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MSFG > SEC Filings for MSFG > Form 10-Q on 9-Nov-2012All Recent SEC Filings

Show all filings for MAINSOURCE FINANCIAL GROUP

Form 10-Q for MAINSOURCE FINANCIAL GROUP


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

(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 subsidiary bank, MainSource Bank ("Bank") headquartered in Greensburg, Indiana, and MainSource Title, LLC ("MST"). The Bank operates under a state charter and is subject to regulation by its state regulatory agencies and the Federal Deposit Insurance Corporation. MST is subject to regulation by the Indiana Department of Insurance.

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, 2011, 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 2012 was $6,986 compared to net income of $5,615 for the third quarter of 2011. The increase in net income was primarily attributable to a decrease of $3,000 in the loan loss provision expense and an increase in mortgage banking income of $686. Offsetting these increases was a decrease in net interest income of $1,739 and a prepayment penalty of $1,313 on a FHLB advance. Diluted earnings per common share for the second quarter totaled $0.32 in 2012, an increase from the $0.24 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 8.30% for the third quarter of 2012 while return on average assets was 1.02% for the same period, compared to 6.83% and 0.80% in the third quarter of 2011.

For the nine months ended September 30, 2012, net income was $19,979 compared to net income of $17,787 for the same period a year ago. The increase in net income was also primarily attributable to a decrease in the Company's loan loss provision expense of $7,000 from 2011 and an increase in mortgage banking income of $2,385 offset by a decrease in net interest income of $4,551, a decrease in securities gains of $3,550, and the aforementioned prepayment penalty of $1,313. Earnings per share increased to $.97 for the first nine months of 2012 from $.77 for the same period in 2011. Return on average shareholders' equity was 7.99% for the first nine months of 2012 while return on average assets was 0.97% for the same period, compared to 7.55% and 0.85% in the first nine months of 2011.

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 $23,331 in 2012 was a slight decrease of 6.9% versus the third quarter of 2011. The decrease in net interest income was primarily due to declining reinvestment rates on loans and securities as well as a $200 million repositioning in investment securities in December 2011. Average earning assets decreased $53 million with the majority of the decrease the result of reduced loan balances of $49 million and fed funds sold of $36 million. Offsetting this decrease in loans was an increase in the investment portfolio of $45 million. Also affecting margin was an increase in average demand deposits, NOW accounts, and savings accounts of $110 million which offset a decrease in higher costing CD and money market accounts of $173 million. Net interest margin, on a fully-taxable equivalent basis, was 4.05% for the third quarter of 2012, a twenty basis point decrease compared to 4.25% for the same period a year ago and flat on a linked quarter basis.

For the first nine months of 2012, the Company's net interest margin was 4.09% compared to 4.27% for the first nine months of 2011.

Provision for Loan Losses

See "Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses" below.


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Non-interest Income

Third quarter non-interest income for 2012 was $11,577 compared to $10,278 for the third quarter of 2011. Contributing to the increase of $1,299 was a net decrease in securities gains of $431 offset by an increase in mortgage banking of $686, service charges (primarily overdraft fees) of $410 and a reduction in OREO losses of $479. Continued organic growth in deposit accounts has resulted in higher fee income. The continued low interest rate environment as well as an increase in mortgage loan originators throughout the Company's footprint has resulted in continued refinancing activities and an increase in mortgage banking income.

For the nine months ended September 30, 2012, non-interest income was $32,142 compared to $31,117 for the same period a year ago. Contributing to the increase of $1,025 was a net decrease in securities gains of $3,550 and other income of $279. The primary cause of the other income decrease was the write down of the book value of six branches closed in the third quarter of 2012. (See Note 12 in the Notes to the Consolidated Financial Statements). Offsetting these decreases were increases in mortgage banking income of $2,385, service charges on deposit accounts of $1,281, interchange income of $342, and higher write downs of ORE property of $827 taken in 2011.

Non-interest Expense

The Company's non-interest expense was $24,403 for the third quarter of 2012, compared to $23,905 for the same period in 2011. The primary increases were a prepayment penalty of $1,313 incurred in connection with the early payoff of an FHLB advance and an increase in consultant expenses on $325. The consultant expenses are related to the third party consulting firm the Company started using in 2011. The increases were offset by reductions in salary and employee benefits of $562, the Company's FDIC assessment of $356, and collection expenses of $477. The Company's salaries and employee benefits decreased due to the Company's efficiency improvement project completed in the second half of 2011 as well as the closing of six small branch offices while its FDIC premium decreased as a result of its exit from its informal agreement with the FDIC and Indiana DFI during the first quarter of 2012, as well as a change in the FDIC's methodology for calculating the premium. The Company's efficiency ratio was 66.6% for the third quarter of 2012 compared to 64.3% for the same period a year ago.

For the nine months ended September 30, 2012, non-interest expense was $71,126 compared to $71,108 for the same period a year ago. The primary decreases were in salaries and employee benefits of $1,184, the aforementioned FDIC assessment of $1,104, and collection expenses of $376. The reduction in employee costs is a direct result of the efficiency initiatives completed by the Company in 2011. Offsetting these decreases were the aforementioned prepayment penalty on the FHLB advance of $1,313 and consulting expenses of $575, increases in equipment expenses of $492 and other expenses of $926. Other expenses increased primarily due to the expenses related to the Treasury's auction of its Series A Preferred Stock in the Company and the Company's bid to purchase such stock and costs related to the closing of six branches announced in the first quarter of 2012. The Company's efficiency ratio was 65.7% for the first nine months of 2012 compared to 63.6% for the same period a year ago.

Income Taxes

The effective tax rate for the third quarter of 2012 was 17.9% versus 12.9% for the same period 2011. The increase in the effective tax rate was due to the increase in GAAP income before taxes while the Company's tax exempt income and credits remained relatively consistent with prior periods.

The effective tax rate for the first nine months was 17.7% for 2012 compared to 14.6% for the same period a year ago. The increase in the effective tax rate was due to the same comment as above. The Company and its subsidiaries file consolidated income tax returns.

Financial Condition

Total assets at September 30, 2012 were $2,755,006, a slight increase from total assets of $2,754,180 as of December 31, 2011. The individual components of the asset side of the balance sheet remained basically the same as the balances at December 31, 2011. The securities portfolio grew $26,088 but this was more than offset be a reduction in money markets and fed funds sold of $35,639. Average earning assets represented 90.0% of average total assets for the first nine months of 2012 and 90.7% for the same period in 2011. Average loans represented 71.8% of average deposits in the first nine months of 2012 and 73.7% for the comparable period in 2011. Management continues to emphasize quality loan growth to increase these averages. Average loans as a percent of average assets were 56.2% and 58.6% for the nine month periods ended September 30, 2012 and 2011 respectively.

Deposits decreased $77 million from December 31, 2011. The increase in noninterest bearing deposits and savings deposits of $42 million were more than offset by a reduction of higher priced CD balances of $80 million and interest bearing demand and money market accounts of $39 million. The Company was in a fed funds purchased position of $17 million at September 30, 2012.


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Shareholders' equity was $339 million on September 30, 2012 compared to $337 million on December 31, 2011. Book value (shareholders' equity) per common share was $15.01 at September 30, 2012 versus $13.87 at year-end 2011. Accumulated other comprehensive income increased book value per share by $1.39 at September 30, 2012 and increased book value per share by $1.13 at December 31, 2011. Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders' equity. As mentioned in Note 11, the Company was able to buy back and retire $23 million of its preferred shares in the first nine months of 2012 at a discount.

Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses


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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 Bank 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. 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 all loans. External loan review personnel examine the top 100 commercial credit relationships. This equates to approximately all relationships above $1,750.

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. During the latter part of 2008, the Company established a separate group to address its deteriorating credit quality. This group consists of six full-time equivalent employees and reports directly to the Chief Credit Officer of the Company. At the present time, this group is charged with the task of efficiently resolving non-performing credits and disposing of foreclosed properties.

Total loans (excluding loans held for sale) decreased $2,854 from year end 2011. The Company is experiencing some overall demand across all segments which have been offset by early payoffs on other credits. Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 24.9% of total loans at September 30, 2012 and 23.8% at December 31, 2011. On September 30, 2012, the Company had $23,929 of residential real estate loans held for sale, which was an increase from the year-end balance of $16,620. The Company generally retains the servicing rights on mortgages sold.

Loans are placed on "non-accrual" status when, in management's judgment, the collateral value and/or the borrower's financial condition does not justify accruing interest. As a general rule, commercial and real estate loans are reclassified to nonaccrual status at or before becoming 90 days past due. Interest previously recorded is reversed and charged against current income. Subsequent interest payments collected on nonaccrual loans are thereafter applied as a reduction of the loan's principal balance. Non-performing loans were as follows (non-accrual loans + loans past due 90 days and still accruing + troubled debt restructurings):

                         September 30, 2012      June 30, 2012     March 31, 2012      December 31, 2011      September 30, 2011
Amount                  $             50,698    $        54,944    $        52,677    $            65,197    $             65,231
Percent of loans                        3.31 %             3.55 %             3.44 %                 4.25 %                  4.18 %

Of the $50,698 of non-performing loans at September 30, 2012, $19,200 had a specific reserve allocated of $6,165.

A reconciliation of non-performing assets (non-performing loans + OREO) for the first nine months of 2012 and 2011 is as follows:

                                            2012       2011
Beginning Balance - NPA - January 1       $ 80,732   $ 102,998
Non-accrual
Add: New non-accruals                       29,181      38,330
Less: To accrual/payoff/restructured        (9,488 )   (27,390 )
Less: To OREO                               (4,216 )   (21,158 )
Less: Charge offs                          (12,243 )   (15,773 )
Increase/(Decrease): Non-accrual loans       3,234     (25,991 )
Other Real Estate Owned (OREO)
Add: New OREO properties                     4,216      21,158
Less: OREO sold                             (8,975 )   (12,725 )
Less: OREO losses (write-downs)             (1,020 )    (1,617 )
Increase/(Decrease): OREO                   (5,779 )     6,816
Increase/(Decrease): 90 Days Delinquent     (2,887 )         3
Increase/(Decrease): Repossessions             (79 )        13
Increase/(Decrease): TDR's                 (14,846 )      (300 )
Total NPA change                           (20,357 )   (19,459 )
Ending Balance - NPA - September 30       $ 60,375   $  83,539

At September 30, 2012, four of the non-accrual loan balances were greater than $1,000 compared to three loan balances greater than $1,000 at June 30, 2012. These loans are primarily land development and real estate backed loans. The Company is working with these borrowers in an attempt to minimize its losses. In the course of resolving nonperforming loans, the Company may choose to


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restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions and mitigate loss to the Bank. Any loans that are modified are reviewed by us to identify if a troubled debt restructuring has occurred, which is when for economic or legal reasons related to a borrower's financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and could include reduction of the stated interest rate other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to insure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates.

During the first nine months of 2012, the Company experienced a $30 million reduction in its Substandard loans and a $47 reduction in its Special Mentions loans in the commercial portfolio. In both categories, 60% of the decrease was in the Hotel category and 30% in Other Real Estate. The loans upgraded were the result of overall improvement in the underlying fundamentals of the credit. This also resulted in a decrease in the allowance allocated to loans collectively evaluated for impairment by $3,841.


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The provision for loan losses was $2,000 in the third quarter of 2012 compared to $5,000 for the same period in 2011 and $2,500 for the second quarter of 2012. For the first nine months of 2012 and 2011, the provision for loan loss was $7,600 and $14,600 respectively. The decrease in provision expense from 2011 was primarily due to the relative stabilization in the amount of non-performing and watch list loans in aggregate and decrease in net charge-offs. The amount of new non-accrual loans in the third quarter of 2012 was approximately $2,000 lower than the second quarter of 2012.

Net loan losses were $5,043 for the third quarter of 2012 compared to $5,029 for the same period a year ago and $12,243 for the first nine months of 2012 compared to $15,772 a year ago. During the third quarter of 2012, the Company executed the sale of approximately $5,200 of problem loans in the secondary market. This transaction resulted in charge-offs of $3,000. The Company had identified and specifically provided for these losses in previous quarters. Approximately 50% of the Company's charge-offs for the first nine months of 2012 was related to 11 commercial credits. All but approximately $2,562 of these charge-offs had an allowance allocated in 2011 or prior.

The adequacy of the allowance for loan losses is reviewed at least quarterly. The determination of the provision amount in any period is based upon management's continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, classified loans including non-accrual and impaired loans, current economic conditions, the amount of loans presently outstanding, and the amount and composition of loan growth. The allowance for loan losses as of September 30, 2012 was considered adequate by management. The allowance for loan losses was $35,246 as of September 30, 2012 and represented 2.30% of total outstanding loans compared to $39,889 as of December 31, 2011 or 2.60% of total outstanding loans. The decrease in the percentage was due to an improvement in nonperforming assets for the nine month period ending September 30, 2012.

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, 2012, the Company had $902,178 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 $43,266 was recorded to adjust the AFS portfolio to current market value at September 30, 2012, compared to an unrealized pre-tax gain of $35,218 at December 31, 2011. 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, federal funds purchased, 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 87.0% and 87.7% of total average earning assets for the nine-month periods ending September 30, 2012 and 2011. Total interest-bearing deposits averaged 84.2% and 87.2% of average total deposits for the nine-month periods ending September 30, 2012 and 2011, 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 $201,119 outstanding at September 30, 2012. These advances have interest rates ranging from 0.51% to 5.90%. All of the current advances, with the exception of the 2012 advances, were originally long-term advances with approximately $80,000 maturing in 2012, $16,000 maturing in 2013, $25,000 maturing in 2014, $0 maturing in 2015, and $80,000 maturing in 2016 and beyond. During the third quarter of 2012, the Company paid off a $10,000 advance that was due in 2015and incurred a $1,313 penalty. The Company believed it had adequate liquidity that allowed it pay off this advance early and save future interest expense.


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Capital Resources

Total shareholders' equity was $338,524 at September 30, 2012, which was an increase of $1,971 compared to the $336,553 of shareholders' equity at December 31, 2011. The increase in shareholders' equity was primarily attributable to the Company's net income of $19,979 for the first nine months of 2012, other comprehensive income of $5,230 for the first nine months of 2012, and an increase in retained earnings of $1,302 as a result of buying the preferred stock at less than par value offset by the purchase and retirement of a portion of its preferred shares of $22,626, and payment of preferred and common dividends of $1,582 and $1,014 respectively.

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, 2012, Tier 1 capital to total average assets was 10.9%. Tier 1 capital to risk-adjusted assets was 17.5%. Total capital to risk-adjusted assets was 18.8%. All three ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Bank exceed regulatory definitions of well-capitalized institutions.

The Company declared and paid common dividends of $0.03 per share in the third quarter of 2012 versus $0.01 for the third quarter of 2011. To prudently manage capital, the Company elected to reduce its dividend starting in the second quarter of 2009. The increase in the third quarter dividend is the first increase in the dividend rate in over three years.


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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 . . .

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