As has been our custom on the day of this Annual Meeting, we reported, earlier this morning, the Company’s first quarter earnings. I will begin today with a summary of that report. First, however, let me preface my remarks by saying that I wish the news could be better—and that I will devote a significant portion of my time to an explanation both of what has led to earnings which are lower than a year ago and to efforts and initiatives we believe will lead to a return to earnings growth.
Using Generally Accepted Accounting Principles, or “GAAP”, diluted earnings per share were $1.57, or 11% lower than the $1.77 per share for last year’s first quarter. GAAP net income was $176 million, as compared to $203 million in the same quarter in 2006.
The company has also provided, both in our press release and on our web site, supplemental reporting of results on a “net operating” or “tangible” basis. As has been our practice since 1998, net operating results exclude the amortization of core deposit and other intangible assets recorded in connection with past acquisitions.
Diluted net operating earnings per share in the recent quarter were $1.67. That was down 17 cents per share, or 9 % from last year’s first quarter. In total dollar amount, net operating income was $187 million, or 11% less than in the first three months of 2006.
Turning to some specifics, net interest margin, which expresses taxable- equivalent net interest income as an annualized percentage of average earning assets, declined to 3.64 percent this past quarter, compared with 3.73 percent for the first quarter of 2006. That decline reflects a banking environment characterized by the so-called inverted yield curve, the condition in which longer-term interest rates have lower yields than shorter-term ones. The effects of an inverted yield curve were compounded by lower prepayments of commercial real estate loans, resulting in lower prepayment fees, and higher rates necessitated by competition for deposits.
On the credit front, we saw a reversal in the trend of improving indicators that had been present in recent years. Although net charge-offs held steady at $17 million, loans considered to be nonperforming increased to $273 million, or .63 % of all loans outstanding at March 31, 2007 from $143 million or .35% a year earlier. While the rise in nonperforming loans was significant, it reflects a return to levels previously experienced from historically low levels of problem loans at March 31, 2006.
Nevertheless, in response to overall credit conditions, we have increased our provision for credit losses to $27 million for the recent quarter, compared with $18 million for the first quarter of 2006.
Those who have attended this meeting over the years or who have followed this Company over the past two decades will recognize immediately that the results I am reporting are atypical. Indeed, for the first time since 1983, except for quarters in which we incurred costs related to acquisitions or changed our accounting policies, our earnings this past quarter were both lower than the quarter previous—and lower than the corresponding quarter of the prior year.
Why such a rough quarter? First, these earnings results are a reminder that banking has not become a risk-free business. In addition to the effects of changing credit conditions and net interest margins, which are an every-day part of banking, our results for the first quarter were also affected by something to which the press is referring as the crisis in “subprime lending” and, in our case, the indirect impact of such crisis on the rest of the residential mortgage market, including that portion in which M&T has been active.
Many of you are familiar with this story, although not perhaps with that portion of it which has affected this company. First, let me state clearly, that M&T has never been a significant player in the subprime lending sector. Rather, we have generally originated so-called conforming, or prime, loans that can be sold to agencies like Fannie Mae or Freddie Mac.
We have also originated alternative, or Alt-A, mortgages to homeowners with good credit histories. This type of loan generally allows the borrower to provide a lesser level of documentation about their income level. Instead of such documentation, the underwriting relies on the value of the mortgaged property or the borrowers’ past loan repayment history. To reiterate, these are not subprime loans. Nonetheless, the market for the resale of Alt-A loans has been affected by the subprime crisis. Here’s why and how.
The industry has seen an increase in delinquencies and foreclosures among the high-risk pool of borrowers whose credit scores make them less than prime. Those increases have, indeed, been substantial. Nationally, 14.3 percent of subprime loans are 60 days or more delinquent, up from 8.4 percent a year earlier. That contrasts with Alt-A mortgage loans where, nationally, just 2.6 percent are more than 60 days delinquent, up from 1.3 percent last year. But because the subprime market now constitutes some 11 percent of all home mortgages, a high and rising delinquency rate is significant and has wide effects. It has led capital markets to decide not to purchase such mortgages—or to offer far less than previously at auction.
In some cases, delinquencies have forced those who previously sold subprime loans to take them back from the secondary markets, leading some who dealt exclusively in such lending into bankruptcy.
The situation at M&T does not in the slightest resemble that of such firms. As I said, we have been an active originator of Alt-A, not subprime, loans. Moreover, our profits may be down but they are still substantial. This is a broadly diversified Fortune 500 company, indeed, just designated as such for the first time this week—and, at number 496, the only Buffalo-based firm included in that listing. We are well prepared to withstand a market fluctuation of this sort. Indeed, net earnings of our residential mortgage banking segment accounted for only 6% of M&T’s entire net income in 2006.
Still, despite the fact that M&T has never been a significant player in the subprime lending sector we are, nonetheless, very much affected by the situation, albeit indirectly. Here’s how. As most of you know, subprime mortgages are not the only ones sold on the secondary market. The Alt-A mortgages which we originate are sold, too.
The change in the secondary market’s appetite has affected not only the sub-prime sector but also that for Alt-A mortgages. As a result, when we went to sell a large block of Alt-A mortgages in early March, we received fewer bids than normal at prices that we deemed unacceptable. Accordingly, we have decided it would be unwise, at this time, for us to sell those mortgages at what would amount to fire sale prices. Instead, as we made clear in a March 30 press release, we have decided to keep some $883 million of Alt-A mortgages on our own books—“in portfolio”—rather than selling them on unfavorable terms. We believe this decision is in our long run interest —but it is a major contributing factor to the reduced net income we have reported for the first quarter.
Put another way, we are focusing on what is best for M&T in the long run, not on a single quarter’s results. Or, as one well-respected independent observer described our decision after reviewing our press release on the topic, “We’re not panicking and we won’t shortchange our investors.” Just so. Moreover, it is our unwavering practice to face up to issues and to clearly inform shareholders about what is going on at M&T.
Our decision to hold Alt-A loans in portfolio, as well as the accounting requirement that the value of such loans be recorded at the lower of cost or current market value, resulted in an after-tax reduction of net income of $7 million in the quarter, or $.07 per diluted share. In addition, conditions may also force us to re-purchase some loans which we had previously sold.
When mortgagors fail to make timely payments during the first 30-to-90 days following the sale of their mortgage in the secondary market, originators such as M&T may be called upon to repurchase those Alt-A loans. Accounting for that possibility led to a further reduction in net income for the quarter of $4 million or an additional 3 cents per share. Taken together, then, these factors related to Alt-A lending account for ten of the seventeen cent decline in net operating earnings per share in this year’s first quarter as compared with the first quarter of 2006.
The nine basis point narrowing of the net interest margin that I noted earlier lowered the recent quarter’s net operating income by nearly $7 million, or six cents per share. That narrowing resulted largely from a decline in prepayments of commercial real estate loans, leading to lower collections of prepayment fees. Of course, fewer prepayments means we are retaining customers. It is also the case that competitive pressure on the pricing of deposits contributed some to the slimming of the net interest margin. In total, the Alt-A and net interest margin impacts that I have mentioned account for nearly the full seventeen cent difference between net operating earnings per share in last year’s first quarter and those of the recent quarter.
It’s important to note that the first quarter losses related to Alt-A lending do not call into question M&T’s fundamental business model, nor will they lead us to change that model significantly. As I said, residential mortgage banking has accounted for a relatively small amount of our net income but we are committed to continuing that business.
We are confident that relatively minor changes in our operating standards can mitigate future risk and guard against a recurrence of events such as those of this past quarter. We will, for instance, no longer hold mortgages for sale in blocks but will instead sell them at the time of commitment, almost loan by loan, rather than building up an inventory.
We will also continue to focus our efforts on originating loans at the very high end of Alt-A. Specifically, we will no longer originate high loan-to-value ratio mortgages unless they are appropriately insured. It is likely, however, that such changes in our underwriting and sales practices will reduce our future originations of Alt-A mortgages.
This is a good occasion for putting such matters as Alt-A lending and the battle to attract loans and deposits, both of which affected our first quarter results, in a broader context. All reflect the intense, and increasing, competition in the banking industry. I’d like to discuss this morning both the nature of that competition and how we at M&T believe, notwithstanding the quarter past, that we can continue to be successful in the current industry environment.
The situation of M&T today is completely different than it was when I first became Chief Executive Officer of this company in 1983. At that time, we held just $1.7 billion in deposits and had 59 branches. Today, we have some $39 billion in deposits and 668 branches. But the nature of the banking industry has changed just as dramatically. Of the top 100 banks in existence in 1983, only 28 remain independent today.
Moreover, as a result of deregulation and the advent of interstate banking, a formidable group of de facto national banks has emerged. Consider the fact that, in 1983, the five largest U.S. banks held 9.7 percent of all deposits. By 2006, they held 29 percent. What’s more, these are banks which, thanks to the reach of national advertising, are willing and able to compete in local markets across the country—including the 14 major markets and 142 communities in which M&T does business. At the same time, a new generation of community banks, specializing in specific local markets, has also emerged.
For a regional banking company—even a “super-regional” as we are sometimes called—this leads to increasingly intense competitive pressures. Indeed, it is certainly true that such pressures helped fuel our interest in the Alt-A mortgage market, one which hardly existed a decade ago and in which we were not then active.
A quarter like that just past is sobering—but does not at all shake our underlying belief in our business model. This is a company with a wide range of business lines which we believe, over time, will balance each other. Yes, we originate home mortgages but so, too, do we make small and middle-market business loans, offer cash management services to employers, trust management and investment services, consumer loans, auto floor plan lending and retail banking services of all sorts. This is, in other words, a full-service bank.
We have, what’s more, continued to take steps to diversify the nature of our markets, specifically through expansion in the Mid-Atlantic area we first entered in 2003. In the past year, we have added to our infrastructure and staffing in that region, which is notable for its strong economic growth.
Nor is the Mid-Atlantic the only source of the increasing diversity of our businesses. In February we announced that we acquired a minority share in Bayview Lending Group LLC, a privately-held mortgage lender which specializes in originating small balance commercial real estate loans throughout the US. This equity investment in a firm with which we have already worked for many years will add diversity to our sources of income both by region and product line and build on an already-solid foundation with a trusted partner.
At the same time, we continue to make new investments in our areas of traditional strength, including right here in our home base of Western New York. In the time since this Annual Meeting was last convened, we acquired 21 new branches in Buffalo and Rochester, bringing with them customers in 55,000 households and 5000 businesses, and adding $1 billion in deposits to our already high share in the region. These are, moreover, exactly the sorts of customers for which banks are competing. The average new customer was a long-term depositor with an above-average account balance.
We believe these sorts of investments will pay off when this past quarter’s results are long forgotten.
Let me take a moment, at this point, however, to discuss the most important investment we have made over time and continue to make—the investment in attracting and retaining talented employees. This must be the highest priority of any successful business. Or as the newsweekly “The Economist” has put it, “Talent has become the world’s most sought-after commodity.”
It is with this in mind that M&T invested, in 2006 alone, some $5 million in recruiting, including the recruiting of new MBAs and college graduates through four specially-targeted training programs aimed at putting them on the fast-track to responsible positions. Almost 600 of those recruited this way over the years are still with M&T, including 32 of those in the ranks of our senior management.
It is well worth noting that two of those senior managers are Mark Czarnecki and Mike Pinto. Mark, who received his MBA from Buffalo’s Canisius College, began as a management trainee—and now serves as president of M&T Bank Corporation. Mike Pinto was recruited from the Wharton School of Business through our MBA training program. He now serves as head of our Mid-Atlantic Division and a vice-chair of the M&T board.
Their long tenure and steady rise at M&T are not unusual. The average years of service for M&T employees overall is 8 years—a reflection of the fact that we are just as serious about promoting good employees as recruiting talented newcomers. Indeed, more than 800 of our employees last year received promotions coupled with additional compensation. Those in the ranks of our senior management average 15 years of service and those in our management group—the body setting overall corporate strategy—average 18 years of service with M&T and 7 years in the management group.
In other words, we believe we have the talent and the business model to weather storms and go on to find both calm waters and new ports of call—that is, reliable markets and fruitful new ventures.
This past quarter was no one’s idea of fun—M&T Bank has been around since 1856 and remains strong and, we believe, resilient. While no one is happy with the recent decline in stock price, the Company’s compounded annual rate of return to shareholders over the last ten years was 14.8%. Since 1980 it was 23.5%. Said differently, shareholders that have invested in M&T for the long haul have done well.
Of the 859 publicly traded stocks that have been continuously traded since 1980, M&T’s 23.5% compounded annual return ranks nineteenth.
To our employees and our shareholders I say, be reassured. A $176 million quarterly profit is hardly the worst news one could get. The fundamentals here remain sound.
Robert G. Wilmers
Chairman of the Board
and Chief Executive Officer