Independent Bank Corp (Michigan) (IBCP) 2008 Q3 法說會逐字稿

Hello and welcome to the Independent Bank Corporation third 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. Michael Magee, President and CEO. Sir, you may begin.

Thank you. Good morning and welcome to our third quarter 2008 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 third quarter. Following Rob's comments, Stefanie will provide an update on our commercial and retail loan portfolios. 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 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 two of the presentation for additional information on forward-looking statements.

I will begin today's discussion with a review of our third quarter financial results, which are summarized on slide four of the accompanying presentation. Certainly, the third quarter was a challenging period for Independent Bank. The continuing credit turmoil evolved into a financial markets crisis which prompted government action of historic proportions and our results were not entirely immune to these negative, broader economic factors.

Although we are disappointed in our bottom-line results for the quarter we continued to make progress on a number of fronts and we remain optimistic that we will emerge from this period even stronger.

For the third quarter ended September 30th of 2008, we reported a net loss of $5.3 million, or $0.23 per share compared to net income of $3.7 million, or $0.16 per share in the third quarter of 2007.

A decline in operating profitability is attributed to a $9 million increase in provision for loan losses as a result of several commercial real estate loans moving through the work out cycle from the watch list to the non-performing status during the quarter. As we have stated throughout the past several quarters these delinquencies are primarily the result of real estate developers experiencing cash flow difficulties as the slowing Michigan economy continues to weigh heavily on the real estate values throughout the state.

While we are disappointed in the increase in the loan loss provision and we continue to remain cautious regarding the current economic conditions, we are pleased to note specific improvements in asset quality during the quarter.

Commercial loan 30 to 89 day delinquency rates were at their lowest level since 2005. Additionally, our level of commercial loan watch credits declined for the first time in more than two years.

Under the guidance of our Chief Lending Officer Stefanie Kimball we have continued to work diligently to manage our way through this difficult credit cycle. Later in the call Stefanie will provide a more detailed update on our initiatives to enhance key credit metrics and improve asset quality as well as a couple of examples of how we are working with our customers to achieve improved outcomes in the work out process.

In addition to the increase in non-performing loans and the credit costs associated with managing them throughout the course of the last year and the most recent quarter, third quarter results were also negatively impacted by security losses. The market declined and the conservatorship of Fannie Mae and Freddie Mac led to the decreased values in the preferred stocks we own. These losses were partially offset by higher net interest income and a benefit in income tax expense.

Additionally, our third quarter results reflect yet another quarter of increased net interest margin. Increases on both a year over year basis and a sequential quarterly basis were due primarily to a decline in short-term interest rates in a steeper yield curve.

For a high level overview of the quarter please turn next to slide five of our accompanying presentation. We are clearly not out of the woods yet in terms of the regional economic challenges we face as evidenced by our continued recognition of nonperforming loans. We will continue to actively monitor and manage our watch lists credits and maintain strong reserves to ensure the strength of our balance sheet and continue to support our well-capitalized position.

Looking ahead, I remain encouraged not only by our operating discipline in the strength of our internal processes, but also by the recent plans enacted out of Washington. We will continue to closely monitor the specifics of these plans and the potential benefits as they relate to Independent Bank.

I am confident that these combined factors will help us guide -- will help guide us towards deposit growth, improved asset quality and enhance operating efficiency throughout -- through disciplined cost containment and return us to profitability in the near term.

With that, I will now turn the call over to our CFO Rob Shuster for review our financial performance during the period. Rob?

Thanks, Mike. Good morning everyone. I am starting at slide seven of our PowerPoint presentation. I will focus my comments on net interest income in our margin, certain components of non-interest income and non-interest expense, asset quality and conclude by making a few comments about capital in the TARP capital purchase program.

As outlined on page seven there were some positive factors evident in our third quarter 2008 results. Most notable was the continued strength of our net interest margin. However, the positives were overshadowed by securities losses and a rise in credit costs.

Page eight outlines a few unusual items impacting the third quarter, including the aforementioned security losses, an impairment charge on capitalized mortgage loan servicing rights and write-downs of ORE properties. 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 decline in the fair value of the preferred stocks and particularly the conservatorship of Fannie Mae and Freddie Mac led to large security losses in the third quarter. Partially offsetting these fair value declines were gains of $1.1 million on the sale of $48.4 million of municipal securities.

Page 10 has details on our securities available for sale at September 30, 2008, and provides both the cost basis and current market values. In the third quarter we did record a $125,000 other than temporary impairment charge on a $250,000 trust preferred position in a small Michigan community bank.

All of our CMOs are investment grade and we have not had any credit downgrades. We have one relatively small sub investment grade asset backed security on which we recorded impairment charges a few years ago, but the market value of this security continues to exceed its adjusted cost basis.

If you move to pages 11 and 12, tax equivalent net interest income totaled $35 million in the third quarter of 2008, which was up $3.1 million or 9.8% on a comparative quarterly basis and was up $500,000 or 1.3% on a linked quarter basis. Average interest earning assets were down on both the comparative quarterly and linked quarter basis. Average loan balances were up, but this increase was exceeded by the decline in average investment securities. The overall declines in average interest earning assets were more than offset by the increase in our net interest margin.

As you can see on page 11, our net interest margin was 4.76% in the third quarter of 2008, up 45 basis points year over year and up eight basis points on a linked quarter basis. In the third quarter of 2008 non-accrual loans averaged $115.4 million, compared to about $104 million in the second quarter of '08 and $58 million in the third quarter of 2007.

Our elevated level of non-accrual loans of approximately $112 million at quarter end creates a drag of about 26 basis points on the net interest margin. Our ability to bring our cost to funds down at a pace faster than the decline in our yield on interest earning assets has allowed us to improve our net interest margin.

Page 13 provides information on the year to date 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.

During the third quarter pricing conditions in the brokered CD market improved and we did issue some term CDs to diversify our overall funding mix.

Looking ahead in assuming that short-term interest rates remain relatively low the yield curve remains upwardly sloped and that non-accrual loans do not rise significantly, we would expect the net interest margin to remain in the 4.75% area or consistent with this quarter. We are seeing some pressure on an outflow of uninsured deposits; however, if we can continue to borrow from the Fed at rates of 1.75% or less these deposit outflows should not have an adverse impact on our net interest margin.

Finally, assuming a relatively steady net interest margin a drop in our overall level of interest earning assets will likely result in some decline in the dollar amount of our net interest income.

Moving on to some of the more significant categories of non-interest income on page 14 of our presentation, service charges on deposit accounts decreased by $149,000 or 2.3% on a comparative quarterly basis, and increased by $252,000 or 4.1% on a link quarter basis. The link quarter increase is primarily due to traditional seasonal variations in 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 reflect belt-tightening on the part of consumers.

VISA check card interchange income was up 14.1% on a comparative quarterly basis and was down slightly on a link quarter basis. The introduction of a rewards program in early 2007 was pushing these revenues higher, but now that the rewards program has been in place for over a year we may see some flattening out of this line item.

Gains on the sale of mortgage loans totaled $1 million in the third quarter of '08 on $52.8 million of loan sales. This compares to gains on the sale of mortgage loans of $1.1 million in the second quarter of '08 on $80.2 million of loan sales. The profit margin on loan sales was up in the third quarter mainly due to a higher mix of FHA loan sales. These loans are sold servicing release and generally have a higher profit margin than conventional loans.

Our volume of mortgage loan originations in the third quarter of '08 was $74.5 million, which was down on both a year over year and link quarter basis. Ongoing changes in underwriting criteria by Fannie Mae, Freddie Mac and the private mortgage insurance companies continued to make it more difficult for borrowers to qualify.

Real estate mortgage loan servicing income declined on both the comparative and linked quarter basis. We recorded a $348,000 impairment charge in the third quarter of '08 compared to a recovery of $996,000 on previously recorded impairment charges in the second quarter of this year.

Mortgage loan interest rates declined a bit in the third quarter, which resulted in using somewhat higher prepayment speeds in the valuation of our capitalized mortgage loan servicing rights. Absent impairment charges for recoveries of such charges, this line item should run at about $650,000 per quarter.

Moving on to page 15 of our presentation, non-interest expenses totaled $30.7 million in the third quarter of '08 compared to $28.4 million in the third quarter of '07 and $31.2 million in the link quarter. We have worked diligently to manage non-interest expenses. Over one half of the year on year increase is due to loan and collection costs, loss on other real estate and higher FDIC insurance rates. Our overall FTE employee numbers are pretty much down across the company except in the collections and our special assets group.

As evidenced on page 16 of our presentation the assessment of the allowance for loan losses resulted in a provision for loan losses of $19.8 million in the third quarter of '08. This level represents about 316 basis points of portfolio loans on an annualized basis.

Non-performing loans, slide 17, increased a bit to $114.6 million, or 4.58% of total portfolio loans at September 30 of '08. The rise in non-performing loans during the third quarter was primarily concentrated in the mortgage loan portfolio. Stefanie will provide more information on our loan portfolio during her comments.

Page 18 of our presentation provides information on the components of our allowance for loan losses which rose to $53.9 million or 2.15% of total loans.

Page 19 is a new slide. Although the entire allowance for loan losses is available for losses on any loan we do allocate the allowance to specific loans and loan portfolios. This slide provides information on those allocations at September 30 of '08. It should be noted that the allowance represents our best estimate of losses as of quarter end. Future changes in collateral values or loan defaults will impact our assessment of the allowance.

Slide 20 is also new. This slide takes the portion of the allowance allocated to commercial loans and breaks it down further by loan rating. The $29.5 million of 11 rated loans denoted charge-off have been charged down to expected net realizable value and the remaining allowance represents only estimated sales, liquidation and holding costs. Net loan charge-offs totaled $17.4 million in the third quarter of '08 or 2.69% of average portfolio loans.

Page 21 of our presentation breaks down the net charge-offs by loan type. Again, Stefanie will address this topic in more detail during her remarks.

Moving on to page 22, despite our third quarter loss we remain comfortably well capitalized and we believe that the TARP Capital Purchase Program could be of significant benefit to our organization in further boosting our regulatory capital ratios.

Page 23 has our estimated September 30, 2008 regulatory capital ratios for Independent Bank which you can see are all up from year end 2007. In addition, I have included our pro-forma regulatory capital ratios assuming that we raised $72 million of Tier 1 capital in the TARP CPP. We believe this additional capital would put Independent Bank in a position of strength to weather even the toughest downturn in our economy and any potential further stress in our loan portfolios. We submitted our TARP CPP application last Friday and are confident that we will be approved.

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

Thanks, Rob. My remarks will follow slides 25 through 41. I will be discussing our credit quality results and lending initiatives which are designed to enable Independent Bank to navigate through this challenging credit cycle.

Starting with page 25, highlights are outlined with regard to commercial lending. As we have discussed on previous conference calls credit quality best practices in a new direction for this business line was put in place mid-2007. That direction emphasizes lower risk clients who utilize a broad spectrum of bank services, particularly deposits.

The results from executing this strategy are now becoming more tangible and measurable. There are several notable improvements in the third quarter that demonstrate the benefits of the credit quality best practices we've implemented as well as the intense focus on our lending initiatives that we have had in place now for the past five quarters.

For example, our overall level of watch credits declined by 8%. This is the first decline we've experienced in two years. Commercial loan delinquency rates declined to their lowest level since 2005. There was a slight $300,000 decline in the non-accrual loans with several larger credits moving into ORE. Given our progress in moving credits through the work out cycle we experienced a higher level of charge-offs in ORE this quarter. With charge-offs increasing $4 million and ORE increasing $8 million, both of which are primarily attributable to one large relationship which we will discuss further.

Each of these items will be discussed in more detail as we look at the graphs later in the presentation. Further, we have had a number of short and long term initiatives in place to manage through the slower economy and potential recession. Longer-term we believe that as the market stabilizes there will be a resurgence in community banking and increased commercial lending and private banking opportunities.

We are repositioning the business to take advantage of these market opportunities with our commitment to continuing education for our commercial lending team. This training supplements our broader strategy which includes tightening credit criteria, enhanced account monitoring, improved watch and work out processes, and independent risk assessments, all of which have already been implemented. Our initiatives are designed to not only produce a portfolio with more consistent and sustainable profitability through a variety of market cycles, but also to further improve our delivery of excellent customer service.

The end results of this shift in the target loan types has been improved loan pricing with returned hurdles implemented, an exit strategy implemented for select watch credits, restrictions on new commercial real estate loans and a growth focus for C&I loans.

With that overview, I will now turn to page 26 to look at the specific credit metrics starting with the trend of outstandings. Commercial loan balances declined $50 million since last quarter to $1.09 billion as we are now executing our deleveraging strategy. However, we continue to add new credits to the portfolio that meet our target criteria. Recently, pricing in the market has been more favorable than we have seen in many years. We have used both increased pricing and exit strategies for select watch credits to contract the portfolio.

Turning to page 27 the progress that we are making reshaping the portfolio is illustrated. Specifically, contracting the commercial real estate categories which include land, land development and construction and increasing our C&I and owner occupied categories of lending creates a more diversified portfolio which we anticipate will have a positive impact on credit quality longer term. I should note that earlier this year we closed out a number of completed construction projects and moved them into the completed income producing, owner occupied and other categories as appropriate.

As the graph on page 27 and also 28 illustrates we have achieved a 34% decline in vacant land, which now totals $40 million, a 20% decline in land development, which is now at $63 million, a 49% decline in construction with the completion of a number of the projects to $55 million. Income producing loans were down a slight 1% to $423 million and owner occupied and C&I categories have increased 6% and 4% respectively for a combined total of $430 million.

Turning to page 28, now looking more specifically at these segments you can see that our overall exposure in the higher risk CRE segment is manageable. More than half of the land and land development loans are classified as watch. The remainder of the land loans are relatively small and these loans are quite granular with only four loans above $1 million. Likewise, our exposure in the land development portfolio is manageable and fairly granular with five loans above $1 million. Also with regard to the construction portfolio it should be noted that about half of it is in support of C&I or income producing segments.

With that I will now turn to the watch credits which are shown on slide 29. This shows the cumulative trend of watch credits in which we reported our first decline since the fourth quarter of 2005. Improvements can be seen in each category. The internal watch credits, which are shown as monitor or watch declined $8 million as the in-slow further slowed from the pace experienced earlier in 2008 and the more rapid double-digit increases we saw in 2007.

Substandard loans declined by approximately $10 million as a result of several larger loans moving into the non-accrual or ORE categories. Non-accrual loans declined $300,000 as the number of credits moved into ORE.

Slide 30 details our commercial loan 30+ delinquency rate for accruing loans which declined to 138 basis points in the third quarter, an improvement over the 179 basis points we reported in the second quarter. As I outlined in last quarter's conference call these improvements are a result of an increased focus on credit quality and the reallocation of our resources allowing us to keep our client's payments as timely as possible.

Also in this challenging environment it has been necessary to renegotiate terms with clients well prior to the maturity date which negatively impacted the end of the first quarter to a greater extent. We continue to emphasize a proactive approach to renewals and administrative issues with our lenders and coach our lenders in handling difficult conversations with their clients.

Turning to page 31 our non-accruals are shown and this quarter we reported a net decline of approximately $300,000. Although we continue to see loans migrate from the other risk rating category this quarter that migration was offset by a transfer of a number of loans into ORE, charge-offs and a $1.6 million recovery.

Turning to page 32 further details are shown on the composition of our non-accruals. Approximately 95% of our non-accruals are some form of commercial real estate, which often takes a significant amount of time for resolution. About 49% are in the higher risk category of land, land development and construction. We have factored the lengthy hold time into our evaluations with loans on average written down by 38%. For example, if a loan was 80% loan to value to begin with this then would equate to roughly a 50% valuation for the property after the write-down. As we have previously discussed from an accounting perspective we are writing these loans down to our best estimate of the market valuation on a regular basis which includes discounts for the anticipated holding time and liquidation costs.

Out of our $73 million in non-accruals approximately two-thirds fall into a category where we are in negotiations or some sort of forbearance with the customers, with the remaining one-third involving legal action such as foreclosure or litigation.

Let me pause for a moment to share a few examples that help illustrate the relationships that underlie these numbers and the more personal issues that need to be managed along with the assets. As I was taught early on in my banking career people pay back loans, not companies. So, let me talk about the people.

First, I will share a success story. We have two clients that owned a problem business that had had several failed attempts at selling. In two of the attempts the purchasers could not get financing. We continued to work with them and on the third attempt the business sold and we were able to work out a plan to have the partners cover the deficiency. This quarter the sale closed and we were able to recognize over $1 million recovery as we did not attribute value to the personal guarantees earlier on while we were in negotiations.

This example illustrates the benefit of our approach in handling problem credits. As we have managed through this difficult cycle we have consistently taken an approach of working with our clients as long as they are willing to work with us. We believe in many cases the clients can be the best brokers of their own properties or businesses as they are well connected to potential buyers and motivated to minimize their personal liability or shortfalls. We have a number of examples of clients that we are working with using this approach.

In this case patience paid off. We were able to collect the deficiency amount from the guarantors by negotiating a payment plan that was secured by a pledge of personal assets, some of which were marketable securities. This example also illustrates our process of charging down loans based upon the collateral value with little recognition of intangible assets such as the strength of the personal guarantors.

Now, I will give an example of a not so happy ending. This past quarter we also saw examples of two different clients where the emotional side of the financial stress they were incurring was too much for them to continue to manage their businesses and in both cases the borrowers turned their assets over to the bank. We were able to avoid the time and cost of foreclosure and move the properties directly into ORE. Although we have taken significant write-downs in both these cases this approach was our best collection strategy in those instances.

As commercial credit is customized for each client at the time of origination so too must be the work out plan which adds to the complexity and challenge. We have staffed our work out group with many of our best lenders to ensure that kind of creativity is applied in our problem solving.

Now turning to page 33, I will discuss charge-offs, which rose this quarter to $12.3 million. These losses were primarily reserved in previous quarters; however, updated appraisals were obtained on several large loans as they neared the redemption period or were ready to move into ORE. In the two examples that I highlighted earlier of clients deeding properties to us the larger of those accounted for 40% or $5 million of our loss this quarter as we took an additional write-down.

In this case in particular the real estate depreciated very rapidly and our current valuations are less than one-third of the original appraisal and just slightly more than half of an updated appraisal that we obtained about 12 months ago. Overall, the provision for the quarter attributed to commercial loans was approximately $800,000 more than the charge-offs. Again, losses like the non-accrual composition are heavily driven by the CRE segments.

At this point I will spend a few minutes augmenting Rob's comments about our overall allowance for loan loss methodology which is updated each year. Standard reserves are used for all loans risk rated eight or internal watch or better and all substandard loans under $1 million. All substandard loans over $1 million and the more adversely rated credits are reserved for with a specific reserve or a loan at a time approach where the collateral is carefully evaluated. And I will share some details regarding each component.

First, the standard reserves use our bank's actual loss history and patterns of default to calculate a reserve for each grade. More specifically, we studied a pattern of default over a year's time. We have used recent experience as the rate of default in this economic cycle is higher than the historical average. These actual defaults are used to estimate the likelihood or probability of default. We then look at the actual loss experience in liquidating a large variety of collateral. We look at five years of experience to ensure a broad enough data set with more heavily weighting in our current economic environment.

Given the current composition of the portfolio a large portion of the reserve is calculated using the detailed collateral valuations to include liquidation and holding costs. These FASB 114 evaluations take considerable time looking at the assumptions used by appraisers and applying our own experience in liquidating similar collateral.

Turning to page 34, our special assets team continues to make considerable progress. To date during 2008, we have collected $19.5 million. Part of the process involves foreclosing and obtaining ownership of collateral when liquidation is necessary to repay the loan. The end of the foreclosure process is our ORE, Other Real Estate, category. Earlier as I highlighted the two largest credits that went into ORE this quarter increased ORE by $8.6 million. The larger of these two credits accounted for 60% of the increase.

I will now turn to our retail portfolios. First, for some highlights on page 35 and then a review of the key credit metrics. The retail businesses new loan originations contracted last year with tighter credit underwriting parameters given our current desire to deleverage the balance sheet we implemented even more select criteria in the third quarter with both consumer and mortgage originations that we intend to hold for our portfolio. Certainly, the secondary market as Rob outlined has also tightened credit parameters which has resulted in slowing volume with the industry as well as our markets. With the continued depressed economic conditions throughout Michigan we experienced an increase in retail delinquencies and losses.

Turning to page 36 we'll look at some specific numbers with regard to the retail loan portfolio balances. At quarter end the balances were down slightly with mortgage loans totaling $858 million and consumer loans $369 million.

As illustrated on page 37 delinquency rates for consumer loans and mortgages rose slightly in the 30 to 89 day category. To keep pace with these increases we have made further additions to our collection staff and made enhancements to our loss mitigation processes.

Turning to page 38 non-performing assets continued to rise in the third quarter. The lengthy foreclosure and disposition process results in accounts in this status continuing decline. We have established a number of channels to assist in handling ORE as we complete the foreclosure process. We have concentrated our ORE management with our bank properties manager. We also have designed a website where we advertise the properties for sale in our communities.

In addition, we have established relationships with realtors and auction houses that know the communities we serve. On average we have written down our non-performing mortgage loans to 62% of the original appraised value. In general, most of our non-accrual loans are very granular. Most of the homes are in the $200,000 and below range, a segment which has had more stable demand from home buyers. As you look into the details of the housing sales statistics in the state of Michigan we continue to see most of the activity is concentrated in those lower-priced homes.

Turning to page 39, retail net charge-offs for the third quarter increased to $1.01 million for consumer and $3.7 million for mortgage. Further, as Rob detailed in additional write-downs for residential ORE properties was recorded in the third quarter again reflecting the most current market conditions.

Turning to page 40 as we consider the economic climate of Michigan and the challenges ahead it's important to look back at the foundation of the credit best practices that have been put in place in both commercial and retail. On page 40 there are highlights of the numerous initiatives and changes that we have implemented since 2007 and continue to enhance. I will highlight just a few of these best practices.

Our watch process has now been in place for five quarters and is functioning effectively. Our special assets team is highly motivated and working hard to address the problem loans and help our clients and our bank through this difficult economy. As businesses value credit availability more than in the past and our competition lessens we have a market with significantly less price sensitivity and we have been able to raise prices for commercial loans. We have done this using our new pricing model.

On the retail side, page 41 highlights some of the key initiatives and actions taken. Our charter and bank consolidation in 2007 has produced significant risk management benefits. Centralized credit decisions have allowed us to effectively tighten credit. The centralized collections teams have produced operational efficiencies and allowed us to leverage internal best practices. Management has also conducted external benchmarking to obtain and incorporate new collections ideas.

In summary, this is certainly a challenging time in the financial industry. It has been some time since we have seen a credit collection this deep; however, Michigan bankers have weathered numerous past credit storms, as have many of our business and consumer clients. Independent Bank has put in place the enhanced credit processes that we believe are necessary to weather this storm. We have adjusted underwriting to parameters that have stood the test of time and many market cycles and we are actively working with our troubled borrowers.

We continue to invest in our employees with training programs for both the short and long term. Longer-term, community banking opportunities appear more attractive and we are building the infrastructure to leverage these opportunities.

I will now turn over the call to Mike Magee.

Thank you, Stefanie and thank you, Rob. Thank you for your patience during this detailed and lengthy presentation. However, we feel that during these extraordinary times it is important to show as much transparency to the market as possible. As one of the oldest and most well-respected banking brands in Michigan, we remain dedicated to our overall goal of providing not only the best community banking services in the industry, the financial results that make IBC a strong addition to your investment portfolio. Rest assured we intend to weather the current storm and continue to distinguish ourselves as the community bank of choice in the markets we serve.

That concludes our prepared comments. At this time we will open the line for questions from investors and analysts.

Thank you. (Operator Instructions). Our first question will come from Terry McEvoy from Oppenheimer & Company. Please go ahead.

Hi. Good morning.

Good morning, Terry.

Good morning.

I had a quick question. On page 25 that last bullet "maintained restrictions on new CRE coupled with increased focus on C&I loans". What specifically do you mean by "increased focus"? Does that mean it's an area you'd like to grow or you're going to increase your focus on managing the credit risk and C&I loans? I didn't know how to read that statement.

Terry, that's a great question and really the intent is both. Obviously, our focus is to move towards more C&I loans and we also have to enhance our monitoring and following of those credits.

And Rob, what happens if you don't get the 70 -- $72 million of TARP related credit? Is there a Plan B? Does their need to be a Plan B?

Well, A, I'm confident we will get it, but you always need to have a Plan B regardless. Again, I think our Plan B would be to continue to deleverage the balance sheet. You can see we made progress on that in the third quarter. I think it would allow us to continue to boost our capital ratios.

This quarter obviously we had the security losses, which we think were fairly unusual in nature. Absent those, we would have had a much smaller loss and the provision was quite a bit higher than where we've been running. So, the combination of eliminating the security losses and even bringing the provision down a bit, but to still very high levels would have us in the black. And you combine that with some deleveraging and I think we'd be able to grow our capital ratios in stages fine while we weather this storm.

We'd look at if there are alternatives, but frankly, the terms on the TARP CPP program are very attractive and I think the terms with the private equity offering or some type of public transaction would be not as attractive, but depending on the length of the downturn and the pressure on the loan portfolio we would look at all options. But we think the deleveraging option is the best because it would allow us to weather the storm, keep our capital ratio strong and not have to go to a Plan B. That would be our Plan B. Like I said, I'm confident that we will qualify for the TARP program.

And then one just last quick question. The $400,000 increase in advertising. Was that Independent Bank playing offense or defense? By defense, I mean just printing out more brochures for the branches and the commercial lenders to make sure your customers feel comfortable and understand the safety and soundness of the bank?

Terry, this is Mike. I will answer that. In working with our marketing department the executive management team made a decision that we actually needed to implement both strategies through our marketing collateral. And that is that we need to reassure our current customer base that their deposits are safe and doing business with Independent Bank Corporation is still something that they don't need to worry about. And then a lot of that had to do with the failure of IndyMac and then the takedown of, let's say, negotiated sales of WaMu and other financial institutions. It heightened the concerns of our customer base considerably because at least with IndyMac we had of had a feel who was the bad banks and who were the good banks, but with the negotiated sales that took place of WaMu and Wachovia it made our customer base extremely nervous about they couldn't tell any more who was the good bank and who were the bad banks.

So, for that reason we needed to spend quite a bit of time working with a lot of our large depositors and also improving our marketing programs to our current customer base. And then also taking advantage of these unprecedented times to basically grow our deposits through customers. There are certain customers that no matter what you tell them or how much information you give them their mind is made up and they're going to move their money where it is insured. So, we're taking advantage of those customers from other financial institutions as well. So, it was basically - I would answer that question - it was an increased marketing expense to cover both strategies.

Thank you.

Thank you. Our next question will come from Brad Milsaps from Sandler O'Neill. Please go ahead.

Hey, good morning.

Hi, Brad.

Good morning.

Stefanie, I'm just curious. Do you have a sense of what you might be able to get back in terms of property during the fourth quarter? Just kind of curious where the ORE balances might end up at the end of the year.

Well, Brad a couple of things. We are in negotiations with a number of other clients, but it's really too early to tell what would move into ORE other than there are a number of things in foreclosure that will move. But nothing that would be as significant as a jump as we saw in this quarter.

Yes, and I know the foreclosure process in Michigan can be fairly lengthy, but I guess I'm a little surprised that you haven't taken more property back at this point.

Well, Brad, what has made it very difficult in a lot of these large relationships has been the amount of second, third and fourth liens that have been placed against the properties. And so, as much as we'd like to negotiate with the borrower to get a deed in lieu of foreclosure, when we perform a title search on the property we find that through mechanic liens and then there are multiple relationships with other financial institutions. Everybody is throwing liens against everything an individual owns right now just to cloud the title so that maybe they can -- they're desperate that they'll be able to obtain some type of proceeds to help go against their loan.

So, as much as we'd like to accelerate the process, unfortunately we find ourselves in many cases having to go the foreclosure route so that our first mortgage position through the foreclosure we can wipe out all of the additional liens that have been placed against the property.

Okay. You may have answered my next question in some respects. If you do get the $72 million of TARP money, my thought would be would you accelerate maybe even faster the write-down of some of these properties in order to clear them off the balance sheet? Or Rob, is it your thought that you would hold on to that capital and kind of play a wait-and-see game at this moment?

I think what we do is what's economically in the best interest of the bank. In other words, if we feel we could get reasonable value we would pursue that. Stefanie mentioned we have a lot of instances where we're working with the borrower and they're slowly able to peck away at it. I don't think we'd change that strategy because trying to just sell wholesale amounts of those assets I don't think is in the economic best interest of the bank.

Now, we may look at doing something creative like forming a sister company to the bank that is a direct subsidiary of the holding company. It's not going to change the holding company numbers, but you could potentially move, sell assets from the bank to that sister company. We could then -- that would accelerate the improvement in the bank's balance sheet which could have some benefits on things like FDIC insurance costs while we still manage those assets in the best economic interest of the organization. So, I think that's going to be our approach.

The $70 million -- or $72 million I think gives us some ability to look at sales if we can get what we think is reasonable economic value, but I don't think it will push us to just accepting distressed prices to just make the numbers look better. I don't think that's in the long-term interest of our shareholders.

And the other thing I think it does give us the ability to do is look at opportunities to grow the organization. We're now focused more on deleveraging, but I think we'd revisit that strategy. We'd still vigorously manage the balance sheet, but I think it would allow us to maybe look at opportunities for growth in certain loans segments. I think that's one of the designs of the TARP CPP program is to get banks lending and growing and help get this economy turned around.

Brad, I would also just add that we do regularly check the debt market to see if there aren't select opportunities to move loans out of the organization. To date, we have found those prices to be very distressed, but we do continue to look to see if there aren't select opportunities. So, I guess I would add to Rob comments that although we're not looking at any kind of wholesale transaction to move a bunch of loans or sell them and take large write-downs, there are select opportunities that we continue to look at.

Stefanie, on the -- if I have my numbers correct here on the large -- one of the large charge-offs this quarter, you said it was $5 million related to one borrower. You're not carrying that at less than one-third of original appraised value and 50% of an appraisal obtained about a year ago. That seems reasonable, but would you say that's atypical in terms of the date of that appraisal? Would you have more up-to-date appraisals on the majority of your loans? It seems like that's a large relationship there to have, I guess, an appraisal that would be 12 months old in this type of market that seems to be changing by the hour.

Well, just to clarify my comments. I'm glad you asked the question, Brad. We do have an updated appraisal on the property that we just got. What my comment was is we had also had one a year ago and we also had one in 2004. And so, I was comparing those three points in time for several properties that are all related to this one borrower.

I think Brad's question is the space of time of the 12 months between the one in late '07 versus the current one. Was that typical or would we have more recent appraisals?

Typically, we would get appraisals at least once a year for a stressed asset like this and we would also want to time those appraisals. So, we would wait and get an appraisal right as we were moving something into ORE like we just did.

That one was a little unique, Brad, because we had done a forbearance agreement and had gotten additional collateral. I would say typically the process is different and so the appraisals are more current relative to say that last point you revalue the property. This one was unique because we did a work out toward the end of last year and took on additional collateral. I don't think it's a situation that is indicative of the typical process or that you'd see that type of write-down, that sort of an anomaly in my view.

The collateral was concentrated in one of the markets that's been the most stressed. And so, it really has dropped significantly in value. That would not be typical for the state in general.

Okay. And final question sort of on the heals of Terry's question regarding advertising. I noticed you're opening, I think, a branch this week. Just curious kind of what your plans are there going forward? Is that sort of the best use of resources in this environment? Thank you very much.

Thanks, Brad. Regarding the branch that we'll be opening on Thursday. We're having its grand opening on Thursday. That actually has been a loan production office in Houghton Lake for several years and very effective loan production office. It originated in real estate mortgages. We licensed that. It was just an office in a strip mall and we basically obtained approval for it to be a branch to accept deposits several years ago. And along with originating mortgages it has received in that store front deposits. And it made more financial and economic sense when we took a look at the projections to move out of the leased space that we were in and to build our own brick and mortar facility full-service branch. Again, based on already the reputation and business that we're generating out of that market.

So, what we're really doing is moving out of a storefront into a full-service branch. It's not opening a brand new branch in an unknown market to Independent Bank. At this point to the overall corporation, we do not have any additional branch or new branch plans on the drawing board for any of our locations. We're looking at remodeling some of our current locations and renovating, but we do not have plans for any additional new branch expansion.

Thank you. Our next question will come from Jason Werner from Howe Barnes. Please go ahead.

Good morning.

Good morning, Jason.

Most of my questions have been answered. Just a kind of follow up. With the loan we just talked about, the large one that was the bulk of the charge-offs, is that the same loan as the bulk of the ORE, too?

Yes. That was also the example of the customer that emotionally just couldn't continue to try to market their own properties. And so, it moved right into ORE and we took that significant charge.

Now that's an example where we did do a deed in lieu because there were not secondary liens. So, it moved quickly and it had been performing prior to that capitulation.

I assume this is some sort of development project. What is the collateral?

The collateral is vacant land and also a retail strip center. And the vacant land is land that is what I'll call on the fringes of the urban development and that is the kind of real estate that we have really seen drop quickly in value. So, somebody who bought land and plans to develop it and it was going to be the next new subdivision, well that kind of development is very stalled and that significantly has impacted the prices and caused for that significant write-down.

And the retail strip center, I'm guessing, is suffering from low vacancies then?

Yes. It just was recently constructed and needs to get tenants.

Okay. You guys said this project was in areas that had more distressed prices. I guess can you be a little more clear on where this property is?

It's and the Macomb County area, which is one of the areas that had very rapid growth prior to the slowdown and that is probably one of the counties that we have seen the greatest drop in values.

Okay. I also had a question about slide 10 on the securities available for sale. Obviously, the unrealized loss through this quarter. You had said that the private label, a CMO that was the sub investment grade you'd already kind of taken a hit on that.

It wasn't a CMO. It's a mobile home asset-backed security. We took impairment charges of about $400,000 collectively or so back in '04 and '05 and it's performing just fine. And now the market value comfortably exceeds the adjusted cost basis, but when you take other than temporary impairment you can't write it back up unless you sell it. So, that's the only security in that grouping that we've had any downgrade on whatsoever.

Okay. But obviously, that's not part of that 6.9?

Most of that is it's just the CMO market in general is off. So, some of these are driven by rates being higher than we originally bought the CMOs. Others just in general sort of the out of favor. But we've gone through and analyzed every one of them and looked at -- we didn't buy in support tranches of any of these. Ours are at the top of the food chain and in almost every instance are these subordination support below us is actually better than when the CMO was originally constructed.

Okay. So, looking at that you don't see much of a chance of an OTTI on that?

No. They all have maturity dates and they're all -- the credit support is good on all of those.

Okay. What can you tell us about this money market preferred that's off almost $5 million?

The money market and I have a footnote -- the money market preferred was backed by or is backed by Bank of America Series E preferred stock and Lehman Brothers had put together a two -- basically a two-tranche asset that had a floating rate piece, sort of in A Piece that represented 75% of it. That was tied to LIBOR and actually it was an auction. They held a quarterly auction to establish the rate.

And then there was 25% of it was an inverse floater, which was the higher risk of the structure. We owned the low risk, what was supposed to be low risk piece of it. And earlier this year the auction began to fail and so the rate for our piece was actually set by a formula and so we were getting a much higher rate. It was an above market rate at the time.

What happened in the third quarter was with Lehman Brothers' bankruptcy that created under the trust a distribution event. And so in November we're actually getting distributed the Bank of America Series E preferred stock and all preferred stocks as you can imagine were down dramatically in the third quarter because of the Fannie Mae and Freddie Mac conservatorship. So, that fair value is the value of the underlying Bank of America Preferred Series E.

At least at this juncture -- and you may be aware the SEC sent a letter to the Fed's beyond perpetual preferreds and they said look to the credit worthiness of the issuer and the certainty of the cash flows. And so, when we evaluate this and look at the credit worthiness of the issuer, which is Bank of America, we're comfortable with that and the certainty of the cash flows we're comfortable with. The pricing on it is LIBOR plus 35 with a 4% floor and recognize that 70% of it is not taxable. It's the dividend received deduction and their coverage ratio on their preferred dividend was like seven or eight times.

So, we felt comfortable that we did not have other than temporary impairment on that, but that's the reason for the steep decline in the cost basis versus the fair value. And finally, we have the ability and intent to hold that until such time as the price recovers.

Once you get possession of the Series E preferred will you keep it in available for sale or will you move that into -- with the other preferred stocks?

We would -- our intent is to keep it in available for sale.

Okay. And then also to kind of go back you said -- and I think I heard you right. You had -- looking ahead you had margin in the 4.75 range. But I think you said that given the shrinkage in earning assets that the dollar level of that interest income is likely to come down. Is that what you said?

I said that if we continue to deleverage I don't know that we can make up that with growth in the margin, although if the Fed moves another half point tomorrow I'd have to revisit that. That would give us, I think, a bit of a boost, but nonetheless I think I had on a slide just to give you an example, we were able to borrow $100 million in the Fed term auction at 1.11%. So, the Fed liquidity has been extremely helpful to us. We've taken as much advantage of it as we can and like I said if the Fed moves again it's likely going to help us.

One other odd thing, Jason, is LIBOR spreads are elevated and that has helped as a bit. We have more assets that are tied to LIBOR loans and some securities that have repriced at higher rates and we have very little debtor borrowings tied to LIBOR. And we have paid fixed interest rate swaps where we're paying a fixed rate and receiving LIBOR.

So, all of that has helped a little bit, too. But again, my basic premise was absent a Fed move there's probably not a lot more upside potential on the margin so if our earning assets are shrinking a bit that's going to have a little move down in our dollar amount of net interest income.

Okay. Thank you guys.

Yes.

Thanks.

Thank you. Our next question will come from Stephen Geyen from Stifel Nicolaus. Please go ahead.

Yes, just one small question. Stefanie, I think I heard you -- jotting a lot of things down at the time, but it sounded like you made some changes to the standard reserve. I'm just wondering what kind of assumptions you're using?

The standard reserves that I was outlining are the methodology that we have had in place all year. We would go through a once a year review and update of that. So, it's not something new.

Okay. Got you. Thank you.

You're welcome.

We show no further questions at this time. I would like to turn the conference back over to Mr. Magee for any closing remarks.

Steph, Rob, thank you. With that, this concludes our conference call today. Thank you for your interest in Independent Bank Corporation and we look forward to speaking with you again next quarter.

A reminder. For an archived webcast of today's call please go to the investor section of our website at, again, www.ibcp.com. The webcast will be archived on our website for approximately 90 days from today's date. If you have any questions in the interim please feel free to contact Stefanie, Rob or myself. Again, thank you and have a great day.

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