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| MSFG > SEC Filings for MSFG > Form 10-Q on 7-Nov-2008 | All Recent SEC Filings |
7-Nov-2008
Quarterly Report
(Dollar amounts in thousands except per share data)
Overview
MainSource Financial Group, Inc. ("Company") is a multi-bank, financial holding company that provides an array of financial services and is headquartered in Greensburg, Indiana. The Company's shares trade on the NASDAQ national market under the symbol MSFG. On September 30, 2008, the Company controlled four bank subsidiaries, MainSource Bank, MainSource Bank of Illinois, MainSource Bank - Ohio, and 1st Independence Bank. In addition to the banking subsidiaries, the Company owned the following subsidiaries: MainSource Insurance, LLC, MainSource Statutory Trust I, MainSource Statutory Trust II, MainSource Statutory Trust III, MainSource Statutory Trust IV, Harrodsburg Statutory Trust I, Independence Bancorp Statutory Trust I, MSB Investments of Nevada, Inc., and MainSource Title, LLC. As required by current accounting guidance, the trusts are no longer consolidated with the Company. Accordingly, the Company does not report the securities issued by the trusts as liabilities, and instead reports as liabilities the subordinated debentures issued by the Company.
Forward-Looking Statements
Except for historical information contained herein, the following discussion and analysis includes certain statements which constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties, including anticipated financial performance, business prospects and other similar matters, which reflect management's best judgment based on factors currently known. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. Factors which might cause such a difference include, but are not limited to, general economic conditions, monetary and fiscal policies of the federal government, demand for loan products, and other factors discussed herein, in our Annual Report on Form 10K for the year ended December 31, 2007, under ITEM 1A "Risk Factors", and our other filings with the Securities and Exchange Commission. The Company does not undertake, and specifically disclaims, any obligation to update any forward-looking statements to reflect the occurrence of events or circumstances after the date of such statements.
Recent Developments
On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the "EESA") enacted by the U.S. Congress in response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions. Pursuant to the EESA, the U.S. Department of Treasury ("Treasury") has the authority to, among other things, purchase mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.
Also on October 3, 2008, the Treasury announced the Troubled Asset Relief Program ("TARP") under the EESA, which gave the Treasury authority to deploy up to $750 billion into the financial markets to address liquidity and related concerns. On October 14, 2008, the Treasury announced several initiatives under TARP intended to help stabilize the banking industry, including a voluntary capital purchase program ("CPP"). Under the CPP, the Treasury will purchase up to $250 billion of senior preferred stock from eligible financial institutions on standardized terms with attached warrants to purchase common stock. If the Company participates in the CPP, the Treasury would purchase from the Company cumulative perpetual preferred shares. The preferred shares would constitute Tier 1 capital and rank senior to the Company's common shares. The Company has currently not made a definitive decision whether to participate in the CPP. If the Company chooses to participate, the range of the Treasury's preferred investment would be approximately $19 million to $57 million.
Also on October 14, 2008, the FDIC announced a new program - the Temporary Liquidity Guarantee Program ("TLGP") that provides unlimited deposit insurance on funds in non-interest bearing transaction deposit accounts not otherwise covered by the existing deposit insurance limit. Institutions eligible to participate have a one time opt-out option available on or before December 5, 2008. The Company has not currently made a definitive decision whether to opt out of the TLGP.
Results of Operations
Net income for the third quarter of 2008 was $5,383 compared to $5,603 for the third quarter of 2007. The slight decrease in net income was primarily attributable to an increase in loan loss provision expense offset by an improvement in the Company's margin on earning assets. Diluted earnings per share for the third quarter totaled $0.28 in 2008, a slight decrease from the $0.30 reported in the same period a year ago. Key measures of the financial performance of the Company are return on average shareholders' equity and return on average assets. Return on average shareholders' equity was 7.92% for the third quarter of 2008 while return on average assets was .81% for the same period, compared to 8.77% and .91% in the third quarter of 2007.
For the nine months ended September 30, 2008, net income was $17,808 compared to $17,021 for the same period a year ago. The increase in net income was primarily attributable to a higher level of earning assets, greater non interest income, and the reversal of a tax reserve and was partially offset by higher loan loss provision expense and the severance accrual related to the resignation of the Company's former Chief Executive Officer. Earnings per share increased to $0.95 in 2008 from $0.91 in 2007. Return on average shareholders' equity was 8.78% for the first nine months of 2008 while return on average assets was .93% for the same period, compared to 8.88% and .94% in the first nine months of 2007.
Net Interest Income
The volume and yield of earning assets and interest-bearing liabilities influence net interest income. Net interest income reflects the mix of interest-bearing and non-interest-bearing liabilities that fund earning assets, as well as interest spreads between the rates earned on these assets and the rates paid on interest-bearing liabilities. Third quarter net interest income of $22,549 in 2008 was an increase of 23.6% versus the third quarter of 2007. The Company's cost of funds in the third quarter of 2008 was approximately100 basis points lower than the same period in 2007 as the Fed's rate reductions during the fourth quarter of 2007 and the first quarter of 2008 had a more positive impact on the Company's cost of funds compared to its yield on assets due to the Company's liability-sensitive balance sheet. The Company believes that the Fed's rate reduction in the fourth quarter of 2008 will have a negative impact on net interest margin as the yield on the Company's earning assets will decrease faster than its cost of funds as many deposit accounts have reached their interest rate floor. Average earning assets increased 8.3% while net interest margin, on a fully-taxable equivalent basis, increased to 3.92% for the third quarter of 2008 compared to 3.48% for the same period a year ago.
For the first nine months of 2008, the Company's net interest margin was 3.82% compared to 3.61% for the first nine months of 2007.
Provision for Loan Losses
See "Loans, Credit Risk and the Allowance and provision for Probable Loan Losses" below.
Non-interest Income
Third quarter non-interest income for 2008 was $7,802 compared to $7,535 for the third quarter of 2007. Interchange income increased $175 and service charges on deposit accounts increased $269 in the third quarter of 2008 compared to the same period in 2007 as a larger deposit base generated additional fee income.
For the nine months ended September 30, 2008, non-interest income was $23,391 compared to $21,093 for the same period a year ago. Increases in service charges on deposit accounts and mortgage banking income were the primary contributors to the increase. Mortgage banking income increased year over year due primarily to a favorable interest rate environment in 2008.
Non-interest Expense
The Company's non-interest expense was $18,104 for the third quarter of 2008 compared to $17,293 for the same period in 2007. The primary cause of the increase was an increase in employee-related costs of $779 related to normal merit increases and the current period effect of the acquisition of 1st Independence. The Company's efficiency ratio improved to 58.3% for the third quarter of 2008 compared to 65.0% for the same period a year ago, positively impacted by the improvement in net interest income.
For the nine months ended September 30, 2008, non-interest expense was $53,191 compared to $51,260 for the same period a year ago. Employee costs increased $2,271 due to normal merit increases and a $600 severance provision related to the resignation of the Company's former CEO in February 2008. The Company's efficiency ratio was 59.9% for the first nine months of 2008 compared to 64.8% for the same period a year ago, positively impacted by the improvement in net interest income.
Income Taxes
The effective tax rate for the first nine months was 21.7% for 2008 compared to 24.9% for the same period a year ago. The decrease in the Company's effective tax rate was primarily attributable to a reversal of a $595 reserve recorded in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. The tax reversal relates to a recent U.S. Tax Court decision that confirmed that a subsidiary of a bank can deduct the interest expense of tax exempt obligations it has purchased. The time for the Internal Revenue Service to appeal the court ruling expired in the first quarter. The Company and its subsidiaries file consolidated income tax returns.
Financial Condition
Total assets at September 30, 2008 were $2,867,149, a significant increase from the $2,536,437 as of December 31, 2007. This increase is primarily attributable to the acquisition of 1st Independence. Average earning assets represented 88.9% of average total assets for the first nine months of 2008 and 87.9% for the same period in 2007. Average loans represented 91.0% of average deposits in the first nine months of 2008 and 87.9% for the comparable period in 2007. Management continues to emphasize quality loan growth to increase these averages. Average loans as a percent of average assets were 67.7% and 65.9% for the nine-month periods ended September 30, 2008 and 2007 respectively.
The increase in deposits of $173,022 from December 31, 2007 to September 30, 2008 was due primarily to the acquisition of 1st
Independence offset by a reduction in interest bearing deposits, primarily certificates of deposit.
Shareholders' equity was $297,310 on September 30, 2008 compared to $264,102 on December 31, 2007. Book value (shareholders' equity) per common share was $14.76 at September 30, 2008 versus $14.22 at year-end 2007. Accumulated other
comprehensive income/loss decreased book value per share by $0.05 at September 30, 2008 and increased book value per share by $0.07 at December 31, 2007. Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders' equity. The increase in long term interest rates in the third quarter of 2008 along with illiquidity in some market sectors were the primary reasons for the large decrease in accumulated other comprehensive income. The Company's investment portfolio is comprised largely of debt instruments which decreased in market value as a result of the change in interest rates.
Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses
Loans remain the Company's largest concentration of assets and, by their nature, carry a higher degree of risk. The loan underwriting standards observed by the Company's subsidiaries are viewed by management as a means of controlling problem loans and the resulting charge-offs. The Company believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company's Board of Directors regularly monitors such concentrations to determine compliance with its loan allocation policy. The Company believes it has no undue concentrations of loans.
Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 44.3% of total loans at September 30, 2008 and 46.1% at December 31, 2007. The Company anticipates this category of loans to decrease as a large portion of future residential real estate loan originations will be sold to the secondary market. On September 30, 2008, the Company had $3,622 of residential real estate loans held for sale, which was an increase from the year-end balance of $2,439. The Company generally retains the servicing rights on mortgages sold.
Non-performing loans totaled $43,471 or 2.22% of total loans as of September 30, 2008, compared to $17,575, or 1.06% of total loans as of September 30, 2007, and $20,493, or 1.21% of loans at December 31, 2007. The increase in non-performing loans since year-end was due to the economic downturn and an overall weakening in the real estate markets as well as the acquisition of 1st Independence which had a large number of non-performing loans. The allowance for loan losses was $26,529 as of September 30, 2008 and represented 1.36% of total outstanding loans compared to $14,331 as of December 31, 2007 or .85% of total outstanding loans.
The provision for loan losses was $5,254 in the third quarter of 2008 compared to $1,184 for the same period in 2007 and $3,471 for the second quarter of 2008. The increase in provision expense was primarily due to the increase in the level of non-performing loans, an increase in specific allocations related to certain commercial real estate loans which exhibited credit deterioration during the third quarter, and the continued weakening in the real estate markets. Net loan losses were $1,900 for the third quarter of 2008 compared to $1,127 for the same period a year ago. For the nine months ended September 30, 2008, net loan losses were $4,287 or 0.33% of average loans outstanding, compared to $2,402 of net loan losses for the nine months ended September 30, 2007, which represented 0.20% of average loans outstanding for that period. The Company's charge-offs for the first nine months of 2008 were primarily small dollar charge-offs related to numerous credits and were not specific to any one industry or geographical area. The adequacy of the allowance for loan losses in each subsidiary is reviewed at least quarterly. The determination of the provision amount in any period is based on management's continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, current economic conditions, the amount of loans presently outstanding, and information about specific borrower situations. The allowance for loan losses as of September 30, 2008 was considered adequate by management.
Investment Securities
Investment securities offer flexibility in the Company's management of interest rate risk and are an important source of liquidity as a response to changing characteristics of assets and liabilities. The Company's investment policy prohibits trading activities and does not allow investment in high-risk derivative products, junk bonds or foreign investments.
As of September 30, 2008, the Company had $518,066 of investment securities. All of these securities were classified as "available for sale" ("AFS") and were carried at fair value with unrealized gains and losses, net of taxes, reported as a separate component of shareholders' equity. An unrealized pre-tax loss of $1,666 was recorded to adjust the AFS portfolio to current market value at September 30, 2008, compared to an unrealized pre-tax gain of $1,958 at December 31, 2007. Unrealized losses on AFS securities have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the securities approach their maturity dates. All securities in the Company's portfolio are performing as expected with no disruption in cash flows and all rated securities are rated investment grade.
Sources of Funds
The Company relies primarily on customer deposits, securities sold under agreements to repurchase and shareholders' equity to fund earning assets. FHLB advances are also used to provide additional funding.
Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits funded 83.7% and 85.4% of total average earning assets for the nine-month periods ending September 30, 2008 and 2007. Total
interest-bearing deposits averaged 89.5% and 89.6% of average total deposits for the nine-month periods ending September 30, 2008 and 2007, respectively. Management constantly strives to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.
The Company had FHLB advances of $358,487 outstanding at September 30, 2008. These advances have interest rates ranging from 2.00% to 6.36%. Approximately $143,000 of these advances were obtained for short-term liquidity needs and had original maturities of six months or less. The remaining advances were originally long-term advances with approximately $7,000 maturing in 2008, $20,000 maturing in 2009, $72,000 maturing in 2010, $16,000 maturing in 2011, $20,000 maturing in 2012, and $80,000 maturing in 2013 and beyond.
Capital Resources
Total shareholders' equity was $297,310 at September 30, 2008, which was an increase of $33,208 compared to the $264,102 of shareholders' equity at December 31, 2007. The increase in shareholders' equity was primarily attributable to shares issued for the acquisition of 1st Independence and retained earnings for the current year.
The Federal Reserve Board and other regulatory agencies have adopted risk-based
capital guidelines that assign risk weightings to assets and off-balance sheet
items. The Company's core capital consists of shareholders' equity, excluding
accumulated other comprehensive income/loss, while Tier 1 capital consists of
core capital less goodwill and intangibles. Trust preferred securities qualify
as Tier 1 capital or core capital with respect to the Company under the
risk-based capital guidelines established by the Federal Reserve. Under such
guidelines, capital received from the proceeds of the sale of trust preferred
securities cannot constitute more than 25% of the total core capital of the
Company. Consequently, the amount of trust preferred securities in excess of the
25% limitation constitutes Tier 2 capital of the Company. Total regulatory
capital consists of Tier 1, certain debt instruments and a portion of the
allowance for loan losses. In order to be classified as having adequate capital
by the regulatory agencies, bank holding companies are required to maintain a
minimum Tier 1 capital to total average assets of 4%, a Tier 1 capital to
risk-adjusted assets of 4%, and a total capital to risk-adjusted assets of 8%.
At September 30, 2008, Tier 1 capital to total average assets was 7.4%. Tier 1
capital to risk-adjusted assets was 10.2%. Total capital to risk-adjusted assets
was 11.5%. All three ratios exceed all required ratios established for bank
holding companies. Risk-adjusted capital levels of the Company's subsidiary
banks exceed regulatory definitions of well-capitalized institutions.
The Company declared and paid common dividends of $0.145 per share in the third quarter of 2008 versus $0.14 for the third quarter of 2007. For the nine months of 2008, the Company declared and paid common dividends of $0.43 per share compared to $0.415 for the first nine months of 2007.
Liquidity
Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year, and money market instruments. In addition, the Company holds AFS securities maturing after one year, which can be sold to meet liquidity needs.
Maintaining a relatively stable funding base, which is achieved by diversifying funding sources and extending the contractual maturity of liabilities, supports liquidity and limits reliance on volatile short-term purchased funds. Short-term funding needs arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company's strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and low-cost funds. Average core deposits funded approximately 72.3% of total earning assets for the nine months ended September 30, 2008 and 71.6% for the same period in 2007.
Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. In addition, the Company's affiliates have access to the Federal Home Loan Bank for borrowing purposes as well as access to Fed Funds. The holding company also has access to a $30,000 line of credit.
Interest Rate Risk
Asset/liability management strategies are developed by the Company to manage market risk. Market risk is the risk of loss in financial instruments including investments, loans, deposits and borrowings arising from adverse changes in prices/rates. Interest rate risk is the Company's primary market risk exposure, and represents the sensitivity of earnings to changes in market interest rates.
Effective asset/liability management requires the maintenance of a proper ratio between maturing or repriceable interest-earning assets and interest-bearing liabilities. It is the policy of the Company that the cumulative gap divided by total assets must be not greater than plus or minus 20% at the 3-month, 6-month, and 1-year time horizons.
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