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| MSFG > SEC Filings for MSFG > Form 10-Q on 9-Nov-2009 | All Recent SEC Filings |
9-Nov-2009
Quarterly Report
(Dollar amounts in thousands except per share data)
Overview
MainSource Financial Group, Inc. ("MainSource or Company") is a financial holding company whose principal activity is the ownership and management of its three wholly owned subsidiary banks ("Banks"): MainSource Bank headquartered in Greensburg, Indiana, MainSource Bank of Illinois headquartered in Kankakee, Illinois, and MainSource Bank - Ohio headquartered in Troy, Ohio. The Banks operate under state charters and are subject to regulation by their respective state regulatory agencies and the Federal Deposit Insurance Corporation. Non-banking subsidiaries include MainSource Insurance, LLC and MainSource Title, LLC. Both of these subsidiaries are subject to regulation by the Indiana Department of Insurance. In the second quarter of 2009, the Company established Insurance Services Marketing, LLC (ISM), an Indiana limited liability company and a wholly-owned subsidiary of the Company. ISM is an insurance brokerage agency that sells insurance products to customers and non-customers of the Company.
Forward-Looking Statements
Except for historical information contained herein, the discussion in this report includes certain forward-looking statements based upon management expectations. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The Company disclaims any intent or obligation to update such forward looking statements. Factors which could cause future results to differ from these expectations include the following: general economic conditions; legislative and regulatory initiatives; monetary and fiscal policies of the federal government; deposit flows; the cost of funds; general market rates of interest; interest rates on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; changes in the quality or composition of the Company's loan and investment portfolios; the Company's ability to integrate acquisitions, the impact of our continuing acquisition strategy, and other factors, including the risk factors set forth in Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2008, and in other reports we file from time to time with the Securities and Exchange Commission. The Company intends the forward looking statements set forth herein to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995.
Results of Operations
Net income for the third quarter of 2009 was $1,388 compared to net income of $5,383 for the third quarter of 2008. The substantial decrease in net income was primarily attributable to an increase in the Company's loan loss provision expense of $8,261 from the third quarter of 2008 offset by an increase in net interest income and mortgage banking income. Diluted earnings per common share for the third quarter totaled $0.03 in 2009, a decrease from the $0.28 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 1.72% for the third quarter of 2009 while return on average assets was 0.19% for the same period, compared to 7.92% and .81% in the third quarter of 2008.
For the nine months ended September 30, 2009, net loss was $(35,503) compared to net income of $17,808 for the same period a year ago. The decrease in net income was caused primarily by a $45,076 goodwill impairment charge taken in the second quarter, an increase in loan loss provision expense of $24,389, and a $1,369 special assessment from the FDIC offset by higher net interest income and mortgage banking income. Earnings/(loss) per share decreased to $(1.87) in 2009 from $0.95 in 2008. Return on average shareholders' equity was (13.81)% for the first nine months of 2009 while return on average assets was (1.63)% for the same period, compared to 8.78% and .93% in the first nine months of 2008.
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 $24,933 in 2009 was an increase of 10.6% versus the third quarter of 2008. Average earning assets increased $332 million with approximately $183 million coming from the August 2008 acquisition of 1st Independence Financial Group, $41 million from the acquisition of three American Founders Bank branches in May 2009 and $108 million from organic growth. The increase came primarily from the loan portfolio which grew by an average of $177 million with investment securities increasing $124 million. Also affecting margin was an increase in average demand deposits, NOW accounts, and money market accounts of $221 million with $59 million the result of the acquisition of 1st Independence and $15 million from the American Founders branches. The average balance of certificates of deposit increased $113 million and FHLB advances decreased $66 million. $48 million of certificates of deposit came from the American Founders acquisition. Net interest margin, on a fully-taxable equivalent basis, was 3.83% for the third quarter of 2009, a slight decrease compared to 3.92% for the same period a year ago and a three basis point decrease on a linked quarter basis.
For the first nine months of 2009, the Company's net interest margin was 3.81% compared to 3.82% for the first nine months of 2008.
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 2009 was $9,796 compared to $7,802 for the third quarter of 2008. Mortgage banking increased $910 in the third quarter of 2009 compared to the same period in 2008 as refinancing activity remained at an increased level during the third quarter of 2009. Service charges on deposit accounts increased $667 in the third quarter of 2009 compared to the third quarter of 2008. This increase was primarily due to the increase in the number of deposit accounts from the acquisitions of 1st Independence and the American Founders branches.
For the nine months ended September 30, 2009, non-interest income was $29,303 compared to $23,391 for the same period a year ago. The aforementioned increase in mortgage banking income and an increase in service charges on deposit accounts were the primary contributors to the increase.
Non-interest Expense
The Company's non-interest expense was $21,671 for the third quarter of 2009 compared to $18,104 for the same period in 2008. The majority of the components of non-interest expense increased during the third quarter of 2009 versus the third quarter of 2008 due to the acquisition of 1st Independence and the American Founders branches. The Company's employee count (on a full-time equivalent basis) increased by 128 from the same period a year ago and 7 additional branches were added from the third quarter of 2008. In addition, the Company's FDIC insurance premiums have increased significantly year over year due to the increase in the number of bank failures during this difficult economic period as the FDIC works to replenish the deposit insurance fund. The Company's efficiency ratio was 60.7% for the third quarter of 2009 compared to 58.3% for the same period a year ago.
For the nine months ended September 30, 2009, non-interest expense was $110,010 compared to $53,191 for the same period a year ago. The largest amount of the increase was due to a goodwill impairment charge of $45,076 recorded in the second quarter. In addition, the Company's FDIC insurance expense increased significantly due to the increase in premiums charged by the FDIC as well as an additional special assessment of $1,369 taken in the second quarter. The Company's efficiency ratio was 105.3% for the first nine months of 2009 compared to 59.9% for the same period a year ago. Excluding the effect of the goodwill impairment charge, the Company's efficiency ratio would have been 62.1%.
Income Taxes
The effective tax rate for the first nine months was (18.0%) for 2009 compared to 21.7% for the same period a year ago. The decrease in the effective rate is due to the Company's tax exempt income and credits which remained relatively consistent with prior quarters combined with a significant drop in GAAP income before taxes. Another cause for the decrease was the reversal in the third quarter of a $600 reserve recorded in accordance with Accounting for Uncertainty in Income Taxes. The tax reversal related to the Company's sale of an insurance agency in 2005. The time for the Internal Revenue Service to appeal the court ruling closed in the third quarter. No valuation allowance has been established as management believes it will generate sufficient income in future years to realize the net operating loss benefits.
The Company and its subsidiaries file consolidated income tax returns.
Financial Condition
Total assets at September 30, 2009 were $2,934,326 and were relatively flat compared to $2,899,835 as of December 31, 2008. An increase in investment securities of $165 million was offset primarily by a decrease in loans of $72 million and intangibles, net, of $41 million. Average earning assets represented 90.2% of average total assets for the first nine months of 2009 and 88.9% for the same period in 2008. Average loans represented 92.5% of average deposits in the first nine months of 2009 and 91.0% for the comparable period in 2008. Management continues to emphasize quality loan growth to increase these averages. Average loans as a percent of average assets were 68.6% and 67.7% for the nine-month periods ended September 30, 2009 and 2008 respectively.
The increase in deposits of $226 million from December 31, 2008 to September 30, 2009 was due primarily to an increase in all categories of deposits with $88 million of the increase coming from the acquisition of the three American Founders branches.
Shareholders' equity was $326 million on September 30, 2009 compared to $300 million on December 31, 2008. The increase in shareholders' equity was the result of the Company's participation in the Capital Purchase Program (see Note 10 to the Consolidated Financial Statements above), offset by the net loss of $36 million for the first nine months of 2009. Book value (shareholders' equity) per common share was $13.43 at September 30, 2009 versus $14.90 at year-end 2008. Accumulated other
comprehensive income/loss increased book value per share by $0.75 at September 30, 2009 and increased book value per share by $0.15 at December 31, 2008. Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders' equity. The decrease in interest rates during the first nine months of 2009 was the primary reason for the increase in accumulated comprehensive income as the Company's investment portfolio is comprised largely of debt instruments which increased 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.
Management maintains a list of loans warranting either the assignment of a specific reserve amount or other special administrative attention. This watch list, together with a listing of all classified loans, nonaccrual loans and delinquent loans, is reviewed monthly by management and the Board of Directors of each banking subsidiary. Additionally, the Company evaluates its consumer and residential real estate loan pools for probable losses incurred based on historical trends, adjusted by current delinquency and non-performing loan levels.
The Company has both internal and external loan review personnel who annually review approximately 50% of the total dollar amount of outstanding commercial loans. External loan review personnel examine all commercial credit relationships over $1 million.
The ability to absorb loan losses promptly when problems are identified is invaluable to a banking organization. Most often, losses incurred as a result of prompt, aggressive collection actions are much lower than losses incurred after prolonged legal proceedings. Accordingly, the Company observes the practice of quickly initiating stringent collection efforts in the early stages of loan delinquency. The Company has established a separate group solely responsible for the collection of problem loans.
Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 42.8% of total loans at September 30, 2009 and 44.0% at December 31, 2008. 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, 2009, the Company had $9,897 of residential real estate loans held for sale, which was a slight increase from the year-end balance of $4,947. The Company generally retains the servicing rights on mortgages sold.
Non-performing loans totaled $89,444, or 4.60% of total loans as of September 30, 2009, compared to $43,471, or 2.22% of total loans as of September 30, 2008, and $59,310, or 2.97% of loans at December 31, 2008. The increase in non-performing loans since year-end of $30,134 was primarily attributable to two credits totaling $23,292 in the Company's construction and land development portfolio. The allowance for loan losses was $54,941 as of September 30, 2009 and represented 2.83% of total outstanding loans compared to $34,583 as of December 31, 2008 or 1.73% of total outstanding loans.
The provision for loan losses was $13,515 in the third quarter of 2009 compared to $5,254 for the same period in 2008 and $10,395 for the second quarter of 2009. 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 $6,121 for the third quarter of 2009 compared to $1,900 for the same period a year ago. For the nine months ended September 30, 2009, net loan losses were $14,952 or 1.00% of average loans outstanding, compared to $4,287 of net loan losses for the nine months ended September 30, 2008, which represented 0.33% of average loans outstanding for that period. Approximately 66% of the Company's charge-offs for the first nine months of 2009 was related to fourteen commercial credits. The remaining losses were related to small dollar loans. 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, 2009 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, 2009, the Company had $678,486 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 gain of $23,387 was recorded to adjust the AFS portfolio to current market value at September 30, 2009, compared to an unrealized pre-tax gain of $4,843 at December 31, 2008. Unrealized losses on AFS securities have not been recognized into income because management does not intend to sell and does not expect to be required to sell these securities for the foreseeable future and the decline in fair value is largely due to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. 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 82.2% and 83.7% of total average earning assets for the nine-month periods ending September 30, 2009 and 2008. Total
interest-bearing deposits averaged 89.1% and 89.5% of average total deposits for the nine-month periods ending September 30, 2009 and 2008, 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 $231,775 outstanding at September 30, 2009. These advances have interest rates ranging from 0.65% to 6.36%. All of the current advances were originally long-term advances with approximately $9,000 maturing in 2009, $71,000 maturing in 2010, $16,000 maturing in 2011, $21,000 maturing in 2012, $15,000 maturing in 2013, and $100,000 maturing in 2014 and beyond.
Capital Resources
Total shareholders' equity was $326,441 at September 30, 2009, which was an increase of $26,492 compared to the $299,949 of shareholders' equity at December 31, 2008. The increase in shareholder equity was primarily attributable to the Company's participation in the Capital Purchase Program offset by the net loss recorded for the first nine months of 2009 and dividends paid. In January, the Company issued $57 million in preferred stock and warrants to the U.S. Treasury. The preferred stock pays cumulative dividends at a rate of 5% per year for the first five years and 9% thereafter.
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. At September 30, 2009, Tier 1 capital to total average assets was 8.9%. Tier 1 capital to risk-adjusted assets was 12.9%. Total capital to risk-adjusted assets was 14.1%. 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 goodwill impairment charge taken in the second quarter did not impact these capital ratios.
The Company declared and paid common dividends of $0.050 per share in the third quarter of 2009 versus $0.145 for the third quarter of 2008. For the first nine months of 2009, the Company declared and paid common dividends of $0.245 per share compared to $0.430 for the first nine months of 2008. To prudently manage capital, the Company elected to reduce its dividend in the second and third quarters of 2009.
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 70.6% of total earning assets for the nine months ended September 30, 2009 and 72.3% for the same period in 2008.
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.
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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