Stefanie will provide more information and details on our portfolio -- loan portfolios and asset quality during her comments. Further, the Form 8-K that we filed today includes a table on the last page that provides a breakdown of our commercial loan portfolio by loan category and information on both performing and nonperforming watch credits.

Page 16 of our presentation provides information on the components of our allowance for loan losses, which rose to $45.3 million, or 1.78% of total loans. Excluding Mepco's finance receivables in the portion of the allowance that relates to these receivables, the ratio of the remaining allowance goes up to 1.94% of the remaining loans. Net loan charge-offs totaled $6.7 million in the last quarter of '07, or 1.05% of average portfolio loans.

Page 17 of our presentation breaks down the net charge-offs by loan type, the elevated level of charge-offs in mortgage and consumer loan portfolios, principally reflect declining residential real-estate values. When we assess commercial loans for impairment, we consider four factors. The amount of cash flows indicated from the current collateral values, the timing of those cash flows, the discount rate at which the cash flows should be present valued, and liquidation and holding costs. In particular, for real-estate related collateral we have seen declines in expected sales price, extended sales time frames, and higher discount rates to present value the cash flows. One other comment on the charge-off data on page 17 is that our net loan charge-offs include checking account overdraft charge-offs that totaled $1.2 million for all of 2007.

Page 18 of our presentation has some historical balance sheet data. During 2007, we have reduced total wholesale funding by $417 million, or over 32%, reflecting the deployment of funds from our sale of Mepco's insurance premium finance business and from our acquisition of branches. Additionally, during the fourth quarter of '07, we experienced a shift out of brokered CDs and into Federal Home Loan Bank advances as brokered CD spreads to LIBOR have been high, and Federal Home Loan Bank advance pricing has been significantly cheaper. This shift has continued into 2008. Our tangible capital ratio slipped to 4.96% at year end, from 5.04% at September 30, 2007. This decline reflects three factors. Our cash dividend again exceeding our earnings, a decline in accumulated other comprehensive income, and a small increase in total assets. Our internal capital policy requires a minimum tangible capital ratio of 5% at the holding Company level. Our bank tangible capital ratio was 7.34% at 12/31/07 due primarily to the downstreaming of funds raised through trust preferred securities at the holding Company level down to the bank.

As indicated on page 19 of our presentation, parent Company liquidity is very strong, with $19 million in cash and access to a $10 million unsecured line of credit. Further, we do not anticipate any need to downstream capital to the bank. We are committed to remaining well capitalized, which we were at year end, in trying to preserve our dividend. Having said this, our dividend rate is at a crossroad. Our Board of Directors will establish our April 2008 dividend in March after considering our earnings in the first two months of the quarter, our parent Company tangible capital level, our liquidity and our updated outlook for credit loss. Bottom line, earnings must be expected to exceed our dividend level and our tangible capital ratio must rise at least modestly.

My closing remarks during last quarter's conference call were as follows. Obviously our fourth quarter results will be significantly influenced by our level of loan loss provisioning which is difficult to predict but we are hopeful that the downward trend in the third quarter will continue. This downward trend did, indeed, occur, but not at a sufficient level to yet allow us to earn our dividend. Once again, we are optimistic that the downward trend in credit costs will continue, but this is very difficult to predict, particularly in light of the weak economic conditions in our state. This concludes my remarks, and I would now like to turn the call over to Stefanie Kimball.

Thank you, Rob. Good afternoon, everybody. My remarks on commercial lending will begin in reference to page 21 of our hand-out. Total commercial outstandings in the fourth quarter were flat in comparison with the third quarter, and they have declined overall by approximately 2% for the year.

What's interesting to note on page 22 is that the composition of the portfolio has begun to shift in accordance with our strategic objectives. As we outlined in the second and the third quarter, Independent Bank has been contracting our exposure to select segments of the commercial real estate business, specifically the land and land development, while commencing a growth strategy for C&I lending. The impact of this shift can be seen from the 15% decline in the two CRE categories and the 8% growth in C&I loans. This will be our continued focus as we move forward in 2008.

On the following page, page 23, you can see that the land, land development segments are really declining and represent a relatively small portion of our commercial portfolio.

Turning to page 24, you can see highlighted our composition of our portfolio where 17% of the portfolio is generating 47% of our watch credits. This disproportionate contribution to troubled credits is one of the reasons why we are contracting our new loans in these categories. As we have discussed, the segment of land and land development have been troublesome for many Michigan investors, particularly those that are investing in residential real estate. One of the reasons for this is that these are non-income producing properties, and it is very difficult for an investor to continue to support those projects over the long duration of which they have been drug out with the stagnation of our real estate sales.

As you turn to page 25, you can see that our overall level of watch credits has increased to just over $200 million. The increase in the fourth quarter is primarily being driven by some new credits moving into the early watch stage. As Mike referenced earlier, the early detection of problem loans is a key component of our credit quality review process which was instituted Company-wide on a consistent basis at the end of the second quarter. We have conducted now three of these reviews and have in place the proper coaching for our lenders who are monitoring credits and a transition plan to the special assets division for those weaker credits. The specialized special assets team commenced operations at the beginning of the third quarter and now manages most of our credits in the latter stages, certainly the nonaccrual and the substandard loans. Most of those are now managed by that team.

As you turn to page 26, just a couple of highlights are summarized. As previously noted, our strategic shift towards more commercial and industrial loans, the traditional areas of community banking is underway. This fits really in nicely with our community banking approach and also with our deposit gathering efforts. We have also commenced what will be a comprehensive training for our commercial lending team that will assist our lenders as we work through this difficult Michigan economic cycle as well as assist them in transitioning to our focus on more traditional C&I credits. Another key aspect of our strategy has been to transition commercial lenders with real estate experience in particular to our special assets team. We expect that as the cycle turns, we will be able to transition some of these lenders back to the line where they will be able to apply the valuable training and lessons of working through this difficult economy.

As we turn to page 27, we'll look at the traditional credit metrics for the commercial portfolio. The 30-day delinquency rate for the accruing loans declined in the fourth quarter. Really, our first decline throughout 2007.

On page 28, as Rob has referenced, the non accrual loans continued to rise, certainly as a percentage of loans, and this is attributable to the real-estate loans that are moving into the nonaccrual category, and as Rob outlined, one of the challenges that we face with real-estate loans is the long time that they he will stay in the nonaccrual category as you go through the foreclosure process. In particular, loans that are secured by residential real estate or have that as a commercial collateral often take 12 months for the foreclosure process.

As we turn to page 29, you can see that the commercial charge-offs have a positive downward trend with $2.6 million in the fourth quarter. We continue to look very carefully at real estate values as we do our loan loss reserve assessment each quarter to make sure that the values are realistic and that the time frames and costs of liquidation are appropriate.

On page 30, a couple of comments summarize the economic head winds that continue to challenge our clients. As Mike pointed out, Michigan's economic environment continues to be a challenge in this -- for our business clients in this state, particularly those with the -- that are dependent upon the sale of residential real estate. We now have record levels of real estate inventory in many communities that we serve. We have experienced significant commercial real estate devaluations. However, most of our commercial real estate exposure in these areas has already been placed on watch status and is moving through the watch cycles. One brighter note is that the geographic diversification within our state does help mitigate the stress that we are currently experiencing in southeastern Michigan. For instance, our Grand Rapids market is growing more, certainly, than the owe that we're seeing tin southeastern Michigan market.

In previous conversations in calls we have talked about a number of credit quality practices that were implemented in 2007. Many of these are summarized on page 31. We believe that these new best practices that have been implemented position Independent well to continue to weather this credit storm. Some key components we've mentioned over the quarterly watch process, our independent risk rating process by our credit officers, which is done up-front, and also includes structure recommendations as new loans have been made. The formation of our special assets group, an increased importance placed on loan review, accountability for our lenders, which has been emphasized in our management objectives this past year. We have developed a new risk-based pricing model which ties in nicely with our shift into more commercial and industrial loans, enhancing our collateral monitoring and monitoring concentrations in the portfolio as outlined previously with our shift towards more C&I loans.

With that I will turn to retail credit quality. On page 32 of our slide. As Rob mentioned, the retail loan balances were up slightly in the fourth quarter, which is a result of an increase in our resort lending division.

On the next page, page 33, you can see that the delinquency rate for the residential mortgage side also declined, similar to what we saw on the commercial side.

Page 34 shows a similar trend with nonperforming assets growing in the fourth quarter. For the residential and consumer portfolios. This is being driven by higher levels of ORE and higher foreclosure rates which are challenging Michigan borrowers. The higher foreclosure rate is being experienced for a number of reasons, one of which is with the decline in the values, it is much more difficult for borrowers to refinance if they get in over their heads with credit cards or other expenditures. In the past, real estate appreciate was a nice out for many of those individuals.

On page 35, you can see the increase in the net charge-offs for the fourth quarter for the mortgage and consumer side. Again, a key contributing factor was the mortgage and home equity loans which experienced write-downs from the reevaluation of the underlying collateral with the decline in Michigan real estate values. With that I will now turn over the call to Mike Magee for his closing comments.

Thank you, Stef, thank you, Rob. As one of the oldest and most well established banking brands in Michigan we have weathered a variety of market cycles and business trends over the years. I am confident that the substantial structural and operational changes implemented in 2007 will begin to positively impact our business in 2008, positioning us for an improved performance over time. That concludes our prepared comments. At this time we will open the line for questions from investors and analysts.

(OPERATOR INSTRUCTIONS) Our first question comes from Terry McEvoy of Oppenheimer.

I'm just trying to get a sense for provision levels in 2008. Looks like nonaccrual loans were basically flat, a decline in 30 days, but you still built a reserve about $2.7 million. Could you just talk about what you're looking for in terms of provisioning for 2008 and how much in excessive charge-offs do you think the provision will be?

Terry, I think the real key on the excess is going to be what is happening with a couple things. One is the overall level of nonperformers. If the level of nonperformers stay flat and the movement of watched credits, we went up, as Stefanie said, to out 204 million, if that starts to flatten out, that's going to be extremely helpful, because we're not going to get a push-up from those two components. We do not -- as you might imagine we don't project much in the way of loan growth in '08 so we don't expect to see a push-up in the provisioning level because of loan growth, and so if you're not seeing any large increases in nonaccruals or watch credits where we have higher reserve levels, and if we don't get any more significant devaluations in property, it's almost hard to imagine that you're going to see much worse than what we're at, because sales are slow to almost zero. All of those things are going to take pressure off the provisioning levels.

As you pointed out, one of the things we felt optimistic about is the 30 to 89-day delinquency levels declined, and if those -- if that metric also stays in place I think what that will do is take pressure off of building the reserve, and you might then get to a situation where basically you're just covering your net charge-offs, and in the event that that occurs, I mean, you could see provisioning levels certainly drop down into the 100-basis-point or so range. I'll caveat everything I'm saying by that is obviously a forecast, but -- and I think there's still concerns regarding the economy, but there's some factors there that lead us to be optimistic.

Then the last comment I would make in that regard before I'm sure Stefanie will have something to add is, if you look at the last page of the 8-K we filed, one other item is in the land and land development categories, which have been the most problematic, there is a finite level of loans there, the total between those categories are about 90 million and about 80% of the land loans and 100% of the land loans in southeast Michigan are already in watch credit or nonperforming, which means we've looked very carefully at valuation, and then about 66% of the land development loans are already in watch credit, nonperforming, or performing watch credit. So the other thing is we're just sort of running out of that category of loans. Stefanie you probably had something to add.

A couple of comments I'll add, Rob, thanks. Is that certainly going into any year you would forecast some of your borrowers that aren't in the watch category to migrate into watch. One of the keys is trying to estimate those that do get better or go through the cycle. And certainly going into 2008, we're not expecting it to be a big growth year or have a lot of recovery in the economy. We do expect a lot of our customers to continue to struggle. Our commercial lenders are working closely with them to see them through this cycle, and hopefully our efforts will result in some of them moving out of the category, and as we help people with earlier problem recognition, the movements will not be as fast through those grades and customers will be able to continue to hang on.

And are you making any assumptions about home values in Michigan, volume of home sales within your internal modelings that help us out on how you see the Michigan housing market shaping up this year?

Well, I think the values have come down quite a bit, and I've said this before. A lot depends on price point. The higher you go, the more potential discounting you get, because the higher priced homes that market is just much thinner. The average -- the average loan amount in our residential portfolio is $116,000. As I'm sure you're aware, our footprint encompasses a lot of smaller to mid-sized communities, and I guess one of the things we feel that will help a bit in that regard is that we're at lower price points in general in the market in our portfolio. Where we've seen higher losses have typically been in either the higher end homes or perhaps, just special type of circumstances, but in general you've got a lot more granularity in that portfolio. So what we're going to kind of pay attention to is that 30 to 89-day delinquency.

If we could really work to keep people from slipping, because what happens, and Stefanie mentioned it, once they get up into that 90-day category, it becomes very difficult for them to solve that delinquency. They can't refinance because the home value is down, and the traditional ways they might have been able to dig themselves out are not there. What we would work with people on is everything from short sales and trying to be creative because our preference is to not take more foreclosed real estate collateral. So I think it's going to be difficult to project, but again, the things we're going to pay attention to, 30 to 89-day delinquencies, and if we can keep those low, I think, net charge-offs there will behave fairly well.

I'd just like to add, because we are watching that 30 to 89-day category closely as Rob pointed out. I think what's going to help, too, is just the interest rate environment right now. It could help the real-estate market. Just a month ago the 30-year rate was 6.25. Today did it's 5.375. The 15-year was 5.875. Today the 15-year is at 4.875. It's a substantial drop in rates, and I think that will help also the mortgage market. As it makes more homes affordable for certain borrowers.

We have -- we're not exactly sure when it's going to turn around, Terry, so we have been basically watching our expenses in the origination of real-estate mortgages. If anything, we have been down-sizing considerably. We feel like if we're in a position that if we need to add staff because all of a sudden there's an increase in demand, we can do that mainly because of the amount of brokers that are currently looking for employment.

The other point I'd like to make, because Rob points to how closely we're watching the 30 to 0--day bucket of performing mortgage loans, I'll tell you how closely we're watching it. The individuals in charge of that area informed me last week that they looked at every 30-day past-due mortgage, and they were pleased to find that all the loans of all the customers that were in the 30-day bucket, all of them had been in that bucket before. All of them had been 30 days past due before. There was not one new borrower that hit the 30-day past due. So they consider that to be a real positive sign that there wasn't a first time someone hitting the 30-day past-due category. The fact that our mortgage delinquency in the 30 to 90-day area is just over 1.5%, and that's a very decent drop since the third quarter of '07. Hopefully that is the beginning of the trend, and we don't see it go back up the first quarter of '08. But maybe with the relief of rates, that should help.

One other comment on the relief of rates. Obviously we hold in our portfolio a fair amount of adjustable rate loans which are tied to the treasury rates, and those are not likely to go up in price, so you're not going to -- you've heard all the horror stories about the subprime issue, but those ARM rates, which are just sort of traditional ARMs with 2% annual caps and 6% life caps, they're likely to be repricing lower, which, again, will take some stress out of the portfolio in terms of borrowers being able to make payments. Similarly, on home equity loans, with prime going down, same type of thing. And some of our commercial customers.

The only thing I would add on the commercial side is that as we did look at our loss forecast and provision estimates for '08 we did factor in some further softening of the commercial real estate.

Thank you.

(OPERATOR INSTRUCTIONS) Okay. Our next question comes from Jason Werner of Howe Barnes.

My first question, looking at the problem loan categories, the land, land development, construction, obviously it's very difficult to kind of figure out what's going to make its way over from performing to watch, and then maybe the nonperforming. I was kind of curious to look at it from the other angle. Looking at this portfolio, what in there -- can you give us an idea of what is really solid, what kind of loans have better ratings where there's pretty solid borrowers that you're pretty comfortable won't migrate over to watch? Do you guys have any sense of what that level is?

We do have, Jason, a number of solid customers that are in that category. They're typically investors that have either a very diversified portfolio of other real estate investments with quite a bit in the income producing category, or they're usually other business owners that have the investor real estate more as a side investment. So we have a number of those borrowers, but as Rob pointed out, we really don't have a whole lot of loans that are not in the watch category in either portfolio.

And what's not in watch is now tends to be much more granular in the sense that they're smaller balances. So even if you have some of those slipping, I guess I'm optimistic that the severity of loss will not be what we've experienced during '07. If they've made it this far, not to say that they -- you can't get some slippage, but if they've made it this far, at least there's some hope that they won't slip, and I think as Stefanie points out, one of the reasons they've been able to make it, as for as they have, is because they have diversified portfolios or other sources of cash flow to support -- to support the credit.

Rob, why don't you comment, too, on the migration analysis as part of our loan loss research. We kind of use a number what might migrate.

Yes, we do a migration analysis as part of the work we do on our determination of the allowance for loan loss. Actually what we do is we figure out a probability of default, and then a loss given default rate, and that then we use that to determine a allowance level by grade of commercial credit. So all of that data was updated using 2007 data, so obviously with looking at 2007 data, that probability of default went up, and that did boost some of our allowance rates on several of the categories. So what you did is basically bring forward with that current data, but I think it's a good methodology in order to try and estimate losses in the loan portfolio.

The only other comment I would add in terms of Rob was mentioning the granularity of the vacant land and the land development category, our largest loan in the vacant land category is $1.6 million. And in the other category, land development it has outstandings of about $2.9, just under $3 million. So, the loans, individual loans in those categories are pretty small, and for the most part those are much more manageable for somebody to keep up the payments, given that they're nonincome producing, for them to be able to take investment income from another source and keep payments up is much easier than when they're the much larger loans.

Those loans you just mentioned, those are the loans that are performing nonwatch?

Correct.

Now, overall, the balance for these three categories didn't really go down much. In fact, actually I think it went up a little bit. I think it was $184.7 million in the third quarter and it's $186.1. I'm assuming that's just drawdowns on construction loans, assuming you're not adding new loans in these categories. I guess my question is really when can we expect to see some of this stuff kind of pay off? To the extent that some borrowers are doing better and able to pay it down?

Well, as Rob was mentioning, the sale of the residential lot is certainly a very sparse market right now. So what we are doing, as we work with each of our clients, is looking at their ability to continue with the investments that they have. I wouldn't expect huge pay-downs from any of the clients unless they were to move their relationship really to another bank, because the lot sales are just not forecasted to be that aggressive in 2008.

Okay.

To your question about new, I mean, there's virtually -- I would say there's nothing new. You may -- as you indicated, you may have draws occurring in the construction category on stuff that's performing or we might be allowing what we would call protective draws for some reason where you're trying to complete, if it's a condo project, complete a building and get it so it's not exposed to weather, that type of thing, but in terms of new stuff coming on, not only do I think banks would be very unlikely to make the loan, there's just no developers who would be out there doing this in this type of environment.

That's kind of what I had figured. Also, I noticed in that same table in the back of the press release the owner occupied commercial real estate saw a pretty big uptick in the watch credit level performing. The nonperforming was up a little bit, but almost a $10 million uptick in the watch part there. Can you give us a little color on what's going on there?

Yes, what that, I believe, is -- the movement of one particular borrower that has moved into the early stage of the watch category, where we have a loan on their premises, as a participation.

Now when you say in the early process of being watched. I know in the last call we had talked about how your watch includes 7 and 8s. This particular loan where does that fit in?

It's in that 7 or 8 category. So it's just moved into that process.

Most of those loans are current. It's just that, with data we get in terms of either debt service coverage or some other factors, we're moving it into that watched credit status. I think the one thing that you will see is we are going to be very proactive in moving credits into those 7 and 8 rated categories, not because -- I mean, in one sense, it makes a table like that not look so good, but it's the management of that credit. If you could get on it early because many borrowers have multiple relationships with many financial institutions, you stand a better chance to shore up or in some fashion, restructure the credit to make sure it does not later default.

Okay. Moving away from credit quality for a second, and over to net interest margin, I was kind of curious what the impact from credit issues were on margin. You had mentioned the narrowing LIBOR prime spread, you didn't say anything about credit quality. Since you didn't have as many -- as big an increase in non accrual, maybe that wasn't as big an impact this quarter as it was last quarter but can you give us some color as to how much credit impacted margin in the quarter?

308,000 for the fourth quarter versus 415,000 for the third quarter. So your premise of it being a little less of an impact is correct. When I say 308, Jason, that's what we reversed and accrued in uncollected interest during the fourth quarter. And it was 415 in the third quarter.

Then last quarter you had mentioned what the -- kind of ongoing drag on the level of NPLs were. Do you have that number for us this quarter?

I said it's 20 basis points is the drag. And I just do that, it's not real -- what I'm doing is I'm just taking our level of nonperformers at quarter end, and I'm essential just multiplying it by our average loan portfolio rate. So, that's not to say those are the exact rates on those loans. I mean, as a practical matter, the loans are all on nonaccrual, so they have 0 rates, but I just use the average rate for the loans of 787 for the fourth quarter as a proxy for what those would have been earning had they been on accrual status. And we had about 76 million of non accrual loans at the end of the year. So I'm just taking that figure times that rate, then looking at it as a percent of average -- total average interest earning assets.

Now that could overstate -- it probably overstates it, because although I'd like to think there would be this panacea, where you had a 0 level of nonaccrual loans, I've never seen that. So there's probably a normal level of nonaccrual loans, whether it's $30 million or whatever, so you're always going to have some amount of nonearning assets because of nonaccrual loans. But the 76, the 20 basis points, that's how I get to it.

Okay. Then last question, and I'll give somebody else a chance, Rob, with your comments regarding the dividend, I guess I kind of -- seemed to me it's a little bit of a change in tone a little bit. Kind of sounds like that if after two months of the year if you haven't earned your dividend then you guys are going to take a hard look at maybe doing something with that dividend. Is that what you're intending -- was that your intended meaning?

Well, I mean, Mike can weigh in. I'm stubborn as all get out. I will defend it to the last bitter breath. I just think it's very important. But we've gone five quarters without earning that dividend. We have slipped below 5 on tangible, although there's no rule that says you have to be at a certain tangible capital level at the holding Company. And as I said, the bank's tangible capital ratio is 7.35%. we've got capital at the holding Company by way of trust preferred securities that are very long-term items. They have maturity dates way out into the 2030s. And so that doesn't get counted as tangible capital at the holding Company. I understand tangible capital is kind of king today.

As you know, we've always been relatively aggressive managers of true common equity capital. And historically, we always had enough earnings where we could cover our dividend, fund our growth, and buy back stock. And we haven't been there for five quarters. And so I don't know if it's -- we've been -- we really do not want to have to adjust our dividend. And yet when you get into that sixth quarter, I guess we're optimistic, and we've made comments about that, that hopefully we're starting to get this credit issue a bit behind us, and as I said, I mean, there's some other things we can look at, maybe some sales of investment securities, deleverage a little bit. So we're going to look at all of those elements, but the last thing we want to do is cut that dividend, but if we really are still seeing that drag from elevated credit costs, it's at the point where you're into the sixth quarter of that, you at least have to really give it some serious thought.

I will just add, based on Rob's comments, I think it's obvious we've had a lot of discussion about this within IBC, and it will -- it's an item that we'll be discussing with the Board in a couple weeks, and obviously towards the end of the first quarter we'll be spending a lot of time with the Corporate Board to make a decision what to do with the dividend going forward. As Rob pointed out, you can't look at the issue in a vacuum. There's so many exterior factors that will have an impact on the decision on exactly what we do with the dividend. What I think -- I'm not sure how much of a dividend cut is already baked into our stock price, because we've had such a tremendous yield on our stock, but we definitely, as Rob pointed out, if we don't have to cut our dividend, we don't want to, we've maintained it where we have because we feel it's really to the benefit of the retail shareholder who is stuck with IBC. It's our way of thanking them for staying with us during these difficult times. So it will be a tough decision for the Board of Directors.

Jason, to me, and I'm not saying this flippantly, but the best solution is -- to the high dividend yield is, earnings up, stock price up, then your dividend yield will go down. And that, to me, is what we want to accomplish. I'm sure banks that have cut their dividend want to accomplish that as well, but I just don't feel like our present situation is dire in any way, shape, or form. I mean, I want to reiterate the fact that our tangible capital level at the bank is 7.34%. Our tier one capital ratios are north of 7 -- tier one leverage, north of 7%, even at the holding Company. We've got plenty of liquidity at the holding Company. We've got $10 million on a line that's undrawn. So it's not a liquidity issue. And if we feel our credit situation is getting better, not worse, then I think those are things that, to me, I'd sure like to hang on to that dividend rate.

Well, thank you, everybody.

Thanks, Jason.

Our next question comes from Brad Milsaps of Sandler O'Neill.

Hey, Rob, I may have missed in this your comments, and probably did, but the operating expenses this quarter, is that a fairly good run rate to use in 2008?

Well, we've probably got about $600,000 of higher items in there, just sort of a hodgepodge of stuff, a few things that sort of rolled over from the bank charter conversion. We did have -- it certainly wasn't as big a number as I saw a lot of banks indicating, but our puny share of the Visa, Inc., litigation settlement was a couple hundred thousand, so that's a one-time item. So there are about $600,000 of one-time items so that would bring you down more to that $29 million or so level. The one thing I am a bit concerned about for next year, and I think in our press release we mentioned it, our FDIC insurance was up a couple hundred thousand in the fourth quarter, and our dividend -- our dividend, or our credit sort of ran out, and so in that sense, we're going to see a little bit higher FDIC insurance costs. Now, going against that, our brokered CDs have gone down a lot as we've shifted out, but that $29 million level, I think that's not an unfair level, and I'm hopeful we're going to work like heck to get that down, but that -- we've got a couple things moving in the wrong direction, like the FDIC insurance.

Okay. So do you feel like you can lean on expenses that much more at this point, or is that kind of played out to some degree?

Well, we're looking at everything. Like Mike said, we're looking at -- we made some changes even since the first of the year, some in the mortgage banking area, where we've down sized again there, and in some other areas. So we're continuing to look at that on an ongoing basis. I mean, there's no easy low-hanging fruit there, but we sure are continuing to go through in every category, even little stuff. We moved Mepco's headquarters in Chicago, and we're going to save $200,000 annually in occupancy costs because we downsized that space. So just a lot of little things we're looking at there. And, in fact, for Mepco, and it's not a big number, but we even had some elevated occupancy costs with them in the last part of the year because we terminated our lease early there and we had to accelerate our write off of some leasehold improvements. So not big dollars but we're counting every penny there anyways.

Not to belabor the dividend issue too much, but should we -- is really all that -- its future really all banking on the direction of asset quality, or is there to some degree that, you guys may decide that share buybacks or growth opportunities, I know they seem at this point few and far between, but that the returns there might be better, should we view it that way as well?

Brad, that's what I meant by you can't look at the decision in a vacuum. I think you have to look at all of those possible strategies as far as if you were to cut the dividend what would you do with the cash. And everything you mentioned is exactly some of the strategies we'd probably look at implementing.

Fair enough.

The other thing I would say, and it may not play out in the first quarter, but hopefully it will eventually play out, is this -- the decline in short-term rates has been pretty dramatic here and brokered CD rates have not yet caught up, and we're fortunate in our balance sheet that, A, our brokered CDs are already down anyways, but we have alternatives between Federal Home Loan Bank advances and the Federal Reserve bank are doing some auctions. Their last auction went off at 10 under LIBOR, and we've got very large capacity with the Federal Reserve Bank, so, I mean, we've got some alternatives, so I hope we see some acceleration in -- we've been fighting that margin now for a year and a half or more on the downward side. Maybe we're going to get into an environment where it starts heading in the other direction, and despite real estate prices being lower, maybe we see a little refinance boomlet here. So I do think it's been doom and gloom in the financial services and banking industry, but maybe there's just a couple little rays of hope to look at, and so, no, I don't think it's all dependent on asset quality, but we can't keep provisioning at 146 basis points a quarter and maintain a $0.21 dividend. So that's -- when I said we're at a crossroads, that's more what I'm referring to, but I don't think it has to go down to 40 basis points. It just -- it needs to get down to 100 or 90 basis points which still is a pretty high level of provisioning.

Fair enough. Thanks, guys.

At this time we have no further questions.

Well, thank you. With that this concludes our conference call today. Thank you for your interest in Independent Bank Corporation. We look forward to speaking with you gain next quarter. For an archived webcast of today's call, please go to the investor section of our website at www.ibcp.com. The website will be archived on our website for approximately 90 days from today. If you have any questions in the interim, please don't hesitate to give Rob Shuster or myself, or even Stefanie a call. Thank you for your participation, and have a great day.

Thank you. That concludes today's conference call. You may now disconnect.