Did mortgage losses spur sudden First Indiana sale?:

August 13, 2007

First Indiana Corp. announced poor second-quarter financial results Aug. 7-which raises this interesting question: Did the city's biggest locally owned bank race to sell itself last month because the results otherwise would have caused its stock to tumble?

Even before the earnings report, banking observers were abuzz that the $529 million sale to Milwaukee-based Marshall & Ilsley Corp. seemed rushed. While many expected First Indiana to sell eventually, CEO Robert Warrington had seemed hellbent on improving results first to drive up the purchase price.

In recent months, the bank had hired a new advertising firm, rolled out a new superhero ad campaign, and brought aboard a new board member and new directors of marketing and commercial real estate lending. It also had dismissed its longtime auditing firm, and its replacement was transitioning into the position.

Then, nine days after the second quarter closed, the company announced it was selling to M&I for $32 a share-a 45-percent premium over where First Indiana shares had traded.

With that deal pending, the disappointing second-quarter financials barely got noticed. In the report, First Indiana said profit totaled $3.9 million-down 40 percent from the same quarter a year earlier.

Sapping results was a $3.4 million pretax charge that included $1.3 million in losses on home equity loans that First Indiana previously had sold off but was required to repurchase. The bank also socked away another $2.1 million in reserves for future home equity loan repurchases.

First Indiana officials did not return calls, and the release did not elaborate on the home equity loan problem. However, observers say First Indiana previously must have agreed to buy back certain loans if they faltered. It surely did so to reduce the risk of the loans to the buyer, thereby maximizing the sale price. The fact First Indiana now has taken a substantial charge indicates bank officials only recently grasped the extent of the exposure.

After the problem surfaced, "they realized their stock price would be significantly reduced, and they did not want to face the music on that," speculated Mike Renninger, principal in the Carmel-based bank consulting firm Renninger & Associates.

While the loss put a dent in First Indiana's results, it barely was meaningful to M&I, a mid-sized player with 25 times the assets of the Indianapolis bank. Assuming First Indiana apprised M&I of the mortgage problem during negotiations, there's no reason to think it will derail the deal, observers said.

First Indiana is far from alone in getting entangled on mortgage woes, many stemming from the weak housing market. Wrenching turmoil in the industry in recent months has knocked some major lenders out of business.

Compared with what other mortgage lenders are facing, First Indiana's $3.4 million charge isn't huge-and it wouldn't have been big enough to decimate the bank's stock. However, it isn't clear whether First Indiana knew the precise scope of the problem when it cut the M&I deal. It also isn't clear whether the Indianapolis bank now has stashed enough in reserves to cover all its potential buyback exposure.

First Indiana had taken steps to reduce its exposure to the volatile mortgage industry even before the segment slid into disarray this year. Late in 2006, for instance, it began originating mortgage loans through a new joint venture with San Francisco-based Wells Fargo Corp. In a conference call with analysts in April, Warrington said he was closely monitoring changes in the mortgage market.

Eventually, First Indiana will have to become more forthcoming about what drove it into the arms of M&I. The proxy statement shareholders will receive before they vote on the deal later this year will include a "Background of the merger" section, which must outline the behind-the-scenes negotiations.

Lawyers write those sections, so they're typically not riveting reading. But in the case of First Indiana, the prose will be worth wading through.

Consider just the odyssey over auditors. In June, it dismissed KPMG LLP without publicly saying why, replacing it with BKD LLP. But after First Indiana announced its sale, BKD quit, saying it didn't want to ramp up for a short-term gig. So First Indiana rehired KPMG.

An awkward situation, to be sure. It's not the sort of mess a bank typically finds itself in-certainly not one that was methodically exploring its sale options for months.

"It's pretty easy to see, they weren't thinking about this at all," one banker said.
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