WaFd Inc (WAFDP) 2006 Q4 法說會逐字稿

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the First Mutual Bancshares conference call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Wednesday, January 24, 2007.

At this time, I would like to turn the presentation over to your President and Chief Executive Officer, John Valaas. Please go ahead.

Thank you. Good morning, everybody. This is John Valaas and with me this morning I have Roger Mandery, our Chief Financial Officer; Scott Harlan, Executive Vice President and head of Residential and Consumer Lending; and Charles Smith, Financial Analyst.

I will start off by noting that this was our 14th consecutive year of record earnings, but our quarter was flat compared to the fourth quarter a year ago. Credit quality remains good. NPAs moved up modestly to 32 BPS, but as we noted in the press release back then to 24 BPS after year end do to a payoff of a couple of loans in Oregon that amounted to $865,000 that were on our NPA list.

I think the noteworthy item for the quarter and certainly wasn't in our outlook was the decline in net interest margin to 3.78% and I'll just cite the usual suspects, yield curve and continued deposit competition, but also note that the nature of our assets, we don't have a lot of construction loans in our portfolio and so we continue to stay very focused on growing our business banking, our C&I portfolio and our residential custom construction portfolio, and of course, sales finance, most of that production of which we have sold.

We did manage our portfolio growth in the quarter and the year via loan sales. In fact, I would point out that our gain on sale from loan sales was double -- more than double in 2006 what it was in 2005, and increased to 3.1 million in 2006 from about 1.4 million in 2005. So again, we've been focused on managing our portfolio growth via those loan sales and generating fee income on gain on sale and service the income on into the future.

Interestingly, we had a record year for loan volume, $546 million in loan volume, but our loans year-over-year both due to loan sales and very high prepayment speeds only grew -- our own portfolio only grew by about $16 million. In fact, our loan sales more than doubled in 2006 to $138 million.

We continue to make progress on the liability mix. Our federal home loan bank borrowings were paid down about $54 million year-over-year, and our time deposits in our banking center -- well, actually in the total bank mix, decreased from 64% at the end of 2005 to 60% of our deposit mix at the end of 2006. We do note in our outlook that we expect continued margin pressure on into the future.

Before I turn it over to questions, I do want to read the forward-looking statements disclaimer. This presentation may include some statements regarding the Company's trends, objectives, anticipated growth, credit quality and other expectations which will be forward-looking statements for purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from those expressed or implied in this presentation.

Additional information concerning the risks and uncertainties are discussed from time to time in filings made by the Company with the Securities and Exchange Commission. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. The Company does not have any obligation to update any such forward-looking statements.

And with that, I will close and open the call to questions.

Thank you, sir. Ladies and gentlemen, at this time, we will begin the question-and-answer session. (OPERATOR INSTRUCTIONS). Matthew Clark, Keefe, Bruyette & Woods.

A few questions. First, could you just talk about your decision to self insure the home improvement production on the new stuff? And I guess, the expectation obviously for secular increase in credit cost going forward and how that may add an element of earnings volatility going forward despite their savings on premiums and I guess your (indiscernible) products or solutions you're going to introduce.

I didn't quite hear the last sentence, I'm sorry.

Just the innovative way of offering the product to new customers given the -- I guess what I'm getting at is how the premium savings and the way you're going to go about pricing it and how we're going to see a high level of credit cost going forward. Just trying to -- obviously it's not a linear relationship, but one to get your thoughts on how you expect results to unfold.

Right. Yes, as their previous policy expired at the end of July 2006, and we were -- I believe we mentioned this in the third quarter conference call, we're in negotiations with the insurance company at that point in time which at that point we're undetermined. In that negotiation, we came to the conclusion and we stated in the press release and I don't know that there's a finer way to put it, that the premium cost that the insurance company was quoting to us were higher than what we thought were appropriate for the kinds of loans that we're doing and the kinds of credit risks that are incumbent in those loans.

So, we made the decision to cease insuring new loans going forward. Primarily, really over the last couple, three years, the insurance product was really driven by the needs and desires of the investors to whom we were selling the pools of loans, and instead of paying the premium expense, which is a fixed, mechanical calculation each and every month, we instead worked to come up with a way that's certainly appropriate from an accounting perspective to sell the pools of loans to investors in a way that effectively mimicked the insurance coverage that they had received prior to that, so they took comfort in that, and also were able for us to essentially save the profit margin that the insurance company was calculating in the mix that -- a premium.

I might defer to John or Roger in terms of how it might impact the variability of earnings going forward. Certainly, the savings and premium expense, it has been -- but a good portion of that certainly will go towards the reserve loan loss calculation and how that works, so I'll turn it over to John or Roger to answer that part.

We sold 3.5 million loans that had FICO scores of 700 or less, and that was the category of loans we used to insure, and so people who had bought those loans in the past would have had insurance coverage up to 10%. So we gave limited recourse to those same borrowers up to 10%.

To the investors.

To the investors, excuse me. The cost of that 10%, we would have had booked that cost right up front, deducted it out of the gain on loan sale, so, in the past, we would have paid insurance coverage on those loans and as long as the investors had them or until those loans were prepaid; but under our new system, as soon as we sell a loan, we go ahead and charge it off and we're done with it. So that's kind of how we substituted limited recourse for insurance coverage for loans that we sold. And again, that's only the loans that had FICO scores of roughly 700 or less. That constitutes about 20% -- 20% to 30% of anything that we sell.

In terms of that same group of loans that we don't sell we keep in our own portfolio, we are anticipating that we will have to provide additional provision, so instead of paying insurance coverage of [2,] 2.5% a year, we are taking the loan loss provision right up front, so there's some volatility in the sense that our loan loss provisions will be sort of front loaded as opposed to being spread out over the life of the loan, which is what we had with the credit insurers. But essentially, we're expecting the same economic effect whether or not we provide for increased loan loss provision or we go ahead and take down the insurance coverage that we used to in the past.

Just a follow-up to clarify that in the fourth quarter, we offered, as we said in the press release, essentially a two item menu to people who are purchasing the pools of loans. One was limited recourse to us and the other was higher yield, higher pass-through rate on the pool and no recourse, and we had sales fall into both categories off that menu in the fourth quarter.

So, we think there is appetite both ways. Also, as far as loans we retain in our portfolio, we're very comfortable with the level of experience that we have now and that was another driver in the decision to no longer take the insurance.

Thanks for all the color. The shift in the deposit mix towards the money market bucket, can you just -- what was the offering there? What was the rate you were offering and, I guess, why such a surge? I mean we know the reasoning behind it, but I'm just curious as to what the rates were.

I have responsibility for the pricing committee so that's partially why I'm answering this question, but the change in mix, especially in the fourth quarter, came from some excellent deposit gathering activities going on in our Business Banking area where they had several customers with larger balances bring those deposits to the bank. The rates were higher than our rate sheet rates for money market for your -- the sort of standard offerings in the banking centers, but they were significantly lower than what the similar cost would be to borrow overnight funds from the federal home loan bank or other wholesale funds.

Okay, but you don't have kind of an average rate for the quarter, kind of what the step up was?

No, not at my fingertips, no.

And then I guess based on the run rate that we saw this quarter, there was some reserve release and I guess, can you give -- what it looks like as we could see a down year in earnings and I'm just curious whether or not I'm way off base -- for 2007.

We don't give an outlook for the year. We will observe and we did observe in our outlook for the quarter that we expect continued margin pressure certainly in the first quarter and frankly, I would say until the Fed drops rates at the short end, net margin pressure is probably going to continue. You probably haven't heard that from any other banks in this quarter.

We're going to continue to stick to our strategy which is a focus on the residential lending that we do the custom construction in particular, and focus on growth in Business Banking, which we think is where long-term this bank should be headed and not attempt to pile on a large amount of construction loans at this point, which are certainly well priced in this market. So without going into a specific outlook for the year, I would say certainly for the first quarter, we're going to expect continuing margin pressure.

But there are no, I guess, initiatives that you're thinking about to unveil some time this year, a change in fee structures or anything like that?

I think in general, in terms of fees, the focus is on fee income generated through gain on loan sales and service fee income. We don't have any big review of other fees like deposit fees, for example, under way. I would point out that we have continued to make steady growth in things like ATM fees and debit card fees, but while they're growing nicely, they're not a significant item to the bottom-line compared to, say, the gain on sale of loan fees. I guess the other thing that we will continue to do is manage our asset growth while we continue to focus on the liability mix.

Jim Bradshaw, D.A. Davidson.

How does the limited recourse reserve work? Are you going to set it up like the insurance was with a 10% cap for sort of each production year or is it going to be a general reserve? I'm just trying to figure out, let's say that you only end up with 5% loss severity on one year's worth of production, would you release reserves at the end of that pool life or would you be able to sort of meter it back in over time as you realize you're not going to hit the cap?

In general, I'll give you an example. If we sold a $10 million pool of loans to an investor and $2 million of that pool had loans with the credit scores below 700 that we would have insured otherwise previously, then the investor would receive up to 10% limited recourse on that $2 million, so we would essentially receive a $200,000 commitment that if the losses exceeded $200,000 amongst that pool of $2 million, then we would cover that first $200,000. If at the end of the life of the pool, there is any money left in that $200,000, those funds stay with the bank, not with the investor.

So you have to wait until the pool life is essentially over before you can recapture that money if they're within a 10% hit?

Actually, we will look at it each quarter. Scott and the folks that run the Sales Finance area have done quite a bit of data analysis, looking at all the claims experience we've had over the year, so we have a pretty good profile of what's going to happen by month. So we will look at it and look see how many loans are left and what month we are in.

Excuse me, let me digress for a second. I forgot to mention each sale is treated as a separate pool, so we analyze it pool by pool each time. And so we will monitor that each quarter and see how many loans are left. What we expect the future charge-off experience will be based on all the historical data we have and then we will adjust reserve in that pool. So we will either increase it or drop it depending on what we think the remaining losses are going to be up to the 10% limit.

And you will report that to us by pool? Is that how you're going to -- it's going to show up in the queues and press releases and stuff?

We certainly could if there was interest level. Right now, we're just probably going to throw it all in a big bucket and know how much we adjusted all the pools. It's kind of like what we do with the servicing right asset. We sort of keep track of the amortization and just throw it in one big bucket, but if there is investor interest in looking at it by pool, we could certainly report that.

I'm not sure who to ask, but I'll ask the group, has your appetite for low FICO score versus high FICO score changed for your own portfolio as a result of this or will it continue to be a similar policy?

No, the appetite has not increased for lower FICO scores because of this. Really it's -- we are originating loans on the same profile that we have always originated them and really, nothing has changed in terms of the business model on the origination side. I will mention that the average credit score of the loans that we originate have increased over the last couple of years and that we consider to be certainly a good trend, and that's just really just based on the mix of business that we are seeing. So, rather than going down, the average FICO score has been edging up slightly over time.

This is truly a forward-looking statement, so remember all those disclaimers that I read, but as Scott points out, we have seen a rise in the average FICO scores in that portfolio in the loans we are originating. We have ended a relationship recently with one dealer and that gives us reason to believe that that rise in FICO scores will continue.

I'd just add a footnote to all that. The low FICO score which results in all the claims and a greater level of charge-offs, again, constitute 20% to 30% portfolio, and necessary that we buy sort of a full range of loans from dealers, otherwise they won't do business with us. So in a perfect world, we would decline to own these loans or to process these loans, but then we wouldn't be able to do business. We wouldn't have an opportunity for the other 80% of the business, which is where most of our serious profits come from.

Last question I had is if you could comment on how morale is at your Company. Obviously, bonus accruals were reversed in the quarter. Just wonder what impact that might have. Do you think there might be any turnover or how you're recruiting efforts might be at this point.

It's probably hardest for me to assess how morale is at the Company because I live in the CEO bubble. Let's be honest. I think that we have managed expectations throughout the course of the year, certainly in the latter part of the year, that don't go out and load up your credit card for year end because it will be tight for a bonus. And certainly, I would point out that this bonus reversal affects the executive management, we get zero, and it affects the support staff, but the originators, of course, continue to earn their incentive comp. We had many, many originators who had a very, very good year because they, in fact, had a very good year. As I indicated earlier, we had record level of loan originations in 2006.

So this is just, if you will, the discretionary portion rather than the contractual portion of bonus compensation, I guess?

Absolutely. The originators, whether they are on the deposit side or the loan origination side, had a very good year as appropriate given the record level of originations, both on in terms of the deposit mix that we were trying to incent for in loan originations.

Sara Hasan, McAdams Wright Ragen.

I was just wondering, I just want to kind of clarify. On the bonuses, kind of going back to Jim's question, so there was -- last year you had a bonus of about $250,000 and that was in the fourth quarter, and so we didn't see that this year, and then also, this quarter, you reversed the accrual in the fourth quarter.

That's correct, Sara.

Okay. Just making sure. And then, on the prepayments, do you guys charge a fee? Have I missed this? Is there some kind of offsetting fee income when people prepay?

This is Roger.

(multiple speakers).

Certain loans do have prepayment fees in them, also, or extension fees, particularly in the construction area where we tend to see that level of activity, so if someone indicates they can build their house in six months and it takes eight months, there's usually a little extension fee for us working with them for their additional two months. But that's where most of those prepayments and extension fees come from.

But Sara, particularly in our income property permanent loan portfolio, where we've had a very high rate of prepayment, those are mostly one year adjustable-rate loans and typically those do not carry a prepayment fee to the extent they might be like a 3-1 adjustable or something like that, and they prepay, then they would have a prepayment fee, but the bulk of that portfolio is the one year adjustable-rate loan and again, given the shape of the yield curve and the very active presence of conduit lenders in the income property permanent lending market, lending out at 10-year fixed-rates that are well below what we would be charging on a one year adjustable-rate. You can see the migration would be obvious from a borrower's point of view, and again, without the prepayment penalty on those one year adjustable-rate loans, that's been a pretty cost-free transfer for a borrower to move into a, say, a conduit on a 10-year fixed-rate basis.

And then any updates on your search for a worthy successor for Roger?

Well, we all agree there is no worthy successor, but we are actively in a search. We have spoken to some candidates. The search goes on and we have no results to announce at this point.

Bill Dezellem, Tieton Capital Management.

We had a group of questions. First of all, relative to the competition that continues to be a challenge, as you look during the fourth quarter, did that competition tend to be from the bigger banks or from the startups?

It depends on where you are. It's really across the board. The bigger banks, as you know because you do look at banks, tend to be less concerned I would say about margin, certainly some of the very large banks have margins -- their net interest margins are well under 3%. Behaviorally, we have seen in the bigger banks is that they tend to ignore their customers until they think their customers -- I'm talking about the Business Banking side -- tend to ignore their customers until their customers are announcing that they are going to leave and then they are absolutely ferocious in their attempts to hang on to those customers, primarily by cutting the margins on their loans to whatever it takes to hang on to those relationships. So, we see a lot of competition in that respect. In kind of the lower middle market area that we focus on in Business Banking, we see competition for deposits more from the other community banks, particularly those who have been very active construction lenders and who have seen their portfolios grow quite rapidly over the last 12 months or so, so they have been very aggressive looking for primarily deposits out to one year to kind of match their growth in their one year construction loans.

And then, yes, the new startups both have capital that they need to deploy and they're probably a little less concerned about margin and, of course, are looking for deposits as well. It's really a long answer to your question, Bill, but it's competition across the board tempered somewhat by the only observation I guess I'd make would be that the larger banks are probably a little less aggressive on the deposit pricing side. That's more in the community bank and startup bank side.

Relative to the Sales Finance business, you've had the Mount Clemens office now for a couple of quarters. To what degree is that going to create the opportunity to accelerate loan originations there and hence the fee income for sale of loans?

I'm not sure how to answer that question in this context, so I'll just do it this way. I am very pleased with the origination efforts going on in the Sales Finance area. We have many good things happening; lots of irons in the fire. Certainly, on the numbers that we have published and that are available publicly, you can see that the trends are good and I guess I'll just sort of leave it to say that I'm optimistic about what I am seeing going on in that area right now and the kinds of initiatives going on with good volume contractors and the potential to do good business in the future.

I would echo Scott's phrasing. We feel optimistic about volumes in that area for 2007 and are also considering at least one idea of a product extension there that probably would not add a lot in volume in 2007, but we think could be a good product line extension in the latter part of the year and certainly on into the future in that business.

Given that you opened that door, John, can you give us more detail?

No.

Thank you, anyhow.

You're welcome as always, Bill, and I don't blame you for asking.

Ross Haberman, Haberman Value Fund.

I want to go back -- I got on a little late. I wanted to understand a little bit more how you're going to set up I guess your self-insurance program on the consumer loans. I was wondering if you could just run -- you're not going back, it's just on the new production for (indiscernible), beginning in '07, correct?

It actually started to some degree in August of '06. We insured a few loans, a couple million dollars of loans between August and I believe the end of third quarter, and then in fourth quarter we -- I purchased no insurance on any new loans originated.

And that's going to be both for the higher and the lower FICO score items?

Yes, we never purchased credit insurance on the higher FICO score. It was the lower FICO scores of about 720 and below in the past, and so, in some respects -- not in some respects -- in the limited recourse that we are offering to and purchasers of pools of our loans will be for the loans that we would have insured in the past with FICO scores of 700 and below. That's the plan today that we are offering investors this quarter.

And that's basically because the insurance rates had gone up more than historic and/or your delinquencies and write-offs were not quite as high as you thought they might have been?

That's really kind of both of those issues coming to a -- one was the insurance company that they looked over their shoulder and looked at the previous claims experience and then -- I don't want to -- I can't understate this enough, and when they add in their appropriate profit margin for them taking on the risk that they did, when we compare the cost of that versus the trends that we were seeing in our own portfolio in our experience going back to the earliest days when we were offering loans nationally and how we have adjusted underwriting criteria and how we have certainly improved our methodology and understanding in the collections area as certainly our understanding of originating approximately $50 million, $60 million of loans nationally and seeing how those performed versus the cost of what the insurance company were quoting us, we made the economic decision to cease insuring.

Could you talk about the loan demand in that category today? And given that you're going to self-insure, how will that affect the volume of loans you end up selling going forward?

I see no effect on the volume of loans that we originate. In terms of the loans that we sell, it's still early with the changes we've made as we talked about earlier. We are offering a limited recourse arrangement option to the buyers of our loans that effectively mimics what they received earlier on the insurance program. Based on our sales in fourth quarter and our conversations in first quarter, it does not appear to have any negative impact on sales at this point in time.

We sold 18 million in the fourth quarter of which 3.5 million ended up with limited recourse. That would probably be about the same ratio that we would have seen in the past if we'd had insurance.

Could you give us a flavor for how you're seeing that part of the business in terms of loan demand today and your expectation for '07? Whether you care to?

Yes, I would just -- I guess at the risk of repeating what I'd mentioned four or five minutes ago, that we're optimistic about the volume, about the origination going on in '07. We have good sales reps out on the field doing the right kinds of things with the right kinds of contractors and I am certainly optimistic looking into '07, having had a better '06 than we had in '05, it seems to be going the right direction based on what I know at this point.

And just, John, one quick question. Any new branches planned for '07?

Currently, Ross, we currently have one under construction and no other plans other than that.

Or relocations or renovations or anything?

None of that. We're all done with that.

You're all done. We're hoping to see the fruits of all that hard work.

Yes, we are too.

Knock on wood. Thank you.

(OPERATOR INSTRUCTIONS) Brian Martin, Howe Barnes Hoefer & Arnett, Inc.

Just a question on kind of your expectations for loan growth, if you will, in '07 based on your expectations for sales of the sales finance or consumer finance. Can you talk a little bit about the [linked] quarter decline in kind of the consumer and residential and just maybe what you think changes as you look to '07 based on this quarter's results and how we might look at that?

I'll talk about the [linked] quarter decline in consumer and residential. Let's talk about consumer first. We have a (indiscernible) prepayment speeds very short life on the sales financial loans. I think they're around a 2.5 year or so average life although it's typically a 10-year fixed-rate loan. We sold virtually all -- by design, sold virtually all of the new production in the sales financial area, so I think that you will not see --- that's the kind of behavior you will see in the course of 2007 there.

On the residential side, we're just seeing a slowing in the market. The Pacific northwest residential market I would guess certainly from my readings as a national economy has been one of the strongest residential markets of any marketplace in the U.S, but we are seeing signs of a slowing here. We are seeing slower lot sales and land acquisition and development side builders certainly slowing down their take-up of lots. Building inventories in the single family side, not so much in King County, which is the county we're in, but a little bit in Snohomish County to the north of us we have seen a steady uptrend over the last four or five months there in single family inventories. And so that naturally gets reflected a little bit in custom construction side in particular that is managed by Scott and the residential firm area, and as that slows down, some of those construction loans that we had in the portfolio there convert to perm and sometimes roll out of the bank, particularly if they're a 30-year fixed, and we've seen a little bit of decline there and I don't expect that behavior to change much in 2007 either.

As far as loan portfolio as a whole, we're just giving an outlook for the first quarter and we're expecting a net increase in loans of up to -- zero to $5 million. We're remaining pretty focused on managing our asset growth and in exchange for that, continuing to focus on changing our liability mix and paying down wholesale borrowings, particularly as I noted earlier, federal home loan bank borrowings.

Can you quantify the level of participations in the quarter? With any material? It says they were a large number, just maybe you could give a little bit more color on that?

Sales of commercial loans constructions?

Yes, we have a table in here.

We're all frantically looking to see if we can find the table that we have it in.

While they look at that table, Brian, can I just give you a footnote? I think our problem probably is more prepayment oriented than it is loan origination. That is, for example, in the fourth quarter of 2006, we had record loan originations, but we've just had this blistering rate of prepayment throughout the year. Our prepayment level, we're at 39%, so you add that plus the loan sales that we've had, we ended up with a flat year.

Did that slow during the year, that 39% level or was it pretty constant?

Excluding that stuff. Yes. Just our portfolio, what's paying off on that, so it was 39% and then you throw in anything that we're selling. But I think we finally found the table to answer your question a little more specifically.

Brian, Page 10 of the press release has a table in the section on non-interest income and we talked both about the gain on sales and then the volume of loans sold. We've sold 18.4 million in commercial loans in the quarter; 30 million in the year 2006; and that 18.4 million in the quarter was up from 5 million a year ago, and then the 30 million for the year, again, this is just commercial loans, was up from 11 million a year ago.

How about just two other questions, if you could. The margin decline in the quarter, obviously better -- more than you expected and you kind of indicated reason. Just wondering if you expect, given your shift on the deposit side, do you expect this level of decline in the quarter to decelerate? You talk about margin pressure going forward. Should the pressure continue just at a slower rate, is that kind of your expectations? Or could you see similar type of declines in the margin in the short run?

Yes, at the very end of the press release, we've got a section called Outlook for the first quarter and we comment in there in the net interest margin that we expect the margin to remain in a range of 3.75% to 3.8% in the first quarter.

I guess beyond that, I guess you talk about the margin pressure continuing. Can you just comment a little bit on what the rate of that pressure? Do you think it's more likely to stabilize or it's more likely to accelerate?

We -- unfortunately, this is not going to be very helpful for you, but we're not at this point giving any -- and never have historically and don't anticipate ever giving any outlooks beyond the succeeding quarter.

How about just on the, lastly on the credit side in the quarter with the reserve release, given that -- can you comment a little bit about your -- you said you had some improvement subsequent to quarter end. I guess how you feel about credit and if you think it's possible that there could be additional releases as you look to '07.

The prospect of additional releases, well, let me back up. Theoretically, I would say we would only be looking at additional releases if the loan portfolio declined substantially and then, of course, that would be if credit quality remained otherwise equal, it might be not unsurprising to see something like that happen, but I wouldn't anticipate that.

We did have a little bit of a decline in the portfolio and looking into the credit quality, we feel very comfortable with the credit quality, so that's how we ended up with a modest release in the fourth quarter. I wouldn't look at that as a trendsetter.

(OPERATOR INSTRUCTIONS). Management, at this time we appear to have no additional questions in the queue. I will turn the conference back to you for any further remarks.

Thank you, everybody, for taking the time to listen in this morning. We look forward to talking to you if not during the course of the quarter, at our next quarterly conference call in April. Thanks and good bye.

Thank you, sir. Ladies and gentlemen, at this time, we will conclude today's teleconference presentation. We thank you for your participation on the conference. At this time, you may now disconnect and please have a pleasant day.