Independent Bank Corp (Michigan) (IBCP) 2008 Q2 法說會逐字稿

Hello, and welcome to the Independent Bank Corporation second quarter 2008 earnings conference call. All participants will be in a 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 Mr. Mike Magee. Mr. Magee, you may begin.

Thank you. Good morning, and welcome to our second quarter 2008 earnings conference call. I am Mike Magee, President and CEO of Independent Bank Corporation. 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 second quarter. Following Rob's comments, Stefanie will provide a progress report on our lending initiatives and risk management. 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 presentation section of the Investor Relations tab of our website at www.ibcp.com.

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.

Let me first begin today's discussion by addressing our decision to move up the release of our financial results in today's conference call from what was previously announced. As many of you are probably aware, the recent weeks have seen significant turmoil within the investment community surrounding events of several financial institutions. Following the failure of IndyMac, for example, there have been a number of reports regarding the strength of banks and the possibility of future failures. These reports generated some concern among our customers and investors. To help address those concerns and speak about our financial results and the strength of Independent Bank Corporation, we made the decision to move up the date of our release. Please know that it is not our intention to continue this practice going forward.

A summary of our financial results can be found on slide four of the accompanying presentation. For the second quarter ended June 30th, 2008, we reported income from continuing operations of $3.3 million or $0.15 per fully diluted share, compared to $108,000, or $0.00 per fully diluted share in the second quarter of 2007. We are very pleased with the improvement in our current quarter results. Before taxes and the provision for loan losses, our income on an annualized basis would be more than $64 million. These results are a testament to the financial strength of Independent Bank and the ongoing efforts of each of our employees.

Turning to slide five. During these uncertain times, adequate capital and liquidity have become extremely important to financial institutions. Thus, our board made the difficult but prudent decision to reduce our quarterly dividend. This action, along with earnings growth and deleveraging the balance sheet will allow us to enhance our capital ratios going forward.

The economic conditions for the Michigan economy, particularly in the residential market remain weak. As a result, we continue to experience elevated loan loss provisions and increased costs associated with managing these credits. Because our non-performing loans remain at an elevated level, this area remains our number one priority. We have begun to experience success from both our retail collections department and our commercial loan special asset group in moving some of these non-performing loans out of the bank.

Despite our cautious outlook on the residential market and the overall economy in Michigan, we are encouraged by the slowing rate of growth in our non-performing loans in watch credits. In addition, we saw improvement in our commercial loan delinquency rates. We do not view this improvement as a bottom in the housing market, but more of a reflection of the ongoing efforts of our team to proactively identify and assess potential problem loans.

As we continue to navigate a challenging economic and banking environment, our outlook on asset quality remains cautious. We have discussed on several occasions the number of strategic initiatives we have implemented to improve credit quality, enhance profitability, and maintain our franchise value. We remain convinced these actions continue to strength Independent Bank's foundation for future growth.

With that, I will not turn the call over to our Chief Financial Officer, Rob Shuster, for review of our financial performance during the quarter.

Thank you, Mike. Good morning, everyone. I am starting at page seven of our PowerPoint presentation. I will focus my comments on net interest income and our margin, certain components of non-interest income and non-interest expense, asset quality, and conclude by making a few comments about capital, our dividend, and goodwill.

As outlined on page seven, there were several positive factors impacting our second quarter 2008 results. Most notably was the strength of our net interest margin. The challenges are consistent with what we have faced for several quarters with credit-related costs still at elevated levels.

Page eight outlines a few unusual items impacting the second quarter, including securities gains, a recovery of previously recorded impairment charges on capitalized mortgage loan servicing rights, a write down of ORE properties, and expenses associated with a few litigation matters. Two litigation matters that were settled for a total of $160,000 relate to bankruptcy preference proceedings and the collection of loan payments from two former borrowers in Mepco's Insurance Premium Finance Business. The other litigation matter involves the release of funds from a deposit account in response to an IRS levy. We have accrued about $300,000 on this matter and intend to vigorously pursue restitution if we ultimately incur any loss. All of these various items actually netted to about zero, and, thus, did not collectively impact the quarter.

As noted in our first quarter 2008 conference call, effective January 1, 2008, we elected fair value accounting for several preferred stocks that we own. Slide nine provides details on these preferred stocks. The market values did not move significantly between the end of the first and second quarters. However, subsequent to June 30, 2008, the market values on these securities have declined. Obviously, we cannot, today, predict where the market values will end up at September 30th, but this change will be reflected in non-interest income in the third quarter. Partially offsetting these potential fair-value declines, are gains that we have generated in July on the sales of municipal securities.

If you move to pages 10 and 11, tax equivalent net interest income totaled $34.5 million in the second quarter of 2008, which was up $2.5 million or 7.7% on a comparative quarterly basis, and was up $2.8 million or 8.7% on a link quarter basis. Average interest earning assets were down on both the comparative quarterly basis and a linked quarter basis. On a link quarter basis, average loan balances were up and average investment security balances were down. The overall declines in average interesting earning assets were more than offset by the increase in our net interest margin.

As you can see on page 10, our net interest margin was 4.68% in the second quarter of '08, up 41 basis points year-over-year, and up 38 basis points on a link quarter basis. In the second quarter of '08, non-accrual loans averaged $104 million as compared to $83 million in the first quarter of '08, and $44.5 million in the second quarter of '07. We reversed $609,000 of accrued and unpaid interest on loans placed on nonaccrual in the second quarter of '08, compared to $797,000 in the first quarter of '08, and $446,000 in the second quarter of '07. Our elevated level of nonaccrual loans of approximately $111 million at quarter end creates a drag of about 26 basis points on the net interest margin.

Our ability to bring our cost of funds down at a faster pace than the decline in our yield on interest earning assets has allowed us to improve our net interest margin. Page 12 provides information on the sharp decline in our level of brokered CDs. Because we issued a lot of callable brokered CDs, we have been able to exercise our call rights and pay off the higher costing brokered CDs with lower cost borrowings from the Federal Home Loan Bank and the Federal Reserve Bank.

Looking ahead and assuming that short-term interest rates remain relatively low, the yield curve remains upwardly sloped and that nonaccrual loans do not rise significantly, we would expect the net interest margin to remain relatively consistent with the second quarter 2008 level. One other caveat is that we have recently seen some aggressive pricing on CDs from some of the very large banks in our markets.

Moving on to some of the more significant categories of non-interest income on page 13 of our presentation, service charges on deposit accounts decreased by $216,000, or just over 3% on a comparative quarter basis and increased by $517,000, or just over 9% on a link quarter basis. The link quarter increase is primarily due to traditional, seasonal variations and NSF occurrences and related fees. However, the comparative quarterly decrease is due to a decline in NSF occurrences and related fees that many banks are experiencing and that I believe reflects belt tightening on the part of consumers.

Visa check card interchange income was up 15.7% on a comparative quarterly basis, and was up 9% on a linked quarter basis. These increases reflect both growth in our debit card base and higher usage rates by our customers.

Gains on the sale of mortgage loans totaled $1.1 million in the second quarter of '08, on just over $80 million of loan sales. This compares to gains on the sale of mortgage loans of $1.9 million in the first quarter of '08, on just over $84 million of loan sales. As you may recall, the first quarter of '08, the gains were elevated by an $821,000 adjustment related to FASB 159 and Staff Accounting Bulletin 109.

Our volume of mortgage loan originations in the second quarter of '08, was just over $111 million, which is down on both a year-over-year and link quarter basis. As you are probably aware, mortgage loan interest rates rose in the second quarter, which slowed down refinance activity. Additionally, continued changes in underwriting criteria by Fannie Mae, Freddie Mac, and the private mortgage insurance companies, has made it more difficult for borrowers to qualify. The combination of higher mortgage loan interest rates and more stringent secondary market underwriting criteria is likely to reduce future origination volumes. However, this may be partially offset by fewer competitors in the marketplace.

Real estate mortgage loans servicing income increased substantially on both a comparative and link quarter basis. We reported a recovery of $996,000 on previously recorded impairment charges on capitalized mortgage loan servicing rights in the second quarter of this year. The aforementioned increase in mortgage loan interest rates resulted in using lower prepayment speeds in the valuation of our capitalized mortgage loan servicing rights.

Moving on to page 14 of our presentation, non-interest expenses totaled $31.2 million in the second quarter of '08, compared to $29.8 million in the second quarter of '07, and $30.3 million in the link quarter. Compensation and employee benefits in the second quarter of 2007, did include $1 million of severance expenses related to staff reductions association with the bank charter consolidation we completed last year.

We have worked diligently to manage non-interest expenses. And if you exclude loan and collection costs and the loss on other real estate owned, our remaining non-interest expenses would be down by about 1% compared to 2007, despite adding staff in our special assets group and collections department.

Loan and collection expenses are higher due to our elevated level of non-performing loans. The loss on other real estate and repossessed assets is elevated due primarily to write downs on repossessed properties based on prices we are liquidating these assets at.

A couple of other comments on this topic. First, we believe that we are presently seeing the worst of the losses in this portfolio, as the weakest credits are now moving through the collections process. Second, as you might expect, the larger losses are coming from larger loans. As a whole, our mortgage loan portfolio has an average loan size of $119,000. Thus, we have limited amounts of jumbo loan exposure.

As evidenced on page 15 of our presentation, the assessment of the allowance for loan losses resulted in a provision for loan losses of $12.4 million in the second quarter of '08. This level represents about 193 basis points of portfolio loans on an annualized basis.

Non-performing loans, page 16 of our presentation, increased to about $111 million or 4.34% of total portfolio loans at June 30 of '08. The rise in non-performing loans during the second quarter was primarily concentrated in the commercial and mortgage loan portfolios. Stefanie will provide more information on our loan portfolio during her comments.

Page 17 of our presentation provides information on the components of our allowance for loan losses, which rose to $51.1 million, or 1.99% of total loans. Excluding Mepco's finance receivables and the portion of the allowance that relates to these receivables, the ratio of the remaining allowance goes up to 2.21% of loans. One statistic that gets a lot of attention is the ratio of the allowance for loan losses to non-performing loans, which, for us, was at 46% as of June 30, 2008. In reviewing this statistic, it is important to note that many of our non-performing loans have very little allowance associated with them because they have already been charged down to the expected net realizable value, including considering estimated liquidation costs. Stefanie will provide more detail on non-performing loans during her comments.

Net loan charge offs totaled $11.3 million in the second quarter of 2008, or 1.78% of average portfolio loans. Page 18 of our presentation breaks down the net charge offs by loan type. In particular, we took statutory charge offs on several commercial real estate loans during the second quarter as they reached 180 days past due.

Page 19 of our presentation has some historical balance sheet data. The $425 million decline in total deposits in the second quarter of 2008, actually, for the first six months of 2008, is primarily due to the reduction in brokered CDs that I outlined earlier in my remarks.

Moving on to page 20. Our tangible capital ratio increased to 5% at June 30 of '08, compared to 4.97% at March 31 of '08. Earnings in excess of our dividend level drove this increase. At the bank level, the tangible capital ratio was at 7.49% at June 30 of '08. We remain well capitalized at quarter end.

As previously announced, we reduced our July 31, 2008 cash dividend to $0.01 per share, or about $230,000 per quarter. Our after-tax interest cost on our trust preferred securities outstanding is about $1.1 million per quarter. Thus, the total current quarterly parent company cash requirement is approximately $1.4 million per quarter, which equates to about $0.06 per share of net income. Parent company liquidity was at $11.2 million as of June 30 of '08.

We do not anticipate any need to downstream capital to the bank, and, in fact, we initiated a deleveraging strategy in the second quarter. Over a longer time period, our goal is to reduce total assets by $300 million to $400 million, with most of this reduction in the loan portfolio through amortization and payoffs in excess of new portfolio loans. Because of the present extremely high cost of capital, our hurdle rates for putting any assets on the balance sheet have increased. We expect this deleveraging to enable us to reduce wholesale borrowings and further increase our regulatory capital ratios.

Our board of directors will establish our October 31, 2008 dividend in September, after considering our earnings in the first two months of the third quarter, our parent company tangible capital level, our liquidity, and our updated outlook for credit costs.

In closing, I want to make a few comments about goodwill. We have approximately $67 million of goodwill at June 30 of '08. About $17 million of the goodwill is contained within our Mepco reporting unit and the balance is at our Independent Bank reporting unit. Typically goodwill impairment testing is done on an annual basis at year end. However, as a result of the significant drop in the price of our common stock during the second quarter, which, in some respects, may indicate adverse changes in the business climate, we are conducting an interim impairment test.

Based on our preliminary review and our strong level of pre-tax, pre-loan loss provision earnings, we believe that we will not have any impairment. However, we have also engaged a third party to assist management with this analysis, and they are still in the process of finalizing their work, which will be done prior to the filing of our second quarter form 10Q. As you know, any goodwill impairment charge would have no impact on our regulatory capital ratios.

This concludes my remarks, and I would now like to turn the call over to Stefanie Kimball.

Thanks, Rob. My remarks will follow slides 21 through 35, and I will be discussing our credit quality results and the initiatives we have in place to navigate through this challenging credit cycle.

Starting with page 22, we have highlights summarized with regard to our commercial lending business. As we have discussed on previous conference calls, our new strategy for this line of business was put in place in mid-2007. Results from the execution of this strategy are now becoming clear. More specifically, numerous initiatives were undertaken last year to position our bank in the short term for the slower economy and in the long term to re-shape the portfolio to achieve more consistent and sustainable profitability and growth. For example, tighter underwriting criteria was implemented, along with a change in the targeted customer base and a realignment of our management by objectives to further those two changes.

The credit initiative and the new loan origination constraints have assisted us in slowing the inflow of new credit into the watch category. Also, we have started to see some credits move out of the watch category in a positive direction, with additional collateral guarantees or improved operating performance. One of the new credit initiatives increased the resources devoted to managing commercial loan delinquency this quarter, which we can see in our improved second quarter delinquency rate.

As loans migrate through the workout cycle, nonaccruals have increased and they have been written down on average 32%. This quarter we have provided more details on the composition of the nonaccrual portion of the portfolio which I will review shortly. Another key part of our credit infrastructure is our special assets group, which has begun to have success with $10 million in pay downs and payoffs in the first six months of 2008.

Turning to page 23, with that as an overview, let's look at the specific credit metrics starting with the trend of outstandings. Commercial loan balances for the year are about flat, as planned. As Rob indicated in the second half of the year, we intend to deleverage the balance sheet and are adding very selectively new loans into the portfolio as we replace some of the runoff.

Turning to page 24, the progress we are making in achieving the strategic shifts in our portfolio segments is illustrated, which demonstrates the reshaping of the portfolio, specifically the decline of the CRE categories of land, land development and construction is in process, while the C&I and owner-occupied categories have risen. This helps us not only manage our concentration in real estate, but also should have a positive impact on credit quality longer term. I should note that in this past quarter, we did close out a number of completed construction projects and move them into their appropriate categories, primarily income producing and owner-occupied.

Turning to page 25, we can look more specifically at these segments and you can see that more than half of the land and land development loans are classified as watch. The remainder of the land loans are quite granular with only four loans above $1 million. The land development portfolio is also fairly granular with only seven loans remaining above $1 million.

Turning to page 26, this shows the cumulative trend in our watch credits, which continue to increase, albeit at a slower rate this quarter. Last year the quarterly increases were double digit, where this year the inflow has slowed to a 4% net increase in the first quarter and again to a 3% net increase in the second quarter. I should note that this graph is cumulative, showing all credits in the internal watch and worse categories to include the nonaccruals.

On page 27, details of our commercial loan delinquency rate are shown. The delinquency rate declined to 1.79% from 3.4% in the first quarter. As I previously mentioned, this is a result of an increased focus and additional resources which help contact clients to keep payments timely. Also, in this challenging environment, it is necessary to renegotiate terms with clients far ahead of maturity dates, which did negatively impact, to some extent, our results last quarter.

On page 28, the nonaccruals are shown and they continue to increase. The composition of these loans is further detailed on page 29. A large percentage of the nonaccruals, as you would expect, are in the commercial real estate category, which often takes quite some time for resolution. Approximately 52% are in the higher risk categories of land, land development, and construction. We have factored lengthy hold times into our valuation of these loans, with an average write down of 32%. For example, if a loan had an 80% loan-to-value to begin with and had the average 32% write down, this would equate to roughly 54% valuation of the property. As we have previously discussed from an accounting perspective, we are writing these loans down to our best estimate of the market on a regular basis to include discounts for the anticipated holding time.

In terms of actual discussions with clients, we are taking an approach of working with our clients as long as they are working with us. We believe in many cases that the clients can be the best brokers of their own properties with proper supervision, and that they are well connected and know a lot of potential buyers in the market and they are highly motivated to minimize their own personal liability for any shortfall. Out of our $73 million of nonaccruals, two-thirds of them fall into this category, where we are continuing to work on some kind of forbearance, either formal or informal, with the client. The balance is in the process of foreclosure and/or litigation.

Turning to page 30, commercial charge offs rose this quarter to 79 basis points or $8.4 million. These losses primarily were reserved in previous quarters, and, as Rob mentioned, had a large percentage of statutory charge offs. The new provision for the quarter attributable to commercial loans is about the same amount of this charge off. Losses like the nonaccrual composition are heavily driven by our commercial real estate segment.

I will now turn attention to our retail portfolio, starting on page 31 with a summary of the highlights and then we'll turn to the key metrics. Highlights for the retail portfolio are shown here. The retail business constrained their new loan originations last year with tighter credit underwriting parameters. Given our current desire to deleverage the balance sheet, we will continue to be even more selective in the second half of the year with both consumer and mortgage originations that we hold for our own portfolio. Certainly the secondary market has tightened, as Rob mentioned.

Retail delinquencies are stable with an up-tick in the consumer segment this quarter, which has been offset by a decrease in mortgage.

Now turning to the specific metrics on page 32. Retail loan balances at quarter end were relatively flat with mortgages totaling $862 million and consumer loans at $367 million.

Turning to page 33. The delinquency rate for the 30-plus categories applying for the mortgage portfolio to 2.06%, which was somewhat offset by an increase in the consumer portfolio's delinquency rate to 1.54%. The easing of the mortgage delinquency is partially attributable to the additional collection resources which were devoted during the quarter.

On page 34, we have details of the retail nonaccruals. They do continue to rise in the second quarter. We have established a number of channels to assist us in handling ORE as we complete the foreclosure process. We have a website internally where we advertise the properties for our employees, and we are in the process of extending that to people outside the bank as well.

In addition, we have established relationships with realtors and auction houses that we know that are operating in the communities that we serve. On average, we have written down our non-performing mortgage loans to 62% of the original appraisal. In general, most of our nonaccrual loans are very granular, as Rob highlighted our average loan amount. Most of the homes are in the $200,000 or below range, which is a segment that has more stable demand from homebuyers.

As you look to the details of housing sales in the state of Michigan, home sales for the first six months were off slightly at 2%. The average price of homes sold declined by 13%, as prices continued to fall but also as most of the activity continues to be concentrated in lower priced homes.

Turning to page 35, we have details on the retail net charge offs for the second quarter. They were relatively stable with a slight increase in the mortgage portfolio, offset by a decline in the consumer net charge offs. Further, as Rob detailed, an additional write down for residential ORE properties was reported in the second quarter, as we continued to reflect the most current market conditions.

In summary, this is certainly a challenging time to manage the lending businesses at this point in the credit cycle. Many factors have to be looked at simultaneously to include housing prices, credit availability, and the structural shifts that we're seeing in our economy, such as that from changing oil prices. Although it's been some time since we have seen a credit correction this deep, Michigan bankers have weathered numerous other credit storms, as have many of our business and consumer clients. We have adjusted our underwriting parameters to those that have stood the test of time in the many cycles, and we are actively working with our troubled borrowers to get through the cycle.

I will now turn over the call to Mike Magee, our President and CEO, for final comments. Mike.

Thank you, Stef. As we have continued to note, Independent Bank remains focused on the fundamentals of community banking. Our trusted relationships, reputation for excellence and local knowledge and expertise have guided us through more than a century of community banking, experience, helping us both optimize and weather a variety of market cycles and business trends. We are confident that our focus on efficient, profitable growth will continue to position us for improved performance in the future.

That concludes our prepared comments. At this time, we'd like to open the line for questions.

Thank you. (OPERATOR INSTRUCTIONS) Our first question comes from Brad Milsaps from Sandler O'Neill. Please go ahead.

Hey, good morning.

Hi, Brad.

Good morning.

Rob, or Stefanie, a question on the chart that you guys include just before, I guess it's on page seven of the 8k I have, just before the presentation. You guys detail your commercial real estate exposure by category. I know, Stefanie, you mentioned that several projects moved from construction into either income producing or owner-occupied. It looks like the land loan numbers are up quite a bit from the numbers I had in the first quarter, and then owner-occupied and income producing -- well, income producing will be up quite a bit and owner-occupied will be down. I just wonder if there's a re-class there or something else that should be reading into that.

Rob, you want to start out with the numbers?

Yes. Yes, Brad. The land, if you compare to March is up and the land development is up and the construction is down. I just think there were some re-classes amongst those categories. We have not made new loans in those groups.

Okay.

Yes. For example, if a loan that was intended for construction also had vacant land and the borrower has now concluded that they're not going to be starting construction anytime soon, we would have reclassified that into the vacant land category.

Okay.

If it was partially developed land with streets and infrastructure, it might have moved into the land development category.

Okay. Does that require any other adjustments in terms of how you handle the charge offs on those particular loans or how you reserve for those?

No, it wouldn't have any impact on charge offs. Those were performing loans that were reclassified.

The thing that will drive the reserves will be the credit rating would be the primary factor. So it doesn't matter the category, it really is driven by the credit rating. Now, I will say, if you're doing an impairment analysis, as it gets into the higher numbers of our watch credit grades, nine and higher, there it would have an impact because, obviously, valuations on land and land development are lower than what you're otherwise seeing.

Okay. And on the $1.6 million write down on the other real estate, I'm just curious how many properties you were able to sell during the quarter. I know you mentioned the last call you were in the process or completing some sales. I'm just curious what you're able to get done and kind of if you break that write down up amongst what you were able to sell, how that translates into a percentage loss, et cetera.

Well, the $1.560 million is not all just write down. Some of it is loss just on the sale. We took, I think it was about $1.2 million of write down, and that relates to the entire portfolio which was about $11 million. So that was roughly 10, a little over 10% on that. The balance, Brad, from the $1.2 million to $1.560 million would be losses and other certain other expenses associated with ORE and it includes ORP, other repossessed, or ORA, I should say, other repossessed assets, which would be cars and boats and trailers and that type of thing. So the $1.2 million was the write down component. I think it was just a hair less than that, and the balance, the 360, would be the loss. So the $1.2 million was sort of a unique portion of it. And that related, like I said, to the $11 million portfolio.

Were you able to complete any sales during the quarter? I'm just curious, based on --

Yes, we had a lot of -- a lot of sales. That's why we -- you know, that 10% adjustment is really based on where we're executing the sales at. So we have reflected our evaluation on the non-performers and the OREs. Stefanie had said we had written them down to about 62%, and that's really reflecting where we're seeing sales executed at. And everything is very unique. You can't -- you could apply percentages to the whole. But, I mean, there's some properties where we actually recover the full loan balance and past-due interest and costs and the like. It's just very unique.

I would say the one generalization you could make is the larger loans and larger credits in the residential sector is where the larger losses have been. And as I said in my remarks (technical difficulty) those weaker, larger credits are cycling through (technical difficulty) the fastest. In other words, they have gone bad and are going through the process now or have been for the last few quarters, where if you look at the portfolio in its entirety with an average loan balance of just over $119,000, that's really not -- the jumbo loan is not the makeup of our overall portfolio. It's largely loans in the 50 to 250 range and that's where we're not seeing, in terms of execution of sales, we're seeing better execution on those sort of mid- to lower-price properties. And even if you have losses, they tend to be much smaller. So I think over time the granularity of the portfolio will help. Like I said, the -- we think the worst is coming through right now where you're -- the larger loans that are more problematic or had weaker underwriting metrics are what's surfacing at the present time.

Brad, this is Mike. I'd just like to add a couple comments, too, in that area. Imagine a bucket, if you would, full of non-performing assets. Since the end of 2006, all we've been doing is basically adding to that bucket non-performing loans in starting the litigation process.

In the state of Michigan, we have to give the consumer a six-month period of time to redeem -- when we have a public sale, when we foreclose on the property, we have to give them six months to redeem the property from the date of the sheriff's sale. On commercial property, it's one year. So imagine a customer being 90 days past due. We start the foreclosure process. It's another 30 days before the sheriff's sale and then another six months before you go through the redemption period. We're now getting to the point, we're up to $11 million of properties that we have taken ownership of.

We're finally to the point in the cycle where we're able to start selling those non-performing assets and actually take some of the non-performing loans out of the bucket. And so as loans are coming out of the bucket, and we anticipate -- and if you look at the report that I received that show how many loans are coming out of the redemption period and going into ORE, on a linear basis, it's -- going forward, we're going to have quite a few loans going into the bucket, allowing them more and more loans to come out of the bucket.

So at some point here in the near future, we expect that we'll hit an equilibrium between the amount of bad loans going in and the loans coming out, and, eventually, we'll have more coming out of the bucket then what we have going in.

So and then the comment on the price that we're receiving for these non-performing assets, we've had internal discussions, because my fear is that we've taken a piece of property that has an appraisal of $100,000 and we've written it down and we feel that the carrying cost, we should be able to get $70,000 for it. But then now we start accepting, when -- and when you have an asset on the books for 70, someone offers you 62, it's kind of like, well, it's so close to 70, and I want to move on, I'll accept the 62. And so what that does is it creates then, well, then the asset must be worth only 62% of the original appraised value, not 70%. And then you get down to 62%, my fear is if you carry it at $62,000 and someone offers you 55, yeah, that's so close to what we're carrying it at, let's accept the 55 and move on and before long, you've got to write down the rest of your ORE. It becomes a self-fulfilling proxy in a way. And we have to be careful that as we write these down, that we are to a point where we can sell them in this market. And as more and more financial institutions are in the marketplace selling their repossessed assets, I think that's what's going to be the challenge for the next couple quarters is just liquidating them faster than your competitors and getting the top dollar.

So right now we're at 62% of the original appraised value. It's possible it could go lower. But I think that we need to -- when you're looking at a market that's only gone down 20%, you have to have some point you have to try to in an orderly fashion liquidate this collateral and get the most possible -- best return you possibly can for the shareholder.

Okay. And final question, I'll back away. Just, Rob, I was curious if you can kind of give us a little more color on the $300 to $400 million of deleveraging. Certainly that all can't come from the securities book. I'm just curious what segments of the loan portfolio you might be pulling back in. And with the economy being slower, does Mepco begin to slow down with some of their warranty finance business? Thank you.

Well, a couple of points there. One is, on the $300 to $400 million, this is going to take a fairly lengthy period of time. We're not not making new loans. We're just saying with the cost of capital that we currently are looking at, the hurdle rates are fairly high. And we certainly are very cognizant of that. So I think what's -- it's a combination with the slow economy and relatively high hurdle rates, it'll make the inflow of new loans a bit slower. In addition to that, we're seeing a lot fewer portfolio mortgage loans because of the, not just us, secondary marketing has tightened underwriting standards, but we certainly have as well. So that's slowing the inflow a bit.

And then you'll have the normal amortization and pay downs and so that, over time, will reduce the loan portfolio. We would probably like to see a little bit more sort of even if you took the whole portfolio, maybe 40%, 35-40% commercial and the balance would be retail between mortgage consumer. And then you mentioned the payment plans at Mepco which have been growing. So overall we'd probably see the mix come down, combination between predominantly commercial and mortgage is probably where you'd see much of it. And then you'd probably see somewhere in the area of about $100 million of it in the securities area. But what we're trying to get to with the high cost of capital is a balance sheet that has less wholesale funding in it and in this market, if we stay at a relatively low stock price and it's going to give us the ability over time once credit costs start to trend down, which at some point they will, we'd be in a position where, and this is certainly a long ways away, but if we're in a position where we can repurchase our stock at these kind of levels, it would be highly accretive to earnings, it would be accretive to book value, it'd even be accretive to tangible book. And those are all good things. So if the market remains inefficient and doesn't recognize that turn in value, I mean, we would be well prepared to take advantage of it.

And your last question about the growth at Mepco. Actually, in tougher economic times, you tend to see people hanging on to vehicles longer and there's probably more people who have interest in purchasing extended warranties because of that. So that business, in some ways, is a little counter cyclical.

Our next question will come from [John Knoll] from Barrington. Please go ahead.

Yes. Hi. What was the core tier one capital at the end of the quarter?

We don't have those figures yet. The final figures, because we haven't -- we file our call report right at the end of July and then we'll have those final figures. I would expect they'll be up a bit from the -- from the first quarter numbers, largely because our earnings were in excess of our dividend and we did have a little bit shrink in the balance sheet.

Okay. Thank you.

Our next question comes from Stephen Geven from Stifel Nicolaus. Please go ahead.

Hi. Good morning. Just a follow-up to Brad's question. I missed a portion of your response. The owner-occupied, the decrease from Q1 to Q2, was that partly reclassification or were there some sales involved too?

That was -- are you speaking about the drop in the shift from the construction portfolio?

Yes, the loan -- the total commercial loan at the end of the 8k, you had loan categories, land, land development, construction, income producing, owner-occupied. Owner-occupied decreased I think about 339, $339 million at Q1 to $227 million at Q2.

Well, one of the things that happened earlier this year in the owner-occupied category is we did have one very large relationship that we worked out of the bank, the pricing and the credit structure was too loose for our taste. So we did have a very large pay down right in the beginning of the year in the owner-occupied category.

Okay.

And the rest of that, I would -- I would say would be the recap -- classification.

Okay. And, Stefanie, you said that two-thirds of the nonaccrual is in workout. Is that just -- is that of the 52% of the land, land development, or is that of the total portfolio?

That's of the $74 million of nonaccrual commercial loans.

Yes, that's for the whole -- the whole portfolio.

Okay. And consumer non-performing loans, they really haven't -- they've been fairly stable. Is that due to quick resolution or are you just not seeing much of a pickup or increase there?

Actually, that portfolio has held in there pretty good.

Yes, the portfolio's held in fairly well. The delinquencies have remained relatively consistent, although they're up a touch in the second quarter. But as you said, Steve, and the other thing is liquidation time frames are much faster, you're repossessing collateral and liquidating it so it moves at a much more rapid pace than real estate, which might kind of outline those long period before we can actually get our hands on the property to liquidate it.

Okay. And last question. The borrowings have gone up quite a bit, the fed borrowings. Just wondering if there's possibility of extending the duration at these fairly low levels.

Well, it's a combination. You're right, the fed borrowings are up to, I think about $270 million. And you can extend the duration on fed borrowings. The longest term that the -- the term auction facility has terms of I think like 28 days, so roughly one month. And the discount window borrowings have about 90-day terms. So you really can't get a lot of extension there. That's a part of the whole idea of the deleveraging would be -- that would be the -- one of the sources of borrowing that we would look at reducing in terms of the wholesale funding component. The Federal Home Loan Bank borrowings which were north of $400 million, you can get longer terms and durations on those borrowings, but you're somewhat limited on the Federal Reserve Bank.

The other thing, and we would probably not get hedge accounting, is we do have caps in place. Now, I will say that the caps are largely above the current libor rate. So they don't give you a lot of protection in the first 100 or so basis points moving up. They do then start to give you some protection after that. But right now our vulnerability to rising rates is still not at a level that we're uncomfortable with. We'd give up a little bit in margin if short-term rates started up, but not significant amounts.

Okay. Thank you.

Our next question comes from David Scharf from FTN Midwest Securities. Please go ahead.

Hi. Thanks for taking my call and also thanks for laying out all this information, it's very helpful.

I kind of wanted to -- Rob, hope you could help me out with just putting some numbers to what was going on with the margin and with the borrowings and what the rates were on the brokered money that you're putting off. I mean, it's a really good job on increasing the net interest margin, and just kind of wanted to put some numbers to it, if you could help me out with that.

The rates on the callable brokered CDs would have been generally north of 5%, pretty much across the board. And it's not just the callable CDs. We did have some very dramatic moves down in the fed funds rate in the first quarter. So because it occurred in the first quarter, some of the benefit was starting to go on, but you really didn't see it in its full, I guess full, whereas, in the second quarter you've really had the complete benefit of it. So you were coming down from rates in the 5, 5.5, maybe even a few above that, down to 2.25 to 2.5. We did do Federal Home Loan Bank borrowings where there's term borrowings there. So those would be at somewhat higher rates.

We also did a few swaps, pay fixed swaps. So those would have been at somewhat higher rates. But we were getting sizeable benefits on that front. And then in addition to that, we managed, if you compared some of the costs in the retail deposit portfolio between periods, you'd also see some fairly good improvements on that front. For example, savings and now accounts. And this is comparing it to the second quarter of '07 versus second quarter of '08. But they're down nearly 100 basis points. If you compare to the first three months of '08, they're down about 45 basis points, and that's on $1 billion. So we've worked hard at managing our rates down on that front. And, similarly, in retail time deposits, we've been proactive in managing those rates down as well. So we saw retail time deposits that were maturing with rates again in the north of 4% area and have been re-pricing it at quite a bit lower rates.

So it's not just the wholesale component. It's managing the entire liability side of our funding structure to try and do as good a job as we can to remain competitive and pay a competitive rate in the marketplace, but achieve what we were looking for, which is growth in the margin, because we think we're at a point where our pre-tax, pre-provision earnings are strong enough that we really have a high degree of confidence that we can successfully work through this credit cycle even if things get a little bit tougher. And the real key is having that strong margin and good non-interest income and good control on non-interest expenses.

That's a -- that's a great trend to see. And I don't think I wrote this number down properly. But you had mentioned that you had several -- or severance expense of about $1 million this quarter. Is that correct?

That was in last quarter.

First quarter --

'07.

Yes, first quarter of '07, we had $1 million. So if you compare there's, you'd see that compensation expense went down a fair amount from the second quarter of '07, and the second quarter of '07 did include $1 million of severance. So if you took that out of salaries for the June 30 of '07 period, you would see salaries are pretty much level compared to June 30 of '07. And that's with adding staff and special assets and collections. So we've kept things fairly level because we've gotten efficiencies in certain areas and that's allowed us to redeploy assets into the management of credit without seeing an overall increase in compensation.

Great. Okay. And then --

When you look at our total -- I'm sorry. When you look at our total management expense, Rob, we also have FDIC insurance.

Yes, and FDIC insurance, obviously, compared to the '07 period is up as well, because banks, like us, we utilized all of our credits that we got in the '07 period. So we're kind of paying full rate right now on deposit insurance.

Then, Mike, my final question. You said something that was pretty interesting to me. And that's how the bucket of ORE is moving and you expect that to kind of ramp up here. Can you give us a little more detail on that or when, I mean, if that's -- if that's going to occur towards the latter half of the year here, should we expect that, all else equal, MPH should be coming in just through the sales or can you -- I mean, that's a new comment I haven't heard you explain that way and I thought it was pretty interesting. So if you could give me some more color on that, that'd be great.

Sure, David. I'll defer a little bit to Stef too on that, because the majority of our non-performing assets are commercial loans in that one-to-four-family residential. And as Stef pointed out in her comments, the majority of the commercial loans that are non-performing loans, she's working with the original customers to try to liquidate the collateral. So hopefully we can move that credit out of the bank faster than if we went through the foreclosure-litigation process and had the 12-month redemption period.

But on the one-to-four-family, we have, I believe it's close to $30 million of non-performing assets --

Loans.

-- of loans in one-to-four-family. And right now, of that 11 -- and then we have $11 million in ORE. So what we're going to see is we're going to see the amount of non-performing assets. Eventually what we -- what I'm -- we're moving towards is you're going to see the non-performing asset number come down, the ORE number go up as loans move through the foreclosure process and the redemption period expires and then we can move it out of non-performing into the ORE bucket.

Now when it's in the ORE bucket, we're in a position where we have title and we can liquidate the collateral. We have found that it is in the best interest of Independent Bank Corporation right now to liquidate the collateral in an orderly manner. We have talked to brokers about packaging ORE assets and -- but the market is inefficient right now. They're low-balling as far as -- they're bottom feeders, I'll say. They're giving us bids of $0.30 to $0.40 on the dollar. Again, we don't feel it's in the best interest of the shareholder to sell these assets at $0.30 to $0.40 on the dollar just so we can reduce our total non-performing asset number. We feel that it's in the best interest of the shareholder to liquidate the collateral in an orderly fashion.

So it's going to take a little longer. But as the loans move out of the non-performing into the ORE and as we have successes like we did last quarter, we expect to have -- you're going to see that number continue to increase as far as the amount of assets we're able to liquidate on a quarterly basis.

At some point here in the credit cycle, and I believe that we're a couple quarters away, you're going to see where you're going to level off as far as the number of increase of non-performing assets because of what -- the equilibrium will take place because you're going to have the same amount of assets going out of the bucket as you've got going in. Eventually, we'll hit the part of the backend of the cycle where you'll have more non-performing assets going out, you're liquidating that collateral, than what's actually going in.

So we're close to that point in the credit cycle where I think there'll be some equilibrium because we're starting to be in a position to be able to liquidate this collateral. A lot of it will also depend on the success that Stefanie has with working with her customers who are acting as her primary brokers to liquidate those loans and sell the -- and pay down the balances.

So I hope that answers your question.

It does. No, that's -- I really appreciate it, too.

And the one-to-four-family, David, I mean, we are seeing very orderly sales. We -- Stefanie commented we're using auctions. And the one difference is these properties are in our markets. I mean, they're not -- it's not like a mortgage lender, a nationwide mortgage lender who's domiciled in some other state trying to liquidate properties in Michigan. We're right in all these markets. So we're doing little discrete auctions in small markets where we might just be looking at six, seven, or eight properties, and we can do that because we're right on the ground level. And we're just seeing a lot better execution and we're responsive to realtors when they have offers which sometimes they say out-of-state lenders, they can't get a hold of someone. So I think we're in a position, because it's close to where we're at, to really be successful in liquidating the one-to-four-family properties.

And, David, this is Stefanie. I'll just add a couple of comments on the commercial side as well. But, in general, as Rob was saying and Mike was outlining, we are looking to leverage the benefit that we have as a community bank that we are in all of these markets and we are working with people in the market that are still interested in investing in the market. And on the commercial side, we have a number of our clients that are interested now that real estate prices have gotten to be quite low, they are interested in purchasing some real estate. And so we are looking at selective individual transactions. Now, that's a lot more work than packaging things up and selling it. But given what we see, the prices in the market, this one-at-a-time approach is much more, much more effective.

Yes. Well, thank you so much for the further detail.

Thanks, David.

Our next question does come from Jason Werner from Howe Barnes. Please go ahead.

Morning, everybody.

Hi, Jason.

Good morning, Jason.

Just hoping you could kind of clear some things up first of all. You had said that the average write down for -- or average turning value for ORE single-family properties is 62%?

Of original appraised value.

Okay. Does -- that's just for the stuff you already foreclosed on?

No. We're also looking at our non-performers as well.

Yes, that --

So we get evaluations, either brokers' price opinions or some other valuation that we're looking at. So it doesn't just include the ORE.

Does that reflect your overall reserve position for that portfolio? I mean, obviously when you have a homogenous portfolio, you're going to --

Well, it's a homogenous portfolio, so we do the reserve based on -- largely based on historical charge offs, but we adjust the overall allowance and provisioning to take into account the observation of where collateral values are falling. So because it's a homogenous portfolio, we -- I don't want to kind of like give you the impression that it's specific to individual loans, but we're looking at the $30 million of non-performing and looking at the valuations and adjusting the homogenous allowance that's based on historical charge offs for what's in that group of loans.

What about performing loans that you may be projecting to eventually go to non-performing? I mean, obviously, you would project kind of a loss factor.

Yes, we do. We use historical loss rates and also project a loss on that portfolio as well.

Okay.

And on the commercial side, Jason, we had an updated migration study that calculates for each risk band what our expected loss is.

Okay. And then on the commercial side, this has come up in previous calls. We talk about reserves to non-performers and you guys have said that you have already charged down a good portion of that. I was hoping you could quantify of that $74 million how much of that is already charged down to liquidation value.

Well, the $74 million in the non-performers has already been charged down by I believe $11 million was the write down on that portfolio.

What I think he's trying to get at, how much of the $74 million has been charged down to net realizable value and, therefore, has very small reserves associated with it.

Correct.

And I'm trying to see if I can get that. I may not have that number right at hand because it's -- certainly the 10 and 11 rated loans would be charged down. And I just -- I'll get you that figure. I just don't have it right at hand here. I have to add up a bunch of numbers on all the 11 rated loans to get to that.

Yes. Jason, one quick overview would be to look at the slide on the watch credits. And all of the loans in the 11 rated category would have been charged down. And so that would be, as of the end of June, roughly $30 million.

Okay.

So those, the loans that we have taken the write down on move into sort of a subcomponent of nonaccrual for us.

Okay.

So the balance of roughly $40 million, $44 million would have reserves that had not been charged down yet.

Okay. That's helpful. I had a question on the margin also. Rob, you suggested that you expect it to be relatively stable. I was just kind of -- you don't, at this point, expect any more further improvement as the rest of those brokered CDs go away, or is that --

Well, there's only about $112 million left. And of that, I think it's a little over $20 million was callable and the rest of the group is -- and those were called in July. So we'll probably be down to a little under $90 million, and then the balance is just term brokered CDs. We have some other borrowings that have a little bit higher rates that are maturing as well. But if I look at, absent further declines and short-term rates, which I think is highly unlikely, there's not as -- there's not that much re-pricing. There's not that much downward movement. So I think -- and again, prime isn't moving down either. So I think, absent changes and any significant changes in rates, we're probably -- it would be -- it would be tough to move that up. The one thing that could move it up a little bit would be change in mix of loans. So if certain components went down and probably the higher -- highest yielding portion of the portfolio, as you're aware of, is the finance receivables, so that grew a little bit and other components shrank and we stayed level, that might bump us a little bit.

But I guess my point is, you're not going to see 30-plus -- I'd love to see it, but I don't think you're going to see 30-plus basis points addition in third quarter. And I would be more of the mind set that it's going to be relatively stable with not a lot more growth available.

Okay. What kind of impact does the deleveraging strategy have on margin? I would think that if you replace or get rid of the Federal Reserve and the fed funds, those are your -- kind of some of the lower rating -- lower costing source of funds right now that could be -- put pressure on margin.

Now, again, as I mentioned, it's going to be done over a lengthy period of time. We're not going out and selling wholesale components of the loan portfolio. So it's going to evolve over quite a bit -- period of time. And one thing that could change it is if we got more core deposit growth, we would then look at that and say, okay, that is going to support more lending.

I guess my point is, we're not going to look at supporting lending growth with wholesale funding. That's really the -- and so we prefer to have some of that come down. And over time, what might have a countervailing impact would be the change in mix within the loan portfolio. So the hurdle rates, as I said, for coming on the balance sheet are a bit higher. I think competition-wise, probably everyone's thinking the same way as we are. Capital is very costly and if you're going to put assets on the balance sheet, they've got to give you a high relative return versus those capital costs.

So one thing that may help is that you see a lift up in yield on assets that sort of counteract some of that. But I would expect, overall when you get from point A to the final point, if we do deleverage $300 to $400 million, that that would reduce, not necessarily the margin, the percentage, but it would reduce the dollars. We would expect by the point in time that that occurs, we would see significant reductions in provisioning levels, loan and collection expenses, and loss on ORE. So at that point in time, we'd still expect to see robust -- and I'm looking way ahead, and this is very theoretical, but robust earnings growth because of those other three components going down that all relate to credit costs. And as I said earlier, if the market doesn't recognize it and we've got the capital to do it, we'd be in a great position to buy back stock at a very accretive basis.

Jason, the other thing I would add is that we have begun to see in the marketplace, as Rob was describing, some rationalization of pricing. We earlier saw a tightening of credit terms and structure and we are also now seeing some improved pricing opportunities. That, coupled with an increased emphasis on commercial lending on including deposits with a relationship is helping us improve our return.

Okay. I was wondering if you could maybe quantify how much loan shrinkage you might see in the second half, just based on where your loan pipeline is and based on what you know to be scheduled maturities and that sort of thing. I mean, just with a ballpark of what you think the loans could shrink by in the second half of this year.

I would say you'd probably be looking at $50 million, or -- if I had to just guess on a number. It's not -- it's going to take a fairly lengthy period of time. Again, I don't want to give the impression that we're not actively seeking new business and trying to make new loans. It's just what we've looked at, we've looked at the implied cost of capital based on where our stock price and trust preferred securities are trading and we then updated our risk-based pricing model that reflects those costs of capital. And, as you imagine, that pushes the rate up. I mean, and based on that we're making changes across the board in pricing and that will tend to reduce the new inflow coming in but not certainly shut it off. And we're going to continually seek new business. So it's not completely turning off the spigot. It's probably just slowing it down. And then the normal pay downs in amortization, if you mix that all together, I guess I -- maybe you're going to be a little -- I would be surprised if it was less than $50 million, but I don't know that it would be significantly higher than that.

Yes. And, Jason, in terms of the pipeline, the pipeline for commercial loans is usually much more extended time frame-wise than on the retail side where that -- those kinds of changes can be made a little more quickly.

Okay. And one last question. This is for Stefanie. I was just kind of curious what your opinion is on, one, the overall macro picture in Michigan, where you guys kind of are in the credit cycle, and, two, where do you think Independent Bank is within that cycle in terms of how far along are we and when do you think you might see some stabilization with the economy?

Well, certainly, taking the first part of your question with regard to the Michigan economy, I think we are looking at a continued very slow economy certainly for the rest of this year and into much of next year. What we see in these kinds of economic environments in Michigan, though, is really shifts in business, not lack of any kind of business. And so, for instance, we're seeing a pretty steady stream of house -- homes being sold in the lower dollar amount as consumers downsize or as somebody who's buying their first home picks a little bit less expensive first home than they might have done when they could get 100% loan-to-value financing in the market. So I think Michigan will go through a number of structural shifts in the economy given where we are.

And in terms of Independent Bank Corp., I am very grateful that we implemented last year a number of the credit processes that we put -- have put in place. It gives us an ability to really work closely with customers, recognize problems pretty early in the cycle to the extent that we can help people get through this, we are. And so I think we're a little bit ahead of -- in terms of having our processes in place of where I would see the general economy.

All right. Thank you very much.

Jason Werner, you had asked earlier about the amount of charge downs out of the $74 million. About $30 million of those loans which are 11 rated, those would be charged down and then have relatively small specific reserves associated with them.

Okay. Great. Thank you.

This does conclude today's question-and-answer session. I would like to turn the conference back over to Mr. Magee for any closing remarks.

Okay. Well, thank you. Thank you for your interest in Independent Bank Corporation. We look forward to speaking with you again next quarter. For an archive webcast of today's call, please go to the investor section of our website at www.ibcp.com. The webcast will be archived on our website for approximately 90 days from today's call.

If you have any questions in the interim, please contact Rob Shuster, Stefanie Kimball, or myself. Thank you and have a great day.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.